Types of Debt Funding

In the vast majority of cases, debt used in the acquisition of a company is underwritten by a bank. The debt is structured into several different tranches until the transaction is consummated. It is expected that some bank debt will be repaid immediately after the completion of the merger; other debt will be replaced by bonds later on. There are three principal uses for the debt:

1. Repayment of existing debt that becomes due under change of control provisions.

   In the United States, a common form of protection for lenders against the risk of an increased debt load after a buyout are change-of-control clauses. If the ownership changes, the debt becomes due immediately. The lender can waive this provision in circumstances where the debt load is not overly burdensome, and the debt remains outstanding. However, in most mergers, lenders seek repayment. This is even more so the case in leveraged buyouts because creditors can get higher interest from new, more risky debt issued under buyout conditions. High-yield bonds often require redemption at a premium if a change of control occurs. If a bond would normally be redeemed at par, the redemption price under a change of control provision is often 101 percent, of course plus accrued interest. Sometimes early redemption under change-of-control clauses is subject to a sliding scale, where the premium is higher in early years and declines later. Change-of-control covenants are used widely in debt of U.S. companies and have been introduced only recently into European bonds after bondholders suffered losses when issuing companies were bought up and suffered from downgrades when they took on additional debt.

   In Europe, straight bonds generally are not issued with change-of-control clauses. This can be a problem for bondholders, as was the case in the acquisition of ISS Global A/S (Chapter 8). Convertible bonds, however, do have change of control provisions. The rationale is that convertible bonds usually are issued at a premium. If they were redeemed at their conversion rate if the company is acquired shortly after issuance, bondholders would suffer a loss. In order to offset such a loss, the conversion ratio is increased in the case of a change of control. Exhibit 7.1 shows an example of such a change of control clause in the case of the 2.5 percent convertible bond maturing on April 7, 2018, issued by Celesio AG, which was acquired by McKeeson in 2014, triggering the change-of-control clause. The bond started accruing interest on April 7, 2011, which gives 2,557 days until maturity. The change of control occurred on January 28, 2014, or 1,530 days before maturity. Using these numbers as well as the formula and numbers from Exhibit 7.1, the new conversion price following a change of control can be calculated to be

   7.1

   On a €100,000 face value bond, the number of shares a bondholder would have received upon conversion was 4,448 (which is 100,000 / 22.48, the initial conversion price). Following the change-of-control adjustment, the bondholder will receive 801 additional shares. The new number of shares is 100,000/19.05, which is 5,249. At an acquisition price of €23.50, this corresponds to an additional value of €18,823, or almost 19 percent. Considering that prior to the announcement of the merger on October 24, 2013, the bond had been trading at a price of 118 percent of face, the change-of-control clause worked exactly as it was supposed to in compensating holders of the bond for the premium they would have lost had the bond been redeemed at par.

2. Payment to selling shareholders.

   The payment to acquire the shares held by the previous shareholders is the biggest expense in a merger. Most public companies have a low level of leverage, and the value of the equity represents the biggest portion of the acquisition value. Only in distressed acquisitions will payments to equity holders be less than debt. However, such transactions tend to pose too much risk to be suitable for arbitrage investments.

3. Transaction costs.

   Expenses for investment bankers and lawyers as well as smaller items such as Securities and Exchange Commission (SEC) filings fees and shareholder solicitation represent several percent of the total cost. Investment banking fees are by far the largest element of these costs and typically amount to 5 percent of the value of the transaction. Golden parachute payments for managers are also a form of transaction costs.

Investors in debt are mainly concerned with getting paid back. Unlike investors in equity, their upside is limited to the interest received, while their downside risk is the entire loan amount. The interest charged on a loan will depend not only on the riskiness of the underlying venture but also on the order in which the debt is repaid. Every homeowner knows that the interest charged on a mortgage is less than that for a home equity line of credit because the risk of loss is higher for the latter than the former. The same principle is true for debt used in the financing of mergers. We will digress briefly to discuss the hierarchy of repayment for different types of debt if a company goes into default.

