Stake building – the new exclusivity?

Whilst ‘hard’ exclusivity is becoming difficult for Australian public M&A, stake building continues to be a useful strategy.

Building a pre-deal stake is a well-trodden (but not bullet proof – more on that later) strategy to manage interloper risk.  We took a deep dive into the data ^[1] for deals over the last 10 years and whilst data can be sliced and diced in a variety of ways, the results highlighted the ongoing use of the strategy.

What does the data say?

Physical stake

Interestingly, 83% of pre-deal stakes in the sample set were undertaken as a direct acquisition of a physical stake (rather than an option or derivative), with 84% of those stakes acquired by strategic bidders and the remaining 16% by private capital.  We were initially surprised that physical stakes were so prevalent in the sample set but it tends to make sense as physical stakes have the highest deterrent effect on potential interlopers by removing part of the register from their reach.  The flipside is that it may sour goodwill from the target Board – more on that below.

Taking a physical stake requires an upfront capital outlay and careful navigation.  Depending on the size of the stake to be acquired, the acquisition may trigger a requirement to seek FIRB approval and will ultimately rely on there being liquidity in the target shares.  An unsuccessful bidder could be stuck with a passive minority stake or be forced to subsequently sell, potentially at a discount.

Putting pressure on the scheme denominator

Unsurprisingly, direct acquisition of a physical stake was less common for schemes than takeover bids – with 43% undertaken by scheme and 57% by takeover bid.  Whilst a physical stake may provide a bidder with a head start under a takeover bid, it involves a trade-off for a scheme.  This is because the bidder and its associates are effectively excluded from voting any target shares they holds on the scheme.  By taking those shares out of the voting pool, other shareholders with significant stakes inevitably have a greater influence on the vote.  When considered together with usual voter turn-out, small to medium stakes can turn into blocking stakes.  Narrowing the denominator can create structural vulnerability which could tempt a clever interloper – this was evidenced recently in the scheme of arrangement for Zenith Energy (read more about the deal dynamics here).

Unwinding a stake before a scheme meeting also needs to be carefully managed as evidenced when the consortium bidder for Australian Office Fund (AOF) trust scheme sold down its 19.90% stake in AOF off market before the scheme meeting.  ASIC raised concerns that the way the sell-down was undertaken undermined market integrity and that not all unitholders would have an equal opportunity to participate in benefits offered under the scheme. ^[2]

Board seats

Holding a large physical stake won’t necessarily entitle a bidder to a Board seat. Boards are under increased pressure to justify director appointments – having to manage independence, diversity, the skills matrix, nomination committees and other governance requirements.  A bidder with stake must be prepared to demonstrate the potential benefit its nominee director candidate could offer the entity’s board.

Securing a Board seat is also not the end of the story.  Ongoing information sharing and governance arrangements have to be navigated, both from an insider trading perspective and also to assist the nominee director in complying directors’ duties.  Managing these issues in conjunction with a potential control transaction is challenging so it’s more common for bidders not to seek a Board seat unless the large stake is held as part of a longer-term play.

Derivative instruments

Only 10% of deals in the sample set with pre-deal stakes used a form of derivative instrument (usually in the form of cash settled equity swaps).  Derivative structures are useful but can be difficult and expensive to fill.  They’ve typically been used in conjunction with another structure (i.e. option or physical stake) to top up the bidder’s ultimate stake.

Option arrangements

16% of the deals in the sample set with pre-deal stakes were undertaken through an option arrangement, typically a call option.

Unsurprisingly, 86% of those deals with option arrangements were entered simultaneously with deal announcement.  Again, this is not surprising as building a pre-deal stake before announcement of the deal tips the market once you hit the disclosure thresholds.

Getting further into the data:

• strategic bidders were more likely to use a call option strategy than private capital
• 62% of call options had a trigger event / exercise condition that was dependent on a rival bid emerging
• 57% of call options utilised some form of top up / upside sharing mechanism
• as you would expect, call options were more prevalent in schemes (86%) than takeover bids (14%). Again, a call option has a better chance of keeping the stake in play for voting purposes (unless other circumstances exist which could place it in a separate class)

Whilst not necessarily to the same extent as a direct acquisition, call options can also be a useful deterrent to scare off rival bidders – but do not require the upfront capital outlay of a direct acquisition.  Care needs to be taken in negotiating option arrangements (especially managing the minimum bid price rule and the prohibition against escalator arrangements in the context of a takeover bid).