Greece is unable to pay its debt. The referendum of this weekend has solved nothing and the course ahead remains uncertain. Chinese equity markets, which are the second largest after the US, just dropped by 30%. Equity markets have been and are still very sensitive to the uncertainties in the economy and in politics. Increased risks are often a hindrance to equity capital markets transactions, be it equity capital raisings through capital increases and IPOs or public M&A transactions. In this capital markets newsletter we have a closer look into how risks can be mitigated within the existing legal framework. Those who apply such mitigation strategies will be able to do sucessfully transactions when others give up.
Equity Raisings and Initial Public Offerings
In equity capital markets transactions the issuer and the investment banks involved want to maximize the offer price of the new shares. Adverse market developments can seriously jeopardize this objective. In particular, adverse market developments can occur prior to the launch of an initial public offering or a capital increase or they can occur once the offering has been launched.
Period prior to the launch of the offering
In case of an initial public offering it is crucial for the issuer and the investment banks involved to have a clear understanding of the market developments and the expectations as to the issuance price. Therefore, the issuer will – with the aid of the lead banks – perform an in-depth market sounding, thereby testing the investors' reactions to the proposed offering. In this process, the parties can verify whether the price targets are achievable despite the adverse market conditions. Should there be a gap between the expectations of the issuer and market participants, it may be necessary to either
- postpone the IPO; or
- to modify the terms and conditions of the IPO.
With respect to a modification of the terms and conditions, there are basically two ways of achieving this objective. In a first instance, the issuer could simply adjust the offer price to a level corresponding to the results from the market sounding. However, the issuer could also modify the underwriting structure. Instead of placing the shares with the general public, the issuer could try to get firm commitments from a number of institutional investors which are willing to underwrite the whole offering. By doing so, the issuer is able to secure the success of the initial public offering.
Adverse market conditions may also jeopardize a rights offering. Wherever an issuer has a solid shareholder base, the issuer is well advised to make sure that the terms and conditions of the rights offering match the expectations of the main shareholders. In such a context it will be necessary to speak with the main shareholders and to seek their binding commitment. This is the most effective way of securing the success of a rights offering. When contacting the main shareholders, issuer will have to make sure that they do not communicate any price-sensitive information which has not been disclosed to the market yet. The entry into a non disclosure agreement, which contains a non-trading undertraking, at the right point in time is important.
Adverse market conditions in the period following the entry into the underwriting agreement
Should markets deteriorate quickly following the entry into the underwriting agreement, the issuer and the lead banks may wish to terminate the underwriting agreement and to abolish the transaction if it becomes evident that the transaction cannot be successfully completed. The underwriting agreement typically contains termination rights in favor of the lead banks. While this seems – at least at first glance – one-sided, also their issuer has an interest in being able to terminate the agreement. A failed transaction entails high reputational risks. Therefore, the issuer may wish not to proceed with an equity offering. Usually, this is not an issue if the capital increase has not yet been registered with the register of commerce. However, in case the capital increase is already completed, the underwriting agreement contains standard mechanism for reversing a transaction (always assuming that the allocation to investors and settlement has not yet taken place). Typically, mechanisms for such an event of non-completion include the following:
- obligation of the issuer to make a capital reduction;
- call option in favor of the issuer (which allows it to call for the shares subscribed by the lead banks);
- put option in favor of the lead banks (in case the issuer does not exercise the call option);
- right to sell the shares in the open market (in case none of the aforementioned measures has been successfully implemented).
There are certain limitations to be observed, in particular, the threshold set forth in art. 659 of the Swiss Code of Obligations, which provides that a company may acquire up to 10% of its shares (up to 20% in case of transfer restrictions). Therefore, in case of initial public offerings with selling shareholders or rights offerings with majority shareholders, it may be an option to include an obligation of these shareholders to acquire any such shares.
In any event, testing the waters with a comprehensive market sounding is key to the success to any equity capital markets transaction.
