Aspiring mergers and acquisitions bankers can learn a lot from reading Delaware Chancery Court opinions, which provide useful and legally binding advice on how not to do M&A. Friday's decision holding Royal Bank of Canada liable for mucking up the 2011 sale process of ambulance company Rural Metro Corporation is a particularly rich vein, but let's start with this:
In January 2011, J.P. Morgan gave [Rural Metro CEO Michael] DiMino a presentation that recommended that Rural execute on its growth plan over the next year. ... J.P. Morgan cautioned against a near-term sale because the "logical strategic buyers" were "focused internally on change of control transactions," and because Rural's growth strategy had not yet played out sufficiently to justify a high multiple from private equity buyers. J.P. Morgan recommended postponing a sale so that Rural could "execute [its] growth plan with further stock price appreciation while strategics are focused internally" and allow "[f]inancial sponsors/strategics [to] become increasingly interested over the next year or so once the larger strategic deals happen & close."
That is a lesson on how not to do M&A. Rural Metro, which had at that point already retained RBC to sell itself, took a random meeting with J.P. Morgan, which told it not to sell itself. Why? The non-cynical answer is that it J.P. Morgan thought that Rural Metro shouldn't sell itself, and wanted to give its (potential) client good advice in the hopes of building a long-term trusting relationship that would ultimately lead to paying business. The cynical answer is that J.P. Morgan knew it was on the outside of an ongoing sale process and so was hoping to scuttle the deal for the bank that was mandated. The right answer is probably both? Still this is sort of an inspiring passage, for a Chancery Court opinion.
The way investment banks normally get in trouble for their M&A advice is for conflicts of interest. If a seller's banker owns a lot of shares of the buyer, say, and doesn't disclose it, that's the sort of conflict that courts look on unfavorably. A particularly popular source of conflict is staple financing, when the bank that advises the seller also offers financing to the winning bidder. That was a major source of conflict here, though there were other, dumber ones.
The defense of these conflicts is, well, "conflicts" is just another word for "relationships." You want a banker who talks to everyone, who knows the market, who trades favors with everyone, because that favor-trading is how he will get the right bidders into your deal, and how he'll convince them to pay more. Staple financing is a way to attract bidders, and to get them to pay more by assuring them that they'll be able to get financing.
But in Rural Metro, RBC seems to have had all the conflicts with none of the benefits. Rural Metro was thinking about selling itself at around the same time that a larger competitor, Emergency Medical Services Corporation, was also up for sale. RBC was not involved in the EMS deal, but hoped that it could get an assignment financing the EMS acquisition. According to the opinion, RBC concocted a plan: "if Rural engaged in a sale process led by RBC, then RBC could use its position as sell-side advisor to secure buy-side roles with the private equity firms bidding for EMS." The quid pro quo would be, you hire us to finance your EMS bid, and we will give you the inside track on the Rural Metro sale.
This ... worked? ... for RBC, but did not go so well for Rural Metro: The bigger private equity firms were distracted by the EMS sale, and couldn't work on both for timing and confidentiality-agreement reasons. So most of the firms bidding on EMS didn't bid on Rural Metro, leaving Rural Metro with a pretty uninspiring list of potential buyers. RBC and Rural Metro's board realized that this timing was sub-optimal and just sort of pressed ahead anyway.
So that was not ideal work from RBC's people. But nonetheless, they managed to get a few bids for the company, and present them to the special committee of Rural Metro's board. Telling your clients that people want to buy their company: Definitely part of a banker's job. There are other parts though:
Meanwhile, Munoz and his RBC colleagues debated whether to provide valuation materials to the Special Committee to enable them to evaluate the bids. RBC had delayed working on a fairness analysis because the firm still hoped to secure a buy-side financing role and did not want to render a fairness opinion under those circumstances. Munoz was again worried that RBC would be asked about valuation. ("I'm . . . afraid board will ask us of our high level views today."). When Daniel told him that "wasn't the plan," Munoz fretted again: "Ok. But we will be asked and to convince [S]hackelton we need to show valuation. Perhaps we just put together 2-3 pages and just send to [S]hackelton." The advisors ultimately prepared and circulated a one-page transaction summary that compared the metrics implied by a $17.00 per share offer to the metrics implied by Rural's closing market price of $12.38 on the prior day. The $17.00 price looked great by comparison.
