Vienna MBAMergers & Acquisitions

Transaction Structuring I

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Outline

• Legal structure of mergers

• Choice of consideration: stock vs. cash

• Fixed value vs. fixed ratio stock transactions

• Deal Collars

• Deal Protection Mechanisms

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1. The Legal Structure of MergersThe merger process:

– Managers come to an agreement– Both boards of directors approve a resolution (the “merger agreement”)– File a proxy statement / information circular with securities regulator– Securities regulator can ask for amendments, which may delay the

process– Proxy materials are sent to target shareholders, who have at least 20

days to vote– The merger plan / plan of arrangement is submitted to state / province,

which issues a certificate of merger

• Short-form merger bypasses shareholder approval and typically requires 80% holdings for insiders

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Minority shareholder: Freeze-out problem

You want to merge with a target:– Buy 51% shares of target– Appoint your brother-in-law as the new target CEO– Appoint your wife, sisters, mother-in-law as the new target

directors– Offer a very low price to merge– Target CEO and board (your wife and mother-in-law) will

approve– Exploit minority shareholders (49% shares)

• Inference: protections needed for minority shareholders

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Rights of minority shareholders

• If a merger is approved, minority shareholders must sell their shares (“freeze-out” or “squeeze-out”)

• U.S.: the minority has “shareholder appraisal rights” to ask for review of fair value in court – Difficult for plaintiffs to win: courts do not like to overturn

business outcomes unless evidence is clear (e.g., just payed 20 for shares and now merging for 10)

• Canada: In a “related party transaction” board must appoint committee to assure fair value for minority shareholders, including independent appraisal

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Trend of Merger Financing 1980-2005By # of deals (would look different for $ value)

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2. Cash vs. Stock

Why All Takeovers Aren’t Created Equal(In Your Readings Packet)

• Article by Roger Lowenstein in WSJ

• Discusses five-year returns following a transaction for bidders who– Pay cash– Pay stock– By whether friendly or hostile– Relative to a neutral benchmark of control stocks

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Five-year stock return after merger

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Choice of consideration

• Interpreting these results– The information content of stock vs. cash

transactions

– Differences in risk

– Differences in motive (thinking about strategic acquirers vs. financial buyers)

– Data mining

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Lots of research attempting to explain, no firm conclusions

Choice of consideration

• Information / signalling– A stock transaction =a cash transaction + a seasoned

equity issuance

– Using stock is a signal that the acquiring management team believes the stock is overvalued

• Risk– In a cash transaction, all of the post-acquisition risk is

borne by the acquirer

– In a stock transaction, this risk is shared with the target shareholders

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Choice of consideration

• Any benefits to stock?– Strategic buyers can use stock to keep the target

employees and management vested in the ongoing firm.

– There are definite tax benefits to using stock

– Only option for firms that do not have sufficient cash

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3. Two types of stock transactions

– Fixed Share (same as “Fixed Ratio”)

• The merger agreement sets what the exchange ratio (e.g., 2:1) will be at the closing date

• Final value to seller’s will vary depending on fluctuations in target share price during closing period

– Fixed value • The merger agreement established what the $ value

of the transaction will be to sellers at the closing date (e.g., $20 worth of bidder stock at closing)

• The final exchange ratio thus depends on the bidder’s share price in a window near closing (usually an average of closing prices over the last couple weeks)

• The acquirer thus bears all pre-closing price risk.

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Fixed Ratio vs. Fixed Value

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• A deal collar– Specifies changes in exchange ratio or fixed value of

a deal depending on variations in the bidder stock price

– E.g., fixed value with two-sided collar specifies a fixed value, switching to a fixed ratio at sufficiently high or low bidder closing prices (Travolta)

– Other examples: fixed ratio with two sided collar (Egyptian), one-sided collars, etc.

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4. Allocating Deal Risk with Collars

Collar Examples

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The Global-Crossing Frontier Collar(Readings Packet)

• A fixed value deal with down-side collar only

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Frontier

$63Global Crossing

1 share

Frontier

1.82 sharesGlobal Crossing

1 share

If Global Crossing stock price falls below $35,then

Allocating Risk Via Collars

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• The fixed value with down-side collar is the most common type of collar. Why?

