In another illustration of the pointlessness of “Go Shop” periods the board of Entrust (ENTU) ignored three buyout offers received in the 30-day go shop period that were higher than that of the group that includes the CEO. Moreover, the Entrust management buyout shows all that is wrong with buyouts by private equity funds where management remains with the firm and has an incentive to lowball the buyout price. Shareholders expected an increase of the $1.85 merger consideration, and shares traded as high as $2.10 during the go-shop period. We believe that due to the high level of dissent from shareholders and even a board member it will be difficult for management to achieve the required approval by 2/3 of the shareholders.
In March 2008, Entrust received a $3 per share cash buyout proposal from a strategic acquirer. The board rejected the proposal and decided to remain independent for at least another six months. In September, Robert Sayle of Thoma Bravo contacted Entrust with an acquisition proposal. This was the second approach by Thoma Bravo. The first had been made one year earlier in September 2007. This time, Thoma Bravo proposed an all cash transaction for $1.75 per share. In February of this year Thoma Bravo increased that price to $1.85.
The financial adviser’s opinion shows that the price is “fair” and mostly falls within the range of values calculated by a variety of methods. However, the ranges are very wide for the most part, and Entrust’s $1.85 is near the bottom end of almost every range. This makes us think that in the first iteration, the acquisition price fell below the range calculated. The analysts then changed the assumptions for the various methods until each range was wide enough to capture the $1.85 acquisition price at its lower end. After all, valuation opinions are highly subjective exercises that can include or exclude comparables for any number of perfectly reasonable justifications. As an aside, the financial adviser originally was Lehman Brothers, and when that firm was taken over by Barclays, the same team was re-hired to continue working on the deal.
Thoma Bravo had indicated to the board that it wanted to keep current management in place. This is a standard practice in private equity-sponsored buyouts. Management responded by barring Thoma Bravo from discussing management compensation during the initial phase of the negotiations. It is common to give management incentives in the form of equity and options once the company is private. The result is that management can make more money selling a company to a private equity fund and growing it than keeping it public. Moreover, the lower the price at which the company is take private, the bigger the eventual payoff for management. It is clear from the proxy that management compensation played a significant role throughout the buyout negotiation between Thoma Bravo. The board was well aware of the potential conflicts between management’s desire to acquire the firm on the cheap and their role as defenders of shareholder interests.
- “[…] in light of Thoma Bravo’s expressly stated reluctance to move forward with the proposed transaction without further direct communications with Company management regarding specific employment terms, the Strategic Planning Committee determined that Thoma Bravo could speak directly with Company management regarding specific future employment terms, but must provide any term sheets in advance to the Strategic Planning Committee and must conclude its discussions with Company management expeditiously. “ Source: DEFM14A, page 34
5.2% holder Arnhold & S. Bleichroeder Advisers has sent a scathing letter to management that objects to the low valuation and points out that since the date of the signing of the agreement the value of all tech firms has increased significantly. Of the 3.2 million shares held by A & S Bleichroeder, 2.7 million were bought between April 20th and May 29th at prices between $1.87 and $2.10 with an average of $1.93. Therefore, they will not be able to vote the shares bought after the record date. It is not clear which accounts of A & S Bleichroeder hold the shares and whether Jean-Marie Eveillard or the First Eagle Funds (FESGX) are involved. A & S Bleichroeder also runs merger arbitrage portfolios with an activist bent whereby it seeks to maximize payout in acquisitions. Some of its wins include an extra dividend payment when SL Green bought Reckson Associates and a 50% increase in the merger consideration in the buyout of public shareholders of the Bank of International Settlements (that’s the one that coordinated the Basel II framework).
Nervous about the outcome of the shareholder vote management postponed the vote to July 10 but kept the record date of May 11. Since the record date more than 24 million shares have traded, compared to 61.5 million outstanding, and the resulting turnover in the shareholder base makes it less likely that sufficient shares will be voted in favor of the transaction. Buyers of the shares can not vote because they bought after the record date, and sellers have incentive to go through the trouble of voting.
One independent director, Douglas Schloss of merger arbitrage firm Rexford Management, took the unusual step of dissenting publicly with the remainder of the board. Typically, board decisions about the sale of a firm are taken unanimously. A public dissent by a director is an extremely rare event and investors should assign it significant meaning. Schloss’ criticisms of the Thoma Bravo deal are quite powerful:
- Based on all of the information presented to the Board of Directors, I do not believe that the acquisition price of $1.85 per share is fair to the shareholders. (Assuming the merger closes either before July 15th or after September 15th and assuming the purchaser utilizes the $23 million of cash that is required to be on hand at closing as part of the acquisition consideration, the purchaser is only paying approximately $1.45 per share to the Company’s shareholders.)
