M&A and Private Equity Viewpoints : Private Equity Lawyer & Attorney : Perkins Coie Law Firm : Mergers & Acquisitions, Recapitalization

Cheryl Scarboro, the head of the new SEC Division of Enforcement's specialized Foreign Corrupt Practices Act (FCPA) Unit, made an interesting comment for M&A counsel, Friday morning at the "SEC Speaks" conference in Washington, D.C.  In response to a question from former Commissioner Campos on whether due diligence efforts in M&A transactions lead to efforts by SEC Enforcement, Ms. Scarboro replied yes: "A lot of the cases come to us because of the [Merger & Acquisition] due diligence process resulting in self-reporting [by registrants]."

This is a good reminder of the importance of the diligence process -- to be aware of the FCPA red flag and, in instances where potential failures to comply with the FCPA are discovered, to conduct a special assessment to determine if that discovery may trigger a self-reporting duty, and whether that is a duty of the purchaser or of the target.

Last year, this FCPA blog quoted Cheryl Scarboro and Mark Mendelson of the DOJ on the increased sophistication of M&A diligence for FCPA http://wrageblog.org/2009/09/17/the-latest-fcpa-forecast-from-u-s-regulators/ - - referring to the Haliburton procedure.

DOJ and Haliburton crafted the "Haliburton procedure" http://www.justice.gov/criminal/fraud/fcpa/opinion/2008/0802.html when Haliburton wished to make an acquisition rapidly, but did not have adequate time prior to closing conduct due diligence and assess FCPA risk. So, Haliburton approached the DOJ to ask if it could separate the business for a period of time post-closing while it conducted post-closing FCPA diligence. Haliburton would then immediately impose its own Code of Conduct and provide FCPA training to all target personnel - -within 60 days of closing. The DOJ agreed to the procedure, with a full FCPA review and reporting in the 180 days post-Closing.

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Yesterday, I met with a friend who is corporate counsel at a large and well-respected private equity fund that, like many financial investors, looks at dozens of potential transactions each week. In most cases, the company seeking funding will request a company-friendly Non-Disclosure Agreement (NDA), fully-stacked with all of the bells and whistles that, frankly speaking, are in some cases mostly absent from the company's agreements with its own employees and strategic partners (which NDAs can ultimately be critically important under some circumstances).  The investor then needs to engage its counsel in the process, a back-and-forth negotiation ensues, it's signed up, and, at least 90% of the time, the deal goes nowhere in any event. 

We were discussing the fact that NDAs have become increasingly complicated over the last several years, and questioned whether the time and effort (including attorneys' fees expended on finalizing the NDA) is really justified in light of the relatively small risk of damages of any significance flowing from a breach of confidentiality (particularly in the context of a private company seeking funding). While a more-detailed discussion of the exciting dueling positions that companies and investors can take in negotiating an NDA may please some readers, I'll relent in favor of the vast majority of you and cut to the chase:  Certainly, there are situations where a fully-negotiated, detailed NDA makes good sense.  That said, is there also a context where it makes better sense to adopt s simpler approach?  Perhaps there are at least some circumstances where a company seeking funding and the potential investor might be better off collectively living with the risk of how a court would fill in the gaps in the very unlikely event of litigation on the matter, and adopt the following as the entirety of their NDA:

"[Potential Investor] hereby agrees to (1) use reasonable care to maintain and protect the confidentiality of all confidential information received by [Potential Investor] from [Company] and Its representatives relating to the Company and the [Investment Opportunity] and (2) refrain from using such confidential information except in connection with its evaluation of the [Investment Opportunity] or a related purpose.

POTENTIAL INVESTOR

x______________________"

Thoughts?

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Corporate carve-outs are on the rise, according to Q2 2009 deal data.  Buyout Magazine found that  corporate carve-outs made up 14% of the overall deal market in the second quarter of 2009.  This represents a 233% increase compared to the full-year 2008, when corporate carve-outs made up only 6% of all reference transactions. 

As recently as 2008, financial buyers were a distant second to strategic buyers acquiring businesses through carve-outs (PDF).  Private equity funds are now increasing their percentage share of the carve out market. 

Historically, carve-outs were done by strategic acquirers to complement or expand their existing business lines. Carve-out targets could be integrated into an existing platform, and the acquiring company would capitalize on efficiencies of scale. 

In the current market, while some strategic acquirors are seizing opportunities to exploit historical lows in valuations of targets, other strategics faced--with declines in revenues and liquidity and cost-cutting pressures--have either slowed (if not halted) their M&A strategy, or have reversed course and disposed of non-core assets and divisions themselves.  These developments have effectively ceded ground to financial buyers eager to step into fill the void. 

Financial buyers performing carve outs currently appear to be targeting the middle market($100 million to $1 billion). This is likely the the result, at least in part, of a lack of available financing drying up deal activity in the higher end market, and its forcing increased competition in the middle market as traditional participants in the larger market focus on middle market carve out prizes. But the Deloitte survey cautions, consistent with our experience, that transactions with lower enterprise values are often as complex (and, in some cases, more complex) as larger carve out transactions and require just as much due diligence to identify and quantify the risks and costs associated with such transactions.

Since financial buyers generally do not approach carve out transactions with an eye towards integrating the target into an existing platform, their due diligence should regard the target as a stand-alone business whose key functions will need to be nurtured and scaled post-closing.  Transition services from the selling parent will be critical during this period following closing, as many of the efficiencies of scale available with the parent will no longer be available.  Due diligence should focus on the cost of implementing a stand-alone platform and related issues including (1) developing intellectual property goodwill that is not dependent on any reputation effect of the parent, (2) identifying intellectual property that was historically exploited by both the parent (or its other affiliate) and the carved-out entity which would require cross-licensing arrangements, and (3) purchasing insurance (and tail coverage) for the target.  Diligence should also examine the underlying reasons why the parent is entering into the carve out transaction (e.g., whether any of target’s principal customers and/or suppliers are at risk of ceasing their own operations or terminating or reducing their level of support for the carve out entity).   These are just a few examples, and each carve out transaction will have its own unique set of business issues that will require proactive diligence, planning and negotiation.

In short, carve out transactions present unique challenges that require comprehensive due diligence efforts that can be far more complicated that a typical acquisition of a stand-alone, independent enterprise.  As financial buyers look to expand their portfolios through carve out acquisitions, they should not underestimate the challenges present in closing a carve out transaction simply because of its enterprise value. 

Posted by Peter Lawrence and Siddesh Bale

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