$ Value to target

Shares to target

Without collar, the acquiring firm is so diluted that it may effectively become the aquired

Allocating Deal Risk: An example

Bidder: $10/share * 20M shares = $200 MTarget: $5/share * 20M shares= $100 M

Three basic structures considered:1. A cash purchase of $120 million, or $6 per share.

2. A fixed share purchase, at 0.6 bidder shares per target share.

3. A fixed value purchase: each target share receives $6 worth of bidder stock, based on bidder’s closing-date price.

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Target

$120MBidder

Announced: Feb. 1, 2000

Closing: June 1, 2000

Allocating Deal Risk: An example

• Market dislikes this deal: The combined value of the two companies is $240 M on closing date (loss of $60 million)– Cash: Acquirer share price is (200+100-120-60)/20 = $6, target receives $6 as

promised the acquirer bore all the risk– Fixed ratio stock: Acquirer share price is (200+100-60)/(20+0.6*20)=$7.50, target

receives stock worth 0.6*7.5=$4.50 acquirer and target share risk– Fixed value stock: Acquirer share price is $6, target receives $6 worth of acquirer stock

(both same as cash), implies that the exchange ratio must be 1:1 the acquirer bears all of the pre-closing risk, but pays for downside risk through dilution rather than paying out cash, the target shareholders are exposed to post-closing risk

Consider other possibilities on your own (who gains / who loses):• Market likes the deal: The combined value is $400 million on the closing

date (gain of $100 million)• Market likes the deal, BUT: 3 years subsequent to the closing, the

combined value is $240 million.19

Target($100M)

$120MBidder($200M)

Feb. 1, 2000

June 1, 2000

5. Allocating Post-closing Risk: Earn-outs

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Earn-out definition: A two-part payment with• A standard up-front payment at closing, and• A deferred payment contingent on target’s future

performance

Motivation: a way to bridge valuation disagreements in negotiations…

• The bidder reduces exposure to the risk of overpayment, or non-realization of synergies

• Helps target to signal quality, and can provide incentives to target management

• Overall, helps cash payment to have a “stock-like” post-closing shared risk allocation

Earn-outs II

Empirical evidence(Kohers and Ang, 2000):• Earn-outs more likely in deals with higher information asymmetry

(private firms, divested assets, different industries/countries, intangible assets),

• Bidder CARs are positive and target premium are higher in deals with earn-outs

Challenges / Limitations:• Agreement on a performance standard; accounting transparency,

differing horizons.• Performance metric on target stand-alone value; merger might need

structural integration.

6. Deal Protection Mechanisms

• Overview– Walk-away right : bidder/target can walk away from an

announced deal

– No-shop provision: prohibits the target from cooperating with other potential acquirers

– The fiduciary out: permits the board of directors to terminate a proposed merger if a better deal arises with another party

– Break-up fee: stipulates fees that would be paid by each party if they cannot complete the deal.

– Stock lock-up : bidder has the option to acquire target’s share

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The No-shop provision & Fiduciary Out

• The “No-shop provision”– An exclusivity arrangement: prevents management from actively seeking out or cooperating with

another bid– But if another bidder comes to the target management, the “fiduciary out” is the idea that

management may be obliged to seek an outcome that maximizes shareholder interest

• Example: Wachovia-Citibank announced Sep. 29, 2008 for $2.2 billion, includes no-shop provision– Wells Fargo reaches merger agreement with Wachovia four days later (Oct. 3) for $15.5 billion – Court challenges, etc., finally favor Wells Fargo

• A similar conflict in one of our supplemental readings, relating to legal battle between Texaco and Pennzoil over acquisition of Getty Oil.

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Break-Up Fee• Break-up fee: specifies penalty for breaking up a deal after merger/purchase

agreement is signed– Break-up fees in the case of Wachovia-Citibank have not been discussed in the press– Break-up fees allow the quick resolution of disputes arising from broken merger agreements since they specify

damages– Typically in the range of 2-3% of deal value, up to 5 or 6%, which courts generally regard as a reasonable upper end

• Meant to compensate buyers for their costs, etc., not make breakup impossible

• If a break-up fee is not specified, then the only remedy for a breached contract is the courts– Damages can be large (e.g., Texaco-Pennzoil) but are uncertain

• Break-up fees may be specified on either or both sides in a merger / purchase agreement– May also be contingent on circumstances: e.g., if shareholders vote against, etc.

