November 03, 2009
Derivatives, Complexity, and Asymmetric Information
Abstract: Traditional economics argues that financial derivatives, like CDOs and CDSs, ameliorate the negative costs imposed by asymmetric information. This is because securitization via derivatives allows the informed party to and buyers for less information-sensitive part of the cash flow stream of an asset (e.g., a mortgage) and retain the remainder. In this paper we show that this viewpoint may need to be revised once computational complexity is brought into the picture. Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Note that computational complexity is only a small departure from full rationality since even highly sophisticated investors are boundedly rational due to a lack of requisite computational resources.
October 30, 2009
Dealmaker of the Week
Congratulations to my partner, Monica Shilling for being named Dealmaker of the Week by AmLaw Daily.
As the story notes, in a complex M&A transaction involving "a multitude of players," including lawyers from Proskauer, Latham, S&C, Sutherland, Venable, and Wilkie Farr, Monica was the "one attorney . . . charged with sorting out the complicated deal." The story goes on to quote our client, who says "This deal wouldn't have happened without her--She quarterbacked the whole thing."
The whole story can be found here.
October 25, 2009
Dodgers Cat-Fight in the Works
I like sales of sports teams. It's one of the few times I can read the sports pages and still pretend to be working. That said, the pending divorce of Dodgers owner Frank McCourt from his wife, Jamie, is shaping up to be a drag-out battle over who will own the team. The LA Times is reporting that she is already lining up investors after having been fired from her position as the team's CEO.
October 13, 2009
Williamson and Deals
I think it’s great that Oliver Williamson was awarded the Nobel Prize in Economics with Elinor Ostrom. Williamson’s work in organizational economics and transaction-cost economics goes to the heart of why and how private actors form firms, vertically integrate and pursue acquisition strategies. It’s also the intellectual center of much of what happens in the “Deals” class. Although it’s offered in a law school, the Deals class is not really a “law” class. It’s more like a course in applied organizational economics (for lawyers).
The Nobel Prize citation summarizes some of Williamson’s contributions here:
Although Williamson’s main contribution was to formulate a theory of vertical integration, the broader message is that different kinds of transactions call for different governance structures. More specifically, the optimal choice of governance mechanism is affected by asset specificity. Among the many other applications of this general idea, ranging from theories of marriage (Pollak, 1985) to theories of regulation (Goldberg, 1976), one has turned out to be particularly important, namely corporate finance.
Williamson (1988) notes that the choice between equity and debt contracts closely resembles the choice between vertical integration and separation. Shareholders and creditors not only receive different cash flows, but have completely different bundles of rights. For example, consider the relationship between an entrepreneur and different outside investors. One class of investors, creditors, usually do not acquire control rights unless the entrepreneur defaults, whereas another class of investors, stockholders, typically have considerable control rights when the entrepreneur is not in default. Williamson suggests that non-specific assets, which can be redeployed at low cost, are well suited for debt finance. After a default, creditors can simply seize these assets from the entrepreneur. Specific assets on the other hand are less well suited for debt finance, because control rights lose their value if they are redeployed outside the relationship.
Williamson’s work along is critical to thinking about how and why market participants undertake deals and the structures they adopt. In particular, his insights into the importance of asset specificity, opportunism and the hold-up problem to investment decisions is critical to thinking about structuring transactions and private ordering.
His books, Mechanisms of Governance as well as The Economic Institutions of Capitalism, are dog-eared and kept close at hand. In addition, Corporate Finance and Corporate Governance (J. Fin., 1988) is an excellent application of his ideas to corporate finance and the problem of organizing firms.
All in all, good choice.
October 09, 2009
Social Networks and Vertical Integration in the Laundry Business
In the category of "deals"-like things to read, here's a new paper on social networks and vertical integration in the laundry business - Airing Your Dirty Laundry. I love these kinds of papers mostly because they use a framework that's familiar to anyone who's taken a "Deals" class in analyzing the structure of an industry and why participants in that sector organize themselves the way they do.
Abstract: This article explores the relationship between an ethnic-based social network and vertical integration decisions in the laundry services industry. We find that stores in the social network are significantly less likely to vertically integrate than nonmember stores. This has three primary implications. First, the social network may be lowering the costs of using the market more than facilitating in-house production. This implies better outsourcing opportunities in a social network and may explain a documented relationship between social networks and firm economic performance. Second, institutional details of our example and the estimated relationship suggest a role for opportunism and reputation as determinants of the boundaries of the firm in a setting without asset specificity. Finally, although we provide evidence that better access to credit can increase the likelihood of vertical integration, we show that better outsourcing opportunities have a dominant effect of the social network in this particular setting.