Here is a list showing the priority of claims (highest to lowest) in a chapter 11 bankruptcy proceeding, which are the bankruptcy proceedings in the United States. Similar priorities have been established in bankruptcy and insolvency proceedings in numerous other jurisdictions. Outstanding payments with the highest priority are paid first, and any funds left over are then available for the payment of the next priority, and so on.

1. Secured debt, to the extent that the value of the asset covers the associated debt
2. Bankruptcy administrative costs
3. Postpetition bankruptcy expenses
4. Wages, subject to limitations
5. Employee benefit plan contributions, subject to limitations
6. Unsecured customer deposits, subject to limitations
7. Federal, state, and local taxes
8. Unfunded pension liabilities, subject to limitations
9. Unsecured claims
10. Preferred stock
11. Common stock

Lenders will try to make secured loans whenever possible. Unsecured loans are much riskier and are not paid until a long laundry list of other claims has been paid. Banks in particular have enough influence on an issuer to negotiate a senior position for themselves in the capital structure. As a result, most bank loans are secured and traditionally have been held by banks. For some time now, however, banks have been more willing to unload loans, in particular in light of capital regulations. For example, when a company's rating is downgraded, capital requirements for banks increase to the point that a loan may become unattractive. Moreover, banks have taken a more active portfolio and risk management approach to their loan exposures and are more willing to sell loans when they see too much exposure to issuers with certain common characteristics than they would have in years past.

The situation changes for bond financing. Bonds are created with the intention of providing an easily tradeable instrument to investors. Although investment banks underwrite bond offerings, thereby providing guaranteed initial liquidity for the issuer, it is not their intention to hold on to the bonds for a long period of time. Instead, investment banks sell the loans to investors. The multitude of investors who each acquires a small piece of the pie reduces their leverage relative to the issuer. As a result, most bonds are unsecured.

Another important difference between loans and bonds is the regulatory nature of the two forms of financing. In the United States, most bonds are publicly traded and are registered with the SEC. This means that the issuer must make periodic filings with the SEC and comply with numerous regulations, in particular Sarbanes-Oxley. In transactions in which the issuer is going private, the issuance of public bonds would negate some of the advantages of no longer being a public company. This problem can be avoided if the bonds are issued as a private placement; however, the transfer of such bonds is restricted, which in turn negates the advantage of having a bond as an easily transferable instrument.

Financing of Mergers versus Tender Offers

There is a subtle difference in the funding of a straight merger compared to that of a tender offer. Tender offers are completed in a two-step process (see Chapter 4), whereas mergers are closed in one single step. In the United States, the financing of the first step of a tender offer is subject to Regulation T margin rules of the Federal Reserve. At the time the buyer has acquired shares of the target through the tender offer, there are still shares outstanding and traded. Therefore, the buyer is simply a controlling investor in a public company. Banks and brokers are prohibited from financing more than 50 percent of the market value of an investor's holdings if the stock is used as collateral. Therefore, tender offers are funded through unsecured bridge loans or private placements to the extent necessary to comply with Regulation T.

Uncertain Merger Consideration

In most merger transactions, the value to be received by the target's shareholders is predetermined. In a cash merger, a set dollar amount is paid for each share. In a stock-for-stock merger, the exchange ratio is either fixed or fluctuates around a collar. Either way, the value is either fixed or can be computed with reasonable effort through a predetermined formula.

However, there are occasionally transactions, mostly involving smaller companies, where the value that will be received is subject to adjustment in a more complex way than through a simple collar arrangement. These transactions require an extra amount of work by the arbitrageur to evaluate. Sometimes uncertainty can come from adjustments that can be made to the merger consideration based on performance benchmarks. In other mergers, the value of the consideration received can be difficult to determine.

Contingent Value Rights

Contingent value rights have gained in popularity in recent years. For a long period of time they were relegated to the footnotes of merger and acquisition activity. Their most common use, albeit rare, was in the biotech sector where potential outcomes follow bimodal distributions. A notable exception was the acquisition of Information Resources, which stood to benefit from an antitrust judgment.

