How Dell Tried to Avoid Potential Buyout Pitfalls

If a runner is the only person in a race and runs really hard, can there still a winner? That’s the feeling I had reading through the acquisition agreement for Dell filed late Wednesday.

No doubt mindful of the poor history of management-led buyouts, the lawyers for Dell’s special committee of independent directors, led by Jeff Rosen and William Regner at Debevoise & Plimpton, appear to have put in every contractual mechanism ever invented to address this problem. But does it really matter when there is only one real possible buyer, namely Michael S. Dell and Silver Lake?

Before we get all cynical, let’s walk through the provisions Dell has negotiated.

Management-led buyouts live under a cloud that management is trying to buy the company at a bargain-basement price by crowding out other bidders. To deal with this, Dell’s acquisition agreement contains a so-called go-shop period. Dell will now have 45 days to solicit potential buyers willing to outbid Silver Lake and Mr. Dell. And under the agreement, Dell appears to be able to elect to reimburse potential buyers for their expenses in preparing a bid. This provides any potential bidder a huge incentive to enter the process, since it has no real downside in terms of costs.

And if a potential second bidder actually steps up during this 45-day period and its proposal is qualified as being one reasonably likely to lead to a bid superior than the one by Mr. Dell and Silver Lake, the termination fee that would be paid by Dell if that bid is accepted is $180 million, less than 1 percent of the transaction value. This is true even if the bid is subsequently accepted after the go-shop period expires. For all other bids that are accepted, the termination fee is $450 million.

JPMorgan Chase was the principal investment bank advising Dell’s special committee led by bankers Jimmy Lee, James Woolery and Kurt Simon. But to further enhance the go-shop period in this situation, the investment bank Evercore, led by Roger Altman and others, was hired primarily to run this process.

According to people close to Dell, Evercore’s fee is based significantly on its ability to find a higher bid through the go-shop period. Finally, to further minimize conflicts, JPMorgan is not providing financing for the transaction, though it has the ability to provide financing to a higher bidder approved by the Dell board.

A second concern in any transaction, let alone a conflict-ridden management-led buyout, are the rights given to the initial buyer and whether they can act to frustrate a competing bid. Here, the rights of Mr. Dell and Silver Lake in this regard are more limited than usual.

The buyers have matching rights, the contractual requirement that Dell give the two buyers the final right to match any competing offer. But these matching rights can be exercised only one time under the terms of the acquisition agreement. (We have seen this limitation appear more frequently of late, including the acquisition of Duff & Phelps announced at the end of last year.) This is an important concession as bidders today often have reset matching rights that give them an unlimited number of chances to match a competing bid. This can deter competing bidders because reset matching rights allow the original bidder to repeatedly bid just above the competing bid to ensure that they do not overpay.

Indeed, Dell used matching rights to its advantage when it got in a bidding war with Hewlett-Packard over 3Par a few years ago. Dell, as the initial bidder, could bid only a few cents above H. P.’s offer while H. P. was forced to raise its offer by dollars a share each time. While H.P. won the bidding, Dell used its matching rights to force its rival  to pay top price. The limitation in Dell’s acquisition agreement is certainly a win that would help any competing bidder.

As for concerns about whether the price is appropriate, the transaction must be approved by a majority of the shareholders other than Mr. Dell. In other words, his shares will not count in approving or rejecting the transaction.

Mr. Dell has also committed to vote his shares for any competing bid that is accepted by the board in proportion to how other shareholders vote. Indeed, the price negotiations were largely handled by Silver Lake, and Mr. Dell took a backseat, people close to the negotiations say.

In terms of certainty that this transaction will complete, there is no financing condition to the deal and Dell and Silver Lake have committed financing from four banks. Instead, the agreement allows Dell to  enforce the agreement. That is, the company can sue to force the buyers to provide the necessary equity to finance the deal. Dell can also sue in such instances to force the buyers to sue the banks to draw on the debt. If for any reason this litigation fails – and such attempts weren’t successful during the financial crisis —  the buyers must pay to Dell a reverse termination fee of $750 million.

This about a 3 percent of the transaction value and while on the low end of the standard range these days, it is quite a large dollar amount. These are important rights because in past management-led buyouts, executives have scrambled to line up financing, sometimes failing miserably with little consequence. In this case, Dell’s shareholders will bear less of the financing risk on the transaction.

Nonetheless, Dell has also committed to repatriate at least $7.1 billion held offshore. If Dell is unable to do so, then the buyers have a right to terminate the deal. In fact, if the failure to do so is because of a change in the law – in other words – the politicians act to prevent the transfer – the buyers have to pay Dell $250 million. If the transaction is not completed by Nov. 5, 2013, either party can terminate the deal.

All told, while the full facts still need to be disclosed, it appears that Dell has gone out of its way to address problems that have arisen in previous management buyouts.

While credit must be given for going the extra mile, in many ways, this is all an easy thing for Mr. Dell to give. In normal times, it is quite unusual for a competing bid to emerge during a go-shop period when management is part of the bidding party with a private equity firm.

But in this case, it is highly unlikely that another bidder will emerge, period. Most private equity firms don’t do technology and Kohlberg Kravis Roberts and TPG have already dropped out. The rest are likely to be scared away by the size of the deal and their inability to get around the problem that Dell is a bit of a melting ice cube. And there appears no strategic bidder on the horizon willing to bid.

And as for price, while there is a premium here, shareholders would be extremely unlikely to reject this transaction even without counting Mr. Dell’s shares. Most shareholders simply prefer a bird in the hand rather than risk Dell’s uncertain future.

So, the actual decision to sell here may be the one that is most controversial despite these procedural protections.

Ultimately, though, even if it is a hollow victory for Dell’s shareholders to win all these protections, one hopes that its terms become the standard in management-led buyouts. No doubt, this standard is likely to have prevented at least one or two deal from hell in years past.