Public Takeover Transactions
In public takeover transactions, there are two situations a bidder wishes to manage in uncertain markets:
- the first are dropping equity prices during the period prior to a public tender offer;
- the second are market disruptions and dropping equity prices during the offer.
Period prior to the launch of the offer
The period prior to a public tender offer is relevant to determine the minimum price the bidder has to offer. These minimum price rule applies if the bidder holds less than the mandatory offer threshold (normally 33 1/3%), the company did not opt out of the mandatory bid rules and the bidder offers for shares that shall bring its holding across the mandatory offer threshold. Most bids will meet these criteria. The minimum offer price is the higher of (i) the highest price paid by the bidder (or parties acting in concert with the bidder) for equity securities of the target during the twelve months before the launch of the offer, and (ii) the volume weighted average (VWAP) price of the target's shares during the 60 days prior to the offer.
An ideal market situation for public takeovers is steadily slightly increasing but not too uncertain markets. The bidder can then offer a decent premium over the sixty days VWAP and a slightly smaller one over the market price at the launch of the offer. Purchases prior to the offer hardly matter because they were at prices below the offer price anyhow.
The situation changes in markets with increased uncertainty and falling equity prices. Of course, a bidder may have done its valuation and may feel comfortable with the offer price. However, in particular when the uncertainty increases, a bidder will wish to avoid overpaying. Thus, a bidder will factor in recent declines of the share price of the target company. However, a bidder also needs to set the offer price such that it will, during the (first) offer period, get with a high degree of certainty to a result of the takeover offer that results in a shareholding of more than 50% of all shares. To properly price the offer in such a situation is the particularly difficult part, because high uncertainty also normally means that the views on valuations differ substantially.
Given this situation, one important elements is to keep one's flexibility to reduce the intended price until the start of the offer. This is possible with regard to the minimum price rule to the extent it relates to the price paid in purchases during the 12 months' period prior to the offer. Normally, it makes little sense to purchase some few shares. Purchasing shares below the reporting threshold of 3% is strategically of little value, since such participation does often not allow to call a shareholders meeting or to put items on the agenda. The only benefit may be that in case of a competing bid, the cost of the takeover attempt could be covered by tendering into the higher competing bid. Purchasing a substantial stake may be of some value. Normally, one would not like to do this in the market because this triggers the obligation to announce one's shareholding starting from 3%. One would thus purchase from some larger shareholders and such purchases can normally be timed such that they happen shortly before the launch of the offer.
The 60 days VWAP is more difficult to control. Measures that would allow direct influence on the 60 days VWAP are forbidden under the prohibition to manipulate market price. One possibility would be to wait with the offer and let the 60 days VWAP adapt. This may however not yield the proper results and may not be operationally feasible. Another possibility is not to offer cash, but shares or a combination of shares and cash. If the shares offered are also listed and have sufficient liquidity, the 60 days VWAP has to be applied to check whether the offered shares or combination of shares and cash meet the minimum price rule. This results in a natural hedge against a too high VWAP. The same may be achieved with illiquid shares and other securities. In these instances, the review body engaged by the bidder needs to value the shares or securities. The review body will have a tendency to value based on a longer term perspective and thus will likely end up at a price meeting the minimum price requirements. The decision to offer a non-cash consideration comes with a further limitation however. If the bidder buys 10% or more target shares during the 12 months window prior to the launch of the offer against cash, the bidder is obligated to offer a full cash alternative to all the shareholders. Therefore, launching an exchange offer or a mixed offer limits certain strategic options.
