Among the valuation issues recently addressed by the Delaware Courts is the question of whether financial buyers pay fair value when acquiring a company, particularly in situations where the competing bidders are also financial buyers.
“Fair value,” under Delaware law, is not synonymous with fair market value, a concept traditionally defined as the price at which property changes hands between a willing buyer and willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. Rather, Delaware law requires the Court to determine fair value “exclusive of any element of value arising from the accomplishment or expectation of the merger” and based on “all relevant factors.”
In other words, the fair value determination must be exclusive of the value of any synergistic benefit and is therefore not necessarily equivalent to the highest price a bidder is willing to pay.
The question of whether financial buyers pay fair value has been addressed recently in post-trial decisions by both the Delaware Chancery Court and the Delaware Supreme Court. However, the findings of the Court are inconsistent.
The Courts’ Findings
In his opinion in In re Appraisal of Dell, Inc., Vice Chancellor Laster found that what a financial sponsor is willing to pay diverges from fair value because of both the sponsor’s “need to achieve IRRs of 20% or more to satisfy its own investors” and the “limits on the amount of leverage that the company can support.”
In In re Appraisal of DFC Global, Inc., Chancellor Bouchard agreed with Vice Chancellor Laster’s view finding that the buyer’s status a financial sponsor, “focused its attention on achieving a certain internal rate of return and on reaching a deal within its financing constraints, rather than on DFC’s fair value.”
However, Vice Chancellor Slights in In re Appraisal of PetSmart, Inc. did not adopt Chancellor Bouchard and Vice Chancellor Laster’s skepticism toward a merger price resulting from a single type of buyer. According to Vice Chancellor Slights, the fact that a private equity buyer constructs its bid with desired returns in mind does not mean that the bid is not reflective of fair value.
Finally, in what is currently the last word on the matter, the Delaware Supreme Court in DFC Global Corporation v. Merion Capital et al. very clearly sided with Vice Chancellor Slights finding that any rational buyer (strategic or financial) “should have a targeted rate of return that justifies the substantial risks and costs of buying a business.”
So which view is correct? Can a market that consists solely of financial buyers be considered a “well-functioning” market? If the targeted 20-25 percent rates of return are justified by the financial buyer’s risk and a thorough canvasing reveals no interested strategic buyers, the answer would seem to be ‘yes’ – but those are two big ifs.
The Auction Process
The PetSmart case illustrates that the question of whether all interested strategic buyers were contacted is sometimes a gray area. According to the Proxy Statement filed in connection with the transaction, Petco (aka “Industry Participant”) was ultimately not “invited” into the exploratory process, but if it wanted to submit a proposal, the board would consider it. Assuming for the sake of argument that this is effectively equivalent to outright refusing to engage with Petco, was Petco’s exclusion justified?
PetSmart cited three reasons in the Proxy for not ultimately inviting Petco into the process: (#1) antitrust concerns, (#2) concerns that Petco would gain competitive intelligence, and (#3) concerns that Petco would disrupt or delay the sales process. Do these concerns warrant excluding what the Court described as PetSmart’s “only one true peer”? A closer look at the process raises some questions.PetSmart’s Initial Discussions with Petco
According to the Background of the Merger discussion in the Proxy, the “exploratory sales process” that ultimately culminated in the sale of the company to BC Partners began in March 2014 with the Board authorizing management to contact Petco to determine its interest in initiating “exploratory discussions” concerning the feasibility of a merger or acquisition transaction.
During the Spring of 2014, David Lenhardt, PetSmart’s CEO, spoke on a few occasions to Petco’s CEO and Petco’s CEO informed Mr. Lenhardt that:
(a) Petco was not for sale; and
(b) Petco’s management and owners believed that antitrust clearance for a combination of PetSmart and Petco would not be received or would be received only with unacceptable conditions.
At this point in time, the PetSmart Board was obviously already aware that (a) a PetSmart-Petco merger would receive enhanced regulatory scrutiny and (b) any meaningful discussion between the parties would involve the sharing of sensitive information on both sides. As for PetSmart’s (#3) ultimate concern regarding the possibility of Petco “delaying” or “disrupting” the process, were such concerns prevalent at this juncture, it seems like a discussion with Petco would be a strange place to begin such a process.Pressure from JANA Partners
On July 3, 2014, JANA Partners filed a Schedule 13D with the SEC disclosing that it had acquired 9.9% of PetSmart’s outstanding common stock and intended to engage in discussions with management and the board with respect to a review of strategic alternatives, including a sale of the Company.
JANA later emphasized in a July 29, 2014 letter to the PetSmart Board that its’ preferred strategic alternative in PetSmart’s case was a sale of the company:
While we typically work constructively with boards and focus primarily on changes that can be made while companies remain public, given PetSmart’s chronic underperformance and significant private equity interest in the Company, a sale in this case very likely offers the highest risk-adjusted return for shareholders.
