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Focus: Private Equity – September 2006

Going-private transactions in Australia – a guide for US financial sponsors

In brief: Australian businesses are attracting increasing interest from US financial sponsors, particularly private equity funds. The two largest Australian leveraged buyout acquisitions, both completed in 2006, have been undertaken by US private equity firms. Those same firms are now involved in a consortium seeking to acquire Coles Myer in a going-private transaction that would dwarf all other private equity transactions in the Australian market. As a guide for US financial sponsors considering a going-private transaction in Australia, Partner David Wenger(view CV) and Senior Associate Tom Story provide an overview of the key differences between the applicable regulatory frameworks in the US and Australia.

Key points
  • 2006 is shaping up to be a watershed year for going-private (or public to private) transactions in the Australian market.
  • US financial sponsors are likely to find that the Australian regulatory framework is quite conducive to going–private transactions in comparison to the US.
  • In Australian going-private transactions, shareholder litigation is less prevalent and the scope of available defence tactics is more limited than in the US. 

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Background

A consortium led by Texas Pacific and its Asian investment arm, Newbridge Capital, acquired the Myer department store business for A$1.4 billion in June 2006 (AAR acted for Coles Myer on the sale of Myer). In July 2006, Brambles sold Cleanaway Australia and New Zealand and Industrial Services Australia to KKR for A$1.83 billion (AAR acted for Brambles on the sale of Cleanaway and BIS). These transactions would, however, be dwarfed by an acquisition of Coles Myer, which has received (and rejected as at the date of writing) an approach from a consortium said to include US private equity funds Bain Capital, Blackstone, Carlyle, KKR and Texas Pacific/Newbridge Capital. 

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What is a going-private transaction?

A 'going-private' (the US terminology) or a 'public to private' (the Australian/UK terminology) transaction refers to the acquisition of a public company by a financial sponsor, such as a private equity firm. Common structures are leveraged buy-outs or management buy-outs.

Going-private transactions have been commonplace in the US since the early 1980s. They have recently hit the headlines with the announcement of the acquisition of HCA, a leading US health care company, by a private equity consortium led by Bain Capital, KKR and Merrill Lynch in a deal valued at US$33 billion. The HCA transaction will set a new record as the world's largest buy-out deal. The compliance burden and governance requirements arising from the Sarbanes-Oxley Act 2002 is one factor that is said to have increased the attractiveness of going-private transactions to US public company boards and senior management in recent years.

In Australia, going-private transactions have been less common, but 2006 is shaping up to be a watershed year in this area. In addition to the possible Coles Myer transaction, Affinity Equity Partners recently received a board recommendation in favour of its A$450 million takeover bid for retailer Colorado. This transaction will be Australia's first successful private equity bid initially made on hostile basis. A number of other Australian public companies are said to be the subject of interest from private equity firms.

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Transaction structure

US public company acquisitions are generally structured in one of two ways: (i) as a tender offer coupled with a back-end merger; or (ii) as a one-step merger. The one-step merger has been the preferred structure for going-private transactions, particularly where there is management participation. This is because of the application of the Securities Exchange Commission's (SEC) 'best price rule' to tender offers, which was introduced to assure equal treatment of tendering shareholders.

A number of US court decisions have led to a concern that compensation arrangements with target management who are also shareholders could be considered in violation of the rule. However, the SEC has recently proposed amendments to the best price rule that, if adopted, are likely to see an increased use in tender offers in going-private transactions. Tender offers can generally be completed more quickly and efficiently than one-step mergers (one month versus three to four months for a merger).

In Australia, the closest equivalent to a one-step merger is known as a scheme of arrangement. A scheme of arrangement is a court approved arrangement entered into between a target and its shareholders. In addition to court approval, the scheme must be approved by target shareholders (75 per cent by value of shares and 50 per cent by number of shares).

The majority of going-private transactions in Australia have been undertaken by scheme of arrangement. The key advantage offered by a scheme is that it involves a binary outcome – the acquirer ends up with either 100 per cent of the target or none at all. There is no possibility of the acquirer being left with a minority stake (assuming no pre-existing shareholding). In a highly leveraged transaction, where direct access to the cash flows of the target is likely to be critical, a scheme of arrangement is generally the optimal acquisition structure. Following completion of a scheme, the acquirer will also have the capacity to undertake sales of the target's assets without needing to consider the interests of minority shareholders.

