[authors: Stephen F. Arcano, Thomas W. Greenberg, Richard J. Grossman, Thomas H. Kennedy, Alan C. Myers]
While global mergers and acquisitions activity has been restrained during the first half of 2012 due to factors including political and economic uncertainty, several significant indicators traditionally pointing to increased M&A activity suggest that the market should be in a position to recover when greater confidence returns. Skadden partners discuss the state of and outlook for the M&A market, as well as two topics of particular importance to dealmakers in 2012 — shareholder activism and judicial scrutiny of the corporate sale process when a transaction participant may have a conflict of interest.
What has the M&A market been like in first half of 2012?
Global M&A activity declined in the first half of 2012 compared to the same period in 2011, with some regions, such as Europe, being particularly hard hit. Activity in the U.S. also decreased, continuing a declining trend that began following 2011’s relatively robust first quarter. The dollar value of M&A transactions involving U.S. targets contracted by approximately 40 percent during the first five months of 2012 from the same period in 2011, according to data from mergermarket.
Factors appearing to be responsible for the lackluster activity include weakness in European economies and concern over the U.S. and Chinese economies; the sovereign debt crisis in Greece, Spain, Italy and elsewhere in Europe and related concern over the fate of the euro; uncertainty relating to the upcoming U.S. presidential election; more rigorous antitrust scrutiny, volatility in the securities and commodities markets; and instability in the Middle East, all which dampen dealmakers’ confidence. As a result, activity levels may be relatively weak until confidence returns to board rooms and the executive suite, notwithstanding that many of the conditions necessary for a vibrant M&A market are present today, as outlined below.
While strategic M&A continues to drive the market, the decrease in activity for the first half of 2012 was greater for strategic buyers than for private equity firms, with the dollar value of U.S. strategic acquisitions dropping about 51 percent, while private equity activity dropped only about 3 percent during the first five months of 2012 as compared to the same period last year, according to mergermarket. The greatest falloff has been among the largest transactions, with deals valued at more than $5 billion representing less than 20 percent of dollar volume for the first five months of 2012, compared to more than 40 percent for the same period in 2011.
Corporate portfolio changes, "bolt-on" or "plug-and-play" acquisitions, sales of non-core business or divisions that are not of the mega-deal variety and acquisitions of minority public interests by controlling shareholders continue to constitute an active portion of the M&A market. One bright spot, including for bigger deals, has been the energy, mining and utilities sector, which mergermarket estimates accounted for approximately 23 percent of the dollar value of all deals during the first five months of 2012. Sales of companies by private equity firms have been another notable exception to the overall trend thus far this year. As older funds reach the end of their lifecycles, sponsors have been actively seeking attractive exit strategies. As a result, according to mergermarket, the dollar value of private equity exits increased by about 48 percent during the first five months of 2012 from the same period last year.
While no one can accurately predict how long the overhang of economic and political uncertainty will continue, there are a number of reasons to believe that many of the underlying conditions exist to support a rebound in the M&A market:
Corporations Hold Significant Cash. U.S. nonfinancial companies have about $2 trillion of cash and other liquid assets on their books, according to the Federal Reserve. This represents about 7 percent of the total assets of nonfinancial companies, the highest percentage since 1963. Worldwide, the top 1,000 nonfinancial companies hold about $3.5 trillion of cash, according to Bloomberg.
Acquisition Financing Has Been Available. While financing terms are in large part dependent on the creditworthiness of the issuer, interest rates that are extremely attractive when measured against any historical standard have been available for both investment grade and high-yield issuers. In addition, "covenant light" deals have once again been available for some issuers. These attractive financing markets may be adversely affected by concerns over economic conditions and bank capitalization requirements, but appear to have some resilience.
Sellers and Buyers Are Focusing on Their Core Businesses. On the sell side, there has been a renewed focus on core businesses, creating buying opportunities for strategic acquirors and private equity buyers alike. One indicator of this renewed focus by sellers is an increase in spin-off transactions. Historically, companies that are spun off are, on average, significantly more likely to be acquired than are companies in general. For strategic acquirors, there is an increased desire to consummate "bolt-on" acquisitions that expand existing businesses, rather than difficult-to-execute megadeals that may be premised on achieving dramatic cost savings. One recent example of a deal involving a strategic acquiror is Pfizer's agreement to sell its infant nutrition unit to Nestlé, reflecting Pfizer's decision to divest a non-core business, while Nestlé described infant nutrition as being "at the heart of the company since it was founded in 1866." On the private equity side, Thomson Reuters recently agreed to sell its health care analytics business to private equity firm Veritas Capital.