- Given current general economic conditions, it does not seem to be the right time to sell the Company. The equity value of “small cap” companies like the Company is generally depressed by the dramatic lack of liquidity in the market. The Company bookings have grown in each of the past five years, the Company is cash flow positive and has substantial cash balances on hand. There is no necessary reason for the Company to be sold at a low valuation at this time, especially in light of the fact that the Company received written indications of interest from two large strategic buyers at significantly higher prices per share than offered by Thoma Bravo.
- Mr. Conner, the Company’s CEO, is scheduled to receive a “success fee” of $2.5 million, plus a 5.7% equity interest in the acquiring corporation, upon closing the merger. In addition, Mr. Wagner, the Company’s CFO and Mr. Kendry, the Company’s Chief Governance Officer, are scheduled to receive aggregate “success fees” totaling $1,402.022 and, collectively, a 2.1% equity interest in the acquiring corporation, upon closing of the merger. Though each of these gentlemen would be entitled to receive similar cash payments under their “change-in-control agreements”, such payments would only be made if they lost their jobs. In my view, each of Mr. Conner, Mr. Wagner and Mr. Kendry is an “interested party” and should have had no involvement at all in the sale process following the negotiation of such success fees with the acquirer. Mr. Conner and other members of management are totally conflicted with respect to the “go shop” period. In my view, the amount of consideration to be received by Mr. Conner, Mr. Wagner and Mr. Kendry in relation to the value to be received by the shareholders is completely unjustified.
- The Company’s largest shareholder, Empire Capital, has a designated representative on the Board of Directors who had strongly requested to serve on the Strategic Planning Committee, which was initially a two-person “special committee” created to review strategic alternatives available to the Company. In my view, rather than representing the interests of all shareholders, Empire’s representative continued to push for a transaction at this point in time given Empire’s previously disclosed intention to maximize the value of its investment.
- Wilson Sonsini Goodrich & Rosati, counsel to the Strategic Planning Committee, is not an “independent” legal counsel as such concept is generally construed in transactions of this nature. Wilson Sonsini Goodrich & Rosati regularly performed legal services for the Company and its management, thus it was not in a position to provide “independent” legal advice to the Strategic Planning Committee (which was functioning as a “special committee” with respect to the merger process) or other independent members of the Board of Directors. In addition, Wilson Sonsini Goodrich & Rosati has an agreement whereby its compensation is tied to the completion of a successful transaction which additionally jaundices its independence.
Management received three acquisition proposals during the go-shop period at a higher price than Thoma Bravo’s $1.85. It is not clear to us why exactly the board classified did not think they were “superior proposals:”
- “Upon the expiration of the Go-Shop Period and as a result of the Company’s solicitations during the Go-Shop Period, the Company received written, non-binding indications of interest from three separate parties, each of which contemplated a per share price payable to Company stockholders higher than the per share price contemplated by the Merger Agreement, but each of which was also subject to significant conditions, including completion of further due diligence, arranging financing and negotiation of definitive agreements. After careful deliberation and consultation with the Company’s financial advisor and legal counsel, the Company qualified each of the three parties from whom the Company received an indication of interest as an “Excluded Party” under the Merger Agreement. Two of the Excluded Parties were modestly-sized operating companies and one was a private equity firm.” Emphasis added. Source: DEFA14A of June 10th
The proposals were non-binding and subject to the negotiation of a definitive agreement. It is to be expected that a potential acquirer take more than 30 days for thorough due diligence. Therefore, the proposals had to be subject to a definitive agreement and further due diligence. The board claims “that extending the negotiating process further would pose significant business risk to the Company, and could place the proposed Merger under the definitive agreement with Thoma Bravo in jeopardy.” Then why is the board procrastinating the vote by a month if time is of the essence? And could that extra month not be used to negotiate with these three parties rather than for soliciting votes on a deal that the market was already trading above? It appears to us that the board has favored a low price by Thoma Bravo over the other contenders. In the absence of appraisal rights under Maryland law, it seems to us that if the deal were to go through, it would be followed by litigation for damages. And given the circumstances the plaintiffs should have a good chance of winning.
And by the way, why does management not disclose which prices exactly these buyers were willing to pay? The absence of this information suggests that they were willing to pay a significant premium to $1.85.
We think that despite Empire Capital’s 19.9% stake, there is a good chance that no-votes and votes against the transaction can kill the Thoma Bravo transaction this Friday. After all, this transaction requires approval by 2/3 of the votes, and with the turnover in the shareholder base coupled with the high level of dissent that reached even into the board, it will be difficult for management to get sufficient votes. The good news is that, in our opinion, the two other strategic buyers and one private equity fund who were interested during the go-shop period stand ready to make bids. This will limit the downside and could even lead to an increase in the stock price if this deal is voted down.
Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which holds shares of Entrust. He is the author of an e-book about alternative strategies as well as the forthcoming book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).