The Harvard Law School Forum on Corporate Governance and Financial Regulation recently carried a post by Theodore Mirvis of Wachtell Lipton, “Delaware Appraisal at a Crossroads?” This HLS Forum post discusses the recent DFC argument – which we’ve posted about – and lays out a variety of thoughts on future questions in appraisal and appraisal arbitrage. For more on DFC, see our coverage here.
The Supreme Court heard argument yesterday from DFC Global and its dissenting stockholders. The court has not yet ruled, and nobody can predict how it will decide the case; the following questions and observations are just some of the points that different members of the full five-justice panel raised during argument:
- The court asked DFC Global why they did not introduce an economics expert to corroborate the reliability of the merger price as the measure of the company’s fair value; the Chief Justice said that by not doing so, they didn’t offer much help to the Chancellor in his evaluation of the merger price and the process of wading through the respective valuation experts’ reports.
- The court observed that DFC’s own expert gave 50% weight to the merger price, so it asked why the Chancellor’s one-third weighting of merger price isn’t entitled to deference.
- The court observed that the statutory requirement that the chancery court consider “all relevant factors” in determining fair value is pretty “squishy,” suggesting that the trial court has the discretion to decide which factors to examine and what weight to give them.
- The court asked both sides to describe the relationship between working capital and perpetuity growth rates and whether the calculation of the growth rate is necessarily based on working capital assumptions; e., does a higher level of working capital inevitably mean that a higher growth rate must be used?
- The court observed that the appraisal statute requires the courts to focus on the fair value of the shares and that the pre-existing, unaffected market price would be highly informative of the stock’s fair value, but the jurisdictional definition of fair value looks beyond just the shares to the value of the company as a going concern.
- One of the justices was “troubled” by the Chancellor’s equal weighting of the three chosen valuation sources – merger price, comparable companies analysis, and DFC – insofar as the support for such equal weighting seemed lacking in the record.
- The court asked the stockholders why their valuation expert didn’t open up his own private equity shop if he really believed in the valuation delta between merger price and his own valuation, which came out nearly two times higher than the merger price.
- The court further asked why none of the 40 people apparently contacted during the sale process bid higher, given that valuation gap; are the markets really that broken?
- The court observed that on average, M&A buyers lose out and tend to overpay.
You can see the complete oral argument here (under the June 7, 2017, listing; DFC Global Corp. v. Muirfield Value Partners).
We will post again when the court issues its decision.
**As previously noted, this law firm was counsel of record on one of the amici briefs filed in this case.
In anticipation of tomorrow’s oral argument before the Delaware Supreme Court, Law360 published this piece offering insights into what may lie ahead for appraisal rights after the DFC Global and Dell appeals are decided.
Further to our prior post about Delaware’s two new appraisal decisions, SWS Group was a small, struggling bank holding company that merged on January 1, 2015 into one of its own substantial creditors, Hilltop Holdings. Stockholders of SWS received a mix of cash and Hilltop stock worth $6.92 at closing. Vice Chancellor Glasscock rejected the sale price as an unreliable indicator of fair value and performed his own DCF analysis, setting the fair value at $6.38, a price 7.8% below the merger price.
At trial, the petitioners persuaded the court that its critiques of the sale process were valid. However, the stockholders failed to persuade the court that SWS was on the verge of a turnaround, as the court instead determined that SWS consistently underperformed management projections and, given its structural problems, a turnaround was simply unlikely.
Problems with SWS’s Projections and Performance
As was true in PetSmart, SWS had not historically performed long-term projections, but only created annual budgets that aggregated projections from individual business sectors. Those single-year projections were then extrapolated into three-year “strategic plans” that assumed the annual budgets would be met. The court found, however, that SWS never met those budgets between 2011 and 2014. Also, despite straight-line growth assumptions in the management forecasts, SWS failed to hit its targets and continued to lose money on declining revenues. The various problems facing the company led the court to embrace the respondents’ theory that SWS would continue to face an uphill climb given its relatively small size, which prevented it from scaling its substantial regulatory, technological, and back-office costs.
Hilltop’s Influence on the Sale Process Rendered Merger Price Unreliable
Even before SWS launched its sale process, Hilltop was interested in buying the company (unbeknownst to SWS). Also, since Hilltop had observer status on SWS’s board, it had unique access to SWS’s board meetings and management not available to others. The court found that Hilltop’s acquisition theses were driven by synergies, as it viewed its acquisition of SWS as resulting mainly in cost savings by reduction of overhead. A Special Committee was formed after Hilltop made its initial offer in January 2014, and the court found that even though the committee engaged legal and financial advisors, the management projections that evolved in the sale process were still overly optimistic and unrealistic about SWS’s projected growth. Only two other bidders emerged, one of which was found not to be credible and the other continued to bid through March 2014 despite apparent pressure by Hilltop to proceed with its deal. Finally, in response to Hilltop’s unilateral March 31, 2014 deadline, the board decided to accept its offer, which at that time was valued at $7.75, consisting of 75% Hilltop stock and 25% cash. As of closing on January 1, 2015, the value dropped to $6.92 per share based on a reduction in Hilltop’s own stock price.