When Information Resources, Inc. was acquired by private equity funds Symphony Technology and Tennenbaum & Co. in late 2003 for $114 million, it was in litigation with the Dun & Bradstreet Corp., A.C. Nielsen Co., and IMS International, Inc. over certain anticompetitive practices by A.C. Nielsen that had kept Information Resources out of the European market. Information Resources was seeking damages in the amount of $350 million, to be trebled for punitive damages. The trust was structured so that Information Resources' former shareholders would receive 68 percent of all proceeds up to $200 million and 75 percent above $200 million, with the remainder going to the new owners of Information Resources. Due to the highly uncertain outcome of the litigation, the buyers were unwilling to risk paying the public shareholders a large amount that they might not be able to recover if they were to lose the litigation. Similarly, the public shareholders were not willing to sell Information Resources if they could potentially recover an additional $1 billion through litigation.

The CVR paid $0.7152 per share in May 2006, the shareholders' share of the aggregate settlement of $50 million minus expenses. An interesting twist on the Information Resources' CVRs is that they were traded publicly on the over the counter bulletin board. This additional liquidity benefited shareholders who wanted to sell at the prevailing market price. In contrast, escrow arrangements are not traded publicly. It is not possible to liquidate them. Their holders must wait until they pay out.

More recently, CVRs have been used in large transactions. In September 2008, Fresenius Medical Care acquired APP Pharmaceuticals Inc. for $3.7 billion ($23 per share) plus a CVR that would have paid shareholders an additional $6 per share if APP had met certain earnings before interest, taxes, depreciation, and amortization (EBITDA) thresholds over the three years after the acquisition. Unlike the CVRs of Information Resources, APP's were not structured as a trust but as a listed debt security of a subsidiary of Fresenius under an indenture that traded like a stock. Unfortunately, the goals were not met and the CVR expired without any payout. During its lifetime, the CVR had been extremely volatile, a property that appears to be common to these securities.

One such CVR was issued by Sanofi to let the shareholders of Genzyme benefit from the upside of its multiple sclerosis drug Lemtrada. Five payments were to be made upon approval of the drug by the FDA and when the drug sales reach certain milestones (Table 7.1). The CVR had several interesting features: Sanofi agreed to report relevant sales data quarterly, and retained the right to purchase CVRs in the open market—an indication that the company saw the likelihood that this CVR may have payouts. Importantly, in September 2012 Sanofi launched a Dutch tender offer to acquire shares between $1.50 and $1.75 per CVR. Of the 86.8 million CVRs Sanofi offered to purchase, only 40 million shares were tendered. Subsequently, Sanofi was rumored to have acquired shares in the open market. Nevertheless, the CVR was highly volatile, as can be seen in Figure 7.2. In November 2013, the Division of Neurolofy Products of the FDA published a report in which three evaluators expressed concerns about the safety profile of the drug as well as the data from trials. The CVR price fell immediately.

Lemtrada Milestone	Payment ($)	Additional Condition
FDA Approval	1.00	Approval by March 31, 2014
$400 million in sales	2.00	Sum of sales in certain countries within four consecutive calendar quarters following approval
$1.8 billion in sales	3.00	Global sales in any four consecutive calendar quarters
$2.3 billion in sales	4.00	Global sales in any four consecutive calendar quarters
$2.8 billion in sales	3.00	Global sales in any four consecutive calendar quarters
Other Milestone
Year 2011 Production	1.00	Production levels for Cerezyme and Fabrazyme [This milestone was not met]
Maximum Total	14.00	At the time of writing, the maximum was $13 since one milestone had not been met

Another CVR that caught the attention of arbitrageurs is that of Celegene, which is based on sales of the drug Abraxene through 2025. This is an unusually long time for a CVR issued in the year 2010. CVRs have also been used outside the United States. For example, in the £12.5 billion acquisition of British Energy Group plc by the French energy group EDF in the year 2009, shareholders and the acquirer could not agree on the future prospects of the target. By issuing a CVR with a face value of £289 million under the moniker “Nuclear Power Note” the different viewpoints were reconciled.⁴ The CVR is linked to British Energy's output as well as energy prices and EDF is required to make payments for 10 years. However, in the case of the EDF, CVR concerns have been raised about the ability of holders to seek recourse against EDF in the case of a breach of covenants. For now this is a merely hypothetical debate, as no such breach has been alleged. Nevertheless, this uncertainty will remain until a test case is litigated in English courts.

