Market Tremors

If last year's big financial story was the return of the M&A market, then this year's big story is the rise of hedge funds.

Hedge-fund investments reached nearly $1 trillion in 2004, according to the Hennessee Group, a hedge-fund investment adviser. With annual growth rates in the 30 percent range, hedge funds are becoming a driving force in U.S. and international capital markets. In some cases, arbitrage activity can make or break a deal, and as issuers and investors seek to understand the effects of the growing power of hedge funds, the capital markets themselves are changing.

"The increasing influence of hedge funds fits the overall situation in the market right now," says Roger Stark, a partner with Kirkpatrick & Lockhart Nicholson Graham. "The overall perception in U.S. markets is that assets are overvalued. We are seeing a lot of discounting as investors look for above-market returns."

As a result, companies are re-examining their financial strategies in light of the rising influence of hedge-funds and other tectonic shifts that have occurred in the capital markets in the past several years.

Specifically, governance issues are driving some companies away from public markets and into the hands of private equity firms. Shareholder power is forcing substantial changes in corporate boardrooms and financial disclosures. And increasing internationalization is putting a new face on corporate finance transactions of all types.

"We're seeing a much less geographically centric approach today than used to be the case," says David Snyder, a partner with Pillsbury Winthrop. "Deals today show how much closer the various financial centers have become, metaphysically, and how much less rigid our geographic borders are in terms of capital markets."

To shed light on these trends, Corporate Legal Times selected several recent transactions that illustrate how companies are dealing with changing market conditions. These transactions provide insight for companies seeking to raise capital and optimize their financial positions in the future.

Arbs On The March

The growing influence of hedge funds and cross-border financial activity has taken some companies by surprise. In one example, AXA Financial faced the possible implosion of its 2004 acquisition of MONY Group, purely as a result of unexpected merger-arbitrage activity by the hedge-fund community.

AXA Financial is the U.S. subsidiary of a French bank, and MONY is a New York-based insurance and investment company that "demutualized" in 1998.

Initially AXA and MONY planned to merge in a stock-for-stock deal. During negotiations, however, the deal evolved into a cash transaction, primarily to eliminate the uncertainty created by fluctuations in currency and markets. To finance the $1.5 billion deal, AXA's parent issued a security in September 2003 that would convert into equity upon closing the deal to buy MONY.

"That nearly perfectly aligned the company's interests with the success of the transaction, and meant we'd only issue equity to finance the deal, and not for other purposes," says Dick Silver, general counsel of AXA Financial.

Unfortunately, as the deal progressed, AXA learned this structure also provided an arbitrage opportunity for hedge funds. "The M&A deal got caught up in the vortex of arbs trading in financial instruments, and the MONY stock no longer traded in a rational way," says Michael Blair, a partner with Debevoise & Plimpton, which represented AXA in the transaction. "MONY stock was consistently trading over the deal price, even though our deal had been out there for months and it was crystal clear there would be no topping bid. One would have expected it to trade at a slight discount to the bid price."

MONY's price went up because hedge-fund investors around the world were buying up the company's shares, as part of a hedge against AXA's convertible bond.

This factor was exacerbated by MONY's recent demutualization. "Many of the shareholders were retail rather than institutional investors," Blair says. "They were accidental investors [who had gained MONY shares for their stake in the former mutual insurance group] and were hard to reach. They don't have stock brokers to call them up."

As a result, the supply of liquid MONY shares in the market was limited. "Hedge-fund opponents weren't selling, and intense competition for a relatively small number of available shares drove up the price," Blair says.

Ultimately, however, circumstances worked in AXA's favor.

AXA had experience working with "accidental shareholders," because the company owns The Equitable, another demutualized life-insurance company. "We had a degree of comfort dealing with the challenge of reaching out to those shareholders," Silver says.

