In our paper, Do Investors Understand ‘Operational Engineering’ before Management Buyouts?, which was recently made publicly available on SSRN, we use a sample of management buyouts (MBOs) from 1985-2005 and a matched subsample of post-MBO firms to examine three questions. First, we examine whether firms undertake different types of activities to lower earnings before MBOs. Second, to see whether outside investors and the market understand such ‘operational engineering’ activities, we study the impact of these activities on target firms’ stock returns and MBO deal characteristics including deal premium and likelihood of deal completion. Third, we examine the relation between pre-MBO earnings-reducing activities and the post-MBO operating performance.

With the Great Recession of 2007-2009 exposing deficiencies of the world’s most advanced financial markets, leveraged buyouts (LBOs) have ‘reemerged’ as a solution to the many challenges facing corporate sectors. Unlike publicly listed firms, LBO firms are characterized by concentrated ownership, active monitoring and high leverage. A growing strand of literature shows that LBO firms can create value through ‘financial, operational and governance engineering’ (Kaplan and Stromberg, 2009). In fact, Jensen (1989) argues that LBOs should replace publicly held corporations as the dominant corporate organizational form.

…continue reading: Do Investors Understand ‘Operational Engineering’ before Management Buyouts?

The topic of this outline is mergers and acquisitions where the target company is “distressed.” Distress for these purposes generally means that a company is having difficulty dealing with its liabilities—whether in making required payments on borrowed money, obtaining or paying down trade credit, addressing debt covenant breaches, or raising additional debt to address funding needs.

Distressed companies can represent attractive acquisition targets. Their stock and their debt often trade at prices reflecting the difficulties they face, and they may be under pressure to sell assets or securities quickly to raise capital or pay down debt. Accordingly, prospective acquirors may have an opportunity to acquire attractive assets or securities at a discount. This outline considers how best to acquire a distressed company from every possible point of entry, whether that consists of buying existing or newly-issued stock, merging with the target, buying assets, or buying existing debt in the hope that it converts into ownership.

Some modestly distressed companies require a mere “band-aid” (such as a temporary waiver of a financial maintenance covenant when the macroeconomy has led to a temporary decline in earnings, but the company is able to meet all of its obligations as they come due). Others require “major surgery” (as where the company is fundamentally over-levered and must radically reduce debt).

…continue reading: Dealmaking in a Distressed Environment

In my article on Inefficient Results in the Market for Corporate Control: Highest Bidders, Highest-Value Users and Socially-Optimal Owners, I argue that, unlike in most other markets, in the market for corporate control allocating resources to the highest bidder will often not produce an efficient result. That is, because of unusual features of that market, the party willing to pay the highest price to acquire the target (the highest bidder), the party who would derive the greatest private benefit from owning the target relative to the status quo (the highest-value user), and the party whose ownership of the target produces the greatest net social benefit (the socially-optimal owner) need not be, and often will not be, the same party. Consequently, allocating the target to the highest bidder will often produce an inefficient result.

The argument begins from the observation that, for most target companies, there are multiple potential strategic acquirers. In general, such parties are willing to pay to acquire the target because ownership of the target’s assets will confer on them a competitive advantage in their product markets and thus increase their future profits. Each such bidder will thus value the target at the present value of the incremental future profits that it expects to earn if it acquires the target, with the bidder having the highest such valuation being the highest-value user of the target.

…continue reading: Inefficient Results in the Market for Corporate Control

With litigation now an inevitable feature of the deal landscape, boards evaluating the sale of their company would be well-advised to understand the variety of claims that are being made by plaintiffs in these cases, and in particular those that have gained traction with the courts. While directors taking appropriate steps to address the underlying issues will by no means ensure that litigation will not be brought, the risk of an adverse outcome can be significantly reduced by advance preparation and proactive engagement. With the ever-changing nature of claims and creativity of the plaintiffs’ bar, the outline below is not intended to be exhaustive, but rather to offer some practical guidance to target boards as they structure their sale process.

…continue reading: Guidance for Target Boards

In a second Chancery transcript ruling on the subject in recent weeks, Chancellor Leo E. Strine, Jr. has made clear that Delaware has no per se rule against “Don’t Ask, Don’t Waive” standstill provisions (which prohibit a party subject to a standstill, including a losing bidder in an auction, from requesting a waiver from its standstill obligations). The Chancellor also provided guidance for using such a provision as an “auction gavel” to secure the best price reasonably available to a target company involved in a sales process. The ruling in In Re Ancestry.com is a welcome clarification that will help maintain the vitality of auctions where a target wants to incentivize bidders to come forth with their highest bid.

…continue reading: “Don’t Ask, Don’t Waive Standstills” Revisited (Rapidly)

The definition of “material adverse change” plays a critical role in public company merger agreements, effectively defining the situations in which a buyer may walk away from the transaction. There is significant case law defining what is (or, much more commonly, what is not) a material adverse change, but the case law only serves to interpret the agreed definitions. The agreed definitions, in turn, are typically very vague in defining what is a material adverse change (leaving lots of scope for judges), but explicit in listing the types of changes that may not be considered in evaluating whether a material adverse change has occurred. The use of these carve-outs to limit what may be considered a material adverse change has expanded significantly in recent years — arguably to a point where it may make sense for the pendulum to start to swing back.

