M&A Is Just Too Easy

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A useful though debatable proposition is that much complexity in the financial world is due to the fact that the people running that world like complexity. It's good for business. If raising money or doing mergers is super complicated, you need to hire expert advisors to do it. If structured products are opaque, you end up paying your dealer more than they're worth. Good times.

But this sort of sucks for the people working for the people running the financial world. I mean, sort of sucks: they get to be employed! They get to be paid lots of money for, like, connecting boxes and arrows in CDOs and drafting environmental reps in underwriting agreements.1 But then they have to do that. It's often unpleasant. And it leads to the cognitive dissonance of analysts updating comp sets in M&A board books at 4am while bitching that the board wants to sell and no one will ever look at the appendix full of comps. Those analysts are wasting precious hours of their young lives doing a pointless thing, and are naturally furious. But the alternative is just not having anyone do that pointless thing, and then what will the analysts do? Get a real job?

Also: M&A lawyers. I was an M&A lawyer once, briefly, and it was awesome and exciting and you get on calls and yell "how can you ask us to schedule these exceptions to our representation about ERISA plans, I'll show you where you can put your ERISA plans!," and then you sit at your desk and re-draft reps and warranties until 4am and you're like, VALUE ADDED.2Or not:

Financial markets are largely indifferent to the legal terms of agreed public company mergers, new research shows. That may be because most transactions close regardless of the fine print. .... After reviewing almost 500 public company mergers between 2002 and 2011, two law professors found that, while target company stock prices rise upon a deal's announcement, they remain essentially unchanged when contract details are disclosed a few days later. The markets, the professors concluded, simply don't care.

Hahahahaha. Here is the paper, by Jeffrey Manns of GW and Robert Anderson of Pepperdine, and if you read it odds are it will fill you with either very mild amusement or CRUSHING EXISTENTIAL DESPAIR depending on your line of work.3

For those who don't know - and I'd hypothesize that this is a lot of people, including not just regular humans but even some M&A bankers - a merger agreement is primarily a document that defines the circumstances in which a merger will not close, and allocates the risks and costs of that happening. You agree to buy a company, but then you have to wait 3-9 months to get regulatory and shareholder approvals before you can close the deal and actually merge. In the meantime, it turns out that its main factory has a bunch of undisclosed asbestos: must you close? Or the factory blows up: close? Or you find massive accounting fraud: close? Or antitrust regulators say you can't close the deal without divesting a factory: close (and divest)? Or you are a private equity firm and the financing markets blew up: close? And, in any case, if the answer is "not close," do you pay the target for their time and trouble? Do they pay you? Who pays the lawyers' bills? (The lawyers' bills always get paid.)

That's pretty much the story, and it's mostly a stupid story, because spoiler alert, the answer is always "close." So the 80 pages of representations about ERISA liabilities give you an excuse to walk away from the deal if they're wrong, but you're not going to do that, because why would you have signed up the deal if you were going to walk away over stupid shit like that? Remember when Bank of America agreed to buy Merrill and then discovered massive crippling losses at Merrill? Did they walk away? Of course not. As the authors put it:

[W]e argue that the most compelling logic for markets’ dismissing the legal terms of merger agreements is the strength of the parties’ will to complete publicly announced deals. Markets understand that the decision to merge appears driven by the hope (or often the hubris) of the greater potential returns for the combined company following the merger and the target company shareholders’ desire for the takeover premium. The costs of walking away from a public company deal are so great that clients and markets do not value the design of deal-specific provisions to walk away from a merger.

To be fair this is only true 95% of the time - in 5% of the deals the authors looked at, the parties did not close for one reason or another. This does not completely vindicate the lawyers; lots of deals that don't close end in some sort of mutually negotiated loss of interest rather than in one part asserting contractual rights against the other. Despite those lengthy contracts, asserting the contractual rights often lands you in court anyway; and sometimes you just negotiate a walk-away (or a reduced-price deal) to avoid the uncertainties of litigation. Automatic walkaways of the form "You materially breached rep 4.17(b)(iii)!" / "Ah, so we did!" / "Okay, see ya" are a minority of a minority.