Further problems of CVRs arise from their lack of liquidity. In the past, many CVRs remained untraded, but in recent years CVRs have been listed. Nevertheless, even though the potential payout may be substantial, the low probability of receiving such a high payout means that their market capitalizations remain small. In addition, trading liquidity is limited. As a result, these are securities that are of interest only to a small segment among market participants.

CVRs are efficient and flexible tools that can help shareholders obtain fair value when a part of the business has considerable upside that is very uncertain. Unfortunately, few boards consider these instruments when they negotiate a sale. Many boards are probably unaware of their existence, although their increasing prominence over the last few years is likely to change this. Others are swayed into believing that uncertain outcomes must be discounted into small present values. Although that is correct in a statistical approach, it does not make sense to leave a large windfall to the buyer.

Conflicted Role of Investment Banks

Until recently, the world of finance was separated into two types of institutions: commercial banks that make loans and investment banks that trade and underwrite securities.

This distinction goes back to the instigation of the Glass-Steagall Act in 1933, when commercial banks and investment banks were separated in order to prevent some of the financial disasters that had struck during the Great Depression: Member banks of the Federal Reserve were prohibited from buying securities for their own account and from “issuing, underwriting, selling, or distributing, at wholesale or retail, or through syndicate participation, stock, bonds, debentures, notes or other securities” (Section 16). Similarly, investment banks were prohibited from engaging “at the same time to any extent whatever in the business of receiving deposits” (Section 21). By the 1990s, pressures arising from the evolving nature of the banking business made the separation of commercial and investment banking appear more and more anachronistic. This led to the partial repeal of Glass-Steagall through the Gramm-Leach-Bliley Act of 1999. Interestingly, Sections 16 and 21 were both left unchanged in the repeal. Instead, the two revoked sections, 20 and 32, deal with banks' ownership of investment banking subsidiaries and the interlock of banks' management with that of securities firms. Commentators often miss this subtle distinction.

Today, the goal of commercial banks is to generate fees from both their commercial and their investment banking operations. A good illustration of their business philosophy is provided by former Citigroup CEO Charles “Chuck” Prince, who said, with unfortunate timing just weeks before the 2007 subprime meltdown began, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance.” By mid-2008, Citigroup had written off $69 billion and raised $36 billion in cash, and Chuck Prince was no longer its CEO.⁵

Another separation within financial institutions that is relevant for arbitrageurs occurs within investment banks. It concerns the distinction between the advisory and the underwriting activities of the bank. Underwriters earn their fees from the placement of securities with their clients, whereas bankers earn a fee for advising firms on the takeover. Typically, a banker will:

• Advise the target on strategic options well before a merger has been decided upon; this is often part of an ongoing relationship with the firm's executive.
• Assist the firm in selecting merger partners.
• Help with the negotiations.
• Value the firm and the principal terms.
• Issue a fairness opinion.

Investment banks have gone to great lengths in recent years to separate their underwriting businesses from their advisory activities. In street jargon, Chinese walls or firewalls keep personnel in the different divisions from talking to each other about pending deals. Nevertheless, the walls are not always as strong as one would hope.

In the 2010 acquisition of Rural/Metro Corporation by Emergency Medical Services, the blurring of the distinction between investment banking and commercial banking turned out to become expensive for the Royal Bank of Canada (RBC). It was acting as financial adviser to the board of directors while also providing financing in the acquisition. As a result, RBC would get paid $5.1 million for its advisory services. This conflict in itself is not unusual and might not have mattered had the particular circumstances in this merger not included several additional conflicts. Two directors of Rural/Metro had conflicts of interest that made them favor a rapid sale over a longer-lasting value enhancing process, which the CEO wanted to implement originally. Moreover, RBC was also interested in providing financing for the buyer, private equity firm Warburg Pincus, for which it would receive an additional $20 million in fees. To make matters worse, the parent company of the acquirer was putting itself up for sale at the same time, and RBC stood to earn a further $35 million in fees from that transaction. A potential acquirer of the parent would not participate in an auction for Rural/Metro as it would end up owning the combined entity anyway. This lack of competitive bidding hurt shareholders of Rural/Metro. After lengthy litigation, the Delaware Chancery Court held RBC liable for damages to Rural/Metro shareholders⁶ and might have to pay as much as $250 million once damages are calculated. To add insult to injury, when it came to the financing of the transaction, RBC did not win the mandate and only made its advisory fees of $5.1 million.

