Mergers and acquisitions are back! If 2005’s strong resurgence of M&A activity in Canada continues, 2006 M&A activity is likely to be brisk. This is our top 10 list of the trends that emerged last year.
1. Hostile Bids
In the last seven years, approximately 70 hostile bids were made in Canada. Yet, in the last four months of 2005 alone, nine hostile bids were launched. Although low interest rates, available cash from private equity firms/hedge funds and a worldwide increase in demand for resources have fuelled the M&A surge generally, these factors alone do not appear to explain the explosion in hostile bids. Other possible factors fuelling this activity are discussed below.
- Regulatory environment is favourable. It is easier to complete a hostile bid in Canada than in the United States. Generally, in the face of a hostile bid, a Canadian target cannot just say no or successfully maintain many of the defensive tactics that are used in the United States. For example, at some point, a Canadian target’s rights plan will expire and the offer will have to be put to shareholders. Accordingly, a bidder for a public company in Canada can generally be confident that eventually the shareholders, not management or the board, will decide.
- Bids force a target into play. A bidder may not necessarily want to acquire the target. Sometimes, a bid is intended to force a transformational transaction—for example, Carl Icahn’s recent partial bid for Fairmont Hotels. Icahn has said that he believes that Fairmont and its shareholders will benefit if Fairmont is acquired by a larger hotel operator that could more effectively take advantage of economies of scale. If successful, Icahn expects that his board nominees will pursue such a sale. Indeed, Icahn said that, if the current Fairmont board is willing to pursue such a sale, he would be willing to enter into discussions with Fairmont to extend the length of his offer to accommodate a sale process.
- Personalities can clash. Negotiated transactions can stall if personalities clash or if the board has unrealistically high expectations about the value of its company. Bidders can become impatient and launch a hostile bid if they perceive that negotiations are not likely to result in an economically sensible transaction.
Hostile bids are still risky ventures. Although the record shows that most hostile bids result in some form of transaction, there is no guarantee of success for the hostile bidder or that the target will be forced into play and a white knight will emerge. A recent example is Constellation Brands’ bid for Vincor. Constellation launched its hostile bid and Vincor responded with a process to attract competing bids. Ultimately, Constellation allowed its bid to expire and Vincor announced that it was terminating its sale process. Vincor also announced that it was declaring a dividend and initiating a share buy-back; so in effect, the bid may have forced a response, but not a sale of the company as Constellation had wished.
2. Private Equity and Hedge Fund Participation
In recent years, private equity and hedge funds have raised large amounts of capital, and with substantial amounts to invest, are looking for acquisitions. Moreover, as the following examples show, they are able to finance even the largest transactions by joining forces, if necessary: the US$11.4 billion acquisition of SunGard Data Systems last August by Bain Capital, Blackstone, Goldman Sachs, Kohlberg Kravis Roberts (KKR) and Texas Pacific Group, among others, and the recently completed US$15 billion acquisition of Hertz by Clayton, Dubilier & Rice, The Carlyle Group and Merrill Lynch Global Private Equity. Funds generally also have a lower cost of capital than strategic buyers and are experienced dealmakers. In addition, in many cases they are in a better position to obtain quick antitrust or competition approval because they have no existing assets in the target industry or sector. These factors can make them formidable adversaries in an auction and, in recent years, funds have tended to outperform strategic buyers in some sectors.
The return in 2005 of the strategic buyer was evident when Whirlpool prevailed over Ripplewood Holdings (a private equity fund) for Maytag, and other major strategic acquisitions were announced, such as Inco/Falconbridge and ThyssenKrupp/Dofasco.
Hedge funds are also more likely to acquire a minority position in a target to exert pressure on the target’s board or on another shareholder. Examples of this in 2005 were Icahn’s acquisition of a toehold in Fairmont Hotels; Creo’s sale to Eastman Kodak (instigated by Goodwood Capital); Golden Gate Capital’s acquisition of Geac (instigated by Crescendo); and KKR’s offer for Masonite, which it increased as a result of agitation by hedge fund holders of Masonite shares.
