VMware’s shareholders enjoyed gains of nearly 60 percent in 2017 as the company positioned itself as an appealing play on cloud computing with substantial growth potential and partnerships with industry leaders like Amazon Web Services. Indeed, in its most recent earnings period, VMware reported revenue growth of 14 percent and earnings growth of 17 percent, handily exceeding expectations for the period ending February 2. One analyst stated that “VMware is poised for its best growth trajectory since the 2008 recession.”
Investors should be celebrating, right? Wrong.
Despite the impressive performance, a dark cloud has hovered over the company since late January, when reports surfaced that highly-leveraged Dell Technologies, led by Michael Dell, is considering a merger with VMware, in which Dell holds an 82 percent stake. Following a CNBC report in this vein on January 29, VMware shares fell 17 percent, wiping out more than $10 billion in market capitalization in a single day.
The market’s harsh reaction to the prospective merger stems in part from the perception that VMware’s valuation will be dragged down by Dell’s slower-growing legacy businesses, as well as its weighty debt pile—VMware has $11.6 billion in cash, which Dell would likely use to trim its $52.5 billion in borrowings. Analysts and investors have assailed a potential VMware-Dell tie-up, with one large VMware investor, Jericho Capital Asset Management, calling it “one-sided” and a “terrible deal,” in a public letter on March 12.
But the depth of the plunge in VMware’s shares—on January 30, the second trading day following the CNBC report, shares shed another 5 percent, bringing to two-day tally to a 21 percent, $12.5 billion bloodletting—isn’t just a reflection of how “terrible” the deal might be. It’s also a reflection of the market’s belief that Mr. Dell will go forward with it despite the outcry.
And this is where the Delaware Supreme Court comes in. Its December 2017 decision in the Dell appraisal case, which sided with Mr. Dell and rebuked shareholders, makes it a lot more likely that Mr. Dell will again pilfer his public shareholders.
First, a bit of background. Appraisal is the right of dissenting shareholders in mergers to seek “fair value” for shares through a legal proceeding. The court determines the fair value of their shares, and that’s what they get, instead of the negotiated merger price. The Dell appraisal challenged the $25 billion private-equity financed management buyout (MBO) of Dell, led by its founder and 15 percent shareholder, Michael Dell, and completed in November 2013. Dell’s two largest public shareholders opposed the deal, claiming that it undervalued the company and was opportunistically timed by Mr. Dell. The deal gained approval only after a turnover in the shareholder base left an estimated 20 percent of shares in the hands of merger arbitrageurs—who tend to vote yes, regardless of ‘fairness”—and an eleventh-hour change in the voting standard lowered the threshold for shareholder consent.
By all indications, Dell’s large shareholders have since been proven correct. Michael Dell, who had an obvious informational advantage over public shareholders, appears to have opportunistically timed his offer and got his namesake on the cheap, paying about six-times earnings when accounting for net cash. Analysts estimate that Mr. Dell’s stake in the company is today worth $35 billion, more than five times the estimated $6 billion to $7 billion of equity that he has contributed. His 500 percent return in less than five years would make a payday lender blush.
So, it might not come as a shock that shareholders seeking appraisal of their Dell shares were awarded a premium to the merger price—in May 2016, the Delaware Court of Chancery ruled that Mr. Dell had shortchanged shareholders by 28 percent.
But Mr. Dell subsequently appealed the decision to the state’s highest court. And on December 14, 2017, the Delaware Supreme Court reversed and remanded the chancery decision, suggesting that the lower court afford the merger price dispositive weight while lionizing Mr. Dell’s efforts to “minimize conflict” and “ensure stockholders obtain the highest possible value.” Never mind that more money for shareholders would have meant money taken directly from Mr. Dell’s pocket—each $1 per share increase in merger price would have cost Mr. Dell an additional $250 million.
The Supreme Court decision spells trouble for VMware’s public shareholders and may explain part of the steep January selloff. Mr. Dell gained his majority voting stake in VMware as part of Dell’s debt-laden September 2016 purchase of the cloud computing firm’s majority owner, EMC. This coming September, the end of a required two-year waiting period after the purchase, Dell will be free to pursue a short-form merger with VMware, because Dell controls more than 90 percent of the company’s voting shares. This type of transaction can be conducted without prior action by the board and without a shareholder vote. Dell shareholders fared poorly after the 2013 buyout despite their right to a vote. VMware shareholders will lack even that protection.
Until September, VMware shareholders will likely be shielded, at least to some degree, by the company’s independent directors, who can negotiate with Mr. Dell or “just say no.”
Once the September deadline hits, however, minority shareholders’ only remedy to contest a value-destructive deal will be—you guessed it—to seek appraisal.
In prior years, the specter of appraisal might have aided VMware shareholders in fending off a value-destructive deal forced upon them by Mr. Dell. If a substantial portion of shares seemed likely to pursue the remedy and the expected judgment of “fair value” were punitive enough, it might have made more economic sense for Mr. Dell to put forth a fair offer from the outset.
But following the Delaware Supreme Court’s Dell decision, Mr. Dell has little incentive to do so. In fact, Mr. Dell has an incentive to do the opposite, because of the court’s advocacy of “deal price” as the preferred remedy for dissenting shareholders—thus, the lower the deal price, the lower the likely payout in appraisal.
In fact, dissenting VMware shareholders might do even worse than that should they seek appraisal. In its Dell opinion, the Supreme Court also asserted the primacy of the “efficient market hypothesis” and “market price,” sentiments at the heart of a recent chancery appraisal opinion, Aruba, which found fair value to equal pre-deal, “unaffected” market price—a 30 percent discount to deal price. In that case, leaks of a prospective deal were timed to coincide with the target’s release of a bullish earnings report, intentionally obfuscating the unaffected price.
Mr. Dell would be smart to also time releases concerning VMware—by driving shares down and muddying the waters with respect to “unaffected” price, he can further limit appraisal liability in the eyes of Delaware’s judiciary.
This would seem to mirror his efforts ahead of the move to take Dell private. In the years prior to his 2013 buyout, the company was viewed on Wall Street as a mature cash cow, with an investor base tending to seek value and to be averse to large, initially dilutive acquisitions. From 2010 through 2012, with Mr. Dell at the helm, the company acquired 11 companies for approximately $14 billion, driving the unaffected’ market price down so far that Mr. Dell was able to make tens of billions of dollars on his well-timed purchase.
From the standpoint of a market practitioner, Delaware courts’ interpretation of “efficient markets” is not only naïve but circular: the strength of the appraisal remedy itself has an impact on unaffected share prices for minority shareholders, as seen in VMware. Unfortunately, the courts’ apparent lack of a basic understanding of financial markets is a serious problem. In 2017, after statutory and judicial efforts in Delaware to make appraisal less effective, the average U.S. target premium dropped to 22.5 percent, the lowest in any year since at least 2005, while deal-related golden parachute compensation more than doubled.
Given the Delaware Supreme Court’s willingness to treat the likes of Michael Dell favorably, VMware shareholders’ best option may be to capitulate and accept whatever consideration Mr. Dell is kind enough to throw their way. The question is, how much longer will investors be willing to roll over before they raise the bar for investing in Delaware Inc.?
This post comes to us from Matthew Schoenfeld, a portfolio manager at Burford Capital and formerly a portfolio manager at Driehaus Capital Management, where he ran the firm’s appraisal rights and shareholder activism strategies. The post was prepared in his personal capacity and does not represent the views of Burford Capital.