Hostile Takeover Activity Remains Strong. Hostile takeover activity has continued apace in 2012, as cash-rich strategic buyers seek to deploy their significant cash reserves, while taking advantage of the availability of financing, target valuations that remain relatively attractive and the widespread dismemberment of takeover defenses over the last several years. Notable recent examples include Coty's attempt to acquire Avon, Martin Marietta's bid for Vulcan Materials and GlaxoSmithKline's offer to acquire Human Genome Sciences. In addition, hedge funds and other financial buyers also have significant cash to put to work and are willing to act on a unilateral basis, as in Oaktree Capital's attempt to acquire JAKKS Pacific. According to Thomson Reuters, for the first five months of 2012 the dollar value of worldwide hostile mergers and acquisitions increased 86 percent over the same period last year, to their highest level since 2008. Some commentators believe that a rise in hostile activity may be a precursor to a rise in M&A generally, as it is a sign of growing confidence, at least in some quarters.
Cross-Border Acquisitions May Increase. As a result of the weakness in European economies, European companies' opportunities for organic growth has been dampened. Many of those companies may look beyond Europe for attractive acquisition targets to help drive revenues and profits.
Taxes May Rise. 2012 may be the last year in which U.S. business owners can take advantage of a low capital gains tax rate on exit, as the Bush-era tax cuts are set to expire. Additionally, private equity firms have an incentive to do complete deals in 2012 in the event Congress raises taxes on their carried interest.
Has shareholder activism continued to be an important force?
The trend of increased shareholder activism continued into the 2012 proxy season, although far more campaigns are commenced than actually come to a vote as companies have shown a propensity for settling threatened proxy contests at an early stage. Boards have been negotiating with activists, avoiding public battles with investors and the significant costs involved in public proxy fights, especially when companies have plans already under way that would address the activists' concerns.
Despite a new focus by activists on U.S. micro-caps, large companies are not immune from challenges by shareholders. Well-known activist investors, such as Carl Icahn and Nelson Peltz (Trian), have been busy pushing for corporate changes (and in some cases even launching unsolicited bids) at companies such as CVR Energy, Oshkosh, Clorox and Family Dollar. Dan Loeb (Third Point) has resurfaced after a dormant period and recently targeted Yahoo! Activists also have pursued companies based in Canada, as evidenced by Pershing Square's high-profile successful contest at Canadian Pacific Railway.
Most shareholder activists remain motivated primarily by short-term profits. In addition to focusing on companies with excess cash or undervalued companies that may be a likely sale candidate, activists also have targeted conglomerate companies where they believe that the parts are worth more than the whole. This effort has prompted some companies to spin off business units or split into multiple parts, such as the split-ups of McGraw-Hill and Fortune Brands.
Activist shareholders also are targeting companies with publicized corporate governance or other issues. After public scrutiny of loans to the CEO of Chesapeake Energy, Chesapeake agreed with its two largest shareholders to replace four of its independent directors; three directors to be proposed by Southeastern Asset Management and one to be proposed by Carl Icahn. Even after this agreement, at Chesapeake's annual meeting two incumbent directors on the audit committee failed to receive majority votes, resulting in those directors tendering their resignations to Chesapeake's board as required by its majority voting by-law.
Institutional investors and money managers who may have been more passive in the past are taking more vocal roles in advocating for better board oversight and corporate governance standards. For example, following a bribery scandal at a Mexican subsidiary of Wal-Mart, several institutional investors opposed the reelection of four of the company's directors, resulting in a significant number of withheld votes for such directors.
In the second year of say-on-pay proposals, preliminary results show negative recommendations from ISS at a level comparable to last year. Several high-profile companies have received a negative say-on-pay recommendation from ISS, including Citibank and Disney. Many companies are proactively engaging with shareholders by sending targeted solicitation materials highlighting, among other things, the independence of compensation committees and the use of long-term performance based awards. Say-on-pay votes will continue to be a viable tool for shareholders to challenge the compensation practices at public companies, resulting in an ever-increasing dialogue between major shareholders and compensation committees. In the proposed merger between Glencore and Xstrata, independent Xstrata shareholders will have the right to vote separately on a $267 million executive retention package, which must pass for the deal to be approved. Large investors already have voiced their opposition to the payments, with one specifically noting the lack of a performance element.
