Discontent is brewing among shareholders of Netsmart (ticker: NTST) over a buyout whose $16.50/share price is seen as too low. In light of other buyouts recently voted down by shareholders at Eddie Bauer (EBHI) and strong resistance at Clear Channel (CCU), there is a good chance that shareholders will oppose the deal and end up with shares worth more than the $16.50 they can receive from the buyers, private equity funds run by Insight Venture Partners and Bessemer Venture Partners.
3% holder Leviticus Partners LP is leading opposition to the deal and has written a letter to the board stating that
Netsmart stock is worth considerably more than $16.50 in any private transaction, and, based on its recent successes, appears to be on its way to a mid $20s valuation as an independent publicly traded entity. […] The proposed buyout price represents approximately 1.5x expected 2007 revenues vs. comparable company public valuations of 2.5 to 5x revenues or more in your market space.
Leviticus is not limiting its opposition to words, but has taken action byfiling a lawsuit for an injunction against the buyout. The case will be heard in the Delaware’s Chancery Court by shareholder friendly Vice-Chancellor Leo Strine, who has set the date for a hearing on the injunction for February 27. The court may require additional disclosures in the final proxy if the lawyers uncovered relevant information during the depositions, which were completed by February 11. According to Leviticus’ co-counsel, a ruling could come out within a week.
The $16.50 price for Netsmart is indeed so low that even the fairness opinion issued by William Blair has to find lame excuses to justify it.
The implied transaction equity values for Netsmart implied by the discounted cash flow analysis ranged from approximately $142 million to $202 million, as compared to the implied transaction price for Netsmart of $115 million. […] William Blair concluded that the Discounted Cash Flow Analysis was a less reliable barometer of value than other methodologies based on historical results.
This is nonsense. Leveraged buyouts are best valued through discounted cash flows. So what do these “other methodologies based on historical results” yield? Unfortunately for William Blair, its analysts find that Netsmart’s valuation is below the average and median of comparable transactions in almost every metric they looked at.
Leviticus surmised in its letter that
Netsmart Technologies seems at quite the beginning of its growth. Backlog is nearly $55million vs. $29million last year. Recurring revenues are up dramatically.
Netsmart’s own projections, which were not yet public at the time of Leviticus’ letter, show that sales are expected to grow by an annual average of 14.6% through 2009, EBIT is expected to quadruple and EBITDA to grow almost 2.7 times over that period. Another, more conservative projection by management sees sales grow 7.5% annually and EBITDA to increase 50% by 2009.
To make things worse, Netsmart’s management can not even claim to have acted in good faith. Leviticus tried to meet with management to discuss maximizing value for shareholders, but
We are also disappointed that our attempts over the past few months to meet with the Company were rebuffed. While we believe you are continuing to show disdain for your shareholders, we do not have the same antipathy for the Company’s management.
Talking of management, CEO and Chairman James L. Conway and CFO Anthony F. Grisanti have already lined up employment agreements for the time after the merger. They will maintain their salaries and will of course receive payments typical for buyout situations of $1 million and $601,500, respectively. They will also be given the opportunity to co-invest in the post-buyout Netsmart. Conway will get an option for up to 2.25% of the shares, and Grisanti for up to 0.5%. The strike prices of these options will depend on the share price paid in the merger. So the less shareholders get paid, the lower the strike price of the options will be, and the more profit Conway and Grisanti will make in the future. This is hardly an incentive for management to maximize shareholder value.
If Leviticus fails to get an injunction to block the deal, it might pull another trick. One of the closing conditions in the merger agreement is that no more than 5% of shareholders are seeking appraisal rights. It is a standard clause in such agreements and in most cases represents no more than boilerplate language. With its 3%, Leviticus could seek appraisal and wait for holders of another 2% to do the same. This might derail the merger, even though the 5% condition can be waived. But chances are that the threat of protracted appraisal litigation would kill the deal, if only because it would complicate the private equity funds’ exit strategy and make it impossible to flip Netsmart quickly. And given the low price for which they are trying to get Netsmart, a quick buck is their most likely motivation.
With the price so ridiculously low, it would not be surprising if shareholders did an Eddie Bauer to Netsmart and voted against the buyout. Shareholders have three shots at keeping Netsmart public and participating in the upside: the litigation, the shareholder vote, and potentially appraisal rights. If any one of them works out, Netsmart shares could rise to the $20s.
Disclosure: The author manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares in Netsmart.