Another factor making the deal price unreliable was that Hilltop was a creditor of SWS pursuant to a Credit Agreement. That agreement contained a covenant prohibiting SWS from undergoing a “Fundamental Change,” which was defined to include the sale of SWS. The agreement thus conferred upon Hilltop a veto right over any competing offers, which right Hilltop refused to waive during the sale process.
Valuation Model & DCF Inputs
The court undertook its own DCF analysis, on which it relied exclusively. The court refused to put any weight on petitioners’ comparable companies analysis, finding that the comp set diverged too much from SWS in terms of size, business lines, and performance to be meaningful. The court held that SWS’s unique structure, size, and business model – particularly its composition of a broker-dealer business alongside its banking line – rendered the stockholders’ selected peers not truly comparable.
In performing its DCF valuation, the court used the existing three-year projection period in the management projections, rejecting the stockholders’ argument that SWS had not yet reached a “steady state” and that an additional two years was needed to normalize SWS’s financial performance. The court found that SWS’s declining revenues in the period leading up to the merger deprived it of any basis to assume (unprecedented) straight-line growth beyond the existing three-year projection period. In addition, the court found that the exercise of warrants three months prior to the merger pursuant to the Credit Agreement, which resulted in a change to SWS’s capital structure by cancelling debt in exchange for new shares, was part of SWS’s “operative reality” for purposes of the fair-value determination. This ruling differed from other cases, such as BMC Software and Gearreald, where changes to the company’s balance sheet resulting from actions by the company solely in expectation of the merger – like the company paying off its debt – was not considered to be within the company’s operative reality.
As to the other DCF inputs, the court adopted the respondents’ perpetuity growth rate of 3.35%, which was the midpoint between the long-term inflation rate of 2.3%, and the long-term economic growth rate of 4.4%. In selecting the appropriate equity risk premium, the court observed that whether to use supply-side or historical ERP should be determined on a case-by-case basis. Nevertheless, it found supply-side ERP appropriate as the “default” method in recent Delaware chancery cases, unless a party provided a compelling reason to use historical ERP. With regard to beta, the court found fault with both side’s approach. The respondents’ expert looked at two years of SWS weekly stock returns, which measurement period included a “merger froth” and too much volatility to be reliable. The petitioners’ expert, in contrast, surveyed multiple betas and used a blended median; even though the court found that this approach relied on comparable companies that were not truly comparable, it nevertheless adopted this beta – despite its apparent drawbacks – as the one more closely in line with the record evidence. Finally, to determine size premium, the court took the midpoint of both side’s decile (which was 3.46%), finding that using market capitalization is generally appropriate for public companies (the respondents’ approach), and yet SWS’s capital structure, including its substantial in-the-money warrants and the outsized influence of its major creditor, made it more like a private company and not susceptible to a market cap approach (the petitioners’ argument).
In reaching its final determination of $6.38, the court said that a sub-merger price award was not surprising here given the synergistic nature of the transaction. Also, given the award of statutory interest, which runs from the January 1, 2015 consummation date, it appears that the petitioners will ultimately recover more than the merger price after all.
Further to our prior post on the recent PetSmart decision, we wanted to highlight some key factors that led the court to peg its fair value determination at the merger price. In PetSmart, the Delaware chancery court found that the sales process, while not perfect, was good enough to produce a reliable indicator of PetSmart’s fair value. The court recognized that its statutory obligation to consider “all relevant factors” did not end with its finding that the merger price was a reliable indicator of fair value; on the contrary, it needed to consider the reliability of a DCF or any other valuation method it could use to reach its final determination of fair value. In looking at the viability of other valuation methodologies, including mainly a DCF analysis, the court found that a DCF valuation would not be reliable since management had not historically created long-term projections and the projections that were created for the sales process, apparently at the Board’s insistence, were too aggressive to be reasonable. And none of the other projections prepared outside of PetSmart (e.g., by the buyer) reflected PetSmart’s “operative reality” for purposes of appraisal.
The pet specialty retailer had announced in August 2014 that it was pursuing strategic alternatives, including a sale, and received final bids in December 2014. A private equity firm, BC Partners, paid $83 per share in cash for PetSmart stock, and the merger closed on March 11, 2015. Among the factors cited in the court’s decision, based on the record at trial, were the following:
Management’s projections were flawed.