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Walk-Away Right

• A walk-away right in a merger / purchase agreement specifies conditions under which one or both sides may walk away without penalty (or with reduced penalty)– E.g., if stock price of acquirer decreases substantially before closing, then the

contract may specify that the target can “walk away”, etc.

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Stock Lock-up• The stock lock-up acts like a break-up fee, but value is tied to value of target to

another acquirer– E.g., suppose an original merger agreement states that acquirer will buy 100% of target for $20 per share– A stock lock-up might specify that if the target breaks up the deal (say to be acquired by another buyer)

then the original buyer will have an option to acquire 10% of acquirer shares, say 100K shares, for $20 per share (or $15 or some other value)

– Suppose that a second buyer comes along and breaks up the initial deal by offering $25 per share– Now the original buyer will be able to make 100K*(25-20)= $500,000 from this break-up– Thus, the more value the target has to a second buyer, the better off is the original buyer who has a stock

lock-up

• Also can mean shares committed to a potential buyer by third-party shareholders of a target (more common usage in Canada)

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Payoff to Initial Buyer in Stock Lock-Up

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• Lock-up has an option like payoff• Initial bidder gains when the target receives a higher offer

• Incentivize initial bidder to maximize target value to second bidder• Rewards initial bidder for their due diligence, etc. that may contribute to a higher second bidder price

Crown Jewels Lock-up

• Specifies that if the target terminates a deal, then the acquirer will have the right to acquire certain (highly prized) assets of the target at a certain price.

– E.g. a specific patent, oil field, production facility, etc.

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7. Extras

• New TSX Rules on Acquisitions bright line test for when acquirer shareholder approval is needed (dilution > 50%)

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Earn-out ExampleeBay to Acquire Skype, September 12, 2005eBay will acquire all of the outstanding shares of privately-held Skype for a total up-front consideration of approximately $2.6 billion, which is comprised of $1.3 billion in cash and the value of 32.4 million shares of eBay stock, plus performance-related compensation.

The maximum amount potentially payable under the performance-based earn-out is approximately $1.5 billion, and would be payable in cash or eBay stock, at eBay’s discretion, with an expected payment date in 2008 or 2009…

eBay reaches deal to sell Skype, September 1, 2009“eBay will keep a 35% stake in the firm, which it has been trying to sell for some time. It has said that Skype had "limited synergies" with it. “

Vienna MBAMergers & Acquisitions

Transaction Structuring II

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Outline

• Reading market reactions

• Accounting treatment of transactions

• Tax Issues

• Antitrust

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1. Reading Market Reactions

• Target price: At least three factors affect the target price after a deal is announced, but before closing

1. Deal risk: What is the probability that the deal will fall apart before closing? • Major obstacles: shareholder dissent, financing, antitrust• Target shares may therefore sell at a discount.

2. Sweetened bid: An improved offer may follow, either from the same or a new bidder• May reduce the discount, or even cause a premium, in the market

price relative to initial offer.

3. In a stock deal where the target also bears pre-closing risk (e.g., fixed share), then the performance of the acquirer will also affect the target price.

Reading Market Reactions

• In a fixed ratio stock deal, we can isolate the effects of the first two components by comparing the implied exchange ratio (from market prices) to the agreed upon exchange ratio.

• Acquirer price: the acquirer price will be affected by– The net synergies anticipated by the market– The premium paid by the acquirer– Not surprisingly, the market anticipates, more often than not, a

net loss to the acquirer– The initial market reaction has been shown to be a good

predictor of the long run performance of a deal

2. Accounting Issues

• Current practice (since 2001 in U.S., longer elsewhere): use purchase accounting for all transactions– Revalue the identifiable assets of the purchased company to fair

market value (FMV) and put them on your books– The “step-up” in the basis of these assets will result in a higher level of

depreciation of the assets– Any excess of the purchase price over the FMV of the identifiable

assets is recorded as goodwill– Annually, test whether goodwill has been “impaired” (i.e., is goodwill

less valuable? Note the difficulty of carrying out the impairment test!) – If goodwill is “impaired,” (i.e., if the accountants tell you to) write down

goodwill to “fair value” and recognize a loss in current year.