To complicate matters further, investment banks often also take on the role of buyer. Aware of the negative perception that clients will get when a bank acts as buyer, adviser, and underwriter at the same time, some investment banks have spun off their private equity divisions into separate firms.

As a result, today banks play a dual role in mergers: They wear the investment banker hat and also that of the provider of financing. As such, they are slowly drifting toward the European banking industry's model of universal banks.

Merger and acquisition (M&A) advice is a major contributor to investment banks' profits and is particularly popular because, unlike trading and principal investments, providing advice requires little capital and hence boosts not just earnings but also return on capital. In the year 2013, global investment banking revenues amounted to $76 billion, of which roughly $17 billion came directly from M&A advisory work.⁷

In most instances, arbitrageurs have little to worry about banks' activities because mergers get funded and the merger closes. In some instances, however, the conflicts within banks will affect the outcome of a merger. Arbitrageurs must be well aware of the potential problems that can arise from the multiple roles that banks play.

A low point illustrating the drive to get the deal done was reached by investment banking legend Bruce Wasserstein in the 1989 sale of publishing firm Macmillan, Inc. in a leveraged buyout to its managers and private equity firm KKR. The litigation accompanying this merger gives a rare and interesting insight into the negotiation process. It is not uncommon for the most dicey aspects of questionable practice to be revealed only in court. How else would shareholders or the public ever know?

What had started as an attempted management buyout⁸ of the undervalued firm Macmillan by its CEO, Edward P. Evans, turned quickly into a full-blown hostile takeover battle when Robert M. Bass, at the time known primarily as a greenmailer and raider, intervened with a $64 per share takeover proposal.⁹ The board had formed a special committee that retained Lazard Freres as its financial adviser. Lazard valued Macmillan at $72.57 per share, but the recapitalization proposal at only $64.15 per share. The investment banking firm Wasserstein, Perella was retained by Macmillan's management as a financial adviser. It advised the board that Macmillan should be worth between $63 and $68 per share, and the board announced a recapitalization plan worth $64 per share in lieu of endorsing Bass's takeover. In response, Bass increased his offer to $73 per share. Only 10 days after their $63 to $68 valuation, Wasserstein, Perella issued a new valuation opinion, now claiming that Bass's $73 proposal was inadequate and that Macmillan was worth more. Lazard also issued a new valuation opinion that came to the same conclusion. The Macmillan board rejected the increased Bass offer.

The distinction between Lazard's role as adviser to the special committee and Wasserstein, Perella's advisory function to the full board is critical. The full board included Evans, who had strong conflicts of interest because he favored a transaction that involved himself and KKR. The special committee, however, was supposed to look out for the interest of shareholders.

Management continued pursuing its own buyout plan and brought KKR into the game. KKR was given access to confidential Macmillan information in order to perform due diligence. In the meantime, another bidder entered the scene: Robert Maxwell made several proposals for cash tender offers for Macmillan, bidding up to $86.60 per share. Management first ignored him but eventually decided to put the company through a formal auction process.

Maxwell knew that he was not welcome and that management preferred to buy Macmillan itself with the help of KKR. He even went so far as to call the auction “rigged.” It turned out that his opinion was correct.

Wasserstein, Perella set out to manage the next round of bidding. Maxwell proposed a $89 per share all-cash buyout, while KKR offered $89.50 consisting of only $82 cash and the remainder in subordinated debt securities. Moreover, the KKR bid was subject to a number of conditions, including lockup and no-shop clauses, that effectively made it impossible for Macmillan to accept Maxwell's bid. Since KKR's proposal had a debt component with face value of $7.50 but uncertain market value, whereas Maxwell was to pay all cash, albeit marginally less, the financial advisers called both proposals a tie.

