Appraisal Actions May Be The Next Frontier For PE Shops

By Fola Akinnibi

Law360, New York (April 20, 2017, 4:07 PM EDT) -- Delaware’s Supreme Court will soon decide if lower courts properly determined that both Dell Inc.’s $24.9 billion management-led buyout and DFC Global Corp.’s $1.3 billion buyout were priced too low, potentially leading more companies to try appraisal litigation as an investment strategy.

In the Dell case, the state’s Chancery Court had added roughly $7 billion to founder Michael Dell and private equity firm Silver Lake Partners’ purchase price, while the DFC case saw the court add about $100 million to Lone Star Fund VIII’s purchase price.

Instead of ascribing significant weight to the agreed deal price, which in both cases was the result of a typical bidding process, the courts have leaned more heavily on analysis tools such as the discounted cash-flow model, among others, to determine fair value for the deals.

However, failing to place significant weight on the deal price in the outcome of these appraisal determinations could create a situation where shareholders would be emboldened to use the process as an investment strategy, by seeking out undervalued deals and using the courts to add value, DFC argued.

And experts say the process has already become an investment strategy for certain, sophisticated parties.

“Over the years there has been greater certainty in the way courts looked at appraisal actions in terms of valuation methodologies. The outcomes become more predictable,” said David Margules, a partner at Ballard Spahr LLP. “Clearly the predictability of the outcome is critical to any investment strategy.”

There were 16 appraisal actions with claims of $129 million filed in Delaware in 2012, and by 2016 there were 62 valued at $1.9 billion, according to Wall Street Journal data. Currently, private equity research provider Preqin tracks 115 hedge funds, which manage about $19.5 billion that employ appraisal arbitrage as an investment strategy.

Minor Myers, a professor at Brooklyn Law School who does research on appraisal arbitrage, said that since 2011 he has seen more filings, more equity value demanding appraisal and more specialized petitioners.

The current appraisal regime in Delaware stems from a basic common-law protection of property rights. Before the system, shareholders would have to vote unanimously in favor of a merger for it to go through, Margules said.

By the 1980s the idea became one of fair value — if a shareholder is going to be forced to give up ownership, then he or she must be compensated at fair value. As the court began to see more of these cases, it got better and better at valuing companies, he continued.

“As greater and greater clarity arose, you could look at a set of cash flow projections and with greater certainty predict where the court was likely to come out in a valuation exercise,” Margules said.

For Myers, what strikes him about the recent rise in appraisal actions are the parties bringing the cases. They seem to be a mix of finance and legal professionals who have a knack for identifying deals that are ripe for appraisal.

“The people who are engaged in appraisal tend to target a set of transactions that generally have abnormally low deal prices,” Myers said. “It frames how they look at this.”

This approach shows that appraisal challengers are drilling down and looking for cases with real potential to win, rather than taking on a scattershot approach, he argued in a 2015 research paper published in the Washington University Law Review. The study showed that between 2004 and 2013 only about 7.5 percent of the 1,168 appraisal-eligible transactions had been brought up for appraisal remedies, whereas more than 58 percent of those deals had been challenged in fiduciary class actions, a common type of litigation in which shareholders claim company directors breached their duties to investors in the sale process by failing to secure the best price.

However, Brad Davey, a partner at Potter Anderson & Corroon LLP, disagreed. He said many of the cases, especially those with smaller price tags, are just like fiduciary claims and, as such, represent the latest trend in nuisance suits. In many cases, it is more expensive to go through the trial process than it is to simply settle, and the concern is that appraisal is becoming a tax on deals, he said.

“At the bottom end of the scale, the settlement value is not created because of the strength of the claim, it’s created thanks to the cost of litigation,” Davey said.

Even with larger deal prices, Davey said, recent decisions in fiduciary merger cases have made appraisals seem much more attractive to those bringing cases.

“There are fewer financial incentives for entrepreneurial plaintiffs’ counsel to pursue fiduciary [mergers and acquisitions] litigation,” Davey said. “Appraisal is a place where they are ending up.”

But as the dust settles, Myers said, he doesn't expect a huge number of new players to jump into the space; the investment isn’t particularly attractive, and the opportunities are few and far between. Also, picking the right deals to challenge is a harder skill than people think, Myers said.

“The other thing about the risk is that a lot of [other] investments, even if you pick them correctly, also promise much bigger returns to offset that [risk],” Myers said. “The best case scenario in a lot of these [appraisal] cases is like 15 or 20 percent annualized, and that’s good.

“You’re never going to triple your money or quadruple your money or 10 times your money the way that in riskier spaces you often do.”

--Editing by Edrienne Su.

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