Although the record-breaking deal activity of 2021 spilled over into 2022, headwinds in the first quarter developed into a significant slowdown during the rest of 2022, with an expectation of continued slowness as we enter 2023
This time last year, the US M&A market continued to be busy with deals in the pipeline from 2021, both deals proceeding to signing, and signed deals in the process of moving to closing.
However, it was evident from early in 2022 that new M&A activity was going to be down significantly from 2021. Cracks were already beginning to show the year before, as the Federal Reserve's language took a more hawkish turn. Talk of inflation being "transitory" shifted. By March, the Fed had made its first interest rate hike in four years. By mid-year, the S&P 500 had entered a bear market.
Since first tightening its monetary policy, the central bank has raised the federal funds target rate by a full 425 basis points (bps). This is the fastest pace of change in modern history. By December 2022, the brakes were being pumped a little less, rounding off the year with a 50 bps increase.
Nevertheless, Fed chair Jerome Powell's language remained resolute at a December 14 press conference announcing the increase: "We have covered a lot of ground, and the full effects of our rapid tightening so far are yet to be felt. Even so, we have more work to do."
Officials forecast up to a total three-quarter point more in interest rate increases this year—the Fed's policy extending longer than many had anticipated. Some are still hopeful that a pivot is not far away. Bond markets have been calling the Fed’s bluff with two-year US Treasury yields peaking in November and dipping below the federal funds rate.
As inflation shows signs of rolling over and economic growth stalls, opinion is divided over what 2023 holds in store—a soft landing or a hard landing. Even if the Fed eventually walks back its recent comments with a course correction, that would suggest that it has overshot the mark.
What is clear is that the first half of 2023 will not carry with it the spillover momentum seen in early 2022, and some investors are bearish on how 2023 will fare. Nevertheless, another camp remains cautiously optimistic. Taken as a whole, 2022 put in a solid performance as compared to historic performance. The real story, however, is that deal activity trended down with each successive quarter as valuations fell, corporate equity issuances became less attractive and debt financing was increasingly costly and less accessible.
As the articles in this report demonstrate, we do not see an early return to a busy M&A market. Opportunistic strategic M&A will dominate until questions regarding a recession are answered and confidence in the stock market returns.
US M&A in review: Momentum can only take you so far
M&A started strong in 2022 with robust deal activity and megadeals dominating the landscape that was largely the result of unprecedented spillover from 2021. But then, things took a turn and deals stalled in the second half of the year, as shifting macro-economic conditions began to take hold.
The US private equity (PE) market in 2022 aligned overall with the broader M&A trend—activity eased off considerably, year-on-year, but remained above historic levels—and like the M&A market at large, it tailed off as the year progressed, but what does this mean for the year ahead?
With some rare exceptions—namely in the oil & gas and energy sectors—deal activity was down in 2022 as a sense of fatigue set in following a prolonged period of high deal activity and as inflation and rising interest rate concerns took center stage.
A flurry of activity early in 2022 sees real estate outperform
Real estate has historically shown resilience during challenging economic periods and is considered a reliable hedge against inflation—but not all assets are created equal, and dealmakers were highly selective in the transactions they pursued in 2022.
Trade Desk: Challenge to certificate of incorporation amendment dismissed under MFW analysis
In City Pension Fund for Firefighters and Police Officers in the City of Miami v. The Trade Desk, Inc., the Delaware Court of Chancery dismissed breach of fiduciary duty claims made in connection with an amendment to the certificate of incorporation of The Trade Desk, Inc. (TTD). TTD's co-founder and chief executive officer proposed the amendment extending the duration of its dual-class stock structure, which would have the effect of prolonging his voting control. As part of this proposal, the co-founder explained his belief that it would be in the best interest of the company if the company "continue[d] to be guided by the same vision and long-term perspective." Since the amendment was an interested transaction involving a controlling stockholder, Delaware's exacting "entire fairness" standard would generally apply. However, defendants argued that since the transaction was conditioned on the approval of an independent special committee and a majority of the minority stockholders, the transaction complied with the framework articulated by the Delaware Supreme Court in Kahn v. M&F Worldwide Corp (MFW) and thus was entitled to business judgment rule deference.
The Court in Trade Desk outlined the specific conditions required for a conflