More than a year after the Delaware Court of Chancery handed down its decision in In Re Del Monte Foods Company Shareholders Litigation, 25 A.3d 813 (Del. Ch. Feb. 14, 2011), there remains an abundance of uncertainty in the financing market as to whether stapled financing is still a viable source of buy-side financing in merger and acquisition transactions. While this structure has received a fair amount of judicial attention in recent years, private equity firms can still take advantage of the benefits of stapled financing, especially when avoiding five specific pitfalls highlighted in Del Monte.
What is Stapled Financing?
“Stapled financing” colloquially refers to the commitment letter and term sheet provided by a target company’s financial advisor containing the principal terms of a financing package that is “stapled” to the back of the offering materials prepared by such advisors and distributed to potential bidders. The financing is generally not required to be utilized by the buyer, and arises in connection with the sale of both public and private companies, including subsidiaries and divisions.
The potential benefits of stapled financing are numerous and well established. In addition to creating a pricing floor, it has the added benefits of strengthening deal certainty and speeding up the transaction, and increasing confidentiality by reducing the need for bidders to contact alternative financing sources. It may also encourage more aggressive bidding by strategic buyers (entities that typically finance an acquisition on their own balance sheets or through the capital markets) as the presence of a stapled financing package could cause a strategic buyer to regard competition from private equity sponsors as more likely.
In a tight credit market, as has been the case in recent years, stapled financing has the added benefit of guaranteeing that financing will be available. It may also provide a level of comfort to bidders that the lender offering the package is, after conducting its own due diligence or from having a prior working relationship with the target, confident in the future profitability of the company.
Conflicts of Interest
The primary drawback to a lender serving the dual role of the target company’s financial advisor and the buyer’s financier is the potential conflict of interest. Given that the lender may stand to make tens of millions in additional fees if a financing package is accepted (fees for advising on a corporate sale are typically around 0.5 to 1.5 percent of the transaction value, depending on the transaction size, while a lead arranger of loans for a leveraged buyout can make up to 3 percent of the loan’s value), it may be inappropriately incentivized to encourage the target company to proceed with a sale that may not otherwise be in the company’s best financial interest. The financial advisor may also be inappropriately incentivized to steer a sale to the bidders that are more likely to use their stapled financing, as opposed to the bidder that may be more strategically appropriate. Furthermore, the bidders participating in a sale may feel undue pressure to pursue the stapled financing in order to ensure equal treatment in the auction process.
Treatment by Courts
One of the leading cases dealing with these issues came out of the Delaware Court of Chancery in 2005 where then-Vice Chancellor Strine explained in In re Toys “R” Us, Inc. Shareholder Litigation, 877 A.2d 975 (Del. Ch. 2005), that “the [board’s] decision [to allow its financial advisor to finance the sale of a subsidiary] was unfortunate, in that it tends to raise eyebrows by creating the appearance of impropriety.” The Court ultimately held that notwithstanding the appearance of conflict, there was no basis to conclude that the stapled financing package offered by the target’s financial advisor influenced its sell-side advice. Chancellor Strine would elaborate on this decision at a conference in California in 2006, where he declared that Toys was really a warning against a case of lenders chasing fees when it had no benefit to the seller.
The Delaware Court of Chancery would revisit the issue six years later in Del Monte where the Court, in response to a motion seeking a preliminary injunction, halted a stockholder vote on the proposed merger between Del Monte Foods Company and a subsidiary of Blue Acquisition Group, Inc. (an entity owned by three private equity firms) because it found signs of inappropriate collusion between the target’s financial advisor and the acquiring group of private equity firms. The financial advisor, although not a named defendant at the time of the ruling, was criticized for appearing to bring together competing bidders in a club deal, thereby limiting the competition and violating certain confidentiality agreements that prohibited joint bids without the written permission of the target company. Vice Chancellor Laster found that the financial advisor, which stood to make an additional $21 to $24 million by providing the financing, “secretly and selfishly manipulated the sale process to engineer a transaction that would permit [it] to obtain lucrative buy-side financing fees.” Despite good faith efforts by the board to ensure that the transaction was in the best financial interests of the company’s shareholders, the Court enjoined the stockholder vote for 20 days to allow for a possible superior bid to emerge and also enjoined the enforcement of the no-solicitation, matching-rights and termination fee provisions pending the postponed stockholder vote.
