Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  The deal not only left Landry’s with substantial expenses but also put Fertitta in a substantially better position than when the process began. According to the Landry’s filings, Fertitta owned 34.6 percent of Landry’s as of August 27, 2007, and 39 percent by July 17, 2008, five days after the initial announcement of this deal. As of January 2, 2009, he held 56.7 percent of Landry’s.39 The special committee had failed to negotiate a standstill with Fertitta and allowed him to obtain majority control of this company while this failed deal was pending. This appears to me to be a spectacular lapse by the committee. I believe it harmed Landry’s shareholders by depriving them of a change-of-control premium and leaving them with substantial unreimbursed transaction expenses.

  In light of the abuses ably illustrated in the failed Landry’s transaction, the special committee process may not provide sufficient protection for nonmanagement shareholders. After all, if there is a no vote, then what happens? There are examples where shareholders have said no, such as in the case of the Dolan family’s repeated attempts to take Cablevision private. However, these cases are rare.40 This is because a no vote is often seen as effectively firing your management, leaving shareholders with a rudderless company. Here, the Landry’s committee may have simply felt it had no choice in negotiating such a beneficial deal to Fertitta. In other MBOs in the past year, management has similarly used its ability to walk and leave the company helpless to drive very hard bargains and then to renegotiate those bargains once the company had agreed to an acquisition. In 2008, these included the failed $1.3 billion MBO of CKX, Inc., the owner of the American Idol brand, and the subsequently completed MBO of Zones, Inc., an intellectual technology provider.

  At one point in time, prominent academics called for a complete ban on MBOs and going-private transactions because of the inherent prospect for abuse.41 It is clear that a board faced with a proposed management buy-out is in a difficult situation. If it says no, management will remain in place but sorely disaffected looking to replace the special committee at some point. But if the committee says yes, it is likely to be unable to attract other bidders because of the head start and insider knowledge that management has.This is why go-shops have been ineffective in transactions with management involvement.42 Moreover, as in the Landry’s case, management is significantly incentivized to bargain for tight deal-protection measures. Though further study is needed, I suspect this means that management is probably able to get a better deal on price than it otherwise would in a competitive bidding arena.

  Because of this, Delaware should not go so far as to ban MBOs but should ensure that MBOs are treated like parent subsidiary going-private transactions and are therefore always subject to an entire fairness review. Moreover, the actions of a special committee, particularly in all going-private transactions, should be heavily scrutinized. They should be required to negotiate within this standard (a) for meaningful recompense if a transaction falls through and (b) for the disinterested shareholders to have a veto on the transaction. The ultimate goal in MBOs should be to make these contests open and allow for outside bidders who can serve as a market check on the actions of management.43

  DealMaking

  Which leads us to the final question: Should dealmaking itself be reformed? The events detailed in this book point to a more disciplined approach to dealmaking by buyers. The failures of too many deals lie in hasty decisions based on personality rather than on solid economic foundations and hard work. The good corporate governance and the failures of deals from the fifth wave have increased the focus on disciplined mergers and acquisitions. But buyer decision to deal will largely remain the domain of market forces. Legal regulation of the buyer decision to make a deal is probably too difficult, and rising shareholder and board power should temper ill-advised CEO empire building in a substantial number of cases. Still, the need for a fully informed shareholder vote in significant acquisitions would aid this process. If a buyer issues more than 20 percent of its stock, then the stock exchange rules require such a shareholder vote. Alternatively, in cash deals there is no required vote under the laws of Delaware. In contrast, such a vote often is required for European companies under their local laws. One possible solution is that, for significant acquisitions, the stock exchanges should require a vote when a buy-out constitutes more than 20 percent of a company’s assets and market capitalization. This would place the same shareholder discipline on companies in all circumstances. Given that shareholders almost always approve deals, this would likely be decried as a formality placing more procedural restrictions on companies and hampering acquisitions. But given the shareholder activism rise and potential to force a more disciplined “deal” decision, this requirement is likely appropriate. Mechanisms that encourage more disciplined dealmaking without significant burdens are a worthy goal.

  It is here where deal reform should come. Management should continue to plan strategically for deals. The deal machine will continue to be an irreplaceable part of dealmaking, but it will also place its own pressures on CEOs to deal. If there are lessons from the past years, it is that the ability to say no or otherwise implement a deal in a coordinated, planned fashion is important. The deal machine must sometimes be ignored on behalf of common sense. Boards and CEOs should make deal decisions within procedures that create independence from the deal machine and foster thinking that can counteract the forces that drive dealmaking for dealmaking’s sake.

  Chapter 12

  DealMaking Beyond a Crisis Age

  Does dealmaking add value? The question is one that must be asked in light of the financial crisis. I believe that the answer is that, on the whole, deals do add substantial value. Dealmaking provides added value by structuring and combining assets more efficiently to reduce the cost of capital and create value through, among other things, synergies and cost savings.