Additionally, the proxy vote was delayed as a result of litigation by dissident investors--some of whom had shorted AXA's convertible securities. This actually worked to AXA's advantage in the merger. "In the context of a transaction where we had a fairly high threshold to get the required 50 percent vote, resetting the record date helped to secure the ultimate vote," Silver says. "It meant we could re-solicit the current holders of MONY shares--many of which had changed hands since the first solicitation."

The vote would still be close, however, and the parties faced more drama before it was over. AXA saw hedge funds betting both for and against the deal, creating nail-biting tension right up until the day of the vote. But in May 2004 the merger prevailed by a slim margin, and the deal closed in July.

AXA attributes the outcome to its success in convincing shareholders to cast their proxies on the basis of the deal's fundamentals, rather than the immediate arbitrage opportunities. That success, however, came at the cost of significant time and worry.

"What should have been a bolt-on deal became much more complicated," Silver says. "One of the lessons learned was the potential for mischief in the financial markets when the financial structure provides an opportunity for creative arbitrageurs."

Attracting Hedge Funds

The hedge-fund trend isn't problematic for everyone; some companies are structuring corporate-finance deals specifically to attract the interest

of arbitrageurs.

One example is Calpine Corp., a California-based developer of independent power plants. Calpine's credit ratings and financial position have suffered greatly over the past few years, largely because of a crisis in the merchant power business. The same crisis drove other companies into insolvency--companies such as Dynegy, Mirant and NRG. "Almost every worst-case scenario that these companies and their lenders considered possible, but remote, has become [the] base-case scenario," said Standard & Poor's in a 2004 report.

Calpine, which had several debt securities maturing, found itself facing a dilemma in early 2004. Specifically Calpine needed to refinance more than $480 million in convertible notes, known as High Tides I and II, that were coming due for remarketing. Remarketing the securities would have been difficult for Calpine, because it would have exposed the company to much higher interest rates than it had negotiated for the original securities.

"We had a choice to either refinance with equity or debt, or with a new convertible offering," says Bob Kelly, Calpine's CFO. "We didn't like the price of our equity, so we didn't want to issue stock. We had a debt ratio of around 78 percent, so we were already too constrained with leverage to issue straight debt. That meant we basically had to do it this way."

Specifically Calpine worked with Deutsche Bank, as well as Covington & Burling and Davis Polk, to arrange a unique structure that combined unsecured convertible notes totaling $736 million, with 89 million shares of newly issued Calpine stock that were loaned to Deutsche Bank for a period of 10 years. Deutsche Bank sold the shares on Sept. 30, 2004, in a registered public offering for $2.75 each, and then used the $245 million it raised to facilitate transactions by which the purchasers of Calpine's convertible notes could hedge their investments through short sales or derivative transactions.

The structure accomplished three objectives for Calpine. First, it allowed the company to tap into its equity without seriously diluting the value of its stock.

"It was characterized as a loan because the banker is contractually obligated to return the shares to the company within 10 years," says Michael Lefever, a partner with Covington & Burling. "The shares are outstanding for corporate law purposes, but as an accounting matter they are not treated as outstanding." Thus when the company computes its earnings per share, for example, it doesn't need to count the 89 million in borrowed shares.

Second, the structure helped Calpine access capital from hedge-fund investors. Calpine's distressed stock price--and the pressure being placed on it by existing short sellers--meant hedge funds otherwise had little room to short-sell enough Calpine stock to cover their positions on the convertible notes. By putting new shares into the market, Calpine improved the liquidity of its stock and gave arbitrageurs a better chance to hedge investments.

Third, and most importantly, the structure allowed Calpine to restructure a large amount of its existing debt at better rates than it otherwise could have obtained. "In the market the hedge funds and investors loved the facility, because they could go out and hedge their investment right away," Kelly says. "It proved to be so successful that we upsized the deal to $736 million." The original offering envisioned $725 million in convertible notes.

Even so, the transaction held a couple of surprises for Calpine; for example, the company's stock dropped more than the company expected--12.4 percent--when Deutsche Bank sold the 89 million borrowed shares. However, Calpine's share price rebounded within days of the transaction. The company redeemed the outstanding High Tides I and II securities and other debentures in October 2004, positioning the company to conduct several other project financing transactions in the months that followed.

