THOUGHT LEADERSHIP

Former U.S. President and General Dwight D. Eisenhower was quoted as saying: “In preparing for battle, I have always found that plans are useless, but planning is indispensable.” The same can be said when it comes to interloping or topping bids in the context of M&A.

Over the past few years, we’ve seen a host of high profile M&A transactions involving interlopers, such as Occidental Petroleum’s acquisition of Anadarko ($56.5bn) and Merck’s acquisition of Versum Materials ($6.5bn) during last year, as well as Disney’s acquisition of 21st Century Fox ($84.2bn) at the end of 2017. When thinking about potential topping bids, it is critical for advisors to help their clients understand the multiple nuances of formulating such a bid in advance of taking any action. Some of the major concepts include, but are not limited to:

1. Type of topping bid: a letter to the Board of the target or a public announcement?

2. Structure of the bid: all-cash or including stock?

3. Impact on the bidder: will there be a shareholder vote required to approve the transaction?

4. Level of the topping bid: a moderate premium to the announced deal or a more material premium?

One of the most important aspects of the interloping bid is whether or not it will be considered a “superior proposal”. While the definition of a superior proposal fluctuates between merger agreements, one of the key determinants of this is the value offered by the bidder (i.e. the higher the premium, the more likely for the bid to be deemed a superior proposal). In fact, for all-cash topping bids with over a 15% premium to the offer on the table, over 50% were considered a superior proposal. For all-cash topping bids with 10-15% premiums, the success rate is closer to 40%. In cases where topping bids contained a portion of stock, they were much less likely to be considered a superior proposal relative to the first offer. [1] Careful consideration is needed to understand what constitutes a superior proposal and how to achieve this in the event of a topping bid.

While the premium is one important factor, there are several other considerations for advisors to articulate to their clients the level of their bid. For example, do you approach the target with a moderate topping bid, which, while it ensures future firepower, leaves the door open for other potential interlopers and may not be determined to be a superior proposal? Or, do you bid more aggressively to demonstrate resolve and commitment, which may run the risk of being viewed as overpaying or leave you unable to win a bidding war if topped again? With any interloping bid, the potential buyer also needs to think about how to best demonstrate their commitment to go “all the way” and potentially launch an unrecommended tender offer/hostile transaction. As seen in some of the more successful topping bids referenced above, demonstrating intent through a more material premium may result in a winning outcome, but it does not necessarily mean that it is the only way to win. 

While each transaction has its nuances and idiosyncratic factors, the ultimate measure of success will always be: how strategic is the target’s business to the interloper, and does it warrant entry into a potentially prolonged and costly battle? This essential question, in addition to evaluating what the potential impact is for shareholders in the event the interloper does win, must be at the forefront of directors’ minds when they evaluate the battlefield that is M&A. As observed by General Eisenhower, significant diligence and duty of care are indispensable upfront, as once one enters the heat of battle, it can become extremely difficult to resist winning at all costs.

[1] Source: FactSet, press releases, company filings, Dealogic. Note: includes all transactions over $1bn since 01/01/04 and deals where there was a signed merger agreement and interloping bidder; totals may not foot due to rounding and pending transactions

Delaware law does not necessarily require the board of a public company to canvas potentially interested bidders widely before agreeing to sell the company.  In the context of a sale for cash or partial cash consideration, directors are only required to take reasonable steps to obtain the best price reasonably available; there is no single blueprint for directors to satisfy their duties in this respect.    

As a result, potential bidders are sometimes caught off-guard by the announcement of a sale transaction by a public company.  They may not have been contacted by the target or its advisors at all, or even if contacted, they may not have had an opportunity to rebid or submit their best and final. 

Although interlopers generally have the deck stacked against them given the incumbent’s deal protections and the more public nature of any negotiations, for those interested in topping an announced deal, there are a number of considerations.

Finding the Roadmap

Although a broad market check is not necessarily required, directors of a public target do need to retain flexibility following signing to consider inbound interest.  Directors will be expected to recommend the agreed transaction to their stockholders.  In order to do so on an informed basis, they need the ability to share nonpublic information and negotiate with an interloper that submits a competing proposal – until such time as the stockholders approve the deal on the table.  This flexibility is typically legislated in a “no-shop” provision that includes certain exceptions to the general restriction on solicitation of competing proposals, in order to permit directors to satisfy their fiduciary duties. The precise terms of these exceptions provide a roadmap for interlopers, including:

• How competing proposal and superior proposal are defined;

• The buyer’s information and notice rights if a competing proposal is submitted;

• The buyer’s matching rights, including the length of the notice period in subsequent rounds of bidding;

• Whether the target board can terminate the agreement outright to enter into an alternative agreement providing for a superior proposal (as is fairly typical) or merely change its recommendation to stockholders (which is more unusual);

• Whether the ‘no-shop’ provision has an initial ‘go-shop’ period permitting the target to approach potential interlopers; and

• The size of the break-up fee (both generally and in the event an interloper emerges during any initial ‘go-shop’ period).