3. Income Funds
Income funds have become attractive targets, both to other income funds and to corporate and other acquirers. Existing income fund structures are sufficiently flexible to permit significant mergers and acquisitions. Because income funds pay out substantially all of their cash to unitholders, mergers and acquisitions may be financed by the issue of new income fund securities to the public and through vendor-retained interests (in addition to new senior debt). Subscription receipt offerings allow an acquiror to raise funds before (but conditional on the completion of) an acquisition and to deliver better valuations to sellers (because of higher income fund multiples). Acquisitions by existing income funds, however, must be accretive to distributable cash. A hostile acquisition of an income fund is more complex than a hostile bid for a corporation, particularly when the acquiror is trying to achieve a tax-free transaction for unitholders. In addition, in negotiated transactions, the amount of break fees that an income fund may be willing to pay may be constrained, because the fund pays most of its cash flow to unitholders.
This segment of the M&A market looks like it will continue to grow. Recent examples include Livingston International Income Fund’s bid for PBB Global Logistics Income Fund and Agrium’s bid for Royster-Clark.
4. Break Fees
Break fees have become a standard feature of negotiated (friendly) takeover transactions. Break fees are intended to compensate the bidder for the risks it faces in putting an offer on the table and possibly triggering an auction for the target. If an auction has already been conducted, a seller’s board can more easily justify a break fee because the seller has already canvassed the market. The amount of these fees and the terms of the related "fiduciary out" clause are usually extensively negotiated.
Recently, we have seen several high-profile transactions with relatively high break fees. They have attracted some criticism, but have not yet been successfully challenged. These include the Toys "R" Us transaction (3.75% break fee upheld by the Court) and the 3.5% break fee for the proposed Inco/Falconbridge transaction. In Toys "R" Us, an auction had been held before the acquisition agreement was signed. This contrasts with the 2% break fee in the ThyssenKrupp agreement to acquire Dofasco, which Dofasco agreed to without an auction process. The Inco/Falconbridge case is also unique. Falconbridge had recently canvassed the market for buyers, and Xstrata was holding a 19.9% block and was rumoured to be considering a bid. In those circumstances, a higher fee was presumably easier for Falconbridge’s board to justify.
5. Reverse Break Fees and Auction Strategies
Another trend that emerged in 2005 was the reverse break fee. A reverse break fee involves the bidder paying a fee to the target. In the recent bid by Whirlpool for Maytag, Whirlpool is required to pay a break fee if the deal is ultimately rejected by the antitrust regulators. The bid contains the usual condition that the bidder must be satisfied with the terms of the antitrust approval, and a very real concern exists that the transaction may not be approved or approved only on condition that Whirlpool sell assets or make other concessions. If no approval is obtained or if Whirlpool rejects the conditions attached to the approval, the transaction will not proceed. However, Maytag abandoned an offer by Ripplewood to accept the Whirlpool bid. Even though Ripplewood’s bid was for a lower price, Maytag’s board would have had a valid concern that it could be criticized for taking the higher but riskier Whirlpool transaction and relinquishing the Ripplewood transaction, which did not raise any antitrust issues. Whirlpool’s agreement to pay a reverse break fee to Maytag helped the board manage this additional risk by compensating Maytag if the transaction fails as a result of regulatory issues.
With the active participation of private equity/hedge funds in M&A transactions and the tendency to use an auction, strategic buyers may increasingly be forced to address regulatory risk to remain competitive, using reverse break fees and other strategies—for example, agreeing to a "hell or high water" clause under which the bidder agrees to assume any regulatory risk or, as in the Cineplex/Famous Players transaction earlier this year, obtaining regulatory approval in advance.
6. Key Court Decision Signalling Greater Deference to Board
In its decision earlier this year in In re Toys "R" Us, Inc. Shareholder Litigation, the Delaware Court examined a variety of issues that often arise in the context of a sale of a public company. The Court was asked to preliminarily enjoin the US$6.6 billion sale of Toys "R" Us to a consortium.
