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Shark repellents that can bite

When a private equity firm exits an investment through an initial public offering the process often includes a number of statutory provisions designed to prevent unwanted takeover attempts of the public company, says William Regner of Debevoise & Plimpton. Here he explains the implications of these ‘shark repellents' for the private equity industry and provides comprehensive legal advice designed to protect the interest of the private equity firm in event of a portfolio company going public.

When private equity firms use IPOs as exit strategies (as they sometimes have, and might again, in better market conditions), the portfolio company going public often includes a full complement of “shark repellents” - provisions intended to guard against unwanted or abusive takeover attempts.  Private equity firms should review these provisions carefully, because some of them can limit their flexibility to cause a sale of the public portfolio company, grant a lock-up to a buyer or, under the right circumstances, obtain a control premium not shared with other stockholders.

The array of shark repellents implemented for a new public company might include, among other things, a staggered board, elimination of shareholders' ability to act by written consent or call special meetings, a shareholder rights plan (a “poison pill”), and advance notice requirements for shareholder proposals and director nominations.

The private equity sponsor that will continue as a major shareholder of a public company should think twice about whether some shark repellents are really in its best interests - in particular, business combination statutes, such as Delaware's Section 203, and poison pills.

Section 203 imposes a three-year moratorium on business combinations between a public Delaware company and any 15 per cent or greater stockholder unless the target's board approves the combination or the crossing of the 15 per cent threshold before the threshold is crossed, the bidder reaches the 85 per cent threshold in the same transaction as it crosses the 15 per cent threshold, or the combination is approved by the board and by holders of two-thirds of the shares not owned by the bidder.  A Delaware company can opt out of 203 by so providing in its charter, but that's really a one-shot opportunity for the private equity sponsor to decide whether or not 203 will apply.

A poison pill works in a similar manner by making it prohibitively expensive for a bidder to cross a specified ownership threshold - often 15% - without prior board approval.  If a bidder crosses the threshold without prior board approval, the pill rights become exercisable to buy stock in the target company at half price.  At the same time, the bidder's pill rights become void - thereby causing massive economic and voting dilution.

Private equity sponsors should seriously consider having a portfolio company opt out of 203 at the time of its IPO.  Even if 203 wouldn't apply to the private equity sponsor - there's an exception for stockholders who crossed the 15 per cent threshold before the company went public - it would apply to a transferee of the sponsor's shares.  That means that the private equity sponsor's decision to sell its shares or grant a lock-up becomes, in part, a board decision - and the board will be looking after the interests of all shareholders, not just the sponsor.  The same is true if the company has a poison pill.

Here's an example of how 203 or a pill can chill dealmaking:
A private equity sponsor takes PortfolioCo public and, after some secondary sales, is left with a 35 per cent interest.  Two years later, BuyerCo would like to acquire PortfolioCo, but will go forward only if PortfolioCo's biggest shareholder - the private equity sponsor –commits to the deal.  If PortfolioCo has a poison pill or is subject to 203, any lock-up agreement between the sponsor and BuyerCo will require PortfolioCo board approval.  Otherwise, BuyerCo will trigger the pill or be subject to 203.

The board approval requirement is not just ministerial.  Based on recent case law, a Delaware company's board will likely be unable, on fiduciary grounds, to approve the lock-up if it would, as a practical matter, preclude a higher bid by a third party.  But if PortfolioCo has no pill and is not subject to 203, BuyerCo could freely enter into a lock-up agreement with the sponsor and then launch a tender offer for PortfolioCo shares - without any involvement by PortfolioCo's board other than its need to make a recommendation about the offer.
Foregoing a poison pill and opting out of 203 should not seriously compromise the ability of a company to defend against a coercive takeover attempt.  The board could always decide to adopt a poison pill in the future, once a specific threat materializes - and a company with a pill shouldn't also need §203.
We looked at a selected group of 21 IPOs by U.S. portfolio companies of private equity firms over the period May 1996 to January 2003.  Of that group, at the time of the IPO, eight companies (or 38 per cent) opted out of 203 and did not adopt a pill.  Another eight companies were subject to §203 but did not adopt pills, and five companies were subject to 203 and adopted pills– meaning that 62 per cent were subject either to a pill, 203 or both.  Down the road, at least some of those firms may wish their companies did not have those particular shark repellents.

Debevoise & Plimpton, an international law firm, was founded in 1931. The firm, which now has more than 500 lawyers, provides international services in corporate, litigation, tax, and trusts and estates law. Debevoise & Plimpton offices are located in New York, Washington, DC, London, Paris, Frankfurt, Moscow, Hong Kong and Shanghai.