Period after the launch of the offer
After the launch of an offer, equity prices may further drop and market crashes may occur. In principle, any such price drop and any crash does not allow to abandon the offer after its launch. In other words, no conditions are allowed that refer to any kind of market developments. The bidder has written a put-option to the shareholders of the target company at the offer price against a zero premium. There are certain possibilities to control these risks:
A first possibility is to include a company specific material adverse change clause. Such clauses have become a standard in takeover bids in Switzerland. However, they have a quite limited scope of application: First of all, they only apply during the offer period. That is the period of normally 20 trading days (up to 40 trading days) starting after a ten trading days' cooling off period. Second, they are limited to reasonably expected impacts of the material adverse change of 5% in turnover, 10% in EBIT or EBITDA, 10% in net income, or 10% in total assets or equity of the target company. The material adverse change may also be a general event, i.e. does not have to be company specific. The material adverse change clause therefore only protects against a drop in equity prices if this is due to an event that is also expected to impact the target company heavily.
A second possibility to control the risk of lowering market prices may be to enter into a (partial) hedging strategy using financial instruments. However, there are a number of draw-backs that limit the application of such strategy substantially: The strategy would only protect against dropping market prices and a market disruption until the settlement of the offer. One could not use the target shares as underlying for the hedging strategy, but would have to use a more or less adequate portfolio, which may be acceptable since company specific material adverse change clauses are possible and also protect partly against market risks. The strategy may work in smaller transactions, but is unlikely to work in large transactions because of the lack of adequate counterparties to set up the hedge. A further disadvantage is that the exact term of an offer is hard to predict, so that the hedging position may have to be rolled-over and prolonged once or several times. There is no certainty that the transaction will succeed, so that one does not necessarily wish to select a hedge that leaves one with substantial cost after the takeover bid failed. On the other hand, a hedging position with such properties will normally come with corresponding substantial upfront costs. Therefore, the conditionality and uncertainty of a takeover bid may make a synthetic hedge using financial instruments a relatively expensive exercise and will therefore often not be feasible.
A third and more obvious option is to offer bidder shares or shares in an entity to be spun-off from the bidder. Offering shares in an entity that shall be spun-off may be particularly interesting if such spin-off helps to solve competition law issues. Clearly that makes the transaction more complicated, particularly if the spun-off entity shall be listed. However, depending on the market on which that entity shall go public, such spin-off is achieved within few months, which is often acceptable in a takeover setting. The complicated part is to properly time the listing with e.g. a regulatory approval sought. The disadvantage of offering bidder shares is that the exchange ratio needs to be carefully explained to the bidder's shareholders and the market. An offer that is not well received may lead to dropping prices of the bidder shares and thus make the takeover bid even more likely to fail.
Instead of offering bidder shares or shares of an entity to be spun-off from the bidder, one could also offer interests in a collective investment scheme that tracks a market index. This has so far not been tested for offers for operating companies. However, in cases where interests in collective investment schemes were offered for shares in an investment company, such interests were accepted in an exchange offer under certain circumstances. As long as the selected index is already widely used for index tracking funds, such as the SMI or Euro Stoxx 50 or the like, one may reasonably expect that offering interests in an index tracking fund would be acceptable. Fullfunding would not have to happen immediately, but could take place after the offer became successful. Since the index can also increase and financing needs to be certain already at the time of the launch of the offer, the bidder would be required to have a certain security margin available or would need to fund prematurely or to purchase the index promptly should there exist a risk that certainty of funds would be missing. The obvious disadvantage is the quite unusual currency. One would therefore provide for the right of the holders of the interests in the collective investment scheme to redeem their interests in the collective investment scheme more frequently after the settlement of the offer. The advantage of the solution is that it enables target shareholders to apply their own hedging strategy. Further, an index tracking security is much less prone to any strategy that bets against the success of the takeover. Substantial disadvantages are that setting up a collective investment scheme adds costs and complexity and needs to be carefully designed in terms of timing. Approval processes may take up to between two and six months and are very difficult to predict. Another disadvantage is that the protection only holds until the settlement of the offer, i.e. when the interests in the collective investment scheme need to be funded the latest. This may be overcome by promptly refinancing the offer price in a discounted share offering of the bidder.
As seen, also in times of uncertainty, there are possibilities to structure a takeover such that proper protection is available. Transactions get more complex and come with increased costs, but those that apply protective strategies successfully will be able to launch and complete better and more successful transactions.