JANA’s letter goes on to inform the PetSmart board that anything outside of a sale would be unacceptable and explains why a sale to a private equity buyer is the optimal yet time-sensitive outcome:
By contrast, a sale very likely offers the highest possible risk-adjusted return for shareholders. As long-time shareholder Longview Asset Management noted in its public letter endorsing exploring a sale, “PetSmart is likely to be valued much more highly by private market participants than by its current public market investors.” This is because a private equity buyer will pay shareholders based upon its confidence in its ability to create value, a confidence which is justifiably absent among current investors. Private equity can also take advantage of a highly attractive financing market, though given the possibly fleeting nature of the current environment PetSmart cannot afford to waste more time by floating ideas for potential standalone strategies whose time has likely long passed.
The JANA letter then closes with the threat of a Proxy fight at the next annual meeting should the PetSmart Board not comply with its demands.Petco Returns
On August 7, 2014, a representative from Petco contacted a representative of J.P. Morgan (the ad hoc committee’s financial advisor) indicating that she had heard rumors that J.P. Morgan was working with the Company and informed the J.P. Morgan representative that, if the Company were to pursue strategic alternatives, Petco might be interested in re-visiting the conversations that had taken place in the spring concerning the feasibility of a possible combination of the two companies. The J.P. Morgan representative reported the conversation to the ad hoc committee.The Board’s Deliberations re: Petco
On August 13, 2014, the PetSmart Board discussed Petco’s most recent communication and reviewed the potential 'benefits and risks' of allowing Petco to participate in the exploratory sale process.
Among the risks discussed were:
(a) the very high risk that an acquisition by or a combination with Petco would not receive antitrust clearances, or would receive such clearances only with the imposition by governmental authorities of unacceptable conditions and the near certainty that the process of seeking such clearances would result in the receipt of a so-called “second request” from governmental authorities and would take eight months to a year, or longer, to pursue, with no assurance of success even after such a delay;
(b) the risk that Petco would obtain competitively advantageous information in the course of due diligence even if it were not the winning bidder or never bid; and
(c) the risk that participation by Petco in the sale process would disrupt or negatively impact the sale process or impose an unacceptable time delay, in either case which would not advance the goal of maximizing shareholder value.
The Proxy does not mention what benefits (if any) were discussed by the Board.The August 19th Announcements
On August 19, 2014 PetSmart announced:
(a) its financial results for the second quarter of 2014 as well as guidance for Q3 and fiscal year 2014;
(b) a definitive agreement to acquire Pet360, an online pure play pet specialty retailer, for $130 million;
(c) a broad cost reduction program that would fundamentally restructure the cost base of the Company; and
(d) the Board’s decision to explore strategic alternatives for the Company to maximize value for shareholders, including a possible sale of the Company.
According to the Proxy, on August 22, 2014, a representative of J.P. Morgan contacted the representative of Petco with whom the J.P. Morgan representative had spoken to on August 7.
During this August 22nd call:
(a) Petco indicated that it was aware of the Company’s August 19 “announcement”;
(b) the J.P Morgan representative informed the Petco representative of the board’s concerns regarding Petco’s participation in the process; and
(c) the parties agreed to speak again in a few days.
On August 27, 2014, representatives of Petco contacted the representative of J.P. Morgan.
During this August 27th call:
(a) The Petco representatives stated that Petco would have interest in discussing the possibility of a combination of the two companies;
(b) The J.P. Morgan representative reiterated the concerns identified by the board that engaging with Petco was unlikely to maximize value for PetSmart’s stockholders; and
(c) The J.P. Morgan representative stated that Petco would not be invited into the exploratory process, but that if it were to wish to submit a proposal or other communication to the Company, the board would consider it.
According to the Proxy, there was no further contact between PetSmart and Petco (or between any of their respective representatives) following August 27, 2014.
#1 – A PetSmart-Petco combination in any form would receive regulatory scrutiny. That was true in March 2014 when PetSmart initially contacted Petco about a potential transaction, it was true on August 7, 2014 when Petco contacted PetSmart about a potential transaction, it was true on August 27, 2014 when Petco contacted PetSmart again about a potential transaction, it was true in September 2015 when Petco and PetSmart again discussed a potential transaction after PetSmart had been taken private, and it is still true today. The regulatory hurdle has been a constant so the regulatory concern (alone) does little to explain why PetSmart would exclude Petco from the sales process, yet engage with them both before and after that process.
#2 – If concerns about disclosing sensitive information prevented competitors from exploring a potential transaction, there would be far fewer strategic transactions. There are many precautionary measures that can be implemented for the handling of sensitive information and antitrust laws limit the exchange of commercially-sensitive non-public information.
#3 – The Boards’ concerns with regards to the risk of Petco “disrupting” or “delaying” the process arose after JANA Partners threatened a proxy fight at the next annual meeting. If there is an alternate context for Petco’s potential to disrupt or delay the process (aside from regulatory delay), the Proxy is silent on it.
#4 – According to the timeline of events as presented in the Proxy, the PetSmart Boards’ concerns regarding a transaction with Petco arose after Petco informed PetSmart that it was not for sale, yet they would apply equally to a combination of the 2 firms regardless what firm played the role of “target”.