September 18, 2009
Post- Closing Purchase Price Adjustments
Agreements to purchase private companies often include a post-closing purchase price adjustment (generally based on closing working capital versus some agreed upon target). In an effort to ascertain current market practice, White & Case surveyed 87 private company purchase agreements that were publicly filed in 2008 and contained purchase price adjustments. Full report here.
September 17, 2009
Be careful out there
Cautionary tales about catastrophic typos, due diligence errors and the like help focus the senses. Here’s one from Law Shucks:
One of the primary responsibilities of junior M&A associates in due diligence is to review material contracts for assignability and change-of-control provisions.
Should be simple, right?
Lawyers at Cravath and/or Cahill Gordon misinterpreted an assignment, and it led to a $115 million reduction in purchase price.
September 04, 2009
Deals and Two-Sided Markets
Marc Rysman at BU has a nice introductory paper on two-sided markets (The Economics of Two-Sided Markets) appearing in the current Journal of Economic Perspectives. Two-sided markets are relatively common and often involve some level of network exteranality. They are interesting from a "deals" perspective because it can be extremely difficult to structure transactions involving two-sided markets. These transactions often involve joint ventures to develop the intermediary - Mastercard and Visa are classic examples of two-sided markets. They have been a big success. But, @Home Corporation (cable-based Internet provider) and Irridium (satellite phone service) are less successful examples. While economists have recently started studying two-sided markets, legal academics are lagging behind. That's too bad, because these are interesting markets where there's a lot of complicated structuring going on.
August 21, 2009
It’s not news to anyone who loves sports that Sam Zell’s Tribune Co. has been in negotiations to sell the Cubs to the Rickett family since 2007. Given the obvious White Sox-bias of the current administration in DC there wasn’t much hope that Zell was going to get any bailout money to sweeten the pot, so in the end, he did the deal with the Rickettsfor $845 million. The deal includes Wrigley Stadium as well as 25% of the local Comcast sports network.
Acquisitions of sports teams are interesting for a couple of reasons. First, all of the transactions involve change in control conditions with real bite. The league – i.e. other owners – has to approve any transfer of control of a franchise. This makes any sale a clubby affair. If the other owners are unhappy with the identity of the purchaser or if the terms of the sale somehow set a precedent that causes fellow owners to hesitate, the deal can die. So negotiations with the seller often have to involve the league and other owners very early on.
Second, all these transactions involve ball parks in one way or another. Ball parks are large “specific assets.” Specific assets are assets that have value when used in one way, but then lose all their value if they are put to another use. Every try to hold an academic conference in a baseball stadium? Right, it’s not going to happen. You can’t even play soccer in a baseball stadium. A baseball stadium, particularly a big one like Wrigley has only one economic use and that’s as a baseball stadium for the Cubs. Separating ownership of the stadium from the team is hard to do. In fact, when it happens more often than not ownership passes to a public entity. Here's a paper by Mildner and Strathman with some data on stadium ownership in baseball and the NBA over the past few decades.
The specificity of the assets involved in sports transactions makes this kind of deal a perfect one for a Deals class. (I’ll write more about Deals classes next week after the semester starts.)
August 12, 2009
Recent Developments In Private Equity Deals
July 29, 2009
What must a Board do to satisfy its Revlon duties?
Milbank, Tweed reviews the decision of the Delaware Court of Chancery in Police & Fire Ret. Sys. of the City of Detroit v. Bernal, et al. and concludes
[The Delaware Supreme Court’s recent decision in Lyondell Chemical Company v. Ryan] confirmed that directors may aggressively pursue a transaction that they determine in good faith to be beneficial to shareholders, despite the absence of an auction process, so long as their actions are reasonable and aimed at obtaining the best available price for shareholders. However, . . . the language used by the Court in Bernal certainly suggests that when a company has attracted more than one bidder, the best way for a board to satisfy its Revlon duties and maximize shareholder value is to follow a robust sale or auction process that avoids taking actions that could be perceived as favoring one bidder over another. As Court of Chancery decisions in recent years have demonstrated, when only one bidder exists, Delaware Courts are reluctant to upset the deal and risk losing an attractive opportunity for target company shareholders. In contrast, when more than one bidder is involved, Delaware Courts are more comfortable scrutinizing a deal and taking steps to permit an auction to continue.
Get the full story here.