However, it is possible for a going-private transaction in Australia to proceed by way of takeover bid, the equivalent of a US tender offer. A number of significant transactions have adopted this structure, including ABN AMRO Capital's A$187 million acquisition of Ausdoc Group and the Affinity Equity Partners bid for Colorado. A hostile transaction must be undertaken by way of takeover bid, because a scheme of arrangement can only be proposed by the target to its shareholders.

Under a takeover bid, the bidder makes offers directly to target shareholders. Although a minimum acceptance condition can be attached to the offers, such a condition will often need to be waived in order to receive significant acceptances. The acquisition of 90 per cent of the target's shares (and 75 per cent of those shares the subject of offers under the bid) is required in order for the bidder to exercise compulsory acquisition rights and mop up the remaining shareholders. Therefore, there is no guarantee under a takeover bid that minority shareholders will not remain at the conclusion of the bid.

In the US, 'top-up' options are possible under which companies may issue to bidders a modest amount of treasury shares so as to allow them to reach minimum tender condition thresholds. Such options have not been used to date in Australia and it is unlikely that they would pass the scrutiny of the Takeovers Panel (the Panel) or the Australian Securities & Investments Commission.

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Dealing with management

Arrangements with management, a common feature of the typical leveraged buy-out, present particular challenges in a going-private transaction. Further complications arise where management may already be significant shareholders in the target. A range of issues need to be considered in the structuring of a going-private transaction involving target management, both in the US and Australia.

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Best price rule / collateral benefits

As discussed above, the potential application of the SEC's 'best price rule' to arrangements with management has resulted in the one-step merger being the structure of choice in US going-private transactions. Similar issues are raised by the collateral benefits prohibition in Australia's Corporations Act 2001. A takeover bidder is prohibited from giving a 'collateral benefit' during a takeover bid, meaning a benefit likely to induce a person to accept an offer under the bid (or otherwise dispose of shares) that is not offered to all other shareholders.

An offer by a private equity firm to target management to participate in the bid vehicle is one transaction that will need to be examined to ensure compliance with the collateral benefits prohibition. Although the Panel has not considered these specific circumstances, an arrangement negotiated and agreed on arm's length terms is unlikely to be considered by the Panel as violating the prohibition. If, however, the terms of the arrangement were heavily weighted in favour of management in order to induce their acceptance of a takeover bid, the collateral benefits prohibition would come into play.

The Panel has previously found that the offer to a target company director of a position on the board of the bidder did not breach the collateral benefits prohibition or constitute 'unacceptable circumstances' (Re Normandy Mining Limited (No 4) [2001] ATP 31). However, arrangements of this type would still need to be considered on their facts.

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Independent committees

In the US, Delaware law requires that where a going-private transaction involves a 'controlling' stockholder, the actions of the target board be subject to the 'entire fairness' test. This requires a more rigorous review by the target board than under the traditional business judgment rule. In these circumstances, a target board will generally establish an independent special committee to approve the transaction in order to counteract potential challengers. Even where management may not be significant stockholders, special committees are common in going-private transactions that involve management participation. The special committee will often play a role in settling stockholder litigation frequently triggered by the public announcement of a going-private transaction.

In the Australian context, general corporate governance principles (rather than specific rules) will require a target board to establish an independent committee to consider a going-private proposal with which target executive directors are involved. The independent committee will be delegated with appropriate powers to respond to the proposal, including retaining an independent expert and external advisers. The executive directors will remain on the board to deal with day-to-day issues, but will absent themselves from consideration of the proposal and generally refrain from making a recommendation to shareholders in respect of the transaction.

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Takeovers Panel

In Australia, litigation risk with respect to going-private transactions is less significant than in the US. The Panel is the primary dispute resolution forum for takeover bids. Under the Corporations Act, private parties to a takeover no longer have the right to commence civil litigation, or seek injunctive relief from the courts, while the takeover is current. Disputes which were previously resolved in the civil jurisdiction of the courts are now resolved by the Panel. Although schemes of arrangement are subject to a court review and approval process, instances of shareholder litigation challenging schemes are less common in Australia compared to similar transactions in the US.