- Management had never before prepared long-term projections;
- When the Board tasked management with preparing long-term projections, the process was vastly different than the process previously employed to prepare short-term (one-year) budgets following PetSmart’s so-called Summer Strategy meetings;
- Even the short-term projections historically created were not reliable, and the company routinely underperformed relative to those projections;
- On top of these factors, the projections were prepared under time pressure, as the board rushed management to prepare them (the Base Case was prepared in the span of a few days, and the Base-Plus Case prepared “extremely quickly”);
- The final set of projections presented to the board — the Management Projections — were aggressive to the point of “bordering on being too aggressive,” and approaching “insanity;” and
- This was an outgrowth of the fact that the Board had pressured (inexperienced) management to prepare increasingly aggressive and unrealistic long-term projections.
The sales process was robust.
- The company’s financial advisor, JP Morgan, spoke with 27 potential bidders, 15 of which signed NDAs and five of which bid by October 31, 2014; four of these bids were $80/share or higher;
- Parties that chose not to bid saw “significant execution risk” in PetSmart’s business and “inadequate potential for upside growth”; and
- The court found Petitioners’ criticism of JP Morgan’s fairness opinion unsupported by the evidence, as JP Morgan had no preconceptions or pre-designed result and worked up its WACC or other component analyses thoroughly and objectively.
Post-announcement, PetSmart’s business was still sagging but “ripe” for a turnaround.
- BC Partners found that PetSmart had been “undermanaged” and could be revived by a new management team;
- Management projections were “not achievable,” at least not with current management in place; and
- BC Partners’ equity syndication memo sent to potential investors included a more conservative “BCP Case” with lower total revenues and year-over-year sales growth and fewer new store openings for the five-year projection period.
In sum, the court’s apparent takeaway was that the deal was fairly shopped and the PE buyer was able to add value through its post-closing strategy, including replacing management and making other changes in plans. In contrast, any DCF that was based on the management projections — which the court found to be unreliable, unrealistic, and not prepared in the ordinary course — would likewise be tainted, and the court was unwilling to rely on a “garbage in, garbage out” valuation methodology. The court thus chose to “defer” to the merger price based on the evidence before it.
The Delaware Chancery Court just issued two significant appraisal rulings, the PetSmart opinion on Friday — awarding petitioners the merger price — and the SWS Group decision on Monday, which actually awarded stockholders less than the merger price. We will post separately about our observations on these rulings.
In the meantime, one immediate reaction is that these decisions might factor into the Supreme Court’s approach to the DFC Global appeal and the upcoming argument in that case on June 7, as the trial judges have again proven that they are ready and willing to peg their fair value award at — or even below — the merger price, without a mandatory Supreme Court rule that might require a merger-price determination result if the sale process proved to be sufficiently robust.
Conyers Dill & Pearman, a firm whose work we’ve noted before has a further update on Cayman appraisal rights. Examining the over 100 page decision in In the matter of Shanda Games Limited (FSD 14 of 2016, 25 April 2017), Conyers Dill recaps the case, including the valuation approach, discount rate, as well as the Cayman court’s consideration of Delaware law. Of particular interest to U.S. appraisal, Conyers Dill notes that the Cayman court determined that the Cayman appraisal statute and the Delaware statute had similar “core concepts and terms” – and the Cayman court referenced Delaware decisions in its ruling.
** Lowenstein Sandler LLP does not practice in the Cayman Islands. We thank Bernadette Carey of Conyers Dill for bringing this work on Cayman appraisal to our attention and thank the authors at Conyers Dill for their coverage of this area.
The Faculty of Law at the University of Oxford are holding an event on May 12th entitled “Valuation, Growth, and Appraisal Arbitrage” with Professor Richard Booth of Villanova Law School. We’ve previously posted on Professor Booth’s work regarding appraisal. If your company, firm, university, or otherwise is holding an event regarding appraisal, please do feel free to let us know by emailing firstname.lastname@example.org or email@example.com.
This piece by Law360, “Appraisal Actions May Be The Next Frontier For PE Shops,” discusses a range of reactions to the closely watched rulings in the DFC Global and Dell appraisal cases currently on appeal before the Delaware Supreme Court. Some commentators see the appraisal strategy becoming more attractive to private equity funds as the valuation methodologies used by the Chancery Court become more refined and formulaic, while critics write off the increase in appraisal activity as a natural outgrowth of the diminished appeal of fiduciary duty litigation.
This Bloomberg BNA piece, “Dealmakers Eye Safeguards Amid Rising Valuation Challenges,” observes the spike in appraisal activity and queries whether M&A buyers are taking added steps to address appraisal risk.