In deciding not to enjoin the sale, the Court commented on the reasonableness of the auction process employed by Toys "R" Us. The plaintiff had complained that the auction had been originally only for one Toys "R" Us division and that when an offer was received for the whole company, the company should have conducted a new auction. The Court concluded that this was not necessary, stating that there was "no single blueprint" for fulfilling the duty to maximize value and noting that the strategic process had been publicized both in a press release and in newspaper articles and that the publicity was effectively an "open invitation" for qualified third parties to make proposals. Furthermore, the auction had already been underway for the largest division of the company for several months, and had been narrowed to four players when one of the players indicated an interest in the entire business. The Court accepted the reasonableness of the board’s conclusion that this group of four was the most likely to be interested in and able to bid for the whole company, and that the company ran a serious risk of alienating this important group if it reopened the bidding and delayed matters further. The Court also commented that any buyer who seriously wanted to buy the whole company could have initiated a bid at any time. Given this history, the Court concluded that it was reasonable for the board to determine that prolonging the auction by opening it up to new parties could have jeopardized the best bids.
The decision in Toys "R" Us signals that the pendulum in the United States is swinging back to a more deferential view of board decisions (as is the case in Canada). The record showed that the board had used experienced external advisers, had reviewed the logical options for the company and had come to reasonable conclusions as to the best alternative to pursue. The Court commented favourably on the fact that the board met 14 times and that its executive committee met 18 times from the beginning of the process until concluding an agreement with the consortium. This highlights the importance of implementing a process that demonstrates due care. The process followed in this case made it relatively easy for the Court not to interfere with the business judgment of the board.
7. Continued Focus on Conflicts: Stapled Financing, Special Committees and Financial Advisory Fees
Despite the greater deference to boards signalled by Toys "R" Us, we continue to see investors, courts and regulators scrutinizing transactions closely for evidence of conflicts.
In Toys "R" Us, the Court made some interesting comments about "stapled" financing in an auction. It has become more common in auctions for the seller’s financial adviser to seek and obtain approval from its client to offer acquisition financing to potential bidders. This benefits the seller, who can then negotiate terms with a preapproved lender before the auction and provide the lender with confidential information, thereby short-cutting a buyer’s (and its lender’s) diligence processes. The seller can also become more comfortable with the adviser’s valuation range and lending multiples by seeing a financing commitment that supports that advice. The board in the Toys "R" Us transaction refused to permit its investment bank to provide stapled financing before the execution of the merger agreement. However, after the merger agreement was executed, the board permitted the Toys "R" Us investment banker to provide financing to the buying consortium. The Court commented that the decision of the board was unfortunate because it raised the spectre of impropriety and conflict. Although the Court stated that it was not making a bright line judgment, it suggested that it would be advisable for investment bankers not to appear to want work from both the buyer and seller on the same transaction.
The case does not create a prohibition against stapled financing, but companies and their bankers will have to demonstrate a reasonable basis for the necessity of such financing and ensure that adequate precautions (such as firewalls) have been taken to protect against conflicts. Sellers of public companies may be more reluctant to use stapled financing in the future, given the Court’s comments in Toys "R" Us, but in many cases these arrangements are very beneficial to the target and result in a more competitive auction. With appropriate attention to the inherent conflicts, a board can be justified in offering all potential buyers stapled financing at the commencement of an auction.
It has become common for boards to establish a special committee of independent directors to consider any change-of-control transaction, and the trend is clearly for boards to do so in a majority of transactions, even where a conflict is not immediately apparent, as a precaution against subsequent criticism of the process. The obvious circumstances for a special committee include (i) management of the target acting jointly and in concert with the bidder in making an offer, and (ii) the existence of a significant shareholder with board representation and objectives that may differ from those of other shareholders. However, it is not always necessary or desirable to establish an independent committee, and, even when it is warranted, the committee’s processes do not have to completely exclude management involvement. It is important, however, that the committee has opportunities to deliberate without management present. In addition, in many circumstances, a special committee will be established not because of conflicts, but because full board supervision of the process is impractical.
If the only conflict is that management will receive industry standard employment arrangements from the merged entity, a special committee may be unnecessary. Officers of the target will often have expertise that is valuable for board deliberations and negotiations, and it may be more harmful to exclude them from the process. However, the board should, whether or not it forms a special committee, take reasonable precautions to minimize management conflict. In Toys "R" Us, the Court approved of the board’s efforts to separate the sale process from discussions about retaining management, by requiring the consortium to remove a condition that existing management be retained. The CEO also refused to discuss future employment with any bidder (and, in the end, the consortium did not offer him employment).