• Old (pre-2001) standard for goodwill (versions of this may still apply in some jurisdictions)– Ammortize goodwill over a specified period (e.g., 40 years)

Origins of the Goodwill “Impairment” Test• Prior to 2001, all of the world except U.S. used purchase

accounting for virtually all transactions

• The U.S. permitted “pooling” accounting (moreso than other jurisdictions), with requirements linked to use of stock for consideration and ongoing interest of target shareholders

• Under pooling, the balance sheets of the two companies are simply combined, with no goodwill, etc.

• CEO’s in the rest of the world complained that U.S. firms had an advantage in M&A because of pooling accounting– Less ammortization expense under pooling = higher future earnings

• Likewise, U.S. CEO’s did not want to lose pooling– Introducing the impairment test to purchase accounting helped to

alleviate some concerns about high levels of goodwill ammortization following a transaction

Why Might Accounting Methods Matter?

• Previously, firms would often pay higher premiums, spend substantial amounts to obtain pooling treatment vs. purchase, or refuse transactions if they could not obtain pooling treatment

• Why might pooling vs. purchase matter even if it has no impact on CF?? – If accounting data matters to market valuation,

independently of cash flows• Generally, the accounting literature finds that accounting

differences which are well understood do not have price impacts – Bond indentures may use accounting data– Management compensation may be tied to accounting

data

Example of the Purchase Method

Bidder purchases Target firm for $1,250 in cash on June 30, 2006.

Bidder Pre-Merger

Target Firm(Book Value)

Target Firm(Fair Market

Value)Current assets 10,000 1,200 1,300Long-term assets 6,000 800 900GoodwillTotal Assets 16,000 2,000 2,200

Current liabilities 8,000 800 800Long-term debt 2,000 200 250Common stock 2,000 400 1,250Retained earnings 4,000 600Total Claims 16,000 2,000 2,300

Example of the Purchase Method

Acquisitor Pre- Merger

Target Firm (Book Value)

Target Firm (Fair Market

Value)Acquisitor Post

Merger

Current assets 10,000 1,200 1,300 11,300Long-term assets 6,000 800 900 6,900Goodwill 100Total Assets 16,000 2,000 2,200 18,300

Current liabilities 8,000 800 800 8,800Long-term debt 2,000 200 250 2,250Common stock 2,000 400 1,250 3,250Retained earnings 4,000 600 4,000Total Claims 16,000 2,000 2,300 18,300

Book Values are not

relevant.

Acquisitor Value pre merger + Target Firm (FMV) = Acquisitor Post MergerGoodwill = Price paid – MV of Target firm Equity

= $1,250 – (MV of target assets – MV of target Liabilities)

= $1,250 – ($2,200 - $1,050)

= $100

Impact of Goodwill Accounting (Impairment Test) in a Negative Environment

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Surf’s Up! Wave of M&A Related Write-Offs seen• (November, 2008) Reuters notes that with share values plummeting,

companies who have done recent transactions will likely face large write-offs due to “impairments in goodwill”

• Possible impacts on covenants, compensation

3. Tax Issues

• Non-taxable (or tax deferred) transactions– Personal taxes: No tax to target shareholders on share

portion of consideration until new shares are sold• The basis to target shareholders is held constant at conversion (I.e. if

shareholder original basis is $10 and exchange ratio is 2:1 then basis in new shares is $5 each)

– Corporate taxes: basis of target assets is carried over to acquirer – no possibility of step-up in FMV of assets

– NOL and tax-credit carryovers, but with restrictions • Restrictions on NOL carry forwards were put forward in 1980s to

reduce pure tax loss motivations for transactions• Maximum NOL use per year is limited (approximately) to the total

value of the loss corporation at acquisition (target) * the interest rate on treasury bills. link

– This amount is roughly what the profits on the target would be if it earned a T-bill rate of return.

