While we are in a contemplative mood with respect to what may happen in 2012, I turned to the topic of mergers and acquisitions. Cleary Gottlieb Steen & Hamilton LLP recently published an advisory about what boards of directors may face in 2012, and one of the major topics was 2012 mergers and acquisition activity. Below is an excerpt from the advisory.
M&A in 2012 – Significant Opportunities … and Risks
While the first half of 2011 continued 2010’s M&A growth trends, growth stalled in the second half leading to only a very modest uptick for the full year. Spin-offs were the one type of transaction that attracted substantial interest last year, as companies decided (sometimes on their own, but sometimes with prompting from activists or other investors) that their businesses would generate better returns and have better prospects if split into two or more companies.
There is reason to expect growth in deal activity in 2012, despite current market and economic challenges. Prospective acquirers have substantial cash resources and reasonable or even strong stock prices, banks are willing to lend for at least some acquisitions, private equity firms have significant unused investor commitments, and hedge funds are actively seeking positive results. In this environment, directors should be mindful of whether the company’s current condition presents opportunities for it and its stakeholders.
- Seller’s market. Interest rates remain low, potential strategic partners looking for synergistic mergers may have significant cash reserves, and financial sponsors are eager for deals. All this suggests that advantageous pricing may be achievable for companies considering a sale of control or selected divestitures. Firms considering strategic sell-side transactions must review the current financial state of the firm, markets, likely bidders and antitrust or other regulatory uncertainties. Careful planning for any transaction process in light of legal requirements is also important. Among other things, boards pursuing these transactions should be sensitive to, and take steps to prevent or limit, potential conflicts of interest on the part of their financial advisors. Recent developments also confirm that antitrust considerations are not solely a buy-side concern.
- Acquisition risks. For companies considering acquisitions, directors must do their homework to understand the business being acquired; integration challenges and plans, including anticipated positive and negative synergies; antitrust or other regulatory risks, both in the United States and overseas; and financing, litigation and other consummation and post-closing risks. For example, acquiring a company that turns out not to be compliant with the Foreign Corrupt Practices Act or similar foreign statutes or regulations (whether or not it was subject to those provisions prior to being acquired), can result in expenses to investigate and fix the problem, loss in income from possible changes in the target’s business model and the payment of fines. In the aggregate, these costs can dwarf the purchase price of the acquisition.
- LBO activity. With financial sponsors on the prowl for opportunities, management teams across a variety of industries may be approached about potential leveraged buyouts. Also on the prowl, however, are plaintiffs’ law firms, which are well aware that a flawed LBO process will create significant legal pitfalls for the target’s board and give rise to potential claims. If a board believes its CEO is likely to be approached by a financial sponsor, the CEO should be instructed to advise the lead independent director immediately of any approach. Appropriate protocols should then be put in place to assure that any process is actively supervised by the independent directors.
- Defense review. The past two years have witnessed a modest but meaningful amount of hostile deal activity and shareholder insurgency, as well as negotiated deals disrupted by interlopers. Given this activity, directors of potential targets should consider a review of their defenses to understand vulnerabilities and be prepared to move quickly to fulfill their fiduciary obligations. One difficult decision faced by some boards this year relates to the renewal or non-renewal of a shareholder rights plan scheduled to expire. In reviewing these plans, boards should take into account potential threats to shareholder interests that may justify such defenses, as well as the policy of ISS to recommend “no” or “withhold” on director nominees who have voted to extend a right plan and the policies of other relevant institutions. Some companies have rights plans “on the shelf” that a board can consider adopting quickly if appropriate when faced with actual hostile activity. But the “on the shelf” approach is not entirely satisfactory for many smaller companies or even for some larger companies, given the expanded use of derivatives by some investors to establish a large economic position that can effectively be converted (after regulatory clearance) into a large ownership position. Nevertheless, given the ISS policy and similar positions of some institutions, it is not surprising that almost 80% of companies with rights plans scheduled to expire in 2011 allowed them to expire, and a majority of the extensions were for periods of two to five years rather than the once-standard ten years.
- The vision. In any contest for control, a company’s strategic plan will take center stage and may very well prove to be the determinative factor. In order to mount an adequate defense against any unsolicited offer or proxy contest – and for more basic reasons of oversight – the board should ensure that the company’s strategic plan is current, has adequate support in company and market data and reflects the best judgment of management.
Balance Sheet Management and Vulnerability to Insurgency
The ratio of liquid assets to total assets of non-financial institutions in the United States is the highest in over 50 years. Feeding this fattening of the balance sheets are a historically low level of business investment relative to pre-tax corporate profits and, in some cases, issuances of debt at low cost without any near-term plans for use of proceeds. While the financial crisis of 2008-09 and subsequent economic uncertainties may have led to this situation, directors should now be asking how much longer their companies can justify retaining significant excess capital on the balance sheet. Indeed, directors should be asking how much longer investors will tolerate this trend. A common misconception is that hedge fund insurgents target only underperforming or distressed companies. In fact, one recent study concluded that the boards and managements that are most frequently attacked in activist filings on Schedule 13D are those overseeing companies characterized by steady cash flows and healthy balance sheets. Directors should be carefully considering:
- Whether to invest more in the business;
- Whether to engage in more strategic acquisitions or similar transactions;
- Whether to return more value to shareholders through share buybacks and dividends; and
- Whether to incur more leverage to have additional flexibility to do any or all of the above.
Studies have shown hedge fund activists to be highly effective at inducing increases in leverage, share buybacks and dividends. The same studies have shown that, despite the frequent adoption by hedge fund insurgents of the moniker “operational activist,” very few of them have proven to be particularly adept at causing improvements to the operating performance of companies. But when a board is perceived to be “standing still” on top of a healthy and growing balance sheet, activists will not hesitate to enter the scene to advocate changes to the board, management and strategic plan. Boards should explore, and push outside advisors and management to help them understand, whether more aggressive uses of excess capital may be appropriate and communicate their conclusions and reasoning to investors. This effort may do more than traditional anti-takeover mechanics to protect a company from interference by an activist who purports to know more than the incumbent directors and management about how to run the business and who, in the face of a seemingly passive board, may generate enough momentum to steer the company in radical directions that are not prudent. Despite the challenges of macroeconomic and industry uncertainties, by focusing appropriately on these issues in advance, boards may be able to reduce the likelihood of activist campaigns or have more credibility with investors if a campaign is launched.
Click here to read the full advisory.
Other M&A Predictions
Other resources regarding M&A activity in 2012 include:
- Citing steadier stock and credit markets steadier, cheap financing and the large amounts of cash on corporate balance sheets, Evelyn M. Rusili writing for the NY Times, notes that companies may need to make acquisitions to drive growth in 2012 in the face of a tepid economy. These factors, together with pent-up demand among buyout shops may fuel M&A in 2012. Tempering these forces in 2012 is uncertainty regarding the European financial system and the uncertainty inherent in a U.S. presidential election.
- According to Ernst & Young LLP’s Transaction Advisory Services, strong fundamentals, which include robust cash positions, strengthening balance sheets and improved credit markets, combined with a mounting pressure for growth in a low organic growth environment, should generate an uptick in deal flow in 2012.
- Financialtimes.com contains a section dedicated to analysis of M&A activity in 2011 and trends in 2012.