Making your Bid Superior

Formulating the precise terms of the topping bid is a mix of art and science, best informed by key decision-makers and advisors, with the interloper having the advantage of knowing the terms of the announced deal and therefore having the opportunity to exploit the target’s and the incumbent’s respective pressure points.  Although the interloper will generally be expected to agree to substantially the same form of merger agreement (with only necessary changes), it has two chief levers:

• Value. The typical definition of superior proposal requires the topping bid to be superior in value, after giving effect to any improved terms offered by the buyer pursuant to its matching rights.  There is significant bid strategy to this.  Does one only beat the deal on the table slightly to retain the ability to sweeten its deal later or does it come in over the top in a preemptive effort?  How aggressive can the interloper be on price without upsetting its own investors (measured against a public failure to top/win)?

• Certainty. Most merger agreements require a superior proposal to provide certainty of closing – defined either by reference to an objective “reasonably capable of closing” standard or to match the certainty of the deal on the table.  An interloper should consider its natural advantages relative to the announced buyer:

  • Is the original buyer’s obligation to close conditioned on its financing banks funding under their debt commitments?  Can the interloper agree to close without relying on a private-equity financing structure? 

  • Does the interloper naturally pose less regulatory clearance risk than the announced deal and/or is it willing to make greater commitments, including with respect to potential divestitures, in order to obtain required approvals?  Interlopers should not expect targets to take incremental risk on regulatory clearances; as a result, an interloper may have to absorb significant contractual risk, with any required divestitures known and financially modeled in advance (particularly if needed to propose a “fix it first” solution to nettlesome regulators).

  • Can the interloper structure its deal to avoid a stockholder vote of its own (or at least mitigate the risk of it by obtaining voting agreements from key stockholders)?

The interloper should understand that its proposal, even if unsuccessful, will have to be made public by the target’s board as part of its duty to inform its stockholders.  In addition, the interloper should consider requiring that an enhanced termination fee would be payable by the target to the interloper if, after the interloper’s superior proposal successfully results in an agreement with the interloper, there is yet another successful topping bid (perhaps by the original buyer).  

The layered complexity of these considerations, coupled with the game theory of bid strategy, makes it important for a potential interloper to consult with experienced advisors.  Target directors will be obligated to consider any competing proposal on an informed basis, with due care.  Accordingly, it’s essential for an interloper to put its best foot forward in a thoughtful, rational manner.

Scrutiny of executive compensation is often exacerbated when a merger or acquisition occurs. Regulators, shareholder activists, and others frequently voice displeasure specifically with change in control benefits provided to executives during a transaction, such as severance payments, vesting of equity awards, and excise tax gross-up payments. However, in working to complete a merger or acquisition, executives of the target company are essentially working themselves out of a job in most cases. Change in control benefits are intended to ensure executives evaluate every opportunity, such as a merger or acquisition, without the distraction of personal considerations.

If change in control benefits to certain individuals exceed specified limits, the individual will be subject to a 20 percent excise tax and the company will lose the tax deduction under the Golden Parachute Provisions of Section 280G of the Internal Revenue Code. These adverse tax consequences can easily balloon into millions of dollars and therefore attract the attention of the executives and the company quickly.

Without the proper alignment of change in control arrangements with executives and shareholders, a company risks putting the completion of a deal in jeopardy. To address the many concerns with change in control arrangements, Alvarez & Marsal partnered with Equilar to complete the 2019/2020 Executive Change in Control Report, which analyzes the change in control arrangements of the top 200 publicly traded companies in the U.S. across 10 different industries. By benchmarking existing plans against other companies, public company boards, their compensation committees and management will be able to validate existing change in control benefits or identify opportunities for change. 

Below are a few of the key findings from the report.

• Average change in control benefits remain substantial, averaging $27,886,556 for CEOs and $9,880,993 for CFOs.

• The most common cash severance multiple in connection with a change in control is between 2 and 2.99 times compensation (49% for CEOs and 53% for CFOs).

• The prevalence of double trigger vesting for equity awards has continued to increase where now 97% of companies have double trigger vesting for some or all of their awards.

• Excise tax gross-ups continue to be phased out in plans and agreements with only 9% and 3% of companies providing this benefit to their CEOs and CFOs, respectively.  However, we observed gross-ups being added during actual deal negotiations at 15% of the top 20 deals during the first 3 quarters of 2019. This is an interesting trend considering the significant backlash companies have faced for having excise tax  gross-ups in the past.

• Boards and compensation committees do not want to be perceived as providing excessive change in control benefits relative to their peers or offering benefits that conflict with maximizing shareholder value. In this environment of heightened scrutiny, companies need to be prepared to stand firm behind their change in control arrangements.