Caveat Emptor: Distressed M&A (legal perspective)

Since the 'hot' area of M&A has become distressed companies, I thought it would be apropos to make a post on the topic. This post comes courtesy of a recent Cooley Godward article.

Risks to BuyCo

1. Indemnification Largely Ineffective. By its nature, BuyCo in a distressed sale cannot avail itself of the Definitive Agreement's indemnification provisions. Practically speaking, BuyCo must "get it right" when the deal is struck because there is little opportunity to cry foul if/when the deal goes sour. TargaCo won't be around!
2. Fraudulent Transfer: Trap #1 that BuyCo may find itself in. If BuyCo's purchase is structured incorrectly, then the creditors of TargaCo may be able to "reach through" the transaction and sue BuyCo for its accounts receivable. The actual Minnesota law on the subject says a transfer made by a debtor is fraudulent if the debtor made the transfer "with actual intent to hinder, delay, or defraud any creditor of the debtor." s513.44(a)(1). The law prescribes a laundry list of 11 factors to determine "actual intent". s513.44(b)(1-11). More generally, if a transfer makes the seller insolvent, then creditors may pursue BuyCo to satisfy their claims against TargaCo. Importantly, the existence of a fraudulent transfer trumps indemnification provisions. Thus, BuyCo may be held liable even though BuyCo and TargaCo expressly provided otherwise in their Purchase Agreement. The fraudulent transfer doctrine is an attempt by courts to prevent corporations from evading their actual debts.
   
3. Successor Liability: Trap #2 that BuyCo may find itself in. The general rule in M&A is that successors aren't responsible for the actions of their predecessors. But exceptions exist - especially in the distressed company setting. One such exception is the generic merger. In a merger, BuyCo is assumed to have taken on the liabilities of TargaCo. This is the primary reason why lawyers never structures M&A transactions as a plain-vanilla merger (but instead use a subsidiary and either a reverse or forward triangular merger). This is true even when the words of a purchase agreement state that it is not a merger -- courts look to the circumstances of a transaction, rather than its title, to determine whether a de facto merger has in fact occurred. *** In some states (though not MN), a successor may find itself liable if the court finds that there has been a "continuity of the enterprise." *** The bigger danger is the "product line" exception. Under this rule, a successor is liable if BuyCo acquires all or substantially all of the manufacturing assets of another company, and undertakes essentially the same functions as the predecessor company. Ray v. Alad Corp., 560 P.2d 3 (Cal. 1977). *** If BuyCo is found liable as a successor, it may be required to pay for the taxes, environmental claims, employee claims, or product liabilities of its predecessor.
   
4. Result of the Risk: Due Diligence must be Excellent. Because the reps & warranties are not meaningful in a distressed setting, the legal (and financial) due diligence must be excellent. There is no room for error. Careful buyers should consider obtaining releases from creditors of TargaCo.
   

Benefits to BuyCo

1. Low Price AND Low Liability. When structured well, BuyCo can purchase a company for a great price and avoid assuming liabilities that would otherwise be impossible to avoid.
2. s363 Sale. 363 sales are a method of purchasing a company through Section 363 of the Bankruptcy Code. It is faster, less expensive, and carries less risk than buying a company out of a Chapter 11 plan. Most importantly, the transfer is blessed by the court. Thus there is no risk of liens/encumbrances/fraudulent transfers/successor liability. A s363 does not require approval by TargaCo's shareholders. *** s363 sales are always done through an Asset Purchase Agreement, since APAs allow buyers to pick-and-choose which liabilities they will assume.
3. Other Options. There are other options in the distressed setting, including the Assignment for the Benefit of Creditors (ABC) and a Friendly Foreclosure. Like anything else, there are goods and bads to each option.
   

M&A 101, by Faegre & Benson

I attended an excellent M&A overview by Faegre & Benson last Thursday. The event was organized by the Private Equity Alliance of Minnesota.

The most impressive part of the evening was that Faegre distilled a very complex topic into sixty minutes. It was a 35,000-foot overview of the subject.

