Challengers to the deal

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Unlike most commercial settings, where “a deal’s a deal” once the principals have agreed to the terms of the transaction, in an M&A there is always the risk of a third-party offer or challenging bid. According to data supplied by Dealogic, since 2005, completed challenging bids represented fewer than 1 per cent of all transactions from 2005 to now, but with an average deal size of $3.1bn, this accounts for almost 10 per cent of the value of all completed M&As. The majority of deal jumping challenging bids are successful.

Third-party offers or challenging bids can arise in a range of situations, and may be considered welcome or unwelcome. Welcome challengers include multiple bidders for a single target that has put itself up for auction and friendly or “white knight” challengers who are sought out by targets to thwart hostile takeovers.

One type of unwelcome challenger (at least from the perspective of the acquirer) emerges after the M&A parties have announced a target, endorsed a friendly offer or signed an agreement. In North America, these challengers are commonly called “deal jumpers”, and their presence effectively demotes the prospective acquirer to first bidder status.

The unwelcome status of deal jumpers is well deserved because most third party challengers are successful. The risk to all parties – first bidder, target and deal jumper – is particularly acute in the megadeal category. From the perspective of the first bidder and deal jumper, a failed bid creates uncertainty. It leaves the market wondering what the losing bidder will do with its strategy. The market will ask – and the losing bidder’s stock price will reflect – whether the loser has a plan B. From the target’s perspective, failure to close a deal may cause other potential acquirers to view the target as damaged goods.

Consider the plan B of of Swiss mining company Xstrata. After losing the struggle last year for Australia’s WMC Resources, Xstrata successfully launched a $17bn challenging bid for Falconbridge, the Canadian copper and nickel group, creating the world’s fifth largest mining company.

The presence of a deal jumper makes a transaction more complex, not only in terms of bid justification but also in terms of bid strategy. From a bid strategy perspective, consider that for all challenging bids announced since 2005, on average, first bidders offered a 19.6 per cent premium and revised their initial bids by 12.3 per cent. By comparison, deal jumpers, on average, bid 24 per cent more than the first bidder’s original bid and were successful in two-thirds of the cases, according to data supplied by Dealogic. Intuitively, it makes sense that big deals attract the interests of competing bidders who may serve to drive up the premium offered to the target. However, the question is: what hurdles must a putative jumper clear to complete a successful leap?

Initial valuation

There are two parts to the initial valuation of the transaction. First, the perceived valuation of the deal by the market and shareholders. Second, the total costs of the acquisition, accounting for any break-up or break fees that would be owed to the first bidder if the deal jumper prevailed.

Form of consideration The initial bidder may offer the target’s shareholders cash, shares or some combination of the each. When faced with two competing cash transactions, valuation is generally simple: more is better. In these situations, the target shareholders do not need to be concerned with whether the initial bidder can actually recoup the premium being offered. Unless there are financing contingencies or difficulties, a risk of regulatory approvals or an adverse non-shareholder constituency response threatening to derail the process, the higher cash bid should prevail. In cash transactions, the initial bidder and deal jumper are limited only by the health of their balance sheets and any impact a transaction may have on any earnings-based valuation.

When faced with two competing share transactions, or a transaction that combines shares and cash, valuation is more complex. Target shareholders will have an ownership interest in the merged company, and this raises two issues: the target’s after-tax operating contribution to the combined company; and the realistic attainment of synergies. Target shareholders care about synergies because failure to achieve them will affect their monetary interest in the combined company, as their fate is joined with that of the acquirer. This, however, allows deal jumpers to enter the fray if they can convince target shareholders that their offer will be stronger than that of the first bidder.

Break-up or break fees These are payments from the target to the acquirer in the event that the deal is not closed. In deals from 2001 to 2005, such fees averaged 2.6 per cent of deal value at announcement in deals over $500m according to Dealogic.

In part to allay the concerns of the initial suitor that it may be used as a stalking horse for a subsequent bid, these are designed to compensate for the time and trouble taken to launch the first bid. Depending on the size of the fee, an additional benefit to the suitor is the deterrent effect it may have on other bidders. It is for this reason that, while they are a common form of limited deal protection in the US, break fees are limited or prohibited in other jurisdictions.