Although the presence of a major shareholder should also be considered in determining whether to form a special committee, the majority shareholder’s interests will often be aligned with the minority’s, in which case a special committee may not be necessary. This was not the case in Lukoil’s recent bid for Nelson Resources. There, the controlling shareholders were prepared to sell control without making an offer to the minority shareholders, and a special committee was appropriate.
Financial Advisory Fees
Financial advisers usually receive different compensation depending upon the type of transaction ultimately concluded. The plaintiff in Toys "R" Us complained that the financial advisory fee structure created a strong potential for bias. But the Court found that neither the financial adviser’s advice nor the board’s decision was tainted by the fact that the financial adviser would receive higher compensation for a transaction for the entire company. This was because the board had concluded that such a transaction would be better for the company, and the Court accepted the reasonableness of the incentive structure.
In some cases fee structures can be problematic. If an adviser receives an additional fee only if a transaction with a particular party is concluded, there may be an appearance of bias in favour of that transaction.
In Canada and the United States, we have seen increasing investor criticism of financial advisory fees in M&A transactions and expect continued scrutiny of the role of financial advisers in these deals. Any engagement letter should be carefully structured to ensure that the financial advisers’ incentives are aligned with the company’s and that no financial incentive will taint the process.
8. Shareholder Lockups
In Canada, recently there were two high-profile instances in which a potential buyer locked up major shareholders, without simultaneously making a bid for the entire company. The first involved Cerebus entering into lockup agreements with Vic De Zen and other related shareholders of Royal Group Technologies Limited, representing just under 19.9% of Royal Group’s shares. The second involved the recently announced Lukoil acquisition of about 65% of the outstanding shares of Nelson Resources.
In the first transaction, the existence of the lockup agreements gave Cerebus leverage in its negotiations with Royal Group. Cerebus negotiated access to confidential information in exchange for its agreement with Royal Group that it would not (i) use the lockup agreements as a way of frustrating a competing higher-value transaction; or (ii) delay any purchase of shares, in each case, for at least 60 days. The 60-day period has since elapsed without any transaction. Despite that, and likely in part resulting from the pressure of Cerebus’s lockup with the De Zen Group, Royal Group announced a number of initiatives to increase shareholder value. Through its agreement with the shareholder group, Cerebus limited its downside by locking up, but not acquiring, any shares, while at the same time sharing any possible upside with the De Zen Group, thus ensuring it would participate in any value created by its actions—a no-lose proposition for Cerebus.
In Lukoil/Nelson Resources, holders of 65% of the shares of Nelson Resources contacted Lukoil directly without involving Nelson Resources’ management. The shareholders were prepared to sell to Lukoil on an exempt basis within the 115% premium permitted under applicable securities laws (this would have allowed Lukoil to purchase the entire block without making a formal bid for all the shares). Lukoil then entered into negotiations with Nelson Resources with significant leverage to persuade the board to support a transaction for the entire company, given Lukoil’s ability to complete a change-of-control transaction without any minority participation and to block a successful transaction with any third party. Lukoil and Nelson Resources later announced that they had reached an agreement for Lukoil to acquire the entire company at the same price it had offered to the major shareholders.
In both these cases, the buyer took advantage of the availability of a significant block of shares to push the company into negotiations. In the Royal Group case, the block was less than the 20% takeover bid threshold, so it could be acquired at any price without making a formal bid. In Nelson Resources, the bidder was careful to buy from five or fewer sellers, at less than 115% of the market price.
This form of acquisition strategy is not often used for a variety of reasons. First, this can be risky because the target may be pushed into another bidder’s arms, as in the recent Inco/Falconbridge transaction. There, Xstrata was rumoured to be interested in acquiring Falconbridge and purchased slightly less than 20% of the outstanding shares from Brascan, thereby creating a significant blocking position to any competing transaction. This probably encouraged discussions between Falconbridge and Inco and enabled the two parties to quickly reach an agreement to merge. Xstrata’s position is not sufficient as a legal matter to block a transaction or a squeeze out of its interest.