The authors of this paper have an interesting idea to make M&A lawyers useful, in case anyone is asking:

If acquisition agreements appear practically to function as unconditional obligations to purchase (notwithstanding the legal closing conditions), the question remains of what lawyers can do to protect acquirer clients? We suggest public M&A lawyers can apply the deal technology already available in private transactions to public transaction context. But innovation in the use of contingent consideration is a viable alternative. ... In particular, contingent consideration offers a more nuanced alternative to the blunt instrument of closing conditions. If the target’s business is worse than expected, but not bad enough to amount to a “material adverse change,” the acquirer can receive some compensation rather than none. In return, acquirers should be willing to pay more for the target in the first place.

So, sure, that seems efficiency-enhancing. Rather than an all-or-nothing proposition where 95% of the time you've got to close even if the target's business has gotten materially worse and they lied to you a bit and 5% of the time you have a giant public screaming fight, you have a sliding-scale proposition where if the business gets a little worse you pay a little less. Again, think of Innkeepers/Cerberus: that pretty much happened - the deal got less attractive, so Cerberus paid less - only with an intervening horrible court fight. If you could get rid of the intervening horrible court fight, that would seem to be an improvement, though you get the sense that Cerberus might prefer things the way they are.

More to the point - surely the lawyers prefer things the way they are? The paper asks "whether the legal terms of acquisition agreements add any value beyond the financial terms of mergers (negotiated by investment bankers)," and that parenthetical is harsh: in this (oversimplified!) model, investment bankers add value by negotiating price terms, while lawyers add nothing by negotiating everything else. But if you move the lawyers' value-added role to negotiating price terms, in the form of contingent consideration, then ... well then that will just be taken over by investment bankers. Indeed the authors point to a recent rise in contingent consideration in public-company M&A, which I posit is driven mainly by bankers trying to rub sticks together to bridge buyer/seller valuation gaps and get deals done,4 not by lawyers trying to provide some value for their billing.

If M&A deals moved from a 95/5 "close automatically / freak out and go to court" system to a sliding scale of automatic closing and banker-negotiated price adjustments, then the alarming thought of "there's a 1 in 20 chance we'll have a horrible trip to court over this deal" would no longer hover over them. If M&A agreements don't mean much, but there's a small-but-real chance that you'll end up in court in an all-or-nothing argument over what they do mean, you might be inclined to hire really good lawyers to write them - and to argue over them if things go wrong. If M&A agreements just automate financial formulas hashed out by bankers and business people, vastly reducing the already small chance of a high-stakes court fight, then what do you need fancy lawyers for?

Breakingviews: U.S. deal lawyers not as valuable as they may think [Reuters]
The Merger Agreement Myth [SSRN]

1.Underwriting agreements! Here let's have a little chat for some segments of our diverse audience.

  • Securities lawyers: Did you know that you are the only people who read underwriting agreements?
  • Bankers: Did you know that when you underwrite a securities offering the underwriting agreement, in addition to saying how much you get paid and whether you're on the left, also says that you don't have to settle the deal if you discover between the time of the deal and the T+3 settlement that the company is materially adversely affected by its failure to comply with certain environmental laws, or something? Honestly I've never read one either; here is Facebook's if you're so inclined.
  • Investors, traders, etc.: Did you know that there's such a thing as underwriting agreements?

2.I exaggerate just a touch for effect. Honestly it really was pretty fun; I enjoyed it and recommend it to anyone with a few thousand hours a year to kill.

3.To be fair to a certain line of work: it's not really the case that the only or even main job of M&A lawyers is to draft merger agreements; the senior ones are actually mostly giving advice on strategy and legal issues and suchlike, and the baby ones are mostly doing due diligence. But, yes, there's a big slug in the middle arguing over disclosure schedules.

4.And/or gin up tradeable situations for their events desks?

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