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The desire to close transactions as quickly as possible has led to an increase in the number of private equity transactions structured as tender offers. There are two primary legal reasons for this increase, in addition to the ever present practical concern about financial market turmoil that was the cause of so many busted deals in 2007 and 2008. The first is the regulatory developments relating to the "best price rule." 1 The second is the recent Delaware case law accepting the use of a crucial structuring device known as a "top up option," making it easier to effect a "short-form" merger following the completion of a tender offer, thereby expediting deal execution and also facilitating compliance with the tricky federal "margin rule" requirements. In several recent sponsor-led take-private transactions, most notably 3G's $3.3 billion acquisition of Burger King and Bain Capital's $1.8 billion acquisition of Gymboree, sponsors have used a tender offer/top-up option-based structure to get deals closed more quickly than would otherwise likely have been the case. Both Burger King and Gymboree closed a bit more than 40 days after signing, as opposed to the 60-90 days generally typical for a more traditional, all cash merger proxy structure.
While the potential timing advantage may be only a matter of weeks or even days, even a single day can help secure a deal in today's volatile markets. Here is more detail on the structure used in these deals, the legal developments that have permitted its emergence, and some limitations and pitfalls to keep in mind.
A Race to the Finish
Under a structure like the one utilized in Burger King and Gymboree, a sponsor and a public target enter into an acquisition agreement in which the parties agree to proceed simultaneously to closing under two separate parallel paths, only one of which will ultimately be used to consummate the deal: (1) a tender offer followed by a short-form merger, and (2) a traditional merger proxy followed by a shareholders' meeting to approve the transaction. The parties ultimately close by whichever path turns out to be shortest. In practice, it works as follows.
Shortly after signing, the sponsor's counsel prepares cash tender offer documentation and the offer is launched. Under the tender offer rules, the offer must remain open for a minimum of 20 business days, so the transaction could potentially be consummated as few as 35-40 days after signing. The catch is that, for reasons explained below, including the need to comply with the "margin rules," embodied in SEC Regulations U and X, the tender offer must be conditioned on acceptance by a sufficient supermajority of the target's shareholders to permit the acquirer to close a short-form merger and acquire ownership of 100% of the target's shares substantially concurrently with the closing of the tender offer. The necessary supermajority varies by state, but Delaware's 90% requirement is typical. Use of a top-up option (discussed elsewhere in this article) and of tender agreements with any stockholders holding large positions in the target can make it more likely that the tender offer will succeed in permitting the buyer to consummate a short-form merger.
Also shortly after signing, the parties prepare a merger proxy, which is then filed as soon as possible with the SEC. This parallel path ensures against the risk of insufficient tenders to allow for a short-form merger. The SEC reviews the proxy while the tender offer is open. If the tender does not result in the buyer having enough shares to close a short-form merger under applicable state law, the parties will instead be able to mail the proxy after resolving any SEC comments and proceed with the traditional merger/proxy solicitation process, culminating in a shareholders meeting to approve the transaction.
The upshot of this approach is to provide the buyer with a path to the fastest possible closing of a going-private transaction if it is in a position to consummate a short-form merger following its tender offer, while also preserving its ability to close on a more typical timeframe for a merger proxy if it cannot consummate a short-form merger following the tender offer.
Making Room for the Margin Rules
There are a number of landmines in the path of structuring the leverage in an LBO that is to be completed as a tender offer. Lenders cannot use the assets of the target as collateral to finance a tender offer, or obtain parity with the target's trade and other existing creditors until the buyer completes a short-form merger and acquires ownership of 100 percent of the target's equity securities. At the same time, the "margin rules" under SEC Regulations U and X severely limit a buyer's ability to secure their third party financing with the stock acquired in the tender offer. The margin rules limit lenders' ability to extend financing for the purpose of buying the stock of a public company (referred to as "margin stock") that is "secured directly or indirectly" by that stock and are, therefore, always a significant consideration in structuring sponsor-led tender offers. The margin requirements are complex, but the bottom line is that to comply with the rules in the tender offer context a sponsor must either write a very big equity check (upwards of 50% of the consideration being paid to the target's shareholders) or use a structure designed to comply with the rules and their exceptions. Our colleagues described a number of these structures in a previous article. 2 Each has advantages and disadvantages, but notwithstanding the recent revival of tender offer based structures, most sponsors most of the time have decided to stick with a single path, traditional merger proxy structure when pursuing a going private deal.
But the sponsors in the Burger King and Gymboree transactions opted to pursue the parallel path approach, in part because in each deal the buyer received a top-up option from the seller, which allowed it to reduce its minimum tender condition in its tender offer to a level significantly lower than would normally be required to consummate a short-form merger immediately after the closing of the tender offer. This allowed the parties to take the view that under the margin rules and their exceptions, there was no purchase of "margin stock" since the closing of the short-form merger which resulted in the sponsor owning all of the target stock would occur substantially concurrently with the closing of the debt financing for the tender offer. Equally, closing the debt financing and the short form merger substantially concurrently permits a sponsor to secure debt financing with the assets of the target company. Had the required tender threshold for a short form merger not been met, the merger proxy process would have proceeded and, again, funding of the debt financing would have taken place substantially concurrently with a traditional merger following a shareholders' meeting approving the deal in which the sponsor would have acquired all of the stock of the target.
