“Fair value” in M&A - Dell and Delaware
| July 18 2016
A Delaware court has rejected a
market-led approach to the question of assessing a company’s “fair
value”, holding that a deal price arrived at through an arms-length
sale process materially undervalued the target company at issue.
We examine the decision and consider
whether similar arguments could be mounted in New Zealand. The
reasoning in the decision could be particularly relevant to
transactions conducted by way of scheme of arrangement.
In 2013, NASDAQ listed company Dell Inc.
was taken private in a US$24.9 billion (US$13.65 per share) deal, with
existing shareholders receiving cash for their shares. The acquiring
consortium was led by Dell CEO Michael Dell, together with private
equity firm Silver Lake. An independent special committee of the Dell
board negotiated the transaction, which was ultimately approved by
shareholders holding 57% of Dell’s shares.
A small group of shareholders who voted
against the transaction exercised appraisal rights under Delaware law,
seeking a higher price for their shares. These shareholders were
largely hedge funds pursuing an appraisal arbitrage strategy - buying
into a company about to conduct a transaction, with the intention of
voting against the deal and then pursuing a higher price for their
shares through the judicial appraisal process.
Under section 262(h) of the Delaware
General Corporation Law, the Delaware Court of Chancery can “determine
the fair value of shares exclusive of any element of value arising
from the accomplishment or expectation of the merger or consolidation,
together with interest, if any, to be paid upon the amount determined
to be the fair value.” In determining fair value, the Court must take
into account all relevant factors.
The Court held that Dell’s fair value at
the time of the transaction was US$17.62 per share, materially in
excess of the $13.65 deal price. In reaching this decision the Court
acknowledged that the sale process was properly conducted (a potential
concern given the role of Dell’s CEO in the acquiring consortium) and
that no other bidder had emerged prepared to offer a superior price.
Why then was the transaction’s $13.65
per share not “fair value”?
The Delaware Court’s analysis
The concept of “fair value” under
Delaware law is not equivalent to the economic concept of fair market
value. Neither market price (in the case of listed companies), nor the
price arrived at following a properly-run sale process, are regarded
as necessarily representative of fair value. This approach rejects the
efficient market hypothesis and is explicitly open to arguments that
markets may not in fact fairly reflect a company’s underlying value.
Pre-announcement market price
In reaching his decision on fair value,
the Judge considered and disregarded the market price for Dell’s
shares, which was US$9.35 when the deal was first proposed, US$13.42
when it was officially signed, and never closed above US$14.51
afterward. In reaching this conclusion the Judge relied on:
“the widespread and compelling
evidence of a valuation gap between the market‘s perception and the
Company‘s operative reality. The gap was driven by (i) analysts'
focus on short-term, quarter-by-quarter results and (ii) the
Company‘s nearly $14 billion investment in its transformation, which
had not yet begun to generate the anticipated results. A transaction
which eliminates stockholders may take advantage of a trough in a
company‘s performance or excessive investor pessimism about the
Company's prospects (a so-called anti-bubble). Indeed, the optimal
time to take a company private is after it has made significant
long-term investments, but before those investments have started to
pay off and market participants have begun to incorporate those
benefits into the price of the Company‘s stock."
This reasoning draws on common
criticisms of stock markets as reliable mechanisms for price
discovery, in particular their focus on short term performance. Dell
had invested US$14 billion in a business transformation project, the
future results of which the Judge considered were not properly
reflected in the share price.
The Court’s approach is best illustrated
by exploring its reasoning for why certain pricing benchmarks (such as
Dell’s share price prior to the announcement of the transaction, or
the deal price) were not proxies for fair value.
The US$13.65 deal price was the result
of a competitive sale process run by Dell’s independent directors. At
least three private equity firms considered acquiring Dell, with KKR
and Blackstone also putting in bids. No trade bidders participated, a
fact the Judge partially attributed to the presence of the Michael
Ultimately no bidder was prepared to
offer more than US$13.65 per share, the final deal price (and well
above the US$9.35 pre-deal market price). In rejecting arguments that
the deal price should serve as a proxy for fair value, the Judge based
his decision on an analysis of the leveraged buyout model often used
by private equity firms, in which returns on capital are amplified
through the use of debt to fund a significant proportion of a
company’s purchase price. Here, the Dell/Silver Lake consortium
pursued a leveraged buyout, with much of the purchase price funded by
In the Judge’s view, bidders pursuing an
LBO strategy targeting high returns (20% or more IRR) could not afford
to pay full value for Dell, as the high returns required by their
business model constrained the price they would be able to pay. In
short, if the acquisition model requires higher returns than “normal”,
it compels you to purchase the asset for a lower price than you could
offer if you were only seeking “normal” returns.
