Stapled finance packages under scrutiny
Richard Hall
Cravath Swaine & Moore
New York
The use of stapled financing in merger and acquisition transactions, both in the US and in Europe, has increased over the last several years. As a result of recent legal developments in the US, however, both sell-side clients and financial institutions are rethinking their attitudes toward stapled financing and this could lead to changes in how and when stapled financing is offered.
In M&A parlance, stapled financing is a proposed financing package offered by the seller's financial adviser to substantially all bidders in an auction. Originally, the proposed terms of the financing package were usually distributed with (or stapled to) the offering memorandum distributed to bidders in the auction. The timing of distribution of the proposed stapled financing package varies based upon particular considerations in each auction. Stapled financing became noticeable in the US a number of years ago, when well-capitalized banks with experience in leveraged acquisition lending sought to use their balance sheet strength to win mandates to act as financial advisers in sell-side auction assignments. The marketing message from banks/potential financial advisers to potential sell-side clients was as simple as "retain us, and we will facilitate the auction by offering stapled financing". The banks/potential financial advisers argued that the availability of a stapled financing package would assure potential private equity sponsor acquirers that the transaction could be financed and so encourage the sponsors to participate in the auctions. The stapled financing product was also pursued by banks that wished to increase their exposure to the leveraged acquisition lending market by offering financing to large private equity sponsors competing in auctions.
While no reliable statistics are available, the US market perception is that few stapled financing packages are used by successful bidders in auctions. Equally, there is no evidence that the offering of a stapled financing package facilitates more aggressive bidding in auctions, at least by large private equity sponsors. There is some anecdotal evidence that the availability of a stapled financing package in an auction might encourage more aggressive bidding by strategic buyers in auctions, as the presence of a stapled financing package could cause a strategic buyer to regard competition from private equity sponsors as more credible. There is also strong anecdotal evidence that the offering of a proposed financing package by the seller's financial adviser acts as a price-signalling mechanism in the auction. A sophisticated private equity sponsor competing in an auction with a stapled financing package should be able to reverse engineer from the stapled financing package (in particular, the ratio of debt to Ebitda) to derive the estimate of the seller's financial adviser as to the price that could be paid by a private equity sponsor for the business being auctioned. This price-signalling effect could be reducing the variability of bids submitted in auctions by private equity sponsors and causing private equity sponsors not to bid in situations in which their proposed bid would be below the price level signalled by the stapled financing package.
Stapled financing raises a number of legal issues for the seller and for its financial adviser/stapled financing source. Most of these issues revolve around broad concepts of conflict of interest. First, the seller's financial adviser will be deriving additional compensation from the transaction as a buy-side financing source; this may be viewed as providing an inappropriate incentive on the part of the seller's financial adviser to recommend a transaction. Traditionally, however, this has not been a practical concern. Most financial advisers with sell-side mandates are compensated on a contingent basis anyway, so the financial adviser always has an incentive to recommend a transaction rather than recommend the seller withdraw the property from sale. At least in the US, courts have consistently approved the use by sellers of contingent fees for sell-side financial advisers on the grounds that such fees more properly align the interests of the adviser with those of the seller. The second concern arises from the fact that the seller's financial adviser is financing one bidder in an auction and so could receive greater compensation based upon who wins the auction regardless of the price. This could be seen to create the potential for conflict of interest on the part of the financial adviser with respect to the management of the auction process by motivating the financial adviser to favour one bidder over another. Once again, assuming that the fact of buy-side financing has been properly disclosed to the seller client, few sellers have been concerned by this potential conflict of interest in the average transaction. In most auctions, the question of who is the winning bidder is clear, and it is only in the rare situation that the advice of the seller's financial adviser will be material to the decision of the seller. A third issue is that of the perception of the bidders. In part in response to the concern discussed above, bidders have expressed concern that they have felt pressure to pursue the stapled financing package to ensure equal treatment in the auction.
Most of these concerns relate not to the offering by the seller's financial adviser of the stapled financing package but to the seller's financial adviser providing any financing at all. In the current market, with private equity sponsor M&A activity high and the number of banks willing and able to lend large amounts in leveraged acquisition financings more limited, the possibility of a commercial bank providing buy-side financing while also providing sell-side advice is quite high, even without stapled financing. By the middle of 2005, most sellers and their legal counsel had become comfortable with sell-side financial advisers offering their stapled financing package and ultimately providing financing to a select number of bidders in auction situations.
