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

As we profiled in October 2009 (click here), the IPO market has significantly bounced back in 2010 with private equity-backed floatations comprising a majority of the overall offerings. Ernst & Young recently released a study of IPO activity in the first two quarters of 2010. (Click here to see the report in its entirety). Of the 62 private equity-backed IPOs, Europe, the Middle East and Africa led the way in total proceeds (followed by the Americas and Asia-Pacific), however the Asia-Pacific IPOs performed best with 78% trading above their offering price (versus 60% for all fund-sponsored IPOs). In total, $15.5 billion was raised in these 62 IPOs. Ernst & Young reports that the deal pipeline continues to build and that healthcare, technology and telecom remain the strongest industries for private equity IPO exits.

While encouraging, the IPO market recovery has been erratic, briefly drying up in May and June. Investors remain concerned about the global economy, pace of recovery and possibility for a double-dip recession. These economic doubts, coupled with investor skepticism regarding the sale of private equity-owned businesses, make pricing and completing IPOs a challenge. Thus, IPO activity is rebounding, but is not yet approaching the pace or valuations from the pre-recession boom years.

The chart below provides a non-exhaustive list of 2010 fund-sponsored IPO activity and identifies whether and how much of the private equity sponsors’ shares were included in the offering.

2010—PRIVATE EQUITY IPO ACTIVITY*

*Information obtained from http://sec.gov. Not an exhaustive list of all fund IPO activity.
1. Percentage of the overall offering made up of shares from selling stockholders.
2. Percentage of the selling stockholders’ shares (from column 1) owned by private equity funds.
3. Percentage of overall shares held by private equity funds included in the offering.

2010 – 2011—REGISTERED OR ANTICIPATED PRIVATE EQUITY IPO ACTIVITY*

*Information obtained from a variety of online news sources.

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At the Society of Corporate Secretaries and Governance Professional's 2010 SEC Hot Topics in Seattle on May 19, Jonathan Ingram, Deputy Chief Counsel of the SEC's Division of Corporation Finance, discussed the Staff's new Staff Legal Bulletin No. 18 issued in March 2010.  See www.governanceprofessionals.org/society/chappn.asp

Jonathan walked through the Division's March 15, 2010 SLB 18. The Staff's goal in issuing SLB 18 is to clarify that acquired public companies – which no longer have public shareholders following a sale – may rely on Exchange Act Rule 12h-3 to suspend reporting obligations under Section 15(d) of the Exchange Act. In a textbook "plain English" explication, Jonathan described the ways that a registrant can terminate or suspend its public reporting obligations. Noting that reporting obligations for acquired public companies with a class of securities registered under Section 12(b) or 12(g) of the Exchange Act arise under Section 13, he explained how these companies deregister their Exchange Act registrations and thereby terminate Section 13 reporting obligations following a sale:

• For a 12(b) exchange-listed company, filing a Form 25; and
• For a 12(g) company with under 300 record holders (or 500 and under $10MM in assets), using Form 15.

Jonathan went on to explain that the vast majority of public companies also have reporting obligations under Section 15(d) of the Exchange Act because they have offered securities pursuant to an effective Securities Act registration statement at some point in their history. For 12(b) and 12(g) companies, the reporting obligations under Section 15(d) technically spring into effect when an issuer has deregistered its securities under the Exchange Act. So, in addition to deregistering securities by filing a Form 25 or Form 15, acquired public companies also need to suspend their Section 15(d) reporting obligations in order to avoid having to file periodic and current reports under the Exchange Act after a sale. Although Section 15(d) itself contains language addressing the conditions under which such reporting obligations may be suspended, Exchange Act Rule 12h-3 is essentially a "safe harbor" rule that allows companies to suspend their 15(d) reporting obligations if certain conditions are met (including the filing of a Form 15).

SLB 18 itself describes the requirements for Rule 12h-3, specifically, that a registrant must:

• Be current in its Exchange Act reporting obligations;
• Have under 300 record holders (or under 500, and under $10MM in assets); and
• Not have had a Securities Act registration statement declared effective or updated under Securities Act Section 10(a)(3) in the fiscal year for which suspension is requested.

It is this last requirement, particularly the Section 10(a)(3) "gotcha", that has raised questions about whether an acquired public company could rely on Rule 12h-3 to suspend its Section 15(d) reporting obligations: most public companies have shelf registration statements (e.g., S-8s and S-3s) that may have become effective in years past but are automatically updated pursuant to Section 10(a)(3) by the filing of their annual reports on Form 10-K each year. On its face, Rule 12h-3 was unavailable to most acquired public companies because they had shelf registration statements that were automatically updated during the fiscal year in which the sale occurred. Because of this "trap for the unwary", the Staff regularly received requests for, and granted, no-action letters permitting acquired public companies to rely on Rule 12h-3 to suspend their Section 15(d) reporting obligations. In an effort to stem the flow of incoming no action letter requests, the Staff promulgated SLB 18.
Now, SLB 18 makes clear that an issuer may use Form 15 to suspend its Section 15(d) reporting obligations under Rule 12h-3 if the registrant:

• Does not have a class of securities registered or required to be registered under Section 12 of the Exchange Act (accordingly, a registrant may need to first file a Form 15 or 25);
• Satisfies the 300 (or 500) record holder tests and otherwise satisfies Rule 12h-3;
• Has deregistered any unsold securities registered on Securities Act registration statements; and
• Has filed all Exchange Act reports required to be filed prior to the filing of the Form 15.