Macmillan's CEO then called KKR and tipped them off about Maxwell's bid. In order to create an appearance of a fair bidding process, Bruce Wasserstein scripted a text that he read to both KKR and Maxwell. He informed them that he was unable to recommend either bid to management and gave them a deadline for submitting any new offers. However, he gave KKR valuable additional information: They would have to make additional concessions if they wanted a lockup. Maxwell was not informed of KKR's special tip or that Evans had told KKR about his bid.

In telephone conversations that followed, Wasserstein gave Maxwell the impression that he was already the high bidder. Maxwell decided not to increase his bid to avoid bidding against himself. KKR submitted a revised bid of $90 per share. During the day after the auction deadline, negotiations were held with Maxwell and KKR over other aspects of their bids. Only KKR was encouraged to increase its price, which it did to a marginally higher $90.05. Maxwell was left with the impression that he had submitted the highest bid and was not encouraged to submit a higher proposal.

In the board meeting that followed the end of the auction, Wasserstein recommended KKR's bid, even though Wasserstein was the adviser to the full board, including Evans, rather than to the special committee that ran the auction process. Lazard did nothing to intervene. Unaware of the unequal treatment of KKR and Maxwell during the auction process, the board decided to accept the higher bid by KKR. As part of the acceptance, it awarded KKR a lockup agreement that allowed KKR to acquire subsidiaries of Macmillan at a discount, should Maxwell prevail eventually.

In a subsequent SEC filing, KKR disclosed that it had been tipped off by Evans about Maxwell's higher bid during the auction. In response to this information, Maxwell increased his bid to $90.25 in cash. Nevertheless, the board, by now aware of Wasserstein's and Evans's shenanigans, maintained that the KKR proposal was superior to Maxwell's.

In the ensuing litigation, Maxwell scored two victories: He had Macmillan's poison pill¹⁰ overturned and the lockup agreement with KKR invalidated. KKR had already received two-thirds of Macmillan's shares in its tender offer, but following his victory in court, Maxwell was able to complete his tender offer. Shareholders preferred his all-cash bid to KKR's mixed cash/debt payment and withdrew their shares from KKR, tendering them to Maxwell instead.

The Macmillan example illustrates to what lengths some advisers are willing to go to help their clients complete deals that are not in the interests of shareholders. Even though Macmillan is a transaction from 1989, conflicts of interest continue to exist among shareholders, acquirers, and financial advisers. The circumstances today are different than the facts in Macmillan. Few financial advisers will favor their client as openly as Wasserstein did in 1989. But there are other opportunities for advisers to favor one side over another, as will be shown shortly in the discussion about fairness opinions.

A different conflict of interest appeared in the midst of the crisis in the 2007 attempt by shoe retailer Finish Line to acquire its competitor Genesco. Genesco had been the object of a bidding war between Finish Line and Footlocker that saw bids surge from an initial $46 by Footlocker to a winning $54.50 by Finish Line. However, the timing of Finish Line's highly leveraged proposal coincided with increasing difficulties by investment banks to sell merger-related leveraged loans in the secondary market. Finish Line's bankers, UBS, would have suffered a loss if it had sold the loans it had committed to providing Finish Line.

UBS and Finish Line attempted to terminate the merger agreement by declaring that Genesco had suffered a “material adverse effect.” However, the merger agreement had a very narrow interpretation of the term, and it was clear that a material adverse effect did not apply in the case. UBS had to find another excuse to avoid having to fund the transaction.

Two arguments were used against Genesco: (1) that Genesco had committed fraud by not providing Finish Line with financial results for May 2007, which showed its deteriorating performance; and (2) that the combined firm would be insolvent due to the large amount of debt used to finance the merger. Therefore, UBS should not be required to fund the deal.

The courts dismissed the fraud claim, but the insolvency argument was never litigated. Instead, UBS and Finish Line settled the litigation. UBS paid $136 million to Genesco, and Finish Line issued preferred stock to Genesco convertible into 10 percent of its outstanding shares. Instead of Finish Line owning Genesco, Genesco ended up owning a big stake in Finish Line.

