Merger arb funds step up to the plate
| Worldwide M&A deals – amount and number of deals |
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THE NEW WAVE of US mergers and acquisitions activity involves a cast of characters that have emerged bruised and battered from the market meltdown determined never to be shortchanged again: shareholders, profit-hungry hedge fund managers, and securities class-action lawyers.
After seemingly never-ending corporate scandals, the actions of politically driven public prosecutors, court decisions, and legislative reform, shareholder rights are now central to M&A deals. These rights, once seen as a loose code of honour rather than any type of serious rule, are now vigorously promoted and protected.
In this world post Enron, Eliot Spitzer and Sarbanes-Oxley, the deal presently attracting most attention is the battle for MCI, the telecoms firm that emerged from WorldCom's collapse. As two bidders, Verizon and Qwest, jostle for victory, all those involved know all their actions will be subject to close scrutiny.
Boards accountable
Class-action lawyers are waiting to pounce on any decision that might be seen to contravene shareholder rights. In effect, these lawyers and the shareholders they might represent are as much deal-makers – or deal-breakers – as the investment bankers advising their clients.
"Shareholders are now extremely sophisticated," says James Rosenor, a partner in the mergers and acquisitions group at US law firm Pepper Hamilton. "Institutional investors, particularly pension fund managers, have stood up and taken notice of exactly what boards are doing. The aggressiveness with which shareholders are holding boards accountable has become far more acute."
Under US common law, which defines the fiduciary duty of corporations to act in the best interests of their shareholders, courts apply a loosely defined "business judgment" rule in assessing the actions of a board of directors. That is, judges find it extremely difficult to step in and substitute their own decisions for the business judgment of a board as long as it acted with good faith and in the absence of fraud.
However, once a corporation is effectively up for sale, what has come to be known as the Revlon Rule kicks in. Established in 1985 when Ronald Perelman and Ted Forstmann fought for control of cosmetics and consumer goods manufacturer Revlon, the rule in its strictest sense states that the board of directors of a corporation has a fiduciary duty to act in the best interest of investors when making decisions regarding a proposed merger and must simply accept the highest price on offer. Although there is conflicting case law as to whether the interests of bondholders, who have a senior claim over assets in bankruptcy, should take precedence over shareholders, there is clear direction in the case of a proposed acquisition: the higher price must win. In the case of an all-cash deal where buyer A offers $30 a share and buyer B offers $40 – assuming both are similarly creditworthy – a board has no choice but to pick the higher price.
However, there is room for manoeuvre in making a qualitative assessment of the net present value of each competing offer, particularly as most offers consist of packages of cash and shares and involve uncertain closing times and transaction risks.
Heart of the battle
Risk analysis is exactly where room for discretionary judgment, argument, and potential for shareholder litigation arises. It is at the heart of the current battle for MCI.
Verizon is the largest telecoms firm in the US, with extensive free cashflow, market capitalization of about $100 billion, and an investment-grade rating. By contrast, Qwest is the US's fourth-largest telephone company, with market cap of about $7 billion and debt of about $17.3 billion, thus presenting much more risk.
If the two firms offered a similar amount for MCI, the choice would be simple. A $6.8 billion offer comprising cash and shares from Verizon (the company's original offer for MCI) would appear superior to the same $6.8 billion offer from Qwest, which might or might not be able to complete the deal. The Qwest offer involves transaction risk since the company might find it more difficult to come up with the cash part of the bid. Further, there is liquidity risk in that MCI shareholders, who would be left holding some 40% of the combined entity, could not simply dump their new Qwest shares on the market.
It is not that simple. Richard Notebaert, Qwest's CEO, made an original bid of $8 billion, outstripping Verizon by $1.2 billion in notional terms. As Euromoney went to press, MCI had agreed to accept an increased Verizon bid of $7.5 billion over Qwest's most recent $8.9 billion. Notebaert then called a press conference and quipped: "The last time I checked with the Federal Reserve, $1.4 billion was a lot of money to leave behind on the table."
The issue for MCI's board is that it is living in a new era of corporate governance; it must act in a way that is not only within its fiduciary duties, but must also be seen by the market to be doing so. Its conundrum was made even more complex in early April when Mexican billionaire Carlos Slim Helu decided to cash in his investment in MCI. Slim started accumulating the defaulted bonds of WorldCom for pennies on the dollar. After WorldCom's restructuring, emergence from bankruptcy, and name change,he found he held 13% of the new MCI, a profitable company with a clean balance sheet.
A special deal
Verizon said it would purchase Slim's 13% stake in MCI for $25.72 a share in cash and throw into the deal an effectively free call option on any appreciation in MCI shares above $35 within one year. Analysts value the option at about $1.55 a share. It is a clear premium to the $23.10 in the cash-and-stock package that Verizon agreed to pay other MCI shareholders in the takeover deal announced in late March. Qwest's latest bid values MCI at $27.50 a share.
