PRINT THIS PAGE The great pushback20/06/2007. Source: Weil, Gotshal & Manges. Michael Weisser, Lindsay Germano 
Taking a public company private is no longer as straightforward a proposition as it used to be, says Weil, Gotshal & Manges. A number of recent sponsor-backed going private transactions have encountered increased opposition and resistance from several sources. Sponsors have recently faced challenges to signed deals by competing strategic and financial bidders, such as Community Healthcare’s bid for Triad, Apollo’s bid for EGL and Fillmore Capital’s bid for Genesis HealthCare. Sponsors are also experiencing increased judicial skepticism with respect to management’s conflicts of interest in going private transactions. Additionally, sponsors are also beginning to see resistance by public stockholders to their proposed buyouts. This pushback by public stockholders is effecting several pending transactions, including Clear Channel and OSI Restaurant Partners, and may impact the structure and strategies employed by sponsors in future deals.
Until recently, conventional wisdom has been that a going private transaction will easily be approved by a significant majority of the target’s stockholders. After all, these transactions are typically viewed as a “sure thing” in the form of an all cash offer with a meaningful premium to current trading prices and typically involve minimal regulatory or other deal risks. However, the great pushback from activist hedge funds and institutional investors alike recently resulted in the termination of the Eddie Bauer and Herbalife transactions and are currently impacting the outcomes of several other transactions. Before embarking on a going private transaction, sponsors should be aware of the threat of public stockholder resistance, the lessons learned from recent deals and strategies that may be utilized to maximize the likelihood of stockholder approval and sponsor success.
Do Your Diligence
As a preliminary matter, it is important for a sponsor to know the requisite stock-holder percentage required to approve a transaction. In most states the stockholder approval required is the affirmative vote of a threshold percentage of stockholders - with abstentions generally counting as a vote against the transaction. Most states, including Delaware, provide for a simple majority stockholder approval requirement. However, certain states, such as Texas which is the state of incorporation for Clear Channel, have a two-thirds or other “supermajority” percentage requirement.
While it may not be expected that a supermajority approval requirement would be a significant obstacle to a transaction, if certain large holders (or proxy advisory firms such as ISS) publicly announce their opposition to a deal, obtaining the requisite vote could prove to be an uphill battle. At the very least, as seen in Clear Channel and other recent transactions, the increased leverage of a few significant stockholders (or proxy advisory firms) could result in increased pressure on the sponsors to sweeten the terms of the merger. Sponsors may wish to consider engaging a proxy solicitation firm to set-up meetings to help persuade proxy advisory firms and significant stockholders. In addition to state statutory requirements, a target’s organizational or stockholder documents may provide for a super-majority or a class voting requirement to approve a merger, as was the case in the recently consummated Univision Communications deal.
Understand Target Stockholder Composition
Understanding the composition of the target’s stockholders is an essential ingredient in determining the most efficient strategy for a sponsor to employ in a going private transaction. By reviewing publicly available SEC filings and talking to management in the course of due diligence, sponsors should be able to determine who the five percent beneficial owners are, the degree of stock ownership concentration, whether such stock-holders are activist hedge funds or institutional or retail investors, the relative investment cost of such stockholders in the target stock, management’s historical relationship with such stockholders and, hopefully, a sense of the likelihood of public stockholder resistance to the proposed going private transaction. Sponsors should also monitor changes to the target’s stockholder composition following announcement of the transaction. Sponsors and the target may wish to strategically determine the record date for the stockholder meeting based in part on the levels of shares held by arbitrageurs and hedge funds.
Minimize Flaws in the Sales Process
Sponsors often have limited, if any, control or meaningful influence over the sales process engaged by the target board of directors. However, sponsors inherit many of the associated risks and costs of a flawed sales process. Not only will the sponsor assume the settlement and other financial costs of stockholder litigation, but it will also bear the risk that a flawed sales process will strengthen the case for any public stockholder resistance to the transaction. One of the lessons of recent court cases, including Netsmart and Caremark, is that courts will not be reluctant to require heightened proxy disclosure regarding the details of the sales process which are necessary to provide public stockholders with sufficient knowledge to make an informed decision on whether to approve the transaction.