July 29, 2009 in Asset Transactions, Deals, Going-Privates, Leveraged Buy-Outs, Management Buy-Outs, Merger Agreements, Mergers, Private Equity, Takeovers, Transactions | Permalink | Comments (2) | TrackBack
June 23, 2009
Suppose a buyer is negotiating the terms of a potential acquisition of a family business when the parties encounter an issue over valuation. The seller’s projections show 500% growth over the three years following the sale. However, the buyer doubts these projections and therefore thinks the business is worth only a fraction of the seller’s asking price. This is a classic circumstance in the M&A world.
Often, the parties will bridge this valuation gap through the use of an earnout. Under such an arrangement, the seller gets paid a percentage of the asking price up front, and the parties agree to additional future payments if the company meets specific financial goals. For example, the buyer might agree to pay 75% of the purchase price up front, with another payout contingent on generating a particular amount of cash flow over a three-year period. This contingent payment could be binary, meaning it is paid or not depending on whether the target is hit, or it could be based on a sliding scale. For example, 50% of the contingent payment is made if 50% of the target is hit, 60% is paid if 60% of the target is hit, and so on.
Earn-outs are complex and must be carefully structured. For example, since the ultimate price payable pursuant to an earn-out provision will depend on future performance, the seller generally attempts to retain control of the business during the earn-out period to assure that changes in operations after the sale do not affect the ability to attain the specified target. The buyer, of course, often resists any restriction on its ability to run the business as it sees fit after the closing.
Here’s a recent article from BNA’s Mergers And Acquisitions Law Report highlighting many of the pitfalls to be avoided.
June 09, 2009
CSL-Talecris Agreement Terminated
June 02, 2009
CFIUS Filing for Hummer Deal?
OK, so GM went the way of Chrysler and filed for bankruptcy yesterday. Earlier this morning there was an announcement by GM’s management that it had entered into an MOU with a mysterious unidentified potential buyer for its Hummer division. Now, it’s leaked to the NY Times and Bloomberg (and just about everybody else in the world) that the buyer is Sichuan Tengzhong Heavy Industrial Machinery Company Ltd., based in Chengdu. They are offering to take the Hummer Division off GM's hands for $500 million in cash.
Of course, a few years ago sale of an automotive division that produces the civilian version of the military’s Humvee would have likely generated cries of outrage about threats to our national security. Remember Dubai Ports? Or how about Unocal-CNOOC? Well, with GM in bankruptcy those concerns are not likely to carry the day. That said, this transaction is a strong candidate for a voluntary CFIUS filing with the US Treasury. Given the nature of the business (vehicles manufacture with a potential military use) and the nature of the acquirer (News articles are murky about that. They say it's "privately" owned. Maybe.), this is precisely the type of transaction that should seek to make a filing. Worst case for GM would be that they announce this transaction and proceed along a path to closing only to have a Dubai Ports/Unocal-like flare-up kill this transaction.
May 30, 2009
The Art of Leaving in High Time
Robert F. Bruner has graciously sent his thoughts on the recent announced spin-off of AOL from Time Warner. Dr. Bruner
“If you have made a mistake, cut your losses as quickly as possible” -- Bernard Baruch
Late last week, Time Warner announced that it would spin off its AOL division. This ends one of the most notorious stories in M&A history. In my book, Deals from Hell, I dubbed the AOL/Time Warner merger one of the worst in business history, a genuine nightmare for almost everyone involved. The announcement of the merger in 2000 pitched it as a deal from heaven, converging old and new media, content and distribution. But it turned out otherwise. While AOL’s shareholders did very well in the deal, Time Warner’s did not. The deal was closed in January 2001. The transplanted organ was not accepted by the host; intramural fighting ensued. Civil and criminal litigation sprouted. Executives were sacked. All of this occurred against the bursting Internet bubble, the recession of 2001, and the slow recovery. AOL’s business withered. By 2003 the rise of broadband and wireless connectivity and the demise of AOL’s dial-up business were clear. AOL’s number of subscribers fell from about 27 million in 2002 to under 10 million at the end of 2007.
One wonders, why did they do this deal?—this is the subject of numerous books and articles. But there is an equally compelling question that has received much less consideration: Why did it take so long to unwind the deal? In contrast to Bernard Baruch’s advice, corporations generally seem slow to cut their losses quickly. Perhaps Time Warner found a way to squeeze cash out of the business, and therefore tarried. The illiquidity of a company’s assets is an obvious reason; under the best of circumstances, selling a business can take a while. But there is more to the story of slow corporate divestitures:
1. Measurement and information problems. It is tough to identify the point of inflection where the acquired business begins to turn sour. Five years ago, newspaper publishers had little clue that classified advertisers would begin to flock to Craigslist and other Internet marketplaces. Those publishers today are taking a pounding from the Internet that would have been very hard to foresee in 2003. Similarly, the demise of the dial-up Internet connectivity (in favor of wired broadband and WIFI) has been faster than many forecasters expected in 2000. Monitoring the trends within the portfolio of a firm’s businesses is difficult to do and fraught with error.