  The backdrop to this value question is a more controversial one: Do those who advise dealmakers add value to deals themselves or are they simply a regulatory tax or other transaction cost? Strangely, this debate comes up over the role of lawyers and not investment bankers. Investment bankers are presumed to add value by providing pricing certainty among other activities.This is per se assumed. In contrast, academics who study dealmaking continue to debate whether lawyers are equally value-creating. I must admit, I find this somewhat puzzling. After all, why do clients pay millions of dollars and fight to retain the best paid legal talent and law firms to make deals? Surely, they must offer some value over and above other lawyers and value in and of itself. In a sense, this book is a testament to that value and perhaps an answer to the debate. Lawyers certainly are a necessary part of a transaction given the increasing regulatory nature surrounding dealmaking. This is a cost. But lawyers likely add more than they cost—they are in the words of Professor Gilson transaction cost engineers—people who design and erect deal structures that maximize value and mitigate and balance risk for their clients. In this mix lawyers provide other roles including a way of thinking and experience that provides sage advice to their clients.1

  This is not to say that dealmaking or deals are a nirvana of value and capital markets perfection. This book has also documented the wasting of assets that dealmaking can produce as well as the way that those who advise dealmakers can make mistakes or act in their own interests adding agency costs to deals and destroying value. Here, of course, the question really is whether dealmaking contributed to the current financial crisis. Certainly, the overleveraging of private equity targets and the securitization process for mortgages led to undue risk and leverage in the economy. But this highlights the need to regulate these activities not the role of dealmaking in them. I’m less certain about blaming of the dealmakers who structured these deals. They did so because they could and were smart enough to be able to do so. Certainly, dealmakers and their advisers are blameworthy for this but in the future regulation should focus on activities not persons. In other words, dealmakers will always find ways to structure and execute deals up t
o and sometimes beyond the bright-line law. The law should take this into account in its regulation of these activities and create incentives that do not permit dealmakers to externalize their mistakes or deals onto the public as happened in the financial crisis.

  Moreover, the financial crisis has upended the world of deals and the dealmaking machine. Three of the five independent investment banks have simply disappeared. The remaining survivors, Goldman Sachs and Morgan Stanley, have been forced to become bank holding companies, subject to heightened regulation, which will limit their trading and lending activities. Meanwhile, traditional banks have struggled under the weight of distressed assets and wounded balance sheets, and private equity firms are occupied with their attempt to salvage their troubled, overleveraged acquisitions, vintage 2004 through 2007. The securitization market, the pipeline for the necessary debt for deals, remains turgid and likely will become subject to increased regulation.

  Amid this turmoil and as I complete this book, the takeover market remains quiet as buyers remain wary of assuming acquisition risk, private equity has vanished from the market, credit still remains scarce, and pricing for deals remains difficult in a volatile market. The global takeover model appears precarious, as currencies revalue and buyers hesitate to risk dealmaking, let alone complicated, cross-border takeovers. Finally, even the lawyers and accountants, the workhorses of the deal machine, appear chastened by the events of the past years, something that will further hamper dealmaking.

  From these ashes, a new, transformed deal machine is likely to emerge. First, boutique investment banks such as Evercore Partners Inc., Greenhill & Co., and Lazard Ltd. are likely to benefit. Investment bankers will turn to these firms as they flee a more regulated and institutional culture in which their banks and sometimes salaries are subject to government regulation and supervision. In the shorter term, clients will turn to them for more independent advice—advice likely to be cherished, given the conflicts that arose during the private equity implosion between clients and investment banks providing both financing and financial advice. Faced with this conflict, these investment banks repeatedly chose their own interests to the detriment of clients. Ironically, private equity firms may also benefit from this trend, as their financial advisory arms expand to offer this unconflicted function to companies. Nonetheless, the large investment banks will continue to exercise their balance sheets and lending power to retain clients and deals.Their success will in large part depend upon coming regulatory reform and whether and how “too-big-to-fail” banks are limited in their trading and lending activities. In effect this would be a quasi-resurrection of the Glass-Stegall Act wherein investment banks were forced to compete on a level playing field without financing and regulatory subsidies. Nonetheless, the big investment banks will likely continue to play an important role in dealmaking. The question is whether they will or should return to their dominance.

  In this regard, the small boutique bank model has the virtue of becoming more stable and prudent than the big investment banking model of years past. In recent years, these large investment banks had abandoned their partnership model in favor of publicly traded capital structures.2 The partnership model allowed investment banks to invest in the future and forgo short-term for long-term gains by providing for individual partners with a strong stake in the future enterprise. In the modern era, though, these banks became publicly traded entities ever more reliant on technology as opposed to human capital. The result was a failure of prudent risk modeling and a severe lack of loyalty among employees.