Um! This brings me back to my own days of investment banking. It is a stressful, labor-intensive, all-consuming business. Well do I remember the late nights and frantic preparation for every meeting, as we'd game out all of the client's most esoteric possible questions and developed deeply supported, exhaustively researched, and highly quantitative analyses to respond to all of them. Imagine the scene at RBC:
Banker #1: Do you think the directors of this company that we're trying to sell, who just got bids in that sale process, will want our advice on how much their company is worth?
Banker #2: I can't see why they would.
Banker #1: I just ... I feel like sometimes companies want to know how much they're worth before they sell?
Banker #2: No, that's not the plan for this meeting. We're going to give them the bids, and then everyone's going to contemplate them quietly. Then there'll be sandwiches. No one will want to talk about valuation. Just relax.
Banker #1: What if we put together a couple of pages of thoughts, just in case?
Banker #2: Fine, but one page, tops. And you can only show it to two of the directors.
Banker #1: Okay, I'll get to work on a discounted cash fl --
Banker #2: No no no, way too complicated. Here's what you do: This is a publicly traded stock. It just closed at $12.38, right? And the bids are for like $17, right? So just compare those two numbers.
Banker #1: Well I mean $17 is more than $12.38.
Banker #2: Exactly. Write that down, slap it on a page, done.
It goes on. Ultimately the only serious bidder was Warburg Pincus, which offered $17. RBC was able to push Warburg up to $17.25, but may not have pushed that hard, because most of its energy was focused on convincing Warburg to use RBC to help finance its purchase. This did not work, which led to bitter and not especially litigation-friendly complaining within RBC. And RBC ultimately did a fairness presentation that, the court found, was monkeyed with to produce the desired answer, that is, the answer that showed that Warburg's bid for Rural Metro was at the top of the fair range. The court disagreed, and has sent the parties back to calculate damages. RBC could end up owing former Rural Metro shareholders a lot of money.
It is always hard to know exactly what to make of cases like this: Just as bankers cherry-pick their data to prove that the deal they're recommending is fair, so the Chancery Court will choose its facts to tell a compelling story of conflicted scheming bankers. The central fact in this story, as in a lot of these stories, is this fee comparison:
RBC hoped to generate up to $60.1 million in fees from the Rural and EMS deals. RBC anticipated earning an M&A advisory fee of $5.1 million and staple financing fees of $14-20 million from the Rural deal. RBC also hoped to capture $14-35 million by financing a share of an EMS deal. The maximum financing fees of $55 million were more than ten times the advisory fee, giving RBC a powerful reason to take steps to promote itself as a financing source at the expense of its advisory role.
Sure! Financing fees are bigger than M&A fees, and that probably does drive things like a preference for private equity bidders and staple financing.
But this deal reads to me less like a story of the financing deal overwhelming the M&A advice, and more like a story of how investment banking is a sales business. From this opinion, you get the sense that RBC's efforts to drum up business, whether financing or advisory, were persistent and intense and occupied most of the attention of RBC's most senior bankers. Meanwhile, its actual execution efforts were sort of halfhearted and not all that well thought out: RBC couldn't be bothered to do a valuation of its client, but it carefully and repeatedly estimated its possible fees from the transaction. So naturally, when the advisory work conflicted with RBC's efforts to drum up new business, the drumming won. But this looks less like a nefarious choice and more like laziness and distraction: Everyone was so wrapped up in pitching new business that they didn't even bother to think about how it was affecting their advisory assignment.