"The hedge was better for shareholders in the long term," Kelly says. "If we had it to do over, we'd sell the securities over three days to give us time to explain to the market what the structure meant. But it worked out the way it should, and we couldn't have done it without the borrow facility."

The transaction established a new approach for companies that, like Calpine, are laboring under the burden of ailing credit but need to raise debt cost-effectively. Also it amply demonstrates the growing power of hedge funds in today's capital markets.

In Like A Lion ...

Many companies are struggling to cope with changes in the U.S. capital markets. For an increasing number of companies, the answer is to withdraw from public markets entirely.

When Germany-based LION Bioscience AG went public in August 2000, the trans-Atlantic offering was celebrated as a brilliant success in an otherwise dismal stock market. A small-capital biotech company, LION (Laboratories for the Investigation of Nucleotide Sequences) raised about ?? 1/2 ?? 1/2 200 million selling shares in Germany on the Prime Standard (formerly Neuer Markt) segment of Deutsche B?? 1/2 rse, and ADRs on the NASDAQ.

After the IPO, however, LION's executives began to wonder whether listing on Wall Street was such a great idea after all.

First, of course, the tech-stock slide turned into an all-out meltdown, and investors fled anything resembling high-tech. Simultaneously, policies coming from the new leadership on Capitol Hill, cast a pall on the genomics industry. LION, which sells cutting-edge IT systems for gene sequencing and other biotech research, was caught in the pinch.

LION's stock plunged along with the rest of the biotech industry, and investors were worried. So the company's CFO, Klaus Sprockamp, went to New York to reassure them. On the morning of Sept. 11, 2001, Sprockamp was meeting with investors on the upper floors of the World Trade Center. He was never seen again.

The tragedy hit the company hard; the 42-year-old Sprockamp was a central figure at LION, and was given much credit for making LION's IPO a success.

Then, when Congress passed the Sarbanes-Oxley Act in 2002, the added compliance burden only added insult to LION's injuries. "It wasn't a turning point," says Gunter Dielmann, LION's vice president of investor relations. "It was an additional point."

Section 404, in particular, presented costs and distractions that LION ultimately decided it couldn't justify. "We calculated that compliance with SEC and NASDAQ requirements reached 8 percent of the company's total costs," Dielmann says. "That is much too high; it bears no relationship to the benefits for a small company. If you are a big company, you need U.S. investors. But we have fallen off the radar."

While few companies have suffered as greatly as LION has in the U.S. public markets, many are feeling similar pains. "I see this playing out at other companies," Snyder says. "Even mid-cap companies are taking a serious look at whether the benefits of being publicly traded are worth the expense and management time and energy. It takes a lot of resources, and I predict we'll see more companies--not just micro-caps--deciding that the burdens outweigh the benefits."

That's the decision LION reached, and subsequently the company delisted its ADRs from trading on the NASDAQ in December 2004. Although the securities are no longer traded in the United States, they can be sold or exchanged for LION shares in Germany. However, LION remains subject to SEC regulation because it still has more than 300 shareholders in the United States. So now the company is working to implement its deregistration plan, which focuses on reducing the number of share owners to 300--not an easy task.

To accomplish it, LION engaged its former general counsel, Sven Riethmueller, who is now international counsel with Goulston & Storrs in Boston. "It is a novel approach that hadn't been done before we came up with it," Riethmueller says. LION amended the terms of the ADRs before they could be sold, giving ADR holders until Feb. 20, 2005, to claim their underlying LION shares. At that point, LION's U.S. broker, J.P. Morgan Chase began selling the LION ordinary shares underlying the cancelled ADR and held the cash for former ADR holders.

"There is no guarantee that shareholders will do this, but we will find out," Riethmueller says.

Beer Barrel Polka

The role of shareholder power in M&A transactions has reached new heights in the past two years, and not just in the United States. One transaction that demonstrates how things have changed is Molson Brewing Inc.'s recent merger with Adolph Coors Co.