2. Biased thinking. This is what economists call “behavioral factors,” such as denial, loss aversion, and “sunk cost” mentality: “I can’t just sell a $100 billion investment for $50 billion”—even though it might be rational to do so if $50 billion is a fair value today. Sunk cost thinking regards the business the way it used to be, not the way it is or will be.
3. Corporate governance practices and incentives. There is a well-known correlation between firm size and CEO pay. This can prompt management to think that bigger is better and that smaller is not better. Boards of directors may not monitor and challenge the thinking of management as vigorously as they should. And various kinds of takeover defenses or share voting restrictions may prevent shareholders from directly challenging the board and managers to sell ailing businesses.
4. Barriers to exit. The Federal Communications Commission took a year to approve the merger of Time Warner and AOL. It might take that long to approve a divesture. A small number of buyers or the existence of unusual liabilities very nearly scratched the sale of Bear Stearns. A price tag in the billions of dollars along with the reluctance of banks to finance a purchase (that, as many private equity firms will tell you, is the situation today) could kill a sale. Uncertain environmental clean-up costs or generous union agreements (think of the auto industry) can drive potential buyers away.
CEOs require strong will and strength of character to cut its losses in the face of these kinds of problems. Plainly, it takes a bias for action, regard for opportunities, careful due diligence, and tough-minded concern for your investors’ return. We want firms to exploit the flexibility to enter and exit from businesses because it promotes dynamism and growth in the global economy. But the devil is in the details. Economic discipline, timeliness of response, and focus on action are all vital.
- Robert F. Bruner
May 30, 2009
May 28, 2009
Matching Rights in Merger Agreements
Rights of first refusal in merger agreements are a little bit of a hobby horse of mine. Except for papers by David Walker (here) and another by Marcel Kahan (here) they don’t get much attention. This is always a bit surprising to me. In the Deals class, the incentive effects of rights of first refusal take up a full class period, but yet there isn’t much attention given them. Maybe they don’t get much attention because their incentive effects are so obvious.
I take that back. Match rights were a central argument in the Toys R Us case. But there Vice Chancellor Strine evaluated the expert opinions of Prof. Guhan Subramanian and Prof. Prescott McAfee and found their conclusion – that the presence of a match right can/should dampen the effects of a competitive auction by deterring potential second bidders – lacking. In fact, he noted that examples of matching rights in merger agreements “are simply not that unusual.” He’s right on that mark. Matching rights in merger agreement are pervasive. In some research I have percolating on matching rights in merger agreements, I found that the vast majority of the merger agreements in my sample had one form or another of a matching right. So, Vice Chancellor Strine is right so far as that goes. On the other hand, I found that transactions with matching rights also had statistically significant lower prices. [An aside: It looks like Toys just announced an acquisition of FAO Schwarz today.]
However, because matching rights come in a variety of flavors – from weak to strong – they are a coding nightmare. For example, take a look at the matching right at question in the Toys case (merger agreement here):
6.5 Acquisition Proposals … (b) Notwithstanding anything in this Section 6.5 to the contrary, … the Company may terminate this Agreement and/or its Board of Directors may approve or recommend such Superior Proposal to its stockholders …; provided, … however, that the Company shall not exercise its right to terminate this Agreement and the Board of Directors shall not recommend a Superior Proposal to its stockholders pursuant to this Section 6.5(b) unless the Company shall have delivered to Parent a prior written notice advising Parent that the Company or its Board of Directors intends to take such action with respect to a Superior Proposal, specifying in reasonable detail the material terms and conditions of the Superior Proposal, this notice to be delivered not less than three Business Days prior to the time the action is taken, and, during this three Business Day period, the Company and its advisors shall negotiate in good faith with Parent to make such adjustments in the terms and conditions of this Agreement such that such Acquisition Proposal would no longer constitute a Superior Proposal.
There is a three day matching period that’s not uncommon. What is less common and gives this right of first refusal its real teeth is the requirement that Toys negotiate in good faith with the initial bidder until such time as the second bid no longer constitutes a superior proposal. This type of match right (the ‘good faith negotiation right’) is the strong form. There are weaker forms.
