PRINT THIS PAGE Lessons from the front30/05/2007. Source: Weil, Gotshal & Manges. Michael Weisser and Matthew Cammack 
The takeover battles between The Blackstone Group and a consortium lead by Vornado Realty Trust for Equity Office Properties, and between The Carlyle Group and Building Materials Corporation of America for ElkCorp, are two examples of the potentially tougher acquisition environment that private equity sponsors may face in 2007, says Weil, Gotshal & Manges, including increased challenges from strategic buyers. In each case, a strategic buyer emerged with a topping bid to challenge a signed sponsor-backed going private transaction. In EOP, the private equity sponsor ultimately prevailed, while in ElkCorp, the strategic topping bid was accepted and entered into after termination of the Carlyle deal and the payment of a break-up fee.
Given this dynamic, and the increased risk of competing bidders emerging to break up a deal, sponsors should carefully consider deal protection measures, deal structure alternatives and the relative advantages and disadvantages of their bid compared to other potential bidders. Both EOP and ElkCorp provide interesting lessons that private equity sponsors should consider before embarking on their next going private transaction.
Sponsors Should Negotiate a Meaningful Break-Up Fee
The size of the break-up fee paid to a buyer if a target enters into a transaction that its board of directors determines is a superior proposal is typically 2.0% to 3.5% of equity value. Although there are judicial restrictions on the amount of the break-up fee, it is in a sponsor’s interest to negotiate a break-up fee at the higher end of the permitted range to reduce the risk that it is leaving the door open to competing bidders.
However, higher break-up fees usually come with a cost to sponsors. Recent deal custom dictates that the amount of the reverse break-up fee paid by a buyer to a target for failure to secure adequate financing to close a transaction is identical to, or closely parallels, the amount of the break-up fee.
By negotiating for a higher break-up fee, sponsors effectively increase their corresponding out-of-pocket dollar exposure associated with the absence of a “funding” closing condition and the inclusion of a sponsor guaranty. However, this type of tactical decision also increases the hurdle for a competing bidder to present a successful topping bid. In any event, sponsors need to carefully assess the likelihood of several factors before agreeing to a break-up fee structure, including the anticipated time period between signing and closing and the potential for competing bids.
Sponsors Should Consider Whether to “Force-the-Vote”
Although rarely appearing in recent sponsor-backed going private transactions, a “force-the-vote” provision in a merger agreement benefits a sponsor by requiring that a target board submit the sponsor’s deal to a shareholder vote notwithstanding any change or withdrawal of the target board’s recommendation as a result of a topping bid. Despite this deal protection device, a target board can still meet its required fiduciary duty by changing or withdrawing its recommendation in response to a competing proposal.
However, a force-the-vote provision takes the power out of the target board’s hands to terminate the deal and gives the power to the the target’s shareholders to determine which offer is superior. Sponsors should, however, be mindful that such provisions are not enforceable in all jurisdictions, and, even if the target board has conducted an exhaustive market check, such provisions may be deemed “preclusive” and “coercive” if utilized in connection with voting agreements that lock-up a significant percentage of the shareholder vote. Nonetheless, in light of the potential for competing bids, sponsors should consider the merits of requiring a force-the-vote provision, particularly where competing bids are similar in value but the sponsor’s deal offers advantages such as all cash consideration, less regulatory risk and speed and certainty of closing.
For example, although Blackstone did not need to rely on a force-the-vote provision to prevail, EOP is illustrative of the type of situation in which a private equity sponsor would benefit from a force-the-vote provision. Though Blackstone’s final all cash offer was arguably lower than Vornado’s final cash and stock offer, Vornado’s bid had several disadvantages compared to Blackstone’s proposal, including risks associated with each of the following: the value of the stock component of the proposal, a longer period prior to closing (including the chances of a material adverse effect occuring), a Vornado shareholder vote (including Vornado shareholder reaction to a potential decline in EOP operating results, or adverse changes in interest rates or the real estate market), a potential antitrust review of the transaction and the possibility that the Vornado board would change its recommendation in the event of a proposed takeover offer for Vornado or for any other reason. If the EOP board had determined that this offer was nonetheless superior to the Blackstone deal, a force-the-vote provision would have given Blackstone the upper hand in forcing the EOP shareholders and not the EOP board to determine the winning bidder.
On the other hand, in ElkCorp, a force-the-vote provision would not have influenced the eventual outcome. Although Carlyle’s offer was attractive because of speed and virtual certainty of closing, BMCA’s bid was higher, all cash and did not create significant regulatory risks. In addition, BMCA’s proposed tender offer structure eliminated most of the timing disadvantages often associated with topping bids.
