Another addition to the graveyard of busted mergers: business development company American Capital Strategies (ACAS) has terminated its agreement to buy Merisel (MSEL) under the “material adverse change” clause that has become a standard excuse for buyer’s remorse. After the exchang of multiple letters between the two firms, Merisel stock reacted predictably with a steep drop and now has a market capitalization below its net cash, despite generating positive earnings and cash flow in 2007.
Merisel started as a hardware retailer and sold its last IT-related business among controversy in 2004. It entered the visual communications business in 2005 and has since rolled-up various specialty print, graphics and imaging firms. Its sudden urge to merge is triggered by the upcoming liquidation of its principal shareholder, private equity fund Stonington Partners, L.P., owner of 60% of Merisel’s shares. (The current edition of Barron’s claims incorrectly that ACAS owns 60%. Rather, ACAS had to report control over 60% in its 13D because Stonington agreed to vote its shares in favor of the ACAS merger) Like all private equity funds, Stonington has a limited life of 10 years, at the end of which it winds down. Typically, private equity funds sell their holdings and distribute cash to their investors. The only way to sell a 60% of a small capitalization firm is the sale of the entire company, and Merisel’s board sought to accommodate their principal shareholder. The alternative would have been a distribution of Merisel shares to Stonington’s limited partners, which would have led to significant selling pressure on this illiquid company. This episode illustrates one of the underestimated risks of dealing with private equity investors – their exit strategy may not be compatible with the business needs of the firm they are invested in. American Capital Strategies’ deal seemed to be the perfect solution, but it now appears that ACAS tries to take advantage of Merisel’s status as a forced seller to impose a lower price under the pretext of one poor quarter. ACAS bets that Stonington will accept any price in order to wind down its fund quickly, for which Merisel is just a small holding.
We have pointed out previously that material adverse change is not easy to show under Delaware law. In a landmark ruling forcing Tyson Foods to acquire IBP, the Delaware Court of Chancery rules that a material adverse change clause
“is best read as a backstop protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner“
In other words: one bad quarter does not constitute material adverse change. A prominent victim of an overly aggressive and ultimately futile interpretation of material adverse change is shoe retailer Finish Line, which tried to invoke the material adverse change clause during its acquisition of Genesco. The saga ended with tables turned: Rather than Finish Line owning Genesco, the latter received preferred stock convertible into 10% of Finish Line’s equity. Unfortunately, Merisel does not have a similarly strong card to play because the merger agreement specifically limits ACAS’s liability to a termination fee of $3.5 million. And even that termination fee will require litigation to be collected, because ACAS attempts to accuse Merisel of misrepresentation in its merger agreement. This bears a strong resemblance to Finish Line’s attempts to accuse Genesco of fraud over financial projections that did not materialize as hoped. That argument went nowhere, and ACAS is likely to face the same fate, albeit only after running up hefty legal bills.
It is difficult to see what ACAS is thinking. As a business development company, it relies heavily on deal flow from small companies like Merisel. A scorched earth strategy with Merisel would damage its reputation and make building trust with other small firms difficult. Who wants to deal with a ruthless financier that will take advantage of any little mishap? A damaged reputation could cost ACAS more than the $3.5 million breakup fee. ACAS must assume that the Merisel deal flies under the radar screen of its other potential clients.
A large loss carryforward makes Merisel’s financial statements somewhat hard to decipher. In 2007, it reported $4.22 earnings after a reduction in its valuation allowance for loss carryforwards. Excluding these tax effects, it made approximately $0.40/share. In addition, it has over $2.50/share in cash, net of debt. At today’s closing price of $2.10, the market assigns a negative value to its core business. We would call it the Stonington discount. Clearly, the original $5.75/share buyout by ACAS was not very expensive. If ACAS thinks that the economic risks may warrant a reduction in the purchase price, we suggest they implement an alternative price mechanism, such as placing part of the consideration in escrow, and disbursing it only if Merisel’s business holds up over a year or two. If ACAS remains a refusenik, we expect that management will find another buyer soon.
Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of Trans World Entertainment.