This is not a huge surprise. Selling financial advisory services is a profitable business. Providing financial advice is less so, particularly since the quality of your services can be hard to measure. (Though, 91-page Delaware Chancery Court opinions about how bad your advice was: Not great for business!) The path to career advancement is paved with high fees, not with high-quality valuation analyses. That's why J.P. Morgan's non-sales pitch to Rural Metro is so refreshing: They told Rural Metro to keep doing what it was doing and not pay banks a big fee, just because they thought it was the right advice. (Maybe!) As the rest of this opinion demonstrates, the temptation of the big fee can sometimes outweigh the desire to provide the right advice.
(Matt Levine writes about Wall Street and the financial world for Bloomberg View.)
In the sense that RBC was in fact a bookrunner on Clayton Dubilier & Rice's financing for EMS. The story that the opinion tells is a little weird, though, in that RBC actually went to great lengths to annoy Clayton Dubilier in its Rural Metro bidding, but still didn't get kicked out of its EMS financing.
The one exception was Clayton Dubilier & Rice, which ended up buying EMS, and which sent in some preliminary bids on Rural Metro, pointing out that synergies between EMS and Rural Metro meant that it would likely be able to pay the most for Rural Metro, but asking for a bit more time to put together a final bid. Rural Metro, advised by RBC, said no.
Themselves not covered in glory in this process. The beginning of the opinion tells an interesting story of a couple of board members who really wanted to sell, for sort of idiosyncratic reasons (the head of the special committee ran an investing firm that was fundraising and wanted a big exit). The chief executive officer, on the other hand, was new to Rural Metro and had just put into place a growth plan that he wanted to see out. So when he did early meetings with potential buyers he was negative on selling. And then the board members yelled at him, and he realized that he might be better off running the firm working for private equity bosses. So he changed his tune.
Tony Munoz was the lead RBC banker. Eugene Davis and Christopher Shackelton were Rural Metro directors and a members of the special committee, which Shackelton led. Incidentally, Davis had a delightful reason for wanting to sell: He was on too many public company boards, and ISS was going to recommend that he not be re-elected to another board unless he cut back on his board service. Apparently the only way to get off a board is to sell the company?
I mean, I can see not wanting to give a fairness opinion because of the financing conflict, but having no "high level views" about the valuation of a company you're selling? Come on.
Many leading investment banks have a standing fairness committee staffed by senior bankers who oversee the opinion process and review opinions to ensure their quality and consistency. The RBC fairness committee is different. Its members consist of any managing directors who happen to be available and willing at the time a request for review goes out. At least two managing directors must respond and be willing to serve as the ad hoc fairness committee.
In Rural's case, the call for the available and willing went out at 10:00 p.m. on Friday, March 25, 2011, for a "committee" meeting the following morning. Ali Akbar and Allen Morton agreed to be the committee. Akbar had never served on a fairness committee before.
This seems to have gotten considerably more senior attention than the M&A process:
On the buy-side financing front, RBC's most senior bankers made a final push. Blair Fleming, RBC's Head of US Investment Banking, David Daniels, RBC's Co-Head of US Financial Sponsors, and James Wolfe, RBC's Head of US Leveraged Finance, engaged in a full-court press to convince Warburg to include RBC. As an inducement, Fleming offered to have RBC fund a $65 million revolver for a different Warburg portfolio company.
That's not quite true, of course: Ultimately RBC did do a valuation for the fairness process. And, tellingly, it had done a preliminary valuation when it pitched for the business of selling Rural Metro: "The only valuation materials the Special Committee had received were the banker pitch books on December 23, 2010." RBC couldn't be bothered to do valuation work when Rural Metro was its client, but nothing was too good for a prospective client.
We talked this morning about how Morgan Stanley and Goldman Sachs bought some league table credit by foregoing fees in exchange for advisory titles on the Forest Laboratories sale. As I said then, league table is important because it's hard for clients to measure the quality of your merger advice, but easy to measure your market share. That would suggest that the incentives are to focus on selling merger advice rather than on providing it.
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