Netsmart’s (NTST) buyout has become a little less likely to go through after a decision by Delaware’s Chancery Court last week that instructs shareholders to seek damages and appraisal rights due to serious shortcomings in the sales process. The buyers, private equity firms Insight Venture Partners and Bessemer Venture Partners, are unlikely to risk protracted litigation, which is almost a given. Netsmart’s stock is likely to appreciate significantly as investors have now seen management’s internal projections forecasting a 50% increase in EBITDA by 2009 (for 2006, EBITDA grew 68% despite $1.6 million in buyout-related costs, and sales increased 55%, partly due to an acquisition).
Shareholders can be forgiven if they are confused about the real outcome of the lawsuit against the buyout. While the company’s press release is titled “Delaware Court Permits Netsmart Merger Vote to Proceed”, both the New York Times and Business Week report the exact opposite: “Judge Bars a Buyout Vote at Netsmart” and “Delay ordered for Netsmart holder vote.” We are not clear whether it was Netsmart’s management or the reporters who got lost in Delaware’s courthouse and sat through the wrong hearing, and so we decided to read Vice Chancellor Leo Strine’s 77-page long decision ourselves.
Court documents always make an interesting read because they summarize information from depositions and internal company documents that otherwise are not accessible to outsiders and go far beyond disclosures in SEC filings. In Netsmart’s case, we learn from depositions that the special committee of independent directors, which had been created to handle the sales process, was not quite so independent. Special committee member and former Trans Global Services CEO Joseph G. Sicinski previously had invited Netsmart’s CEO James L. Conway to serve on the board of his company. The judge suggests that this could potentially compromise Sicinski’s independence, who may feel obligated to Conway because the latter helped him out by filling the vacancy.
Similarly, management’s motivation for selling the firm becomes much clearer from one detail of a board presentation prepared by executive VP Kevin Scalia. One version of the presentation contains a bullet point about the benefit of getting a “second bite at the apple” in a buyout. He refers to management cashing out in the buyout, and then receiving new options to profit from the upside of the private company. Clearly, this is not information that management would want shareholders to see.
Finally, we learn from internal documents that the approval of the minutes of the special committee meetings was done only after shareholders had filed a lawsuit against the deal. This alone raises eyebrows. But it gets even better: for one key meeting on May 19, which is described in detail in the proxy, no written record or minutes exist, although the board decided at that meeting not to sell the firm to a strategic acquirer and to consider only private equity buyers.
It is just this decision which has come to haunt the board. According to judge Strine, failure to seek a strategic buyer is a key shortcoming of the sales process. The board
“failed to take any reasonable steps to explore whether strategic buyers might be interested in Netsmart. I believe on this score that the plaintiffs are, if this preliminary record is indicative of the ultimate record in the case, likely to be successful on this point.”
This amounts to as much free legal advice as a judge will ever give you without compromising the dignity of the office. He is practically encouraging shareholders to sue for damages in another lawsuit, because the board breached its fiduciary duty to hold a proper auction. Given that Netsmart is below the radar screen of larger firms due to its small size, it is unlikely that a strategic buyer would have emerged out of the blue simply on the basis of a press release announcing the sale:
“To test the market for strategic buyers in a reliable fashion, one would expect a material effort at salesmanship to occur. To conclude that sales efforts are always unnecessary or meaningless would be almost un-American, given the sales-oriented nature of our culture.”
Finally, with respect to appraisal rights (which we addressed in an earlier article here), shareholders get more free legal advice:
“dissenting Netsmart stockholders might have comparatively greater success in relying upon analyses based on discounted cash flows or market comparables in appraisal than stockholders whose boards more aggressively shopped their companies.”
Again, we can read this as a quasi-encouragement to exercise appraisal rights and sue Netsmart and the board.
If we were a director of Netsmart, we would be alarmed by the unambiguous language about directors’ liability for selling the company on the cheap. Add to that the recent headline that former Hollinger president David Radler paid $28 million in a settlement, and we would lose quite a few nights’ sleep. And as a private equity buyer, we would not touch a firm if we face many years of litigation and eventually a settlement that would increase our price significantly. Not to mention that the favorite private equity strategy of flipping a company is out of the question while this litigation is pending. It is in the best interest of both the board and the buyers to terminate the deal and let shareholders realize the true value of Netsmart.
The author manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of Netsmart.