Dealpolitik: Why Navistar’s Poison Pill is Good Medicine

Dealpolitik: Why Navistar’s Poison Pill is Good Medicine

By Ronald Barusch [COMMENTARY]

When we last left Quest Software’s independent committee, it seemed to be doing a pretty good job of paving the way for a strategic bidder to bid up the deal even though that mysterious bidder is competing with a buyout group that includes Quest’s chairman and CEO, who has the advantage of having 34% of the votes

The management buyout group, which has been expanded and now includes Vector Capital in addition to Insight Venture Partners, has topped the secret strategic bidder’s $25.50 bid by 25¢ per share. The Quest independent committee took the deal and signed up the management group. But did it do the right thing for shareholders? There are some curious developments in the new deal.

First, the fees and expenses payable if the management group is topped have increased from $13.3 million to $37 million, or around 28¢ per share. That sounds like a lot for a 25¢ per share price increase.

But that is a bit of an unfair analysis. The breakup fees and expenses are still only 1.7% of the total price. The original breakup fee was probably unusually low because of management’s participation. Now that a full-fledged auction has started, a higher breakup fee may be justified. In arms-length deals, breakup fees can be as high as 3-4%.

What is more troubling is that a “reverse breakup fee” remains at the extraordinarily low level of $9 million in a deal valued over $2 billion. That means that if the management group cannot come up with its debt financing, it has the right to walk away by paying a $9 million fee—and then only has to pay if Quest can prove that all the conditions to closing were satisfied. That fee, which is less than half of one percent of the market capitalization of Quest, probably would not even compensate Quest for its expenses.

For the initial deal, perhaps that was justifiable as there was no competing deal Quest risked losing. Now with Quest turning down a comparable deal with a mystery strategic buyer, Quest appears to be taking a significant risk by letting a financed deal get away.

That is because a strategic buyer is almost always required to put its entire substantial balance sheet behind its obligation to close a deal. The financing risk is generally its problem and it even usually agrees in the merger agreements that a judge can order the strategic buyer to close—so called “specific performance.” In any event, there is usually no limitation on the damages if for some reason the strategic buyer defaults. Without the $9 million set fee in the management deal, damages here could easily be hundreds of millions of dollars if a buyer can’t close a $2 billion deal.

The independent committee and its financial advisers have undoubtedly done a lot of diligence on the management group’s ability to come up with the money for the closing. They probably think the chance the financing won’t be there is remote. But that is what we all thought in deals like this before the global financial crisis destroyed the debt markets. A significant shock to the system or an adverse development in Quest’s business could be put management’s deal at risk.

That leads to the question of why for just 25¢ per share more, the Quest independent committee took what seems to be a less-certain deal where the management group can walk away for a relatively small payment if it can’t come up with the debt financing. Quest hasn’t disclosed the terms of its mysterious proposal from the unidentified strategic bidder, so perhaps it has defects as to certainty as well. But a 1% bump seems like a small amount to take if in fact the strategic buyer’s deal is significantly more certain.

It is possible that the independent committee found itself tied to the management deal by a few words in its merger agreement which, although standard, appear problematic as applied to this situation.

In order for Quest to be able to take a competing bid, Quest must determine that the new bid is reasonably likely to be consummated. But then, under the agreement, Quest still cannot take the strategic bidder’s deal unless “if consummated, [it] would result in a transaction more favorable to the Company’s stockholders… from a financial point of view than the” (emphasis added) revised management deal. In other words, to take a competing bid, the bid must produce a higher price if consummated. The words “if consummated” imply that a strict comparison of price is required without reference to conditionality. By management raising to 25¢ per share over the strategic bid, the independent committee may have concluded that it was unable to take the competing bid.

But that is a potential weakness in that language and hundreds of similar agreements like it. The board should be free to take the best deal (not just the highest), particularly where a deal is financed and there is an ability to walk by making a minor payment if the financing is not available.

The strategic buyer may still rebid at a higher price, and even if it doesn’t, as long as management comes up with its money this will all be a theoretical issue in this deal. But if there is a problem with the debt markets when it comes time to close, the independent committee’s decision could be controversial.


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