Due diligence possibilities

One advantage of a friendly transaction is that the first suitor can perform some level of due diligence on the target. Through this process, it can assess the likely synergies to be achieved and identify reasons to justify the premium it proposes to pay. In certain circumstances, however, the desire to create a level playing field limits the ability of the target to avoid providing the same information furnished to the original bidder to other potential acquirers.

In the US, where it is common to have a merger agreement in a recommended transaction, the parties may seek to contractually proscribe the manner in which the target board of directors may respond to challenging bids. Common proscriptions may include the condition that the challenging bid be deemed superior to the first suitor’s bid and/or that the first suitor has the ability to match a proposal – often for a specified number of days.

There are, however, certain things that the first bidder may not be able to discover in due diligence. To protect itself in these circumstances, the first bidder may request a negative condition in the offer – the so-called material adverse change provision (MAC). In general, however, parties do not want to walk away from the deal, and MACs have traditionally been used to renegotiate the price of the transaction.

Laws of the jurisdiction

Deal jumpers look for opportunities presented by regulatory hurdles, such as competition clearance, and any additional governmental approval required in sensitive industries. In the case of cross-border jumps, this includes restriction or pre-clearance of foreign ownership of shares.

Offers may be conditional on such approvals. When conditions involve a lengthy approval process, they create an opening for a deal jumper because transaction timing affects the true value of the initial bidder’s bid. For example, to obviate any concerns about certainty of value, medical device manufacturer Boston Scientific agreed that, if its transaction with Guidant did not complete by March 31 2006, the offer price would be increased by $0.012 in cash for each day until the transaction closed.

Equally important are the political ramifications, particularly if the deal jumper is foreign. In a media interview about Cnooc’s failed $18.5bn effort to acquire California-based Unocal, Fu Chengyu, chairman of the Chinese energy giant, declared: “We learned to be more prudent in terms of public relations and political lobbying… and then if those things work out, you turn to talk about the deal.”

What’s a jumper to do?

Below, are some practical steps for jumpers to consider.

Take out your pencil Understand the first suitor’s pricing threshold. In a cash deal, the first suitor will be concerned about the balance sheet and any earnings-based valuation measures. At some level, its financial ratios will start to deteriorate. The good news about a cash deal is that it is harder for the target to argue that $10 is better than $15. In stock deals, exchange ratios will provide a measure for evaluating the target’s pro forma ownership in the merged entity.

The target’s contribution, after taking into account potential synergies, should approximate that level of ownership. At some point, an increase in the exchange ratio will outstrip the target’s contribution at a reasonable level of synergies. And remember to factor in the costs associated with any break-up fees.

Assess the realistic due diligence possibilities Due diligence is important when assessing the likely level of synergies needed to justify the premium offered. The desire to create a level playing field may afford the deal jumper the opportunity of due diligence on terms similar to that of the first suitor.

Understand the political environment In addition to considering governmental concerns over acquisitions in sensitive industries, care must be taken to position a bid as a win-win for employees, customers and suppliers of the target.

Convey a simple message Selling the deal to the market and other stakeholders is critical. The focus should be on the credibility of the transaction. A simple, consistent message may be the best advertisement for the deal.

■ ■ Deal jumpers usually win, but they need to be prepared to pay. Jumped deals imply big stakes for both the first suitor and jumper.

In making a bid of this magnitude, the initial bidder and the jumper may be conveying messages about their strategic needs to the marketplace. If the jump is unsuccessful, the jumper needs to be prepared to convey to the market its next move to maintain strategic growth and retain shareholder confidence.

Donna M. Hitscherich is a member of the faculty of Columbia Business School, where she teaches advanced corporate finance and M&As in the MBA and executive MBA programmes. Prior to joining Columbia, she was an investment banker specialising in M&As and corporate lawyer at Skadden, Arps, Slate, Meagher Flom.

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