Sponsors should be mindful of the impact of the target board’s key sales process decisions, including the formation of a special committee, hiring independent advisors, the structure of the target’s investment banker fees, any evaluation of strategic alternatives (including the option of continuing as a public company), the scope of any market check, determining whether to use a post-signing go shop and the timing and substance of the sponsor’s arrange-ments with the target’s management team. Sponsors should also review management’s existing employment agreements and other incentive arrangements. Total cash payments to key executives, including as a result of stock ownership, acceleration of options, single trigger change of control payments and retention and stay bonuses, will be disclosed in the proxy. In certain recent transactions, large executive payments in connection with the proposed change of control transaction triggered media scrutiny and public stockholder backlash which further hampered sponsor’s efforts to secure the requisite stockholder vote.
Since a flawed sales process could strengthen any public stockholder resistance to a going private trans-action, sponsors need to carefully balance the deal protection and other desired transactional benefits, on the one hand, and the increased likelihood of litigation risk and public stockholder resistance that could result from such activities, on the other hand.
Don’t Go Naked on Expenses
As a downside protective measure, sponsors should try to negotiate in the merger agreement for expense reimbursement if the target’s stock-holders fail to approve the proposed transaction (often referred to as a “naked no vote”). Sponsors should resist any efforts by the target board to condition expense reimbursement on the existence of a publicly announced competing acquisition proposal at the time of the stockholder meeting. However, sponsors should be aware that a break up fee, as compared to an expense reimbursement, payable solely as a result of the target stockholders failure to approve the deal (i.e., not tied to the announcement or consum-mation of a competing acquisition proposal) could be challenged by stock-holders as coercive and unenforceable.
Consider Strategic Alternatives
If a sponsor anticipates stiff public stockholder resistance, the following strategic alternatives may be considered in addition to the old-fashioned alternative of increasing the cash offer price:
Stub Equity - “Stub equity” has been included as a feature in several recent transactions, including Harman, Clear Channel and Aeroflex in the United States and Country-wide in the United Kingdom. Stub equity gives public stockholders the option to choose either cash or stock in the company post-leveraged buyout. Stub equity is intended to deflect concerns that the going concern value of the target is worth more than the sponsor takeout price by offering the public stockholders the ability to choose, at least in part, to roll its investment going forward (possibly on a tax deferred basis). The amount of stock that may be issued to public stockholders is typically contractually capped by the sponsors.
Generally, caps have been in the 20% to 30% range of the company’s equity post-leveraged buyout, although in at least one transaction, Countryside, the cap was set at 55%. Stub equity has a number of disadvantages to sponsors, such as the requirement to register with the Securities and Exchange Commission the shares to be issued to the public stockholders and the requirement that the target remain a public company and file Securities and Exchange Commission reports for some period of time after the closing. This structure also has certain drawbacks for public stock-holders, particularly retail investors, as the sponsors may not be required to maintain a NYSE or Nasdaq listing for the stub equity so there may be very limited liquidity. This potential lack of liquidity coupled with the fact that public stockholders will unlikely have any meaningful governance rights calls into question whether stub equity is a viable option for certain institutional investors.
Contingent Value Rights - Similar to stub equity, contingent value rights provide a mechanism to bridge a perceived value gap and could help mitigate public stockholder opposition. Contingent value rights give public stockholders additional value if future hurdles are met and, as an example, can be tied to future financial targets or the sales price in the event of a divestiture of a division or key assets.
However, unlike stub equity, contingent value rights customarily give public stock-holders limited upside potential and don’t carry any downside risk. A variation of contingent value rights was recently part of a stockholder derivative settlement in the Sabre Holdings going private transaction. The sponsors agreed to pay the public stockholders a percentage of any profits above a certain benchmark price if the sponsors flipped the company or divested certain crown jewel assets within a six month period following closing. It will be interesting to see if this type of “schmuck insurance” for public stockholders becomes more common in stockholder derivative settlements or whether this type of provision is negotiated for by target boards in merger agreements. Conclusion
Time will tell how the great pushback by public stockholders affects the sponsor-backed going private trend. As public stockholders in some transactions ultimately choose to “stay the course” as a public company rather than electing to approve a sponsor-backed all cash premium offer, many of us will be tracking future financial results and stock performance to see if the stockholders chose correctly and how the real story ends. However, most going private transactions are not predetermined to this fate and sponsors are not left helpless. By doing your diligence, understanding the target stockholder base, minimizing flaws in the sales process and employing alternative strategies, such as stub equity or contingent value rights, sponsors can maximize the likelihood of stock-holder approval and sponsor success.
Weil, Gotshal Manges is a leading legal specialist in private equity services, with dedicated private equity lawyers in major financial centres throughout the world. For more information please visit www.weil.com.
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