The fact that only private equity
bidders participated in the sale process compounded the issue for the
“Financial sponsors using an LBO model
could not have bid close to $18 per share [the Judge’s
ultimate valuation, based on a modified DCF analysis] because of
their IRR requirements and the Company's inability to support the
necessary levels of leverage. Assuming the $17.62 figure is
right, then a strategic acquirer that perceived the Company‘s value
could have gotten the Company for what was approximately a 25%
discount. Given the massive integration risk inherent in such a
deal, it is not entirely surprising that [strategic bidders] did not
engage and that no one else came forward."
With respect to parties pursuing LBO
models, such as private equity, the Judge’s view perhaps focuses too
much on the “financial engineering” aspects of such transactions,
while discounting the broader operational improvements that can result
from leveraged buyouts.
The Judge considered that a traditional
DCF valuation, assuming a “reasonable” cost of capital, was a better
proxy for fair value, and arrived at a valuation of US$17.62 per share
by adopting competing experts’ DCF models and adjusting relevant
inputs to what the Judge considered reasonable – unusual reading in a
Assessment of the decision
The suggestion that the price arrived at
through a properly-run sale process can be successfully attacked has
caused considerable disquiet in U.S. M&A circles. One journalist
summed up the reasoning as follows:
"The proof that $17.62 was the fair
price is that no one was willing to pay it:
shareholders won't pay fair value for Dell, because they are
obsessed with the short term and can't understand the long-term
private-equity buyer would pay fair value to buy Dell, because
private-equity firms only buy companies at a discount."
strategic buyer would pay fair value to buy Dell, because that would
Some commentators have sought to limit
the case’s findings on the basis that it involved an MBO so should not
be extended to more ordinary contexts.
Beyond these practical concerns,
reactions to the decision probably turn on one’s attitude towards
markets, and their utility as a mechanism for price discovery. For
many, the price of an asset arrived at through a reasonable market
process is “the price” – any other suggested price is theoretical. For
others, the flaws of market processes (such as those highlighted by
the Judge in Dell) would justify departing from a strictly market-led
approach to valuation.
Application to New Zealand
Appraisal-style rights are included in
the New Zealand Companies Act. If a New Zealand company resolves to,
among other things, approve a major transaction or amalgamate with
another company, and a shareholder votes against that decision, then
that shareholder is entitled to require the company to purchase his or
her shares either at an agreed or arbitrated price, which in either
case must be “fair and reasonable”.
The logic applied in the Dell case could
equally be applied here. However, Companies Act appraisal rights are
typically easy to structure around, for example through the use of
wholly-owned special purpose vehicles. The logic of the Dell decision,
and the concept of challenging values arrived at through market
processes, could have greater practical relevance to schemes of
Schemes of arrangement are back in vogue
for New Zealand M&A transactions, with recent legislative reforms
having put to rest a period of tension between schemes and the
The Companies Act grants the High Court
wide latitude in approving schemes, with the Act giving little
guidance on the relevant factors that should be considered by the
Court. In most cases, schemes progress through court with little
controversy, with the need for shareholder approval typically being
the substantive hurdle.
However, there is nothing preventing
shareholders who oppose a scheme from seeking to challenge it on the
basis that it undervalues their shares. Although the New Zealand
market lacks aggressive hedge funds willing to pursue tactics like
appraisal arbitrage, a sufficiently motivated and resourced
shareholder could bring a challenge. Given that an independent
valuation report would almost certainly have been prepared, any action
would need to demonstrate why the report’s (presumably) positive
finding was incorrect.
In New Zealand this kind of challenge
could be brought as part of the scheme approval process, unlike in
Delaware where appraisal actions can only be taken after the
transaction has been consummated.
Although it’s unlikely that a New
Zealand court would participate in the kind of judicial valuation
exercise seen in Dell, the possibility of a challenge on these grounds
delaying implementation of a scheme is a real one and is a factor for
parties to consider when contemplating a scheme.
The full judgment, In re Appraisal of
Dell Inc., can be accessed
Chapman Tripp -
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