The irony is that while UBS was arguing that Genesco had suffered a material adverse effect, it fought simultaneously the opposite battle in the acquisition of Sallie Mae by private equity firm J. C. Flowers. While Flowers argued that Sallie Mae had suffered a material adverse effect, UBS argued that it did not. Had the Sallie Mae acquisition closed successfully, UBS would have made $50 million in fees.

UBS's argument about insolvency is rooted in a real provision of bankruptcy law. There is indeed a section in the bankruptcy code that can be a problem for a secured lender in an LBO. Section 548 is a fraudulent conveyance rule providing that a secured lien can be voided if the company was insolvent at the time the lien was given, or became insolvent as a result of the lien; had “unreasonably small capital”; or incurred debts beyond its ability to pay. To complicate matters further, the definition of insolvency in the bankruptcy code differs from that under GAAP. Under GAAP, a company is solvent when its assets are sufficient to pay debts as they occur. Under the bankruptcy code, however, solvency means that a company must have sufficient assets at fair value to pay all probable liabilities. In a leveraged buyout, this solvency test is much harder to meet because LBOs are structured on the basis of future cash flows rather than present assets, and liabilities often exceed hard assets, in particular if the acquisition price included payment for goodwill and other intangibles.

The recent innovation of stapled financing can also be problematic. Banks advising the target can have an incentive to push the firm to accept a transaction that is not in its best interests, or that has too low a price, because the bank will earn fees from providing financing for the deal. Even if the provider of the financing and the adviser to the seller are not the same bank, it may be to the advantage of the target's adviser to push the transaction if it expects to be part of the syndicate that will provide financing.

The club of banks that provide financing to mergers is a small world involving the same firms and bankers. Banks are well aware that their advisory revenue depends on getting deals done and that their revenue from financing depends on other banks getting a deal done. If one bank advises a target on a deal, it may not be part of the syndicate that provides financing for the same transaction; however, it will be part of future syndicates involving other targets. Because there is a limited number of banks that syndicate financing, no bank can afford to be too harsh in its advisory role, or it would jeopardize its ability to join future financing syndicates.

Fairness Opinions

If Bruce Wasserstein's fairness opinion is an example for the conflicted rule of investment banks, it is also a sign of the sloppy work that sometimes is performed by investment bankers when drafting fairness opinions.

Fairness opinions are issued by an investment bank as an independent party to assure the board of directors of a target that the merger consideration is “fair from a financial point of view.” The use of fairness opinions can be traced back to a Delaware Supreme Court ruling in Van Gorkom, discussed in more detail in Chapter 8, in which it found that a board of directors had not made a good faith effort to take a well-informed decision. The court suggested that reliance on a fairness opinion could have solved that problem.

Today, fairness opinions have become a standard ingredient in mergers, even though the Van Gorkom court stated clearly that they are not a legal requirement. Most boards are unaware of this detail; they are convinced by their advisers that a fairness opinion is needed and believe that it is a checkbox requirement that, if fulfilled, will show that they have acted in the best interests of shareholders. The fairness opinion is provided by the same investment bankers who advise the company on a merger, and they can charge an additional fee for this extra service.

The problem with fairness opinions is, of course, that the same bank that advises the target on whether to merge also provides the opinion on the fairness. If it were to find that the merger is unfair and the merger were not to happen, then the investment bank would be paid less. Therefore, fairness opinions must always be taken with a grain of salt. In many cases, they are irrelevant and constitute no more than bureaucratic paperwork that justifies extra fees.

Fairness opinions will always conclude that a merger is fair to the shareholders of the target. Wasserstein, Perella's opinion about the fairness of the Macmillan buyout, which flip-flopped as the bidding war progressed, is not uncommon. Fairness opinions will go to great lengths to dismiss their own finding that a transaction is actually quite unfair. When Netsmart was acquired by its management team, with the backing of private equity funds Insight Venture Partners and Bessemer Venture Partners, the fairness opinion issued by investment bank William Blair found an implied transaction equity value “by the discounted cash flow analysis ranged from approximately $142 million to $202 million, as compared to the implied transaction price for Netsmart of $115 million.” William Blair then dismissed its own analysis by claiming “that the Discounted Cash Flow Analysis was a less reliable barometer of value than other methodologies based on historical results.”¹¹

