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Comparable Transaction Analyses and the Economic Crisis

March 11, 2009


Introduction


The current economic downturn presents an array of challenges to the financial advisory practice. The severe dislocation of global capital markets has altered the dynamics of the mergers and acquisitions market. This alteration affects not only the negotiation, structuring and execution of corporate acquisitions, but will also affect the manner in which Delaware courts review the work of financial advisory and valuation professionals in litigation relating to breaches of directors’ fiduciary duties, fairness opinions and appraisal rights.

Comparable Transactions Analyses (M&A Comps) and the Dot.com Bubble

The comparable transactions analysis (M&A comp analysis) is a standard tool used in preparing fairness and valuation opinions and advising board of directors on strategic alternatives. In two cases following the bust of the dot.com bubble, Delaware courts were critical of M&A comp analyses post-bubble that used transactions announced or completed during the heyday of the dot.com bubble. [1]

In both cases, M&A comp analyses were largely based on M&A comps from 1999; the subject transactions were signed up in 2003. (In one case a single M&A comp from 1999 was used, in the other case four out of seven M&A comps were from 1999.) Neither transaction was in the high-tech industry. The Delaware courts simply noted that transactions from 1999 (or the late 1990s and early 2000s) were part of a “strong bull market” and a “market bubble”. Their reasoning was based more on changing market conditions than on the mere passage of time, although sufficiently “stale” comps, based on the passage of time, would likely also have been scrutinized.

Looking Ahead

The severe market dislocation of the dot.com bubble was limited to a discrete set of industries. Our current downturn is, of course, much broader. Delaware courts, however, were critical of M&A comp data from the dot.com era being used post-bubble in non-high tech deals. Thus, there is every reason to believe that Delaware courts will continue to apply this reasoning to M&A transactions in the post-Dow 10,000 world. Fairness and valuation committees of financial advisory firms should begin considering policies and/or “best practices” to address this issue.

Financial advisors should keep this issue in mind with respect to both buy side and sell side opinion analyses, but for different reasons. The issue is straightforward in the buyside context. Including “bull market” comps in a buyside transaction could assist a board of directors in determining that it was acceptable to pay a higher price in an acquisition than would otherwise be justified.

In the sellside context, the reason relates to deviations from a mean or median in M&A comp analyses. Delaware courts have ruled that significant deviations from mean or median results suggest that the comp criteria is not really comparable, thus the analysis is unreliable. Two cases have disregarded analyses using 48% discounts from the means. Another case has disregarded an analysis in which the exercise of judgment arrived at a 22% discount from the median and 33% discount from the mean. [2]

Thus, even if inclusion of “bull market” comps in an M&A comp analysis make it “tougher” to render a fairness opinion in a sellside context, it may also steer a deal team toward a greater deviation from a mean or median result. Doing so increases the risk that a Delaware court will conclude such analysis is unreliable.

This does not necessarily mean that information regarding such transactions should be entirely excluded from a board book (or even from an M&A comp analysis page in a board book). It does mean, however, that the exercise of judgment should be applied as to the inclusion of transactions in the “formal” analysis, as opposed to the conclusion reached after reviewing the resultant mean or median.

There is no exact prescription for dealing with issues of this nature. The Delaware courts understand this. With their growing sophistication, however, Delaware courts also expect financial advisors to be able to articulate and defend their choices in preparing financial analyses. As a result, the fairness committee process should be viewed in part as a dress rehearsal for potential litigation involving fairness opinions. Fairness committees should not avoid asking deal teams the sort of questions that one would expect from the Delaware judiciary, and deal teams should prepare their analyses accordingly.

If you have any questions regarding the matters discussed herein (including additional methods to address the issue presented), or other questions regarding fairness opinions or other valuation matters, please call Scott Widen at (212) 326-2191.


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[1] See, Highfields Capital, Ltd. v. AXA Fin., Inc., 2007 Del Ch. LEXIS 126 (Del. Ch. August 17, 2007); Andaloro v. PFCC Worldwide Inc., 2005 Del. Ch. LEXIS 125 (Del. Ch. August 19, 2005).

[2] See, Highfields Capital, Ltd. v. AXA Fin., Inc.; Dobler v. Montgomery Cellular Holding Co., Inc., 2004 Del. Ch. LEXIS 139 (Del. Ch. September 30, 2004); Taylor v. Am. Specialty Retailing Group, Inc., 2003 Del. Ch. LEXIS 75 (Del. Ch. July 25, 2003). These cases involved means and medians for comparable company analyses, but Delaware courts would apply the same reasoning to M&A comp analyses.