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By Matthew Quinn
CFOZone's Matthew Quinn recently spoke with David Grinberg, chair of the mergers and acquisitions practice group at law firm Manatt, Phelps & Phillips, about current trends in deal making, including the effects of the ongoing tightness in the credit markets. Here's what he had to say:
CFOZone: Tell us about poison debt and why it's become an issue in hostile takeovers.
David Grinberg: It operates sort of like a poison pill. Poison pills are something that a target company adopts that makes it prohibitively expensive for someone to come in and take them over without having the board redeem the pill, because of various dilution issues.
Poison debt works in a similar way. If someone comes in in a hostile transaction and tries to take over another company, what often happens is the change of control provisions in the target's debt will be triggered, which usually means that the debt is accelerated. You in essence have to refinance the debt. But in this tight credit environment, it's very difficult to refinance debt.
That's why they call it poison debt because it operates like a pseudo hostile takeover defense mechanism, simply given the very difficult environment for refinancing certain companies.
CFOZone: How prevalent is this?
Grinberg: Usually most if not all debt has a change of control provision if someone buys more than 50 percent of the company or if more than 50 percent of the board is replaced without the recommendation of the board.
But that provision really only serves as poison debt if it becomes difficult to refinance that debt.
If the company is investment grade and is doing very well, then the poison part of the debt is a lot less of a concern. If the company is struggling and is going to have a hard time refinancing, then it becomes a different story
CFOZone: So how can a buyer get around it?
Grinberg: The idea is to structure the transaction so the debt's change of control provisions aren't triggered.
For instance, one way is to structure the deal as an inverse acquisition where the target is the survivor.
CFOZone: Do bondholders ever take exception to these types of end-arounds?
Grinberg: Not sure it's their choice. It either triggered it or it doesn't. Now, they could make an argument that there's form over substance. But those change of control provisions are drafted very carefully. I'm not sure the bondholders care all that much as long as they're paid. But the problem is that you can't refinance to pay them.
Do they get nervous when you try to do a transaction that gets around the triggers -- that you don't have to pay them, but the company looks a little bit different from when you issued the debt? Yeah, and that's when they may argue form over substance. They may try to get their trustee if there's an indenture trustee to argue that, "Guys, this is really triggering it. You can't do this funny business."
CFOZone: How big of an issue is poison debt?
Grinberg: No longer can you just do a hostile transaction and figure out the debt later. You've really got to realize: number 1) if you're going to trigger the change of control and number 2) are you going to be able to refinance the debt.
Targets' shareholders and board directors are going to be looking at this to address the issue because they understand that the credit environment is difficult. Now, three years ago, when the credit environment was open, everyone was getting these loosey-goosey commitment letters from banks to refinance any debt. Banks are not issuing those anymore or it's much more difficult to get them. There are a lot more conditions around whether the bank actually has the funds.
You can't just deal with the debt issues later. You need to think about them even before you go public with your offer.
CFOZone: What other impact is the credit environment having on deal structures?
Grinberg: The buyer would love to have in its best-case scenario a financing condition in the merger agreement that says we don't have to do this transaction unless we get financing that we approve solely at our discretion. That's a huge out.
Sellers are like, "That doesn't give us any certainty." Sellers like to have certainty when they execute a merger agreement.
The problem -- now this is with friendly merger agreements -- is that the buyers know financing is tough. And it's very often that they aren't able to completely arrange all of their financing prior to the deal. So they need to set up financing conditions.
With the Pfizer deal for Wyeth, there is a limited financing condition tied to Pfizer's credit rating. In other words, it's not like they can get out at any time. But if Pfizer's credit rating dropped for any reason, then they could exercise their financing out because essentially their credit rating is tied to the type of terms and amount you can get. It's sort of an indirect way of saying, "Look, if our credit goes below a certain rating, we know we aren't going to be able to get the funding on terms we like, so we're allowed to walk."
With Merck and Schering-Plough, it was a little more direct and a little broader. Merck had postponed the closing due to a lack of financing. The financing condition permitted Merck to indefinitely postpone the closing due to a lack of financing and either party can terminate the agreement if the closing slips beyond a "drop dead" date. That was obviously a lot broader.
CFOZone: How have things changed within the buyout industry?
Grinberg: Looking at it from the perspective of a target, if you the buyer want all sorts of financing conditions, they're going to want a big reverse breakup fee. They'll want it painful for the private equity fund to walk away. The days of private equity not walking away because of the threat of reputational harm are gone.
Sellers are also looking for much more detailed commitment letters from buyers. They want guarantees from the fund itself and not shell companies.
From the targets' perspective, they just can't give a broad financing out. That's just the environment. And even if the environment improves greatly, I think it's still not going back to the way it was when private equity funds walked away free. Those days are over.
CFOZone: How about the ability of private equity funds to spend all their dry powder?
Grinberg: There's a lot of money out there. For good deals for good companies, there is financing, but not in $10 billion, $20 billion amounts. In private equity, what you're seeing is funds taking majority and minority positions rather than buying the whole company. If they buy the whole company, they're using all equity and hoping to refinance some of the equity out when the debt market opens up.
Private equity funds are hungry. Starving.
There are a lot of factors that go into that. Buyers and sellers have to reach valuation agreements, which is still an issue. There's still a delta there between what sellers think their business is worth and what buyers think.
CFOZone: Why are we seeing so many all-cash deals?
Grinberg: It's not necessarily that companies are more comfortable spending their cash. It's that they're less comfortable spending their stock.
The reason is that valuations are still low. So if you want to buy a company for $500 million and your stock is trading at $10, you've got to spend more shares than if the stock is trading at $18.
These days, cash is king. If I'm a seller, would I rather have the sure thing or take shares in even a good company? Cash speaks.
At the end of the day, everyone likes to conserve cash and use their currency when their currency is trading high.
CFOZone: How would you characterize the current deal-making environment?
Grinberg: I think things are a lot better than even six months ago.
Strategics are getting back into the market, especially the ones that have cash. For the most part, they've dealt with all the internal issues and problems that have gone on over the last 18 months.
What I would call it is, there's a lot of chatter. So the question is then do you get to closing deals? That, I think, still remains to be seen.
CFOZone: What's the biggest hindrance?
Grinberg: It's just a matter of timing. The chatter has only picked up recently. We'll need to look back and see if the chatter in January led to closings in June and July.
But we can anticipate what will still be the problems closing deals: financing will still be a problem; buyers just being overly cautious about what they're buying; doing due diligence that lasts much longer than it did before; walking away for reasons that they may not have away from three years ago. And, look, it will only take one more big event - one more Lehman Brothers - to set us all back.
But I generally think you will see an increase in deals closing. I think 15 to 20 percent over 2009 seems right to me.
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