There are 6 areas of M&A law. In chronological order, they are:

1. Confidentiality agreements
2. Letters of intent
3. Legal due diligence
4. Deal Structure (most complex, and merits a separate blog posting)
   
5. Definitive Agreement, and
   
6. Indemnification provisions

Here are a few highlights from each of those areas:

1. Confidentiality Agreements. There are actually two distinct CAs: the initial one between the company and its banker, and the subsequent CA between the company and various potential suitors.
   

• The purpose of the CA is to limit the consequences of TargaCo revealing sensitive information. The CA will state what purposes the recipient of the information may use the information for. This is especially important to prevent competitors of TargaCo from acting interested so that they can obtain proprietary accounting numbers from its competitor.
  
• The CA may further require that recipient must destroy the information within a certain amount of time.
  

2. Letter of Intent -- The legal due diligence comes after the business due diligence.

• The lawyers will look at all the "nooks and crannies" of TargaCo's contract and ensure that there is nothing in those contracts that would spoil the benefits of the transaction.
• Especially when TargaCo is a family-owned business there can be unusual terms from previous contracts. Common examples include determining the severity of existing lawsuits, determining what the change in control might trigger (parachute payments, rights of first refusal, or key supplier agreements).
  

3. Transaction Structure

• This can be complicated and confusing.
• To clarify, remember Bruce Engler's clarifying statement that "at the end of the day, the transaction must be either a stock deal or an asset deal."
• To be more thorough, there are two necessary steps for a transaction: 1) the consideration received (stock or assets), and 2) deal structure (reverse or forward triangular).
  

4. Definitive Agreement

• This document "sets in stone" the deal.
  
• It will be either a Stock Purchase Agreement or an Asset Purchase Agreement.
  
• All the information gathered in due diligence and structure strategizing (from accounting and tax standpoints) are brought to bear on this document.
  
• It articulates the purchase price and the composition of that price (cash, stock, debt, seller notes), the reps and warranties, covenants, conditions to closing, and indemnification provisions.
  
• Here are 2 interesting aspects to definitive agreements:

1. The reason why there is often a gap between signing and closing (an Executory Contract) is that, subsequent to signing there remains the need to get financing, third-party consent, or a Hart-Scott-Rodino filing is necessary (when deal size is greater than $70 million).
   
2. Covenants are much different than conditions to closing. A condition to closing, if not met, severs any obligation to fulfill the contract. It is much harsher. A covenant, in contrast, cannot break the fulfillment of the contract.
   

5. Indemnification Provisions

• Indemnification provisions are promises made by both parties in the Definitive Agreement that obligates the party to "make whole" the other party if what they said in the Definitive Agrement isn't true. If a rep/warranty of covenant is breached, the indemnification provision is the ex ante term the parties look toward to resolve their dispute.
  
• The most important term of indemnification is the basket:

1. Baskets set the threshold number when liability will accrue. There are both "deductible" and "dollar one" baskets.
2. In a deductible basket, the guilty party pays every dollar above the basket for the breach. Thus, if there was a $100 deductible basket and $120 in damages, the party would owe $20. Deductible baskets occur 78% of the time that a basket is present.
   
3. In a dollar one basket, the guilty party pays every dollar from "dollar one" once the threshold is crossed. Thus, if there was a $100 dollar one basket and $120 in damages, the party would owe $120. Dollar one baskets occur 22% of the time that a basket is present.
   

My visit to KKR

I took this photograph on Saturday while at KKR's 42nd floor office in Manhattan's Solow building. Not a bad view of Central Park!



I spent an hour speaking with an acquaintance who is an associate at the firm. Our conversation ranged from his career, (he was a St. Thomas undergrad in finance) to the last 2 years working in the capital markets, and from KKR's business strategy to its upcoming Dutch IPO. It was an excellent learning opportunity.



I also got the chance to pick up KKR's 2008 Annual Review and have spent a number of hours reading its contents.



While KKR does not have an office in MPLS, I thought that there is valuable information for us MPLS dealmakers to glean from the most respected private equity firm in the world.



In that vein, here are a few of my thoughts from my visit:

Point #1: The Public/Private Irony. Private equity firms argue that companies 'win' when they go private because they are not subject to the public scrutiny required by 8Ks, 10Ks, and the incessant need for manage earnings. Instead, the argument goes, companies can focus on creating long-term value. They can make investments now (R&D, or PP&E) that have long-term payoffs later. So, "it's better to be private" the argument goes.

