Buoyed by the recent surge in mergers & acquisitions (M&A) activity and demand for higher-yielding investment opportunities in a low interest rate environment, litigation-style investments are gaining momentum. Appraisal rights, in particular, have become a more common type of shareholder activism.
More than half of all US public companies are currently Delaware-incorporated. Between 2004 and 2010, approximately 5% of M&A transactions involving companies incorporated in the US state of Delaware were subject to appraisal rights cases. By 2014, this had risen to 15%. Minority shareholders of Delaware-incorporated companies generally seek to receive “fair value” for their shares when a company they are invested in is acquired.
Appraisal rights strategies can be accessed by international investors either through a dedicated appraisal rights fund, providing the ‘purest’ exposure to the strategy, or via multi-strategy funds where appraisal rights are just one of several strategies in which the manager invests.
Let’s take an example. Say Company A is trading at $5 per share when Company B announces its intention to acquire Company A for $6 per share in an all cash deal - a 16.7% premium to its current price. However, minority shareholders in Company A believe that the $6 per share offer significantly undervalues Company A’s worth and demand fair value.
To this end, these shareholders seek appraisal of their shares by forgoing the merger consideration (in this case $6 per share). They do this by voting against, or not tendering, their shares and petition the court for an independent appraisal. These shareholders hope that the judicial process reveals a valuation price materially higher than the original deal price, or that a settlement is reached beforehand for a higher amount.
Not a single case in a study of all identified resolutions between January 2000 and June 2016 produced a total negative return.
An attractive element for those seeking appraisal is that they are also entitled to receive statutory interest equal to the US Federal Reserve (Fed) discount rate, plus 5% per annum to compensate for having their capital tied up during a potentially lengthy legal process, which can take up to three years or longer.
Generally, the worst-case outcome for those seeking appraisal is the agreed-upon deal price (in the example above $6 per share) plus the statutory interest earned during the appraisal litigation process less legal costs.
On the surface, there is minimal volatility until resolution. The investment would appear to only be exposed to idiosyncratic drivers of risk and return and not systemic or market risk because outcomes are based on a negotiated settlement or court decision.
Historical outcomes have favored claimants. Burford/Gerchen Keller, an experienced investor in appraisal rights, indicated that 80% of appraisal claims are typically settled before a court judgment. What’s even more compelling is that not a single case in a study of all identified resolutions between January 2000 and June 2016 produced a total negative return (‘Appraisal: Shareholder remedy or litigation arbitrage?’ by Jiang, Li, Mei and Thomas, July 2016). In fact, only eight of 126 identified resolutions produced a valuation lower than the original deal price, but the statutory interest offset the applicable discount and resulted in positive returns to claimants.
However, the tide may be beginning to turn, and appraisal claimants may have to start recalculating their odds of success.
Legislation has been introduced to curb potential profits and may continue to impact this investment strategy. In August 2016, changes were made to Delaware appraisal law allowing companies to pay claimants their merger consideration, thereby reducing a potentially significant statutory interest liability. This has the potential to see fewer cases settled before court.
Legislative risk, process risk and litigation costs are potential deterrents that we believe should not be overlooked.
Furthermore, there have been a handful of recent cases where the court ruled that fair value was below the deal price. Such was the case in a ruling on 30 May this year where a Delaware court ruled that the fair value of shares of SWS (a bank holding company that was bought out by Hilltop Holdings) was nearly 8% below that of the announced deal price. According to law firm Wachtell Lipton Rosen & Katz, this marked the first time in modern appraisal arbitrage that fair value was deemed below the announced sale price.
Another example followed on 21 July. A Delaware court ruled that the fair value for Sprint’s buyout of Clearwire was $2.13 per share instead of the agreed-upon deal price of $5 per share, a 57% downward price revision, and the largest in the court’s history.
In our opinion, it is clear that the word is out on this strand of shareholder activism. Investors are trying to capitalise on the asymmetric return potential. Legislators are trying to combat certain advantages sought out by those who seek appraisal.
Legislative risk, process risk and litigation costs are potential deterrents that we believe should not be overlooked. Appraisal rights is as much of a legal strategy as it is an investment strategy. Recent appraisal decisions suggest that there are greater burdens on the petitioner to prove flaws in the sales process and a deficient valuation.
As a result, those with proper legal experience and investing experience are likely best suited to evaluate the most attractive appraisal opportunities.