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Defence tactics

There is a significant disparity in available takeover defence tactics between the US and Australia. In the US, shareholder rights plans or 'poison pills' have been adopted by public companies on a widespread basis since the 1980s as a defence against unsolicited takeover bids.

In Australia, anti-takeover devices such as the poison pill provisions commonly found in the US have never been a feature of the market. The primary reason for this is that takeovers are much more highly regulated in Australia than in the US. Therefore, there has never been a need for Australian public companies to protect themselves against unacceptable bid structures (eg two-tier, front-end loaded bids), as such bids are already subject to regulation.

Furthermore, Panel policy in Australia now significantly restricts the actions which target directors can take in response to a bid. The Panel's 'frustrating action' policy requires, subject to some exceptions, that actions which may frustrate the objectives of a bidder in relation to the target must be submitted to target shareholders for approval. As a result, the scope of takeover defence tactics is more limited in Australia compared to the US.

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Fairness opinions / independent expert's reports

The SEC requires extensive disclosure of fairness matters to target stockholders in 'affiliate-sponsored' going-private transactions. Parties subject to the rule must file, among other things, any material financial or strategic advice that they have received from third parties in the process, such as independent reports commissioned in relation to the fairness of the transaction. The rule will generally capture going-private transactions which involve target management receiving a material amount of the surviving company's equity or representation on the surviving company's board.

The Corporations Act only requires the target to obtain an independent expert's report where there is an overlap between the target and bidder board of directors or the bidder already has 30 per cent or more of the voting power in the target. However, even in circumstances where an independent expert's report is not legally required, it is now relatively common practice for target boards to obtain a report to support their recommendation to target shareholders.

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Timing of disclosure

In both the US and Australia, pre-announcement negotiations with management need to be carefully managed in order to avoid triggering early disclosure of a going-private transaction. A US private equity firm will have a disclosure obligation under federal securities laws when it acquires beneficial ownership of 5 per cent or more of a public target. Such disclosure will often be triggered when the firm executes voting agreements with target stockholders, which will generally take place at the same time as agreement is reached with the target. Early disclosure may also be required where a significant stockholder has a Schedule 13D on file with the SEC that requires amendment due to an arrangement with a private equity firm.

In Australia, if management (or management together with the private equity firm) hold more than 5 per cent of the target, the creation of an association will give rise to a substantial holding disclosure obligation. A private equity firm will become associated with management if they have, or propose to enter into, a relevant agreement for the purpose of controlling or influencing the composition of the target board or the conduct of the target's affairs. The exact point in time at which an association arises is difficult to determine, particularly given the reference to 'proposing' to enter into a agreement. At a minimum, some meeting of the minds will be required between the private equity firm and management on the terms of the management arrangements that will apply post-closing.

Such discussions need to be conducted carefully, because the inadvertent creation of an association could have negative consequences for a going-private transaction. Premature disclosure of a transaction, particularly before agreement is reached with the target, will generally be undesirable from the perspective of the private equity firm. A target board in discussions with a private equity firm will also need to consider the application of the ASX Listing Rules to determine at what point disclosure may be required, particularly where market speculation has developed.

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Floor price rule

Private equity firms may also need to consider Australia's 'floor price rule', under which purchases of target shares made by the bidder or an associate within four months prior to the bid set the floor for the bid consideration. An association with target management may bring the rule into play.

The floor price rule may also apply in circumstances where, prior to the bid, management roll-over existing equity in the target for shares in the bid vehicle. Such a transaction may require the bidder to independently value the unlisted shares in the bid vehicle to ensure compliance with the floor price rule. However, as the floor price rule only applies to takeover bids, not schemes of arrangement, a change in structure may enable these consequences to be avoided.

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Deal protection – lock-ups and exclusivity agreements

In the US, a key focus of deal protection in a going-private transaction is the extent to which a private equity firm can lock up a deal through the execution of voting agreements with management or target stockholders.

The Delaware Supreme Court considered the issue in its Omnicare decision. In Omnicare, a bidder negotiated a 'force-the-vote' provision ie, a covenant in the merger agreement requiring that the deal be put to a stockholder vote even if the target board were to withdraw its recommendation. At the same time, the bidder obtained voting agreements from the target's two major stockholders who controlled 65 per cent of the vote. The court held that the target board had violated its fiduciary duties by approving a merger agreement with no 'fiduciary out', given the existence of the voting agreements that assured stockholder approval of the deal.