The transaction would ultimately be approved by shareholders in a special meeting, but Del Monte and its financial advisor would pay a combined $89.4 million in a later settlement with shareholders. This figure, one of the largest in a shareholder lawsuit challenging a merger or acquisition transaction, has had a chilling effect on the use of stapled financing, has encouraged lenders to implement stricter review processes for stapled financing situations and has led some private equity firms to take the costlier approach of seeking outside financing in a merger or acquisition transaction because of the litigation risks involved. Following Del Monte, a private equity firm is right to be more cautious about the use of stapled financing, but it should not completely disavow its utility as long as certain steps are taken.
As evidenced by Del Monte and other prior Delaware rulings, decisions by boards of public companies in a merger or acquisition context are highly scrutinized as they have a fiduciary duty to obtain the highest value reasonably available for their shareholders. However, since a privately-held company is usually only accountable to a smaller group of private investors, the risk of future shareholder litigation in connection with a merger or acquisition is greatly reduced, especially when a substantial portion of the shareholders are not “unaffiliated” or otherwise passive investors. In either context, a private equity firm engaged in the bidding process and interested in using a stapled financing package offered by a target company’s financial advisor in a transaction governed by Delaware law will greatly abate the risk involved in such a course of action if the following steps are proactively taken:
- Ensure the Target’s Board of Directors is Actively Involved: To the extent possible, a private equity firm interested in bidding for a company where stapled financing is offered should verify that the target’s board of directors has fulfilled its fiduciary duty. This includes, but is not limited to, considering any potential conflicts of interest with your private equity firm (including what actions the advisor may already have taken with respect to a possible acquisition), demonstrating the clear benefit of the stapled financing, ensuring there are provisions in any non-disclosure agreements that limit clubbing and seeking a fairness opinion of both its primary financial advisor (which may be entitled to a success fee upon the consummation of the transaction) and a second financial advisor (which would not be entitled to any additional fee upon the consummation of the transaction). It is of course helpful if the target company’s engagement letter with its primary financial advisor includes a provision in which the fee for a fairness opinion from the second financial advisor is partially or fully creditable against the fees to be paid to the primary financial advisor in the event stapled financing is utilized.
- Ensure the Target’s Board Mandates Proper Disclosure: The Court in Del Monte focused on the fact that the financial advisor had explicitly sought to obtain lucrative financing fees regardless of any potential benefit to the target company and had engaged in strategic discussions with potential bidders without the explicit knowledge or prior written consent of the target’s board. A private equity firm must not only avoid engaging in the latter, but should take an active role in ensuring that any engagement letters entered into in connection with the transaction mandate certain provisions. Such provisions should include, but not be limited to, the disclosure of all communications between the financial advisor and prospective buyers, the disclosure of all known conflicts of interest by the financial advisor and a covenant requiring the financial advisor to cease all discussions about the transaction with certain third parties if so requested by the seller’s board.
- Ensure the Lender Offering Stapled Financing Maintains Strict Internal Guidelines: Although the Delaware Court of Chancery posited in Del Monte that the “buck stops with the board,” the lender offering stapled financing has its own obligation to ensure that the conflict of interest created by its dual role is sufficiently diminished by the imposition of strict internal guidelines. A savvy private equity firm will inquire into whether an offering lender maintains informational barriers between its buy-side and sell-side teams that are commensurate with standard market practices, especially when dealing with smaller lenders who may not maintain the same internal controls as some of the larger financial institutions. The stricter the policy, the lesser the likelihood of future judicial scrutiny.
- Avoid Conduct that Interferes with the Target Board’s Duties: Do not engage in discussions with the target’s financial advisor on matters pertaining to the financial advisor’s own economic interests. This may be interpreted as interfering with the target board’s fiduciary duties. If you plan on engaging in such discussions with the financial advisor or other potential bidders, obtain written consent from the target beforehand, even when not contractually required to do so.
- Adhere to Confidentiality Agreement Provisions: Do not violate the terms of any confidentiality agreements executed in conjunction with the proposed transaction, especially through discussions with competing bidders. The Court in Del Monte explicitly mentioned the acquiring private equity firms’ non-adherence to such confidentiality agreements as a reason to enjoin the shareholder vote.
Should these five steps be taken by a private equity firm engaged in a merger or acquisition transaction where they agree to use a stapled financing package, or any financing package for that matter, the risk of a negative impact on their investment created by potential future shareholder litigation will be substantially reduced.