Despite increasing political tensions and evolving trade policies, the U.S. M&A market in 2018 enjoyed its second-best total deal value ever, according to Mergermarket. Activity through the first three quarters appeared poised for a new record, before slowing in the final quarter as stock market volatility spiked and questions arose about the direction of economic growth.
Key sectors led the way:
Source: 451 Research
Prospects for 2019 remain strong, with companies eager for growth and capital still abundant and relatively cheap, despite the Federal Reserve’s recent moves away from its low interest policy. However, there are risks that could slow M&A activity. In this alert, we review some of the key trends and developments arising from last year’s M&A activity, and consider how they might affect the level of M&A and how deals are done going forward.
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1. Tax Reform Presents Both Challenges and Opportunities
Many aspects of 2017’s Tax Cuts and Jobs Act (TCJA) remain to be refined in the coming year (or even years). However, several trends emerged during 2018 and tax savings will continue to be a source of potential value in 2019.
Deal Structure and Terms
Key structuring considerations include:
General Choice of Entity
The use of the corporate form relative to pass-through entities has received renewed focus due to a variety of considerations, including:
Impact on Specific Industries
The significance of tax reform has varied among industries and types of businesses. For example:
2. U.S.-Trade Trade Tensions and National Security Concerns Move the Goalposts….
As we predicted last year, U.S. national security concerns and the Committee on Foreign Investment in the United States (CFIUS) played a major role in cross-border transactions for both strategic buyers and PE sponsors. Trade tensions with China, increasing market volatility, and new legislation and regulations are impacting whether and how cross-border deals are structured and getting done.
The Foreign Investment Review Risk Modernization Act of 2018 (FIRRMA), signed into law in August 2018, expanded CFIUS’ scope and process. Highlights include:
Most of the changes implemented by FIRRMA will become effective once CFIUS issues implementing regulations, expected late this year.
However, the U.S. Department of Treasury (as the CFIUS chair) published interim rules implementing the critical technologies “pilot program” contemplated by FIRRMA that imposes a mandatory declaration filing requirement, with penalties for failure to file equal to the value of the transaction.
These regulatory challenges are expected to impact PE sponsors, including those with foreign LPs as well as those based outside the U.S. Asset managers generally have been increasing allocations to private equity, and sovereign wealth funds have been ramping up direct investment activity, especially in U.S. technology companies. Given the voluminous dry powder in the PE industry, as noted elsewhere in this alert, PE sponsors are expected to challenge (or even surpass) strategic technology acquirers in closing acquisitions in the technology sector, which has emerged as the hottest industry vertical for PE investment. Consequently, PE sponsors and backers of other private investment vehicles will need to be especially mindful of the new regulations.
Dealmakers will need to follow the CFIUS regulations as they continue to roll out, and carefully coordinate the timing and terms of their transactions around national security concerns to the extent the deals involve foreign investment. These changes have already begun to result in process changes for deals, including targeted front-end diligence for all parties involved to answer the threshold question of whether they are looking at a covered transaction and whether a declaration is required.
Despite these concerns, the U.S. market continues to attract significant investment interest from abroad, and while the regulatory landscape continues to evolve, deals continue to be done.
3. Continued Creativity Expected Following a Strong Year for PE Buyers
2018 was a strong year for the private equity industry. Available capital was at an all-time high, and 2018 deal volume for PE buyers exceeded record levels.
Source: 451 Research
Financial sponsors remain nimble and attractive buyers, and the increased fundraising over the past few years has allowed more active PE participation at all levels of the market, from mega deals to smaller deals. Dry powder now eclipses $1 trillion by some estimates. The trends noted above should continue into 2019, along with an increase in take-private transactions.
That being said, the outsized returns that have been delivered by PE funds over the past decade are at risk as sellers’ expectations and corresponding prices have continued to rise. Creativity will be imperative, as PE funds seek value-enhancement strategies to differentiate themselves in a crowded field. PE funds will also need to be mindful of broader market trends, noted elsewhere in this alert.
While the threat of a general economic slowdown lingers, available capital and creative investment strategies, particularly with respect to assets that may become distressed in any such slowdown, should continue to drive an active PE market throughout 2019.
