October 3, 2007
Yesterday, the SLM buy-out consortium issued a mid-market day proposal to renegotiate the SLM transaction. The buy-out consortium offered a renegotiated price of $50 per share plus 0.2694 of a warrant per share. The warrants would be exercisable five years after issuance and pay out based on the earnings of SLM over that five year period. The maximum pay-out for each warrant would be capped at $10 per warrant. The warrants would pay-out only if the buyers achieved a 15% IRR over that five year period.
Sallie Mae quickly issued a brief statement later in the day holding firm. SLM stated:
Our contract is with Bank of America and JPMorgan Chase, two of America's largest and strongest banks. We expect these banks to honor that contract, not breach the contract."
For those trying to determine which of the buyers is driving this MAC renegotiation note that SLM made no mention of the third buy-out partner here, J.C. Flowers.
A few more points:
- The Times and others are playing this offer as a "clever" way for SLM to show its hand. The reasoning is that the warrants will force SLM to admit that a MAC has occurred since they can no longer stand by their projections. I guess so. But really the issue is over the parties' assessment of the MAC claim and their negotiating positions. The buy-out group doesn't have to offer warrants to get SLM to make this assessment -- they already have. And remember, this negotiation is happening under the specter of the $900 million reverse termination fee which limits the buy-out group's liability.
- The warrants here are a form of an earn-out. Every few years or so you see the use of warrants in this situation to close a price gap. It permits the buyer to appear to be offering more consideration and is a way to close a gap between the projections of the seller and the buyer. But these warrants are hard to price. Here, they are European options so you can use Black-Scholes to do so. But to calculate the Black-Scholes value you would have to estimate what the volatility is for this new company. A hard and uncertain thing. Because of these problems, when I was in private practice the bankers typically and privately ignored this type of consideration as a cosmetic. Here, the warrants certainly do not have a $10 value -- estimates are that they are worth about $.50-$1.50 at best.
- If a warrant component is included it will push out the SLM deal timetable 2-4 months in order to prepare a registration statement and file it with the SEC. More time for further Fed rate cuts and an improvement in the credit markets. This will also give the buy-out group more control over the timing of the transaction as they will be responsible for preparing this registration statement. NB. the use of an equity-type instrument in this manner and the slowing of the time-table it brings is partly responsible for cratering the Harman deal.
- The buy-out group is now negotiating publicly with SLM presumably because SLM is refusing to strike a reduction of the buy-out price. This is something you often see in hostile takeovers, but not in renegotiations which typically happen behind closed doors. SLM and the buyer group are likely far apart at this point for the buyer group to go public in this manner.
- Flowers has a partial MAC analysis in their press release. They state that not only has a material adverse change occurred but that it is not excluded under the applicable law disproportionality test in clause (b) of the MAC definition because:
A "change in Applicable Law" does not have to be "materially more adverse" to trigger an MAE. The word "material" is not there. "Any" legislative change "more adverse" to Sallie Mae than the already material legislative changes described in the 10-K counts.
Here, they agree with my full analysis (see the SLM Legal Case (Redux). In addition, the buy-out group make a good point about how the MAC clause was specifically negotiated to address these issues, and clearly something worse has occurred. The buy-out group states:
Near the end of our negotiations, Senator Kennedy made a proposal that called for subsidy cuts deeper than the cuts described in the 10-K. The company asked us to accept the risk that the Kennedy proposal would become law. We refused. We drew the final line -- the maximum pain we were willing to take -- at the Bush Budget Proposal.
The bottom-line is that, although far from certain, the buy-out group still appears to have a good case here that a MAC occurred, particularly since this issue was so highly negotiated and accounted for in the MAC and what is happening now appears to be worse. SLM may not be buying into this argument -- but they know they are playing a dangerous game given the $900 million termination fee and the buy-out group's case. This may be the buy-out group's first offer and therefore lower than what they are willing to pay, but the incentives are still for SLM to settle. Ultimately, I take the warrants more seriously than others and illustrative of the strong position the buy-out group thinks it has. People who talk of the warrants not passing the "giggle" test in my view may be seriously under-estimating the buy-out group's negotiating position.
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