For example, in AMD’s acquisition of Broadcom last year, the parties included the mildest form of a matching right – ‘information rights.’ Here’s the relevant language (merger agreement):
4.2 No Solicitation (b) … In addition to the foregoing, if … Seller or any of its Representatives receive any Competing Proposal or Inquiry, Seller shall immediately notify Purchaser thereof and provide Purchaser with the details thereof, including the identity of the Person or Persons making such Competing Proposal or Inquiry, and shall keep Purchaser fully informed on a current basis of the status and details of such Competing Proposal or Inquiry and of any modifications to the terms thereof, in each case to the extent not prohibited by a confidentiality, nondisclosure or other agreement then in effect and entered into prior to the date hereof …
This language places no obligations on the seller other than to keep the initial bidder fully informed. Presumably a fully informed initial bidder that is actively interested in completing a purchase will be able to use such information to engage in ongoing negotiations and match any other offer on the table. Still, information rights are the weakest form of matching right – mostly because there is no “right” involved.
There is another matching right solution. This involves a combination of information rights and a delay before the seller is permitted to terminate the agreement, change its board recommendation, or have its board meet to consider a superior proposal – a ‘delayed termination right’. For example, you can find an example in the D&E Communications transaction (merger agreement here).
6.2 No Solicitation of Transactions … (4) f) Notwithstanding the foregoing, at any time prior to obtaining the Company Shareholder Approval …, the Board of Directors may (x) make a Company Adverse Recommendation Change or (y) cause the Company to terminate this Agreement pursuant to Section 8.4(b) if: … the Company delivers written notice to Parent (a “Notice of Superior Competing Transaction”) advising Parent that the Board of Directors intends to take such action and specifying the reasons therefor, including the material terms and conditions of any Superior Competing Transaction that is the basis of the proposed action by the Board of Directors (it being understood and agreed that any amendment to the financial terms or any other material term of such Superior Competing Transaction shall require a new Notice of Superior Competing Transaction and a new five Business Day period), and after the fifth Business Day following delivery of the Notice of Superior Competing Transaction to Parent the Board of Directors continues to determine in good faith that the Competing Transaction constitutes a Superior Competing Transaction …
In the example above, the initial bidder gets information rights combined with a 5 day delay during which time the initial bidder can presumably negotiate its way back into the picture.
Or, what the heck, you could just draft a match right that all elements of the above – below is Sumtotal Systems recent agreement (merger agreement) that includes information rights, good faith negotiation rights and a delayed fuse on both termination and a board recommendation.
5.3 No Solicitation (f) (iv) in the case of clauses (x) and (y) above, (A) the Company shall have provided prior written notice to Newco at least three (3) Business Days in advance (the “Notice Period”), to the effect that absent any revision to the terms and conditions of this Agreement, the Company Board has resolved to effect a Company Board Recommendation Change and/or to terminate this Agreement pursuant to this Section 5.3(f), which notice shall specify the basis for such Company Board Recommendation Change or termination, including in the case of Section 5.3(f)(y) the identity of the party making the Superior Proposal, the material terms thereof and copies of all relevant documents relating to such Superior Proposal; and (B) prior to effecting such Company Board Recommendation Change or termination, the Company shall, and shall cause its financial and legal advisors to, during the Notice Period, (1) negotiate with Newco and any representative or agent of Newco (including, without limitation, any director or officer of Newco) (collectively, “Newco Representatives”) in good faith (to the extent Newco desires to negotiate) to make such adjustments in the terms and conditions of this Agreement such that the Company Board would not effect a Company Board Recommendation Change and/or terminate this Agreement, and (2) permit Newco and the Newco Representatives to make a presentation to the Company Board regarding this Agreement and any adjustments with respect thereto (to the extent Newco desires to make such presentation); provided, that in the event of any material or substantive revisions to the Acquisition Proposal that the Company Board has determined to be a Superior Proposal, the Company shall be required to deliver a new written notice to Newco and to comply with the requirements of this Section 5.3 (including this Section 5.3(f)) with respect to such new written notice
The effect of all of these common provisions is to reinforce the position of the initial bidder and dissuade second bidders unless the second bidder has a private valuation that it believes is substantially higher than the private valuation of the initial bidder. I’ll post some more thoughts on matching rights another day.
Update: I've posted a draft of my paper (Match That!: An Empirical Assessment of Rights of First Refusal in Merger Agreements) on SSRN. It includes data from from my review of transactions with rights of first refusal, etc.
May 27, 2009
Deals from Hell
May 20, 2009
Why deals died
Lawyers at Gibson, Dunn examined the 70 U.S. deals identified by Thomson Reuters' as"withdrawn" in 2008. The two largest causes of the busted deals? No surprise here: (1) almost 40% of the deals fell apart because of a deterioration in the condition of one or more of the parties and (2) another 21% failed due to the buyer's inability to obtain financing. You can read the full report here.