4. Delaware Court (Finally) Finds an MAE – But Leaves the Bar High and Not Much Clearer
Until the Delaware Chancery Court’s decision in Akorn v. Fresenius on October 1, 2018, no Delaware court had found a material adverse effect (an MAE) that justified the termination of a merger transaction.
Many practitioners have equated MAEs with disasters. Here, the court repeatedly referenced the target’s performance as a “downturn,” albeit a “dramatic” and “unexpected” one. Akorn had particularly egregious facts:
While many undoubtedly will search for significance underlying this 21%, V.C. Laster added that “[n]o one should fixate on a particular percentage as establishing a bright-line test.”
The court also raised questions about the extent to which such a downturn must be “unexpected,” rather than allowing the parties to allocate the risk contractually, and drew attention to the interplay between the differing levels of materiality that often apply in different reps and covenants.
What to Do?
In a pre-Akorn world, the inclusion of an MAE qualifier comforted many targets when agreeing to expansive reps and warranties or preparing disclosure schedules. Now that a Delaware court has found an MAE and has emphasized the importance of contractual risk allocation, targets may require more guidance to understand the practical implications of including an MAE qualifier in their merger agreements for their specific businesses.
Although recent transaction documents already show evidence of parties being influenced by Akorn, one occurrence of an MAE does not a trend make. The threshold for an MAE is still high. The outcome of Channel Medsystems Inc. v. Boston Scientific Corp., which will decide the validity of another buyer terminating a deal due to an MAE, may give Delaware courts another chance to decide whether Akorn is an anomaly or the first of many more MAEs to come.
5. Non-Tech Companies Buying Tech Companies
One trend that continues to reshape the M&A market is the participation of “non-tech” companies as major buyers in the technology market.
According to 451 Research, strategic acquirers from outside the tech market have now spent more than $40 billion on tech M&A in each of the last three years. Prior to that period, according to 451 Research, non-tech acquirers never spent more than $35 billion in any single year following the dotcom bubble of 1995 to 2001.
And deal-makers anticipate this trend will continue, with 68% of respondents to MoFo’s October 2018 Tech M&A Leaders’ Survey predicting an increase over the next three years in non-tech companies acquiring tech companies.
Source: 451 Research
The shift correlates with the increasingly blurred lines between what is considered a “technology” and a “non-technology” business, as connectivity, automation, mobility and data have permeated the business world and traditional non-tech companies are now utilizing technology in order to solve internal gaps or enhance external offerings.
The speed at which technology disruptors can enter and reinvent a targeted market has also added pressure on non-tech companies to develop their tech arsenal at a rapid pace or risk losing ground. Oftentimes this means acquiring an established technology business rather than attempting to internally develop a digital platform.
Combining tech and non-tech companies can require both sides to learn more about each other. For example, a non-tech company will need to spend time on diligencing, or learning how to diligence, the source and scope of the intangible assets that underlie most tech companies. They will also need to consider how to motivate and retain a workforce that may be focused on equity incentives. Target companies will want to know that their non-tech suitor will understand (and hopefully pay for) the scalable value they think they represent, and will do what’s appropriate to retain the workforce needed to continue developing the technology.
6. New Privacy Laws Sweep in from the EU to California and Beyond
Privacy and data issues continued to gain prominence in 2018, as new laws required companies to adopt new compliance procedures and exercise increased vigilance and the risk of the occurrence and costs of breaches continued to increase.
As the risks and requirements grew, and the portion of businesses that were implicated expanded, buyers expanded their diligence investigations. Buyers also have taken care to conduct diligence in compliance with the new rules and exercised additional caution in requesting and handling personal information. In acquisition agreements, buyers have expanded reps and warranties and, in some cases, specific indemnities. For the longer term, buyers have also increased their attention to data-related integration issues.
2018 was a milestone year for changing privacy laws, but 2019 promises to be at least as groundbreaking. M&A dealmakers will need to keep pace with the changing privacy landscape, especially for tech-driven and data-driven deals.
7. Shareholder Activism Drives M&A and Affects Strategies
Activist campaigns hit a record pace in 2018, with 226 companies targeted by shareholder activists, up from 188 in 2017. The U.S. remained the focus, but activism also expanded abroad, particularly in Europe and Asia Pacific.