All of this is of course open to interpretation but for the sake of argument, let’s assume Petco’s exclusion was somehow justified, does that make the market for PetSmart something less than “well-functioning”? The answer then would seem to depend on whether a financial buyer’s targeted rate of return is, in fact, justified by “the substantial risks and costs of buying a business.”
Financial Buyers’ IRR Targets
A June 2016 article in the Journal of Economic Finance based on a survey of 79 private equity investors with combined assets under management of $750 billion found that “PE investors typically target a 22% internal rate of return on their investments on average (with the vast majority of target rates of return between 20 and 25%), a return that appears to be above a CAPM-based rate.” The survey found that both gross and net (of fees) IRR targets seem to exceed what one would expect in a CAPM-based framework.
It should come as no surprise then that the same survey found very few private equity investors using DCF or net present value techniques to evaluate investments, relying instead on internal rates of return and multiples of invested capital. A WACC-based DCF approach was reportedly used in only 10.9% of deals while a gross IRR approach was used in 92.7% of deals.
These findings are supported by the most recent findings from the annual Private Capital Markets Report from Pepperdine University. According to the 2017 Private Capital Markets Report, the median private equity target fund return was 25%. In addition, only 29% of the private equity investors surveyed reported using a discounted future earnings valuation method.
Returning to the Supreme Court’s finding in DFC Global:
“any rational buyer should have a targeted rate of return that justifies the substantial risks and costs of buying a business”
Using the typical definition for cost of capital: the expected rate of return available in the market for other investments of comparable risk, we can revise the Courts finding above to “any rational buyer should have a targeted rate of return that is justified by that buyer’s costs of capital.”
But do financial buyers’ targeted returns equal their cost of capital? No. At least not if they intend to be successful. As (Metrick and Yasuda 2011) note, “It is important to note, however, that the targeted return is not the same thing as the cost of VC. When VC’s discuss targeted returns, they are referring to successful investments.”
This makes perfect sense. Financial buyers, like corporations, prefer investments with a positive net present value (i.e., a return that exceeds the cost of funding the project). But therein lies the point – an IRR calculation is not the same thing as a reshuffled discounted cash flow analysis solving for a different variable. If that were the case, then the IRR should equal the cost of capital.
The financial buyer’s targeted IRR reflects some premium above its cost of capital as most PE funds have hurdle rates that must be met before the manager takes a carry (share of the profits). Earning higher premiums allow general partners (GPs) to negotiate more favorable terms with limited partners (LPs) when raising additional funds.
Is this alone proof that financial buyers do not typically pay fair value? Not necessarily but it is clear that a financial buyer’s targeted returns are based on factors beyond solely the perceived risk of buying the business. The returns are informed by interest rates, liquidity, LP demand as well as competition for assets from other financial buyers. According to the 2017 Preqin Global Private Equity & Venture Capital Report, dry powder (funds raised but not yet invested) held buy PE funds increased in 2016 to an all time high of $820 billion at the end of 2016. The dramatic increase in dry powder is both a function of near-record fundraising and increased competition for deals as asset values continue to increase.
All of this suggests to me that the financial buyer’s winning bid (in an all financial buyer auction) falls on the spectrum of fair value depending on a multitude of factors. The greater the competition among financial buyers for solid deals that provide the type of return demanded, the more likely the winning bid will be to reflect fair value. Furthermore, inviting the obvious strategic buyer into the process, particularly in situations where competition amongst financial buyers is less pronounced, should have a similar effect.
Given that the Dell case is currently in front of the Supreme Court, we can expect to hear more on this topic soon.
. United State v. Cartwright, Executor., 551 (U.S. 1973).
. Del. C. § 262(h).
. In re Appraisal of Dell, Inc. C.A. No. 9322-VCL (May 31, 2016), p. 63.
. In re Appraisal of DFC Global, Inc. C.A. No. 1017-CB (July 8, 2016), pp. 62-63.
. In re Appraisal of PetSmart, Inc. C.A. No. 10782-VCS (May 26, 2017), p. 78.
. DFC Global Corporation v. Merion Capital et al. C.A. No. 10107 (August 1, 2017), p. 3.
. Gompers, Paul A. and Kaplan, Steven N. and Mukharlyamov, Vladimir, What Do Private Equity Firms Say They Do? (June 1, 2016). Journal of Financial Economics (JFE), Vol. 121, No. 3, 2016. Available at SSRN: https://ssrn.com/abstract=2447605 or http://dx.doi.org/10.2139/ssrn.2447605
. Everett, Craig R., 2017 Private Capital Markets Report (April 1, 2017). Pepperdine University.
. Metrick, Andrew and Yasuda, Ayako, Venture Capital and the Finance of Innovation. 2nd Edition, John Wiley and Sons, Inc., 2010. p. 180.
. 2017 Preqin Global Private Equity & Venture Capital Report, pp. 16, 86.