Second, the securities regulators will carefully examine any transaction that may take advantage of a temporary pricing anomaly to structure an exempt bid, and they can, if they believe the transaction is abusive, stop the transaction.
Third, purchasing a block can impede a future transaction for the remaining shares. Prebid integration rules would restrict a buyer from making a follow-up formal bid at a lower price during the 90-day period after acquiring the block or from making a partial bid. More significantly, perhaps, the business combination and related party rules would require the acquiror to obtain approval of a majority of the remaining minority shares before effecting a squeeze out, whereas if the acquiror had locked up and acquired the significant block as part of a formal bid on identical terms, the block could have been counted toward minority approval. In addition, if the target already has a rights plan in place, the plan would typically prevent these types of acquisitions as a practical matter (which argues in favour of having a rights plan in place in advance rather than implementing one on a strategic basis after a bid is launched).
9. MAE Conditions
Given the recent renegotiation of the Johnson & Johnson bid for Guidant and recent U.S. court decisions on the use of "material adverse effect" (MAE) clauses, we expect these clauses to receive increased attention when M&A transactions are being negotiated.
The question whether a party can exercise an MAE condition in any given circumstance is highly uncertain and fact-dependent. No leading Canadian cases have considered the effect of MAE clauses, but parties can look to U.S. court decisions as some indication of how the concept might be interpreted in Canada. The leading U.S. cases, In re IBP Shareholders Litigation and the more recent Frontier Oil v. Holly decided in 2005, stand for the principle that a traditional MAE condition is likely to be read as a backstop protecting the purchaser only from the occurrence of unknown events that substantially threaten the overall earnings potential of the target for a significant duration.
The Johnson & Johnson/Guidant transaction highlighted both the inherent uncertainty of these clauses and their usefulness in providing purchasers with leverage to renegotiate before taking the more draconian step of walking away from a deal. Johnson & Johnson announced in December 2004 that it had agreed to acquire Guidant. However, Guidant later announced product recalls and related regulatory investigations that led Johnson & Johnson to conclude that an MAE in respect of Guidant had occurred. Johnson & Johnson refused to close the transaction. Guidant filed a civil suit in November 2005, alleging that Johnson & Johnson was required to complete the acquisition under the merger agreement. Rather than fight the case, the parties renegotiated the terms of the merger: the net acquisition cost was lowered from US$76 to US$63.08 on a per share basis. The existence of the MAE condition in favour of Johnson & Johnson provided it with the leverage to renegotiate the transaction terms, but the inherent uncertainty of the MAE clause may also have prevented it from walking away completely in the face of Guidant’s court challenge and the tough position taken by the U.S. courts on these clauses.
10. Greater Focus on Foreign Investment Review?
The year 2005 may also mark a resurgence of a protectionist attitude in the United States and Canada toward foreign acquirors. When the China National Offshore Oil Corporation (CNOOC) bid for Unocal in the United States, political pressure was brought to bear to stop the transaction. CNOOC offered a number of voluntary concessions in an attempt to allay concerns and offered to escrow a significant portion of the purchase price as security against any breach of its commitments. However, even though it offered a higher price, the terms of the escrow were not sufficient to resolve the board’s concerns about potential political interference and CNOOC’s bid was rejected in favour of the lower, but safer, Chevron bid.
We may see similar issues arise in Canada in the future, given recent proposed amendments to the Investment Canada Act. Those amendments were introduced after the attempt by China’s Minmetals to acquire Noranda. Although the negotiations never came to fruition, they raised concerns in Canada about resource companies falling into the hands of Chinese-controlled companies. The proposed amendments would allow transactions to be reviewed and rejected, regardless of their size, if they could be injurious to "national security" (which is not defined in the proposed legislation but seems intended to go beyond, for example, the defence industry). With the upcoming federal election, this legislation is now off the table, but it may well be reintroduced depending on the election outcome. In recent years foreign investment review in Canada has not posed a significant impediment to M&A deals. However, the new attitude demonstrated by this proposed legislation may signal a change.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.