Taxable Transactions• In a taxable transaction, the target shareholders pay any capital

gains taxes immediately (depending on their original basis)

• The acquirer uses as much as possible of the purchase price over original book value to step up the depreciable tax basis of assets – Asset basis step-up for tax purposes increases future depreciation and

decreases future taxes– In certain settings, goodwill may be ammortizable for tax purposes (e.g.,

in U.S. goodwill ammortized for tax purposes over 15 years)– Note that accounting treatment and tax treatment are not necessarily the

same (in fact are often different, see link above)

• Cannot carry over NOLs and target tax credits in a taxable transaction

Impact of Tax on a Recent Transaction • On Tuesday, Sep. 30, 2008 the U.S. Treasury announced a new

interpretation of Sec. 382 of the code which limited use of NOL carryforwards in an acquisitions.

• The new IRS interpretation focused specifically on bank mergers, and had an immediate impact on the Citibank-Wachovia transaction, announced one day earlier link– Under existing estimates, an acquirer of Wachovia would write down approximately $74

billion of losses on the Wachovia loan portfolio– Prior IRS interpretation would limit use of the NOL’s to approximately $1 billion per year,

for a maximum of 20 years.– The new ruling could remove limits on using the entire amount of NOLs, producing large

potential benefits for a potential acquirer– Wells Fargo is profitable, Citibank is not– By the end of the week (Oct. 3) Wells Fargo announced its $15 billion offer for

Wachovia

• The new IRS ruling as a policy tool in encouraging profitable banks to acquire damaged balance sheets.

Hypothetical Value of Wachovia

Tax Status of an Acquisition• Three basic types of transactions

– Purchases of assets– Purchase of shares– Statuatory merger / amalgamation

• If a transaction is appropriately structured, consideration received in shares can be tax-deferred to acquirer shareholders, while cash is immediately taxable.

• In Canada, the acquirer must be Canadian for a transaction to receive tax-deferred status– A foreign acquirer will typically set up a Canadian

subsidiary to carry out a transaction if it wants to obtain tax deferred status

Tax-Free Reorganizations in U.S.

• Type A – statuatory merger or consolidation– Generally no more than 50% of consideration in other than voting stock– The “boot” – other consideration such as cash, debt, convertible, may be

taxed immediately on its tax basis– Tax basis in new shares proportional to previous tax basis– Includes forward triangular below

• Type B – acquisition of stock– Must buy at least 80% of target stock

– Only consideration allowed is voting common

– Includes reverse triangular below

• Type C – acquisition of assets – not common in U.S.

Triangular Mergers

• Triangular mergers: variants of basic transaction structures; the acquirer uses a subsidiary to purchase or merge with the target– May help to isolate liability in the subsidiary– May help to to avoid a vote of parent shareholders

• Forward triangular: subsidiary acquires assets or stock of target or target merges into sub

• Reverse triangular: subsidiary merges into target – (e.g., the target acquires the subsidiary, giving parent target shares and making target a

parent subsidiary)

4. Anti-Trust ConsiderationsMain statutes in the U.S.• Sherman Act (1890)

– Sec 1 prohibits all contracts, combinations, and conspiracies in restraint of trade

– Sec 2 prohibits any attempts or conspiracies to monopolize

• Clayton Act (1914)– Makes transactions illegal that adversely affect competition (more

general)

• Hart-Scott-Rodino (1976)– Provides for pre-merger review (30 days for mergers, 15 for tender

offers)– Agencies can issue “second requests” for information to get more

time for review

Anti-Trust Considerations

• The evolution of antitrust theory– Concentration Ratios– The Hirschman-Herfindahl Index– Potential competition and barriers to entry– A trade off between innovation and pricing?– The goal is consumer protection– Globalization and product market convergence have led to

more relaxed standards in recent years. That may change in the future…

Concentration Ratios• Concentration ratio: market shares owned by the top 4

firms in an industry

– 1968 Justice department merger guideline

– highly concentrated industry if this ratio >=75%

Market Bidder Target

Highly concentrated 4% 4% +

10% 2% +

15% 1% +

Less concentrated 5% 5%+

10% 4%+

15% 3%+

20% 2%+

25% 1%+

Hirschman-Herfindahl Index2 ( market share of th firm)

n

i ii

HH S S i

2 28 12.5 =1250n

ii

HH S

Consider an industry composed of 8 firms; Each firm has a 12.5% market share

If two of these equal-size firms merge, then new HH is

2 26 12.5 +25 =1562.5HH

HHI perceived to be a better measure than concentration ratio• Dominated by market weights of large players, but captures information about structure of entire market