But KKR has been trying for years to go public. In summer 2007, KKR filed with the SEC to issue a $1.25 billion ownership stake in its management company (this occurred 2 weeks after Blackstone's IPO). They pulled the offering after the credit crunch, and are trying to perform a reverse merger of its Euronext affiliate, KKR Private Equity Investors.

So how can PE funds legitimately say that going private is best, but still go public themselves? Isn't this a double-standard? No, it is not. I believe there is a legitimate reasoning, and it can be summed up in one word: funding.

The funding of private equity firms is likely to be very difficult for the next couple years. PE funds' investors are "LPs" (limited partners -- usually accredited investors under "Reg D"). The actual identity of these investors is almost always institutions: university endowments, pension funds, and HNW (high net worth) families. The money managers that run these funds usually have a specific sector allocation: 40% US equities, 20% fixed income, 10% private equity, etc.

Now, think of how quickly the value of some of those sectors get reported: at the end of every trading day, a money manager knows exactly how much his US equities portfolio is worth. But he does not know what the PE portion of his portfolio is worth -- those assets are not publicly traded. The result of this difference in reported valuations in the context of the Fall '07- March '09 selloff is that the percentage of a money manager's portfolio allocated to private equity has significantly increased in the past 18 months.

What does this mean for the manager of a private equity fund? It means that he will have a much more difficult time convincing LPs to provide new money into the manager's fundraising efforts. Liquidity dries up. This is especially pernicious when you consider that corporate valuations have come down, and PE managers may be spotting good investment opportunities.

So -- getting back to KKR -- the primary reason I believe that KKR is going public is so that it can quickly raise capital in a poor fundraising environment. Unlike at Blackstone, KKR's senior partners (Roberts and Kravis) are not selling any of their ownership in the fund. (Pete Peterson, founder of Blackstone and former CEO of Lehman brothers, did sell his ownership and received a $1.5 billion dollar check in the mail. ("pre-tax!", he reminds people -- see his Charlie Rose interview for more from him))

Point #2: Diversification. A second interesting point regarding KKR is its effort to diversify its abilities so that it can a) find new ways to develop cashflow and b) distinguish its capabilities from other firms. Put simply, KKR is not your regular buyout firm. KKR is increasingly providing a full suite of financial capabilities, including:

1. KKR Asset Management (KAM). In December 2008, KKR launched KAM to make investments across the entire capital structure of companies. The bulk of its assets are in senior secured (80%), but there is also high yield (15%) and second lien/mezz (5%). The thinking here is that, with capital markets still tepid, corporations will have a 'financing gap' that may be increasingly filled by non-traditional lenders like KAM.
2. Global Infrastructure Group (GIG). The GIG is an "upgrade" of the firm's energy industry team, and represents KKR's realization that there is a large global need to invest in infrastructure. KKR estimates that infrastructure -- especially in Asia where it has recently opened offices -- is a $3.0 trillion/year industry.
3. KKR Capital Markets (KCP). KCP supports transactions in its private equity, KAM and GIG. It's essentially an in-house investment bank that ensures dedicated banking services are available to all portfolio companies and retains the transaction fees that would otherwise go an I-bank. Among its capabilities are 1) raise debt/equity financing in public/private markets, 2) provide strategic capital market advice, 3) provide hedging strategies, 4) provide insight into adjusting/deleveraging capital structure, and 5) underwrite security offerings.
4. An "in-house global public affairs capability." With public scrutiny of large corporations getting stronger every day, KKR has astutely formed a team to address various stakeholder interests. The purpose of this group is to further the due diligence on a potential acquisition (or assist a portfolio company) on environmental, social, and regulatory issues.

In summary, KKR is expanding the types of services it provides so that it can ensure money is coming in the door, even when that money is not coming from its LPs. Additionally, providing these services makes KKR a more attractive suitor since any offer by KKR is accompanied by a best-in-class public affairs and capital raising teams.

While most Minneapolis firms are not large enough to provide this array of financial services, it is useful to see the strategic changes KKR is making amidst the chaning economic climate. Smart firms should consider how they can be making necessary adjustments too.