Then along came Toys "R" Us. In 2005, Toys "R" Us Inc, a US public company, conducted an extensive review of its strategic options and ultimately agreed to be acquired by a club of private equity sponsors led by Kohlberg Kravis Roberts & Co. In a legal challenge to this proposed acquisition, the public stockholders of Toys "R" Us made a variety of allegations, including a claim that the financial adviser to Toys "R" Us, Credit Suisse First Boston, suffered from a conflict of interest arising out of its possible role in financing the KKR-led group. During the auction process, CSFB raised the possibility of providing buy-side financing to potential bidders. The board of directors of Toys "R" Us rejected that possibility and insisted that CSFB not discuss potential financing with the KKR-led group, or any other bidder, before approval of the merger. After approval of the merger and execution of a merger agreement between the KKR-led group and Toys "R" Us, CSFB again sought permission to finance the KKR-led group. In response to this second request, the board of directors of Toys "R" Us agreed.
The Delaware Court characterized this set of facts as "unfortunate" in that the Court believed these facts raised the possible perception that CSFB's advice to the seller throughout the auction process was tainted by a desire on the part of CSFB to obtain additional fees from financing the successful bidder. The Court ultimately held that, notwithstanding the appearance of conflict raised by CSFB's requests for permission to finance potential bidders and the fact that CSFB ultimately did provide financing to the successful bidder, the advice of CSFB was not in fact motivated by the desire to generate additional fees from providing buy-side financing. In doing so, however, the Court made the following statement:
"By stating this, I do not want to be perceived as making a brightline statement. One can imagine a process when a board decides to sell an entire division or the whole company... when roles on both sides [sell-side adviser and buy-side financing source] for the investment banker would be wholly consistent with the best interest of the primary client company [the seller]. In general, however, it is advisable that investment banks representing sellers not create the appearance that they desire buy-side work, especially when it might be that they are more likely to be selected by some buyers for that lucrative role than by others."
The Toys "R" Us board of directors received fairness opinions from CSFB and also from Duff & Phelps, and there was no claim that Duff & Phelps lacked independence. The challenge to CSFB, and the Court's observations, were directed solely to the possibility that CSFB's conflict of interest would have tainted its advice with respect to the conduct of the auction. Toys "R" Us also involved a difficult judgment as to the conduct of the auction – whether to reopen broadly the auction process in response to a decision by the board late in the process to sell the entire company rather than just a major division.
These judicial observations led to an immediate and extensive review by US investment banks and their counsel, and sellers and their counsel, of the propriety of what had become conventional stapled financing arrangements. Some commentators suggested that the Toys "R" Us decision would lead to the complete demise of stapled financing, as well as the end of the practice of sell-side advisers providing any buy-side financing outside the stapled financing context. As time has passed, however, cooler heads appear to have prevailed, and it now seems the Toys "R" Us decision will result in fewer changes in stapled financing practice than had initially been feared.
First, as a practical matter in the stapled financing arena, US financial advisers and sellers (and their counsel) are reading the Toys "R" Us observations as limited to situations involving the sale of the entire company or at least to M&A transactions that are substantial relative to the size and sophistication of the seller. Anecdotal evidence suggests that now, in mid-2006, sellers and their financial advisers remain generally unconcerned about the use of stapled financing packages in small sell-side auction assignments. This seems to represent a sensible balancing of risk and reward. In a small sell-side auction, the seller will obviously be less dependent upon its financial adviser for advice with respect to selection among competing bids and with respect to the conduct of the auction, while the rewards to the seller from a properly conducted auction with aggressive bidding by private equity sponsors would seem enough to offset any risks.
Market practice in the US does not, however, seem to be consistent with respect to the availability of stapled financing, or of any other form of buy-side financing, in situations directly analogous to Toys "R" Us: the sale of the entire company. Boards of directors of target companies remain justifiably concerned about the comments in the Toys "R" Us decision. One point from the Toys "R" Us decision, as discussed above, was that the challenge related to the conduct of the auction and not merely to the fairness of the final consideration price. For this reason, it is difficult for boards of directors of target companies (and their counsel) to feel comfortable that any conflict of interest created through the sell-side adviser also providing buy-side financing can be solved with a second opinion from another, independent financial adviser. It would, in theory, be acceptable for the target board to have two advisers equally involved in the auction process, but this is a difficult arrangement in practice and it is also difficult to justify the additional cost and transaction complexity for the questionable benefit to the seller of the availability of the stapled financing package. An additional factor in the US is the increasing scrutiny of the independence of directors and their advisers in considering and approving M&A transactions that raise the spectre of a management conflict of interest (such as a leveraged buyout with ongoing management participation). Because any decision by the target board to approve the offer of a stapled financing package must occur at an early stage in the auction process, at a time when the board does not have insight into the likely outcome of that process, the target directors must remain conscious of the need to maintain the independence of their financial adviser and the integrity of the auction process.
The US banks now have policies with respect to stapled financing in the context of a sell-side assignment involving an entire public company. At least for the moment, it seems that conservatism on the part of boards of directors is setting the bar at a level that is not permitting sell-side advisers to provide buy-side financing, at least in the absence of a second investment bank on the sell-side that is fully involved in any auction process.