Activist M&A Goals
M&A is typically one of the most commonly announced objectives for activists, occurring with about the same frequency as demand for board changes. Activists also push for other M&A-related objectives, such as divestitures, and other capital allocation steps, such as dividends and buybacks.
The number of activists has also continued to grow. 131 activists were responsible for campaigns in 2018, up from 108 in 2017. Despite that growth, a small number of activists accounted for a large percentage of activity, with Elliott Management alone accounting for 9% of campaigns.
Boards contending with activists in an M&A setting need to keep in mind their legal duties within the company’s overall context, as well as the demands of activists and the apparent wishes of their shareholders. Courts have generally been reluctant to apply greater scrutiny to board decisions merely because they are made under threat of a proxy contest, but when combined with other facts relevant to the company, or to the sales process, other shareholders may complain that directors have failed to comply with their duties to make their own decisions.
As 2019 begins, activism is not expected to recede in any meaningful way. Directors will need to be prepared and remain engaged with their shareholders and act in accordance with their duties when faced with activist pressure.
8. Proper Deal Processes Support Reliance on Deal Price
Delaware courts in 2018 continued the trend in appraisal cases towards reliance on the negotiated deal price as an indicator of a target company’s fair value. This bodes well for buyers whose transactions fit within the requirements for such reliance, since it reduces the chances that they will be required after closing to pay a higher price to stockholders seeking appraisal.
The Delaware Supreme Court has refrained from setting a “bright line” rule requiring reliance on deal price. However, in its 2017 decisions in DFC and Dell it emphasized that a deal price set through “an open process, informed by robust public information, and easy access to deeper, non-public information” “deserved heavy, if not dispositive weight.” Deals that do not follow such a process, particularly where significant conflicts are involved, on the other hand, could end up with the court calculating a different fair value.
The trend seems to be playing out in the incidence of appraisal litigation as well: In 2017, the number of appraisal cases filed in Delaware declined to 62, from 85 in 2016, and in 2018 the number dropped even further, with roughly 30 appraisal cases filed in Delaware. The changing landscape has also resulted (in our experience) in more modest settlements in existing litigation.
In its 2018 decisions, the Delaware Chancery Court highlighted deal process features that increased the likelihood of reliance on a deal price, as well as features that tended to make the court reject the deal price and seek other ways of valuing the company:
Dealmakers continue to watch for signals from the Delaware courts, including the anticipated ruling in the ongoing appeal of the Aruba decision noted above.
9. Rep and Warranty Insurance – Wider Usage by Strategic Buyers
Rep and warranty insurance has been used by PE buyers for several years, but it is still used by just a fraction of strategic acquirers. The prevailing theory for the difference is that strategic acquirers can leverage deal synergies to justify higher valuations than their PE competitors, and as such their proposals are viewed as attractive despite the increased escrow and indemnity obligations that accompanied their bids.
More recently, however, some strategic acquirers have become more comfortable with the idea of deal protections through representation and warranty insurance. This willingness by some strategic acquirers to compete on both value (taking account of strategic synergies) and escrow/indemnity terms will put pressure on other strategic buyers to get comfortable with rep and warranty insurance in order to remain competitive.
Terms Continue to Improve
More generally, rep and warranty insurance policy terms have continued to improve from the perspective of both the buyer and the seller, although not with the same scope of changes that followed the policies’ introduction to the market. While terms still can be negotiated, currently:
Coverage by rep and warranty insurance continues to be limited to unscheduled and unknown breaches. Buyers thus continue to explore other mechanisms, such as specific indemnities (or, in some cases, other kinds of insurance), to address issues disclosed by sellers or otherwise known to buyers.
 Read our Nov. 2018 Client Alert discussing the Commerce Department notice. Commerce Department notices with respect to “foundational technologies” will be issued separately.
 See our article, Five Key Legal Risks for Data-Centric Technology M&A.
 For examples, see In re Tangoe, Inc. Stockholders Lit’n, Del. Ch. Nov. 20, 2018; In re PLX Technology Inc. Stockholders Lit’n, Del. Ch. Oct. 16, 2018.
 See Shareholder Litigation Involving Acquisitions of Public Companies: Review of 2017 M&A Litigation, Cornerstone Research (2018). Includes quasi-appraisal claims as well as appraisal claims.