This is completely counter to the typical valuation exercises performed in buyouts, where valuation by discounting cash flows is the preferred methodology. Netsmart was going through a rapid growth phase at the time of the transaction. Management forecast annual growth of 14.6 percent for the next few years, with a quadrupling of earnings before interest and taxes (EBIT) and EBITDA growth of 2.7 times. It is clear that a valuation based on historical performance will undervalue a company undergoing such rapid growth and improvement in performance. William Blair's claim that historical methodologies are superior to a forward-looking method such as discounted cash flows can be explained only by its own favoritism of management over shareholders. The litigation about Netsmart's buyout had other important legal implications, which are discussed in Chapter 9.

The fairness opinion usually is rendered by the same financial adviser that has been retained by the target to arrange the sale. The investment bank has two sources of revenue: a percentage of the transaction value, plus a fixed fee for rendering the fairness opinion. Typical fees for fairness opinions range from a few tens of thousands of dollars in small transactions to several hundreds of thousands of dollars in larger mergers. The fee based on a percentage of the transaction size is the larger amount of the two. Therefore, it is not surprising that the fairness opinion will always conclude that a transaction is fair. It would be in the best interest of shareholders if the fairness opinion were rendered by a different firm than the adviser that arranges the transaction. However, under the current disclosure regime, this is not required. Instead, it is sufficient if the fee arrangements are disclosed.

Particularly egregiously misleading are fairness opinions where companies create financial projections specifically to justify a valuation in a fairness opinion. These companies effectively have two sets of books: internal projections that reflect what management really believes the prospects for the business are and external projections that are shares with investment bankers and the board so that a transaction can be deemed “fair.” The author is familiar with instances where this has occurred, and the real projections were revealed only during shareholder litigation. It is possible, and likely, that even the investment bankers were not aware that two sets of books existed.

Due to these problems, it is not surprising that when investors perfect appraisal rights (discussed in Chapter 13), courts normally all but ignore valuations from fairness opinions. Instead, valuation experts are retained to come up with valuations. In theory, these experts simply duplicate the work performed by the investment bank. In practice, however, courts do recognize that fairness opinions are fraught with conflicts to the point that they are of little practical use.

Systemic Risk

So far, the discussion about availability of financing has focused on the funding of the particular merger under consideration. However, there are times when financing is independent of the characteristics of a transaction but becomes difficult to obtain for any merger. This occurs roughly once every decade and is known as a credit crunch.

Credit crunches generally are triggered by poor oversight of banks, whose lending standards decline and who make increasingly risky loans. Some trigger, such as one large default, leads to a sudden reassessment of all lending risks by all banks at the same time. The result is a drastic reduction of the availability of credit.

The merger boom of the 1980s came to an abrupt end when the junk bond market collapsed. First Boston was unable to place $475 million of 15 percent bonds of the Ohio Mattress Company. The junk bond market had been jittery since the bankruptcy of LTV Corporation in 1986, which was the largest bankruptcy at the time. Spreads widened for several months but returned to normal shortly thereafter. By early 1989, the supply of new junk bond issues had increased to levels that made it difficult for the market to absorb at the current spreads. Some high-yield issuers responded by withdrawing their offerings and launching new ones at much higher yields of 15 percent and higher. But even at these levels, Ohio Mattress failed to place its bonds.

The going-private boom of the new millennium came to a sudden stop when the effects of the subprime crisis began affecting banks' ability to fund buyout transactions. At the same time, investors became wary of any debt issued for buyouts and were unwilling to acquire such debt from banks. Therefore, the entire debt-funding machine came to a halt. A chain reaction was set in motion: Funding vehicles such as CLOs or structured investment vehicles were unable to obtain short-term funding in the money markets and had to end their purchases of leveraged loans. This, in turn, left banks with large inventories of loans that could not be sold and whose market prices were dropping. As a result, banks curtailed their lending to leveraged borrowers, which ended many pending buyouts. Figure 7.3 shows the impact of the credit crunch on spreads in the leveraged loan market. Within a few months, spreads widened from slightly over 200 basis points to over 500.