HHI Analysis Matrix• In analyzing competitive effects of a horizontal merger, regulators consider both post-merger concentration and the change in concentration

Change in HHI

<50 50<Δ<100 >100

Post-Merger HHI

<1000 Unlikely to have adverse competitive

1000<HHI<1800 effects Raises significant competitive concerns

>1800 Raises significant competitive concerns

Presumed to create or enhance market power

• The initial analysis of HHI concentration in a market is often followed by further consideration of additional factors (potential competition, efficiencies, failing firm concerns, etc.)

DOJ/FTC Horizontal Merger Guidelines (1997)

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Horizontal Merger Analysis: Five Steps1) Define the relevant market or markets where there is current or

potential overlap between merging parties– Market defined by product and geography

2) Carry out the HHI analysis in each market to determine where there are potential concerns

3) Consider the impacts of potential entrants, and how they could minimize anticompetitive impacts– Relevant question: In the event of a significant increase in prices (5%)

would new entry be “timely, likely, and sufficient” (enough to deter the price increase in the first place)

4) Are the economic efficiencies to be gained from the merger sufficient to outweigh competitive concerns? – How large are the efficiencies? Will they be passed on to consumers? Are

there other ways of achieving these efficiencies besides merger?

5) “Failing firm” defense: will one of the firms disappear anyway if this merger does not occur

– Need to show real economic losses and no alternatives

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Potential Outcomes• A preliminary merger analysis might lead to the conclusion

that there are no significant problems, in which case the merger can proceed

• The agency may on the other hand ask for more information (“second request”) which substantially delays the consummation of the merger

• Ultimately, the agency may decide to– Let the merger proceed– Negotiate with the parties conditions under which the deal may

proceed (“remedies”, e.g., asset sales / divestitures in problem markets, licensing agreements with competitors, etc.)

– Block the deal

• The parties have legal rights to contest agency decisions in courts, which is both time-consuming and costly

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Horizontal Merger Analysis Example

• In 1996, Staples proposed to acquire Office Depot.

• The FTC carried out an analysis showing that prices were substantially higher in areas covered by only one “office superstore” relative to markets where competition existed.

• The agency concluded that after the merger Staples would have been able to raise prices an average of 13%.

• Ultimately, the agency decided to block the merger, and their decision was upheld in U.S. District Court.

See a comparison of this decision with a similar case where two of three competing railroads were allowed to merge, with “disastrous consequences for freight shipments in the American Southwest in the late 1990’s.”

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Vertical and Conglomerate Mergers

• Vertical mergers occur within the value chain. – Example: U.S. Steel and Tennessee Coke and Coal

• Antitrust concerns:– Theory of potential competition: combination of a current player with

a potential player– Barriers to entry from vertical mergers: if two markets are tightly

linked, the need to enter both simultaneously could create barriers to entry (product tying, exclusivity arrangements, etc.)

• Conglomerate mergers occur among firms unrelated by value chain or peer competition (e.g., GE)• Generally do not raise anticompetitive concerns (but also do not

generally have obvious economic synergies)

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Events in Antitrust1. (Oct. 17, 2008) DoJ / FCC expected to clear wireless deals

– Verizon acquiring Alltel for $28.1 billion, creating largest cell company in North America, closes on January 9, 2009

– $14.5 billion wireless broadband pact involving Sprint Nextel Corp., Clearwire Corp., Google Inc., Intel Corp. and three cable providers.

2. Policy differences seem to appear between DoJ and FTC enforcement another link

– DoJ perceived as soft – “Antitrust enforcement has been a low priority for the Bush administration. How

low? Until recently, the Department of Justice hadn't challenged a single case in court.”

– FTC (another agency jointly responsible for enforcement) wants a more aggressive approach, previously attempted to block merger of Whole Foods and Wild Oats Markets, blocked a hospital merger, etc.