2012 is the first year under SEC rules in which shareholders were permitted to submit proposals seeking to implement a proxy access regime on a "private ordering" basis. A hodgepodge of proxy access proposals from shareholders were submitted at approximately 20 companies this proxy season, some of which never came to a vote because they were excluded from the company's proxy materials pursuant to the SEC's no-action process. Many of those proposals were aimed at companies that either have had well-publicized issues or where there is a perceived disconnect between pay and performance. Following a highly publicized issue involving a $100 million payment to the former CEO of Nabors Industries Ltd., earlier this month Nabors became the first company at which shareholders adopted a nonbinding proxy access proposal. These proposals will continue to evolve and will likely gain increasing shareholder support in future years.
Public companies continue to operate in an environment that requires diligence and engagement on many fronts. Facing a landscape of increased activism, scrutiny of compensation practices and proxy access proposals, public companies should continue to be proactive in their outreach to major shareholders. Increasingly, these engagement efforts include making certain directors (e.g., the lead independent director or committee chairs) available to meet with major shareholders under appropriate circumstances. Boards also should consider companies' vulnerabilities and anticipate potential challenges from activists. Thinking through these issues and developing response plans in advance should best position managements and boards to have constructive discussions with investors, if and when the need arises.
What is the impact of recent case law on the corporate sale process?
Previously, we have written about the wide degree of latitude afforded directors in determining how to proceed in pursuit of a corporate merger or sale transaction. Under Delaware law, in stock merger transactions where there is no controlling shareholder, disinterested directors' actions generally will be reviewed under the deferential Business Judgment Rule. Even where an enhanced level of judicial scrutiny of director conduct is applicable in the context of a sale of corporate control, it is the role of the board, not the courts, to design a process intended to maximize the outcome for shareholders; the court's role is to review the reasonableness of the board's actions, not to impose an aspirational standard of what the court might in retrospect consider to be "best practice." In June 2011, we reviewed several Delaware judicial decisions illustrating this point. At the same time, we cautioned that it is important for a board to make an informed decision based on the company's individual circumstances.1
One of the circumstances a board must consider is whether relationships exist among directors, management or advisors and transaction participants that merit particular scrutiny. When these relationships indicate the existence of material conflicts, a board should act on an informed and careful basis to address those conflicts. Failure to do so could result in other aspects of board decision-making or transaction process being called into question, with attendant risks including transactional delay or liability.
Over the years, Delaware cases have provided numerous examples of judicial scrutiny of board process and oversight where the court identified material conflicts, generally on the part of controlling shareholders, directors or members of senior management. As a result, boards and their counsel have developed processes, such as special committees and director recusal, to deal with such situations.
Several recent Delaware Court of Chancery cases also have examined alleged conflicts and actions of other transaction participants, including financial advisors to the target company. For example, in the 2010 Del Monte Foods Shareholder Litigation case, the court focused on banker behavior in concluding that the target board of directors had not adequately overseen the transaction process. In the more recent El Paso Corporation Shareholder Litigation case, the court identified as material conflicts both on the part of the target's chief executive (the lead transaction negotiator) and the investment bank serving as the target's financial advisor and the individual serving as the lead banker (both the bank and the individual owned stock in the acquirer), and determined that the target board had not taken adequate steps to address these identified conflicts. While these cases must be read as specific to their facts, they and other recent cases suggest that there may be a trend of greater court scrutiny of the perceived conflicts and the behavior of transaction team members.
Although these cases have raised concerns among transaction participants, they should not cause undue alarm. The Delaware courts have continued to confirm that not all potential conflicts are, in fact, material conflicts. In cases such as SeraCare (investment bank's prior representation of target did not taint transaction where bank subsequently represented acquirer) and Micromet (investment bank's ownership of small percentage of acquirer stock in trading accounts did not create material conflict in representing target), the Court of Chancery has looked at the substance of alleged conflicts and determined that they were not material.
Recent case law does make it clear, however, that a critical task for a target board of directors engaged in a corporate sale process is to attempt to understand and assess the potential conflicts on the part of directors, management and advisors. Having made such an assessment, the board should take material conflicts into account in establishing a transaction process designed to result in the best outcome under the circumstances for the company and its shareholders. Directors who act in this fashion — assessing their alternatives on an informed basis and carefully determining how to proceed — are acting in accordance with their fiduciary duties and their reasonable determinations as to precisely how to proceed should be respected by the courts.
1 See “Midyear Outlook: Continued Corporate Focus on Strategic Growth Drives M&A Market,” Skadden, Arps, Slate, Meagher & Flom LLP (June 21, 2011), available at http://www.skadden.com/Index.cfm?contentID=51&itemID=2453.