Time to Re-Evaluate Go-Shops?
As in EOP and ElkCorp, sponsors are accustomed to negotiating for a no-shop provision with a fiduciary out that permits the target board to respond to, as compared to solicit, competing offers that the board believes could reasonably lead to a superior proposal.
However, as discussed in the December 2006 edition of Private Equity Alert, because target boards are becoming increasingly concerned about their fiduciary duty to ensure a fair sales process that maximizes shareholder value and reduces the potential for shareholder litigation, several recent deals have included go-shop provisions that enable the target to actively solicit higher offers for a limited period of time post-signing. Although neither the EOP nor ElkCorp merger agreements included a go-shop provision, both deals highlight the increasing risks associated with a sponsor agreeing to its inclusion, particularly in light of the increased potential for competing bids.
Before agreeing to a go-shop provision, sponsors must proactively assess the likelihood of a competing bid and, as appropriate, seek to limit the go-shop time period, avoid or minimize a reduced go-shop break-up fee and resist efforts by the target’s board to permit the target to reimburse the expenses of, and effectively subsidize, potential competing bidders during the go-shop period. In addition, sponsors should ensure that they have matching rights with respect to topping bids, both during and after any go-shop period.
In negotiations, sponsors should keep in mind that go-shop provisions are not legally required. Moreover, many question the practical need of go-shop provisions, particularly when private equity deals grab headlines and pricing and other material terms are often spelled out on the front pages of financial and other publications, thus drawing competing bids with little or no solicitation by the target. However, sponsors must be aware that agreeing to a go-shop often reduces their first mover advantage and levels the playing field between sponsors and potential post-signing topping bidders.
Sponsors Should Consider Pros and Cons of Tender Offer Acquisition Structure
Sponsors have avoided tender offers since the mid-1990s due to interpretative issues surrounding the SEC’s “all holders, best price” rule, which requires that all tendering shareholders receive the highest consideration paid to any shareholder during the tender offer. Different court interpretations, around whether payments made to management (including equity grants in the surviving company, rollover opportunities and other compensation arrangements) should be included as “consideration” made “during the tender offer”, caused sponsors to purposefully avoid tender offers. However, recent revisions to the “all holders, best price” rule, which serve to clear up the confusion, put tender offers back in the spotlight as a potential acquisition structure for sponsors, either in connection with an initial bid or to counter a topping bid. The risks, benefits and complexities of a tender offer acquisition structure should be considered by sponsors in the current deal environment where there is a risk of a competing bidder emerging.
A tender offer provides sponsors with potential tactical advantages by minimizing the time period between signing and closing and, when used as part of an initial bid, reducing the risk that a competing bidder will emerge. Tender offers must remain open for 20 business days under federal securities laws, following which, assuming 90% of the shares are tendered and no regulatory issues exist, a second-step merger can be closed almost immediately pursuant to a short form merger if permissible under state law.
Conversely, the typical going private transaction structured as a one-step merger generally takes three to four months to close. The practical advantages of a tender offer were highlighted in the ElkCorp transaction where Carlyle was forced to adopt a tender offer structure to match the timing advantage offered to ElkCorp and its shareholders by BMCA’s competing tender offer proposal.
Obtaining debt financing for a cash tender offer is more complicated, and often times more costly than a one-step merger, because sponsors do not have access to the target’s balance sheet to secure the financing, and margin rules restrict borrowings secured by public company stock to 50% of the stock’s market value.
The typical tender offer financing structure, as used by Carlyle in ElkCorp, involves a tender offer bridge facility borrowed directly by the sponsor acquisition vehicle. The bridge facility is secured only by a pledge of the target shares acquired in the first-step tender offer. As a result of the margin rules, sponsors typically are forced to over-equitize the initial funding of the tender offer. Upon completion of the second-step merger, the bridge facility is replaced with permanent debt financing secured by the assets and stock of the target and its subsidiaries and the equity investment is often refinanced to effect a more typical leverage ratio.
Conclusion
If January is any indication, sponsors could face a potentially tougher acquisition environment in 2007. With the increased potential for topping bids, sponsors are well advised to strategically market their offers to a target’s board and its shareholders, highlighting the advantages compared to a potential transaction with a strategic buyer, including the lack of regulatory risk, speed of closing and certainty of value in an all cash transaction. Sponsors should also revisit deal protection devices in light of this risk and be prepared to use a tender offer as an alternative acquisition structure.
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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