  This led to the relationship model of investment banking being replaced with the institutional model. In the latter model, the primacy of the long-term benefit of the client guaranteed in the form of a strong personal relationship with the bank’s managing directors was traded for the bank’s financing capabilities.3 But again, the financial crisis has exposed the conflicts inherent in the institutional model, a development likely to benefit the boutique banks that focus on relationships. Because the boutiques are more focused on individual employees and creating long-term relationships, they are likely to provide better-quality advice to companies while creating a more stable investment banking model more attractive to many investment bankers.

  In light of these developments, the methods and means by which dealmakers raise capital are likely to shift. Both lenders and borrowers are terribly wary of each other at this point on account of the conflicts that arose during the financial crisis. In the short term, lending will become a more documented affair, as lenders and borrowers struggle for deal certainty and trade heightened contractual terms for missing trust. In a world of limited credit, this is likely to further hamper dealmaking as these parties fail to reach sufficient agreement to provide each other assurances to proceed with a transaction.

  In the longer term, any new regulation placed upon the securitization process is likely to drive the creditor-lender relationship. Until then, deals are set back to the 1980s, as buyers are forced to piece together their capital structures from scratch and on an ad hoc basis. To the extent regulation restores credibility to the securitization market through enhanced disclosure requirements, this may be a good thing for all involved. The revival of the securitization market for dealmaking, created by private equity back in the 1980s, will be particularly important because capital requirements are likely to be heightened under any regulatory reform, further limiting bank-originated borrowing to the extent that it cannot be securitized and sold.

  This strained credit relationship and reduced availability of credit will continue to drive the structure of transactions. It will ensure that private equity firms continue to demand maximum optionality in their transactions and that strategic buyers continue to attempt to incorporate such features into their own agreements. However, targets will continue to balk, and the inappropriateness of more optional features in strategic transactions will continue to be apparent. The result will be that strategic transactions will continue to shift in structure, as buyers and targets in financed transactions realize that their relationship is really a threesome, including the banks, and they structure and bargain among themselves to accommodate this added complexity.

  In this mix, alternative capital sources are likely to become more important. Private equity, hedge funds, and sovereign wealth funds will continue to serve as one-off capital providers for deals. They will also serve as co-investors in strategic transactions where capital is unavailable. Until they become institutionalized, though, both hedge funds and sovereign wealth funds will continue to be only supporting characters with unfulfilled potential. These financial investors need to develop the mechanics so any capital they have can be quickly and regularly accessed. This may occur, but it is likely to be a gradual process. In particular, hedge funds will have to become more like private equity funds and seek longer commitments from their investors that allow them to provide a long-term capital and investing function.This is a process that is occurring, as hedge funds attempt to recover from the immense capital withdrawals of the past year.

  The terms of debt will shift. After the 1989 RJR/Nabisco deal, when KKR structured its acquisition debt to take advantage of preexisting bondholders, event risk covenants became standard to protect debt holders. In the credit boom of 2004-2007, these went by the wayside as covenant-lite debt and PIK-toggles became the norm. But as the travails of Realogy, Freescale, and other distressed private equity portfolio companies show, these protections were there for a reason. In the future, investors will demand more protection and the restoration of the pre-2004 status quo. Debt is likely to become less complicated, and the slicing and dicing of capital structures that private equity specialized in will slow as investors seek simplicity and transparency.

  The continued trend of tradable debt will continue making pricing easier and debt more utilizable. Moreover, the financial revolution will enable buyers and their bankers to structure and price new forms of capital and risk-allocation devices. Still, the terms of debt negoti
ated in this bubble time will put private equity in the catbird seat for companies apparently verging on the edge of insolvency, such as Harrah’s and the like. Expect more debt-for-equity exchanges in the meantime and a continued struggle between distressed debt investors and private equity.

  In this market, shareholders are likely to continue to flex their power. The good governance trend and shareholder activism of hedge funds were a start. The disruptions of the past two years will heighten the shareholder function, as boards remain particularly attuned to shareholder and public pressures and regulators attempt to increase shareholder say in the corporate enterprise. In the dealmaking world, the failures of Yahoo and others adopting a just say no strategy will continue to encourage boards to be more open to hostile transactions. This should create a self-fulfilling loop, further spurring hostile transactions and creating opportunities for more acquisitions and consolidation.

  The rise of the technology hostile and the mainlining of hostile transactions in the strategic sphere will further spur this activity. Buyers in these circumstances are more likely to be greeted rather than booed. Still, this is a prediction, and stronger responses by targets adopting 1980s-style defenses may result in changes in the Delaware law governing such responses. The gaps in Delaware’s law in the short term will also probably result in further lockup creep and perhaps more novel transaction defenses, a trend Delaware courts should harshly scrutinize. The depressed market may spur new abuses that receive regulatory attention. I have highlighted the potential in the case of MBOs for this type of inappropriate activity.