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Paul Weiss Discusses Appraisal Risk in Private Equity Transactions

Although still a minority of M&A transactions, appraisal actions are on the rise. In 2012, 20 transactions involving Delaware-incorporated target companies were challenged, but in 2016, this number increased to 48, representing a 240% bump in four years. Further, these figures do not include transactions where appraisal demands were settled before the 120-day deadline for filing an appraisal petition.

With this recent uptick in appraisal litigation, private equity firms should understand the associated risks for, including some that may be unique to PE deals. Recent Delaware decisions and anecdotal perceptions (real or otherwise) have suggested that private equity-led buyouts may result in lower merger consideration being paid to stockholders for reasons ranging from the demands of an LBO pricing model to alignment with target companies’ management to reluctance to make topping bids after a company has entered into a definitive agreement with another private equity buyer.  These perceptions in turn have led to less judicial deference to the transaction price as representative of the fair value of the target company. In contrast, deal prices that result from a robust, arm’s-length sale process are more likely to be accorded substantial weight in determining fair value, particularly where both private equity firms and strategic buyers participated in a pre-signing market check. Private equity firms should weigh the risks of an appraisal action before inking a buyout, and may be able to address such risks through comprehensive due diligence, factoring the risk of appraisal  in merger price negotiations, focusing on company value broadly and negotiating appraisal conditions (although there may be some risk to such conditions as we discuss in more detail below).

What Are Appraisal Rights?

Appraisal rights are a statutory remedy available in many jurisdictions to stockholders who object to certain extraordinary actions taken by a corporation (such as a merger or consolidation). The remedy allows dissenting stockholders to receive a cash judgment equal to the “fair value” of their shares immediately before the extraordinary corporate action is taken, as determined by a court, in lieu of the merger consideration. The policy rationale behind appraisal rights is to protect minority stockholders from being squeezed out of a corporation by the majority stockholders at an unfair price. At a practical level, demanding and perfecting appraisal rights can be legally formalistic, lengthy, costly and speculative as courts have a lot of discretion.

The mechanics of an appraisal action vary from state to state, but Delaware’s appraisal statute (§262 of the Delaware General Corporation Law) is the most commonly used:

Why the Increase in Appraisal Litigation?

There are several explanations for the increased appraisal litigation, including the following:

What Are the Appraisal Risks Unique to Private Equity Firms?

The judicial and academic commentary on the use of merger price as an indication of fair value in private equity-led deals is mixed. Recent appraisal decisions from the Court of Chancery reveal a subtle, implied perception that strategic bidders are willing to pay more than financial bidders and that transactions in which a management team has affiliated with a financial sponsor (such as an MBO) will not generate top bids.

With this backdrop, private equity firms should understand the common features of PE deals that may increase appraisal risk:

In contrast to typical private equity deals, the Court of Chancery has demonstrated a willingness to defer to the merger price where there has been a pre-signing market check involving competitive bidding by strategic buyers and private equity firms. In a 2015 decision, Re Appraisal of Ancestry.com, Inc., the Court held that if there are shortcomings in the three valuation methods and if the merger price was generated at arm’s length in an auction process, a court may rely entirely on merger price as the best indicator of the corporation’s value.

How Should Private Equity Buyers Address These Risks?

Appraisal demands are a headache for target companies and bidders.  If the appraisal value of the shares exceeds the merger consideration, the surviving company will experience an immediate drain on its cash position, thereby impacting its financial viability. Private equity bidders can mitigate the risk of an appraisal action in a few ways:

This post comes to us from Paul, Weiss, Rifkind, Wharton & Garrison LLP. It is based on the firm’s memorandum, “Appraisal Risk in Private Equity Transactions,” dated May 2017, and available here.

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