3. Microsoft raises antitrust concerns about Google-Yahoo

Competition Policy in Canada / Worldwide• Competition policy in Canada and Europe is similar in principle to U.S.

• In Canada, governed by the Competition Act and implemented by the Commissioner of Competition

•Challenges may be brought prior to or within three years following a transaction•Pre-merger notification of Competition Commissioner is required

• In a global environment, merging two large multinational corporations may require numerous simultaneous reviews in different jurisdictions

• Example: In 2001, the merger of GE and Honeywell – both U.S. corporations – was blocked by the E.U.• Commission: “The merger between GE and Honeywell … would have severely reduced competition in the aerospace industry and resulted ultimately in higher prices for customers, particularly airlines." • GE: “We strongly disagree with the commission‘s conclusions… This acquisition would have clearly benefited consumers in terms of quality, service and prices.“

5. Due Diligence

• Due Diligence: The process of thoroughly investigating the value of a transaction to shareholders• A fiduciary duty of managers and directors

• Who carries out due diligence, acquirers or targets?• In general, both• For targets, especially important if stock consideration is involved

• When does the process begin and end?• Begins with first negotiations, does not end until closing• A process of continually increasing the level of scrutiny, negotiating

for greater access, etc.

The Due Diligence Process• Due diligence is much more difficult for a buyer in a hostile

situation than in a friendly setting• Access to information is more difficult: Citigroup complained about having

less access to information than Wells during their dispute over Wachovia

• Negotiating the specifics of due diligence to be facilitated/allowed by the other party is an important part of the transaction structuring process in a friendly transaction• Analogy to placing “inspection” conditions on a real estate purchase• In a common scenario

• The buyer wants as much information as possible before closing

• The seller wants to receive consideration quickly, with as few conditions as possible

• Both sides are sensitive to prematurely allowing access to competitively sensitive information

• Due diligence complexity is one reason for lengthy closing periods

How Due Diligence Fits with Deal Structuring

• Ideally, the due diligence process is about closing gaps in information asymmetries, while protecting the interests of both parties• A well-structured merger agreement should allow economically

beneficial agreements to close• At the same time, a merger agreement should provide a way out for

deals that are found during the due diligence process to have negative economic consequences

Due Diligence as an Excuse

• In the Wachovia battle, Citigroup publicly maintained a commitment to completing the deal at all times, but in unattributed comments, as the tide favored Wells Fargo, Citigroup insiders expressed to the financial press the idea that they backed off the deal because of due diligence findings. • “While Citigroup insisted publicly that it still was willing to buy most

of Wachovia, people close to the company said that additional due diligence uncovered questions that made executives uncomfortable about proceeding with the deal. An important sticking point was the valuation of Wachovia assets, particularly the bank's large securities portfolio.”

Due Diligence in Practice

• Laundry lists: Legal; accounting; tax; IT; risk and insurance; environmental; market presence and sales; operations; property; intellectual and intangible assets; finance; cross-border; organization and HR; culture; ethics• Specific concerns: inventories, pension plan assets, debt

guarantees and covenants, threatened litigation, tax delinquincies, warranties and defects, severance payments, uncollected receivables, etc.

• Sources: SEC filings, 8-K, 10-K, 10-Q; proxy statements;auditor’s work; management letters; operating budgets; cash flow

projections; consultant opinions; interviews with employees, customers, and analysts, etc.

• The ideal is complete and thoughtful probing of the business model…

6. More on Citigroup, Wells Fargo, and Wachovia

$2.2 B $15 B

$60 B Lawsuit

Citigroup: our shareholders have been unjustly and illegally deprived of the opportunity the transaction created.

Wachovia: We look forward to completing our merger with Wells Fargo, which is in the best interest of shareholders, employees, creditors and retirees as well as the American taxpayers.

The exclusivity agreement: “Wachovia shall not …encourage any other Acquisition Proposal…”

•“The parties agree that in any breach, the parties would be irreparably harmed, and could not be made whole by monetary damages.” •Compare with the idea of a breakup fee.

• Buffet bids for Burlington– Berkshire Press Release (great transaction structuring issues)

• EU objects to Oracle’s takeover of Sun– EU says US comment on Oracle Sun deal “unusual”

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