posted 13 Nov 2007 in Volume 10 Issue 6

Deal protection in the South African public to private environment

By Sally Hutton, partner, Webber Wentzel Bowens

THE INTENSIFYING competition for quality assets in the South African market, combined with the increasing scarcity of such assets, has highlighted the need for a successful bidder to protect a deal it has secured.
Many disposals of listed companies these days follow an auction process, at the end of which the target board selects a preferred bidder. Typically, a substantial portion of the transaction costs will have been incurred at this stage. In most cases, a full due diligence will have been done, the deal will have been structured and full debt documentation will be in place (third-party debt funders will not issue cash confirmations without this being the case).
The nominated preferred bidder is not, however, home and dry just because it has been selected as such. Apart from the usual execution risks associated with a leveraged buy-out, it is possible that, once the terms of the winning bid are made public, another participant will sharpen its pencil and make a further bid for the asset.
The fiduciary duties of the target board dictate that it must always consider the terms of a competing offer in the interests of shareholders. The Rules of the Securities Regulation Panel (‘SRP’) require the target board to express a view on the offer. The risk is that once they have recommended one offer, they may, if a substantially more attractive competing offer is made, need to withdraw their recommendation from the first and endorse the second.
In comparing two competing offers, price is obviously key but a number of other factors may also be relevant. For instance, if the competing offer is priced higher but would entail significantly more execution risk (for example, because regulatory approvals would be harder to obtain, or because significant shareholders have undertaken to the preferred bidder to vote against any competing offer), the target board must take these factors into account. A lower offer that will be implemented more quickly may be more valuable than a higher offer that will be delayed. Another consideration may be whether the offeror has offered a reinvestment option. As exchange controls limit the ability of South Africans to invest abroad, this is an attractive feature, particularly for institutional shareholders in our market.
Even if the target board decides to switch its recommendation, there is no guarantee that the formerly preferred bidder will not come back with an improved bid. The board could therefore find itself flip-flopping between proposals. It may be that there is so little between them that the board is hard-pressed to choose one. In such circumstances, it may be compelled to recommend neither, to cooperate with both offerors and allow two competing schemes of arrangements to be put before shareholders. This is clearly not optimal as the execution risk of implementing either is then high.
In this context, deal protection not only offers comfort to the preferred bidder, but also to the target board. The classic example of deal protection is a break fee that typically becomes payable if, after the offer has been recommended, a competing offer is recommended and completed. The primary purpose of a break fee is not to compensate the preferred bidder for wasted costs. Although this is a factor, it typically far exceeds the quantum of wasted costs in amount. Rather the economic rationale for it is to compensate the preferred bidder for creating a floor price for the asset, and thereby delivering value to shareholders.
Although not yet market practice, break fees are becoming increasingly common in South Africa. The SRP has taken a policy decision to limit break fees to one per cent of deal value. For instance, in the recent Edcon transaction, it approved a break fee at this level (approximately R250 million). Clearly a break fee of this magnitude provides comfort. The quantum of a break fee and circumstances in which it becomes payable constitute material terms of the offer and, accordingly, need to be disclosed in the firm intention announcement and the subsequent circular. Not only does its existence act as a deterrent (a competing bidder now has to pay more for a company that will immediately have an additional substantial liability) but it also assists the target board in weighing up competing offers. The new one has to be significantly better to justify the payment.
Another form of deal protection that is becoming an increasingly common feature of a South African take private transaction is an agreement between the preferred bidder and the target regulating the manner in which the offer will be implemented. This agreement is usually concluded simultaneously with the publication of the firm intention announcement and creates a contractual nexus between the two. If the target breaches its undertakings the preferred bidder will have a contractual claim for damages against the company. While the preferred bidder always has a right to match a competing offer, an implementation agreement can bolster its position by regulating how and when this right can be exercised. In particular, if the target is obliged to notify it of the precise terms of a competing offer, the target may be contractually compelled to resist any requirement of confidentiality that a competing bidder seeks to impose on it. The known existence of a contractual right to match may also deter competitors. A number of other useful protections can also be incorporated in the implementation agreement, such as an undertaking on the part of the target board not to solicit any more competing offers and their commitment to a timetable, as rapid implementation is often the best defence against a competing bidder.
Traditionally, target boards have been resistant to any form of deal protection. However, in the current environment, deal-protection mechanisms will be raised by most potential bidders at an early stage of proceedings. In considering their various options, target boards should be mindful of the reciprocal protection such mechanisms can provide.