As noted above, a key development facilitating the parallel path structure is the growing acceptance of the top-up option by Delaware courts in recent decisions. A top-up option is a feature of a negotiated merger agreement structured as a tender offer in which the target company agrees to issue to the acquirer at the closing of the tender offer any unissued shares of common stock that it is authorized to issue under its charter. The result is to lower the hurdle to achieving the supermajority threshold necessary for a short-form merger.
The top-up option is not a panacea. Since each additional share purchased by the acquirer under the top-up option increases the denominator as well as the numerator in the calculation of whether at least 90% of the target's shares have been tendered, a target must have a very large number of authorized and unissued shares in order to meaningfully reduce the percentage of outstanding shares that must be tendered in the offer and still allow for a short-form merger. But, if the target has sufficient authorized but unissued shares, a top-up option can provide a meaningful boost as it did in Burger King and Gymboree. The acquirers in those deals were able to set the minimum tender condition at 79.1% and 66% respectively, rather than the 90% that would otherwise have been required.
In the Burger King transaction, there was another helpful element. While Burger King was publicly traded, 31% of its shares were held by private equity sponsors. These sponsors agreed as a part of the deal to tender their shares into the tender offer, significantly increasing the likelihood that the 79.1% threshold required in that deal for a successful tender offer would be met.
The other key legal development was the SEC's late 2006 clarification of Rule 14d-10--known among deal professionals as the "best price" rule. As a result of judicial decisions in the early 1990s holding that typical buy-out and employment arrangements with target management teams may violate the requirement that all security holders be paid the highest price paid to any security holder in a tender offer, the tender offer had become a disfavored structure for negotiated acquisitions because of the potentially exponential impact on the cost of consummating the tender offer. The SEC amendments to the "best price" rule clarified the circumstances under which such arrangements were permitted, opening the door to the revival of tender offer-based buy out structures.
Is This Structure Right for My Deal?
While there are important advantages to the Burger King/Gymboree structure, it is not for every deal. The structure is only attractive if the target has a sufficiently large number of authorized but unissued shares to permit the requisite supermajority vote for a short-form merger to be obtained at a threshold meaningfully lower than 90%, a "Mr. Big" shareholder able to sign up a tender agreement easing the path to meeting the minimum tender condition, or both. Where the target is not a Delaware company, buyers need to consider the risk that a top-up option will be deemed invalid if challenged by shareholder plaintiffs.
Buyers should also keep in mind that if there are significant regulatory hurdles to the closing of the transaction other than a routine Hart Scott Rodino antitrust filing, there will be no opportunity for meaningful time savings. While the U.S. authorities will provide expedited treatment of an HSR filing in the case of a cash tender offer (with a 15-day waiting period rather than 30 days, in each case subject to early termination where there are no real issues), non-U.S. authorities do not generally provide such expedited treatment. Transactions in regulated industries are also likely to have closing conditions that will take longer to satisfy than it would take to obtain approval at a shareholder meeting. (Indeed, in these cases it will be preferable for a sponsor to seek shareholder approval at a special meeting before regulatory approvals have been obtained. While a tender offer cannot be closed until regulatory approvals are in hand, competing bidders are foreclosed from jumping a deal once shareholders vote their approval at a special meeting.)
Adopting the parallel path structure will also obviously add complexity and transaction expense. Any relatively novel structure will require additional time by counsel on both sides to work through the details and negotiate key points that have not yet settled into clear market practice. The need to pursue, simultaneously, both a tender offer and a merger proxy will also add to the effort of the deal team and ultimately to the legal expenses incurred by the sponsor.
Sponsors should also consider whether they wish to subject their deal to an initial referendum in which a supermajority vote (even in the form of a reduced minimum tender condition) is required to move the deal forward, even with a merger proxy as a back-up for which a lower voting threshold is required. In a deal where it may be uncertain whether shareholders will support the transaction, sponsors should consider whether they would rather shareholders have a single voting opportunity in which the sponsors may be more likely to prevail. Tender agreements with large shareholders and a strong top up option can mitigate this risk, but they cannot assure the reduced minimum tender condition will be satisfied. Litigators should be consulted as to the atmospheric effect of a failed tender on any anticipated shareholder litigation.
Sponsors should also take care that their desire to get the deal done quickly does not outstrip their ability to execute on a financing package. Given the need to prepare an offering memorandum (including preparation of pro forma financial statements), some cushion should be built into the timeline for launching the tender offer to ensure that the debt marketing can take place simultaneously with the tender offer period. Sponsors should, as always, take care to seek protection against the possibility that a failure by the target to provide necessary cooperation with the financing in a timely manner does not result in a sponsor breach, and, potentially, the obligation to pay a substantial "reverse termination fee." This is a particularly sensitive issue when the timing is tight, as it can be in these deals.
Equally, before commencing the marketing of the debt offering, sponsors should take into account the additional expense that may be incurred if the debt must be closed into escrow or the debt offering must be delayed because the tender offer is unsuccessful, and the merger closing does not occur when anticipated.
Above all, sponsors considering proceeding with this structure should be certain to work with sophisticated counsel, and take the time to understand the risks and traps for the unwary, as well as the potential advantages, of this new approach.
1 See "The Tender Offer Returns: What Does It Mean for Private Equity," Debevoise and Plimpton's Private Equity Report, Winter/Spring 2007.
2 See note 1, supra.
An earlier version of this article appeared in the Spring 2011 Debevoise and Plimpton Private Equity Report.