Although (at least in Delaware) absolute lock-ups may be struck down, arrangements short of an absolute lock-up have subsequently been found to be outside the scope of Omnicare. A recent Delaware Chancery Court decision upheld a controlling stockholder's voting agreement with a potential bidder that required the stockholder to vote against competing bids for a period of 18 months.

The Panel has issued a guidance note which covers exclusivity agreements and other lock-up devices in Australia. The Panel's general approach is that a lock-up device may be unacceptable if it prevents a control transaction (such as a takeover bid or scheme or arrangement) from taking place in an efficient, competitive and informed market.

The Panel generally does not require that a no-shop obligation binding a target board be subject to a fiduciary carve-out, because a no-shop provision only prevents the target from soliciting additional bidders or alternative transactions. However, the Panel does require that a no-talk provision contain a fiduciary carve-out allowing the target board to respond to an unsolicited approach if to do so would be in the best interests of target shareholders. Appropriate limitations on the scope of the carve-out are acceptable, such as a requirement that the target notify the bidder of any approaches made by potential rivals.

It should also be noted that a pre-bid voting or acquisition agreement in an Australian going-private transaction must be limited to shares with no more than 20 per cent of the voting power in the target. This is necessary to ensure that the general prohibition in the Corporations Act on acquisitions of relevant interests is not breached.

The Foreign Acquisitions and Takeovers Act 1975 may also apply to require regulatory approval for a pre-bid acquisition of more than 15 per cent if the bidder is considered a 'foreign person'. The Australia-United States Free Trade Agreement has granted extensive foreign investment concessions to US investors in Australia. These concessions include an increased notification threshold for US investors from A$50 million to A$800 million. The threshold relates to the gross assets of the company being acquired, not the actual amount invested. Certain sensitive sectors are excluded from this concession, including media, telecommunications, transport and defence.

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Deal protection – break fees

In relation to break fees, the Panel applies a '1% guideline' as a starting point for assessing whether a break fee is likely to be anti-competitive or coercive. However, on the facts of a particular case, a break fee of higher than one per cent of equity value of the deal may be acceptable.

The Panel's decision in Ausdoc Group [2002] ATP 09 involved a going-private transaction undertaken by ABN AMRO Capital by way of takeover bid. A break fee of A$3.5 million, or 1.87 per cent of equity value, was not regarded as being unacceptable because of the previous public tender process carried out by the target, the high cost of preparing and carrying out the bid and because the premium being offered to shareholders was many times the amount of the break fee.

Break fees of the size commonly payable in US transactions would generally not be considered acceptable by the Panel. In US, the decision of the Delaware Chancery Court in the Toys'R' Us buy-out shareholder litigation confirmed that a 'bright-line' test is not considered appropriate by Delaware courts. Target boards may accept break fees that create bidding cushions as part of 'a good faith negotiation process in which the target board has reasonably granted these protections in order to obtain a good result for stockholders'. The court upheld the decision of the Toys'R' Us board to agree to a 3.75 per cent break fee, but did note that the court will not turn a blind eye to the adoption of excessive break fees that 'present a more than reasonably explicable barrier to a second bidder'. The Toys'R' Us decision is likely to set a new benchmark for US break fees.

Selected US deals have also featured reverse break fees payable by a bidder in the event that the deal failed due to anti-trust concerns (Whirlpool / Maytag) or the bidder's inability to obtain financing (the leveraged buy-outs of Sunguard, Neiman Marcus and Hertz). Reverse break fees have featured in the Australian market on a number of occasions, particularly in agreed mergers by way of scheme of arrangement.

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Acquisition finance

The current market framework for acquisition finance in Australia was recently reviewed by Partner Phillip Cornwell (see Focus: Acquisition Finance – September 2006).

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Conclusion

A US financial sponsor considering a going-private transaction in Australia may recognise, from US experience, many of the legal issues that need to be addressed. However, the structuring of a transaction to deal with those issues is, in many respects, quite different in Australia compared to the US. Although differences exist, they do not represent additional impediments to the implementation of Australian going-private transactions. In fact, US financial sponsors are likely to find that the Australian regulatory framework is quite conducive to going-private transactions compared to the US, as shareholder litigation is less prevalent and the scope of available defence tactics is more limited. 

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