This article was published in ACG’s Middle Market Growth Weekly and in ACG New York Private Equity in Review 1H 2016 on August 18, 2016. It is reprinted here with permission.
Delaware state courts have seen a rise in appraisal petitions filed by shareholders dissenting from mergers, with 34 actions filed in the first half of 2016, compared to 16 in all of 2012, according to a recent Wall Street Journal article.
Much of the rise in appraisal petitions is attributable to "appraisal arbitrage," a strategy where investors, primarily hedge funds, invest in companies after a merger announcement to obtain returns through an appraisal proceeding rather than through the merger itself.
In Delaware appraisals, shareholders receive the fair value of their shares, as determined by the court, rather than the price offered in the merger, plus interest at a rate of 5 percent over the Federal Reserve discount rate. This relatively high interest rate encourages appraisal arbitrage, driving more than 45 percent of petitions filed and accounting for 60 percent of returns in Delaware appraisals from 2000 to 2014, according to a recent study by Wei Jiang, Tai Li, Danqing Mei and Randall Thomas.
Attempt to Curb Appraisal Arbitrage
Two amendments to Section 262, effective August 1, may discourage some appraisal petitions, but likely will not be enough to reduce appraisal arbitrage.
The first amendment requires, with some exceptions, that the total number of shares entitled to appraisal exceed 1 percent of the outstanding shares eligible or $1 million in value. Yet, the amendment fails to address the high statutory interest, limiting its impact on appraisal arbitrage.
The second amendment allows companies to prepay shareholders before the fair value determination. This eliminates interest payable on the difference between the fair value and the cash prepayment, reducing potential returns for arbitrageurs. However, it also sets a floor on the investors downside and gives them access to immediate cash.
Guidance from the Dell Appraisal Decision
Unlike the amendments, the recent Dell appraisal case provides a roadmap for investors on where appraisals may be most effective.
In particular, the decision, which valued Dell shares around 30 percent more than the amount paid in the 2012 management buyout at issue, highlights three reasons why the merger price in management or leveraged buyouts may not reflect fair value:
- Leverage-based valuation models focus on what buyers are willing to pay, not going concern value.
- Buyouts often take advantage of valuation gaps between market price and the long-term value of the company.
- Structural issues in buyouts (e.g., information asymmetry, restrictive go-shop provisions) may inhibit price competition post-signing, emphasizing the need for robust pre-signing competition.
Investors likely will continue to challenge merger strategies built on the teachings of Dell, hoping that a court will find the target similarly undervalued. Rather than be eliminated by the amendments to Section 262, appraisal arbitrage can be expected to remain a trend in 2016, especially in mergers involving management buyouts or leveraged buyouts.
As a side note, one of the largest opponents of the Dell transaction, T. Rowe Price, lost out on two counts. First, the automated voting protocols voted for the transaction when the fund thought it had voted no (a necessary predicate to appraisal rights). Second, it mistakenly waited two years to receive the merger consideration, costing its investors $190 million, without interest, that the fund says it will repay.