It has been traditional for adverse effects attributable to changes in general economic conditions to be excluded in considering whether a material adverse effect has occurred, such that e.g., a loss of sales attributable to the great recession, no matter how severe, would not give buyer the right to terminate a merger agreement. This carve-out from the material adverse change definition can be grouped with others, such as carve-outs for downturns in the target industry, changes in law or accounting policies, acts of war, etc. — all of which shift to buyer the risks associated with the environment in which the target operates. What is notable is that over the last several years, not only has the percentage of deals that shift these “environmental” risks to buyer increased significantly, but MAC carve-outs that shift to buyer the risk of the deal, and (anecdotally at least) even the risk of running the business, have also increased markedly.

…continue reading: Runaway MAC Carve-outs

Mergers are among the largest and most disruptive events in a corporation’s lifetime. The proper assessment of their value implications has been of foremost interest to policy-makers and academic researchers alike. Much of the research on mergers and acquisitions aims to assess which transactions create, or destroy, how much shareholder value, including a recent debate about “massive wealth destruction” through mergers (Moeller et al. (2005)).

Empirically, the measurement of the causal effect of mergers is challenging. The standard approach in the literature is to use stock-market reactions to merger announcements and to interpret the combined change in target and acquirer values as the expected total value created. This approach builds on a number of assumptions, including the assumptions that markets are efficient, that mergers are unanticipated and unlikely to fail, and that merger bids reveal little about the stand-alone values of the merging entities. Various studies document a small positive combined announcement return of targets and bidders, and interpret this finding as evidence in favor of value creation.

In our recent NBER working paper, Cash Is King — Revaluation after Merger Bids, my co-authors (Marcus Opp of UC Berkeley and Farzad Saidi of New York University) and I argue that a large portion of the announcement effect reflects target revaluation rather than value created through mergers, and that this portion varies with the type of payment: Targets of cash offers are revalued by +15%, but there is no revaluation of stock targets. We also find significant negative revaluation effects for stock bidders, but no effect for cash bidders. Our results imply that the widespread use of announcement effects significantly distorts the assessment of mergers.

…continue reading: Revaluation of Targets after Merger Bids

Overview

We regularly conduct studies on private equity buyer acquisitions of U.S. public companies with equity values greater than $500 million (“large market” deals) to monitor market practice reflected by these high-profile transactions. Recognizing the importance of M&A activity in the $100 million to $500 million target equity value range (“middle market” deals), we are commencing a new deal study that identifies “market practice” involving private equity buyer acquisitions of U.S. public companies in the middle market. We also compare our findings for middle market deals to our findings for large market deals. During the period from January 2010 to June 30, 2012, there were a total of 36 middle market deals and 43 large market deals that met our parameters.

Part One

Key Observations: Market Practice and Trends in the Middle Market

• 1. Activity in the middle market is down year over year. Only 5 deals were signed in 1H 2012 compared to 11 in 1H 2011, a decrease of 55%. Mean equity values of deals in 1H 2012 rose 21% when compared to 1H 2011. The year started with no activity — all of the 1H 2012 deals were signed in the second quarter. (See Chart 1.)

…continue reading: Middle Market Private Equity Buyer/Public Target M&A Deal Study

The large private equity buyer/public company segment of the U.S. M&A market (all cash deals over $500 million) was significantly affected in the first half of 2012 by troubles in the U.S., European and global economies. Only six trans­actions within our deal parameters were executed. Five of them had key deal terms generally consistent with our prior observations; the remaining transaction, Insight Ven­ture Partners/Quest Software, had certain key deal terms (“go-shop” period, target break-up fee and buyer reverse termination fee) that were outliers. Accordingly, for certain of our observations below, we have expressed the data including and excluding Insight Venture Partners/Quest Software (“Quest Software”). [1]

1. Fewer deals were completed in 1H 2012 and average deal size decreased. The decline in deal activity that began in Q1 2011 continued in 1H 2012. In 1H 2012, deal activity was down 33% compared to 1H 2011, and down 25% compared to 2H 2011. On an annualized basis, deal activity in the segment surveyed decreased 29% in 2012 compared to 2011. Equity values were also lower. For 1H 2012, in the deals within our survey, mean equity value fell 21% when compared to 1H 2011 and 54% when com­pared to 2H 2011. (See Chart 1 below.)

…continue reading: Private Equity/Public Target Deals: Mid-Year Update

In Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., [1] the Delaware Supreme Court explained that when a target board of directors enters Revlon-land, the board’s role changes from that of “defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company.” [2]

Unfortunately, the Court’s colorful metaphor obfuscated some serious doctrinal problems. What standards of judicial review applied to director conduct outside the borders of Revlon-land? What standard applied to director conduct falling inside Revlon-land’s borders? And when did one enter that mysterious country?

By the mid-1990s, the Delaware Supreme Court had worked out a credible set of answers to those questions. As for the borders of Revlon-land, the Court had explained that:

…continue reading: The Geography of Revlon-Land