See the SLB at www.sec.gov/interps/legal/cfslb18.htm
 

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After two years with few new issues, private equity firms are helping drive what appears to be a resurgence of an IPO market. The IPO market is showing some signs of resiliency for the remainder of 2009 and potential for significant growth in 2010 (see deal charts below). For private equity funds, the IPO market's rebound provides opportunities for liquidity and enables their portfolio companies to clean up their balance sheets by increasing equity and using the proceeds of an offering to pay off outstanding debt.

The recent up-tick includes issues on both U.S. and foreign exchanges (e.g., the U.K., Canada, and Australia are also experiencing increased fund-related IPO activity). Analysts project that the best prospects are in recession-proof sectors, such as education, energy, health care, and discounters.

Despite the recent up-tick in IPO activity, the capital markets remain unpredictable and fragile, and investor appetite for new issues may very well show volatility. Equity in highly-leveraged companies is increasingly difficult to sell, affordable credit is scarce, and the dilutive effect of new issuances on existing equity exposes companies and their boards to investor scrutiny. Private equity’s ability in the near-term to navigate these challenges will be critical in obtaining liquidity in the capital markets.

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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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The FTC and DOJ just published their fiscal year 2008 HSR enforcement statistics. Although the total number of filings was down 22% from FY 2007, 82.4% of filings went through without any agency inquiry. In cases where one of the agencies opened a preliminary investigation, 86.1% of the investigations were ultimately closed without issuance of a second request. These percentages are on line with earlier years.

But of the 41 unlucky deals that did draw second requests, 90% (37) were challenged, resulting in a consent decree, litigation or an abandoned deal. This is a higher percentage than in prior years (traditionally 65% to 80%). So, more than ever, issuance of a second request is the kiss of death, to be avoided at all costs by pre-filing analysis of antitrust issues and effective advocacy during any preliminary investigation.

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Indian tribes do not qualify as "accredited investors" under Section 501(a) of Regulation D under the Securities Act.  This blanket exclusion restricts the ability of Indian tribes to invest in private funds, with two fairly obvious but important effects:  diminished investment opportunity for financially secure tribes, and reduced access to a large investor pool for private funds that companies raising capital could otherwise tap. Despite taking affirmative steps to include Indian tribes as accredited investors (PDF), the Securities and Exchange Commission (SEC) has not yet adopted a final rule providing accredited investor status to qualifying tribes.  With private funds it increasingly difficult to access committed capital, the timing is ripe for the SEC to move quickly and consider granting Indian tribes accredited investor status. 

Private funds often prefer to limit the sales of securities to accredited investors.  By doing so, private funds can better manage compliance with federal and state securities laws (PDF), thereby reducing legal and business risks associated with the  offering and reducing fund advisor costs. Indian tribes, however, are complex combinations of tribal government and tribally-owned entities chartered under state, federal and tribal law which do not neatly fit within any of the definitions of an accredited investor under section 501(a) of the rules under the Securities Act. 

Recently, a substantial minority of Indian tribes has experienced economic success through ventures into gaming, manufacturing and government contracting. As Native American Capital, LP (NAC) points out (PDF), the omission of Indian tribes in the definition of "accredited investor" is a matter of concern for these prosperous tribes and their financial advisers as they seek to put their capital to work.  Through the work of numerous professionals (including the NAC and Professor Gavin Clarkson), the SEC has taken notice of the increasing demand to provide Indian tribes with accredited investor status. In 2007, through its notice and comment procedures, the SEC proposed a rule change providing accredited investor status for qualifying Indian tribes (PDF). However, as of the date of this post, no final rule has been adopted, as the SEC seems to have prioritized other action items in light of the global recession and other recent developments.

Private fund-raising was down 75% in the first quarter of 2009 (PDF) (as compared to the same period a year ago), and Indian tribes can provide a desperately needed source of capital for private investment.  With yearly revenues from tribe businesses topping $35 billion, the NAC acknowledges that Indian tribes are poised to make private fund investments if given the opportunity; and from their previous complex financial dealings, it is clear that Indian tribes have sufficient understanding and resources to bear the risks of private fund investment.  The significance of providing accredited investor status to Indian tribes should not be underestimated.

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