As a Canadian company, Molson isn't subject to Sarbanes-Oxley or other recent U.S. governance reforms. The company is, however, subject to similar pressures--namely, higher expectations among investors regarding ethical business practices.

Many of Molson's largest shareowners, including former Vice Chairman Ian Molson, resisted the merger with Coors in hopes of getting a better deal with another suitor. With a proxy contest brewing, Molson's officers launched an all-out war to make the deal happen.

In the first volley against dissenters, Molson officers gave stock-option holders (mostly Molson executives and directors) the right to vote on the merger along with Class A shareholders. Additionally, management announced that all stock options would vest immediately upon a successful merger with Coors, and performance provisions in executives' options would be canceled. Many shareholders, especially large institutional investors, were outraged.

"It does not make sense for executives to include their own option votes in a class with shareholders, because their interests are in conflict with the Class A shareholders," said Stephen Jarislowsky, president of fund-management firm Jarislowsky Fraser. "They haven't even paid for the shares yet and are trying to give themselves the same rights as existing shareholders."

Canadian law allows this kind of deck stacking, but in the post-Enron, post-Parmalat era, investors in many markets around the world are holding companies to higher standards. Molson's approach elicited criticism in the financial press and galvanized dissident investors' opposition to the deal. Before long, Molson was forced to back down.

In October 2004, the company modified its proposal, scrapping the plan to allow option holders to vote on the merger with Class A shareowners, and amending change-of-control provisions for two executives--provisions some investors criticized as being exorbitant and unnecessary. And in November 2004 the suitors upped the ante with a special dividend for Molson shareholders, totaling about $316 million. Notably, Pentland Securities, the holding company for Eric and Stephen Molson's shares, agreed to forego participating in the dividend.

These steps helped win support for the deal among some investors, but another challenge arose in the 11th hour. Namely, SABMiller, the world's largest brewing company, announced in January 2005 that if shareholders rejected the Molson-Coors merger, SABMiller would offer them a better deal.

Ultimately this pressure forced Molson to sweeten the deal yet again by increasing the special dividend to $532 million, and Coors increased its offer by $1.81 per share, or 6 percent. The payout secured the approval of many large investors, and Molson shareholders finally voted to approve the deal on Jan. 28, 2005.

Later, however, many investors were dismayed to learn that on the day of the vote, Molson's outside directors had voted to give themselves a bonus of $50,000 each. Furthermore, shares of Molson-Coors Brewing Co. declined sharply in the weeks after the companies merged. And in early March, Standard & Poor's downgraded Molson-Coors credit ratings, citing weak sales volume and "higher than anticipated debt levels" arising from the $532 million special dividend.

At this writing, the merged company's stock price had recovered much of the value it lost in February and March. However, the contentious deal provides a lesson for companies pursuing M&A opportunities. In the future, many companies likely will rely less on brute force and more on careful consideration of stakeholder interests.

A Better Mousetrap

With capital markets in flux and the deal climate changing, many of the approaches that companies relied upon in the past are less effective than they once were--and in some cases, those approaches have become downright dangerous. Facing such changes in the market, GCs and CFOs are re-evaluating their companies' finance strategies.

"We are in the transition to a different kind of marketplace," says Martin Tilson, a partner with Kilpatrick Stockton. "I don't think anybody has figured out what the next market will look like, but it will be global. We've just come out of three years of economic adversity, and now there's a pent-up need for consolidation. There's $75 billion of private equity on the sidelines, and the M&A markets are increasingly global."

Such factors, viewed against the backdrop of higher governance standards and empowered shareholders, complicate the environment for M&A and other transactions.

"A new level of sophistication and foresight is required," says Jeff Rosen, a partner at Debevoise & Plimpton. "The lesson of all this smart money is that banks and issuers need to think harder about creating something that will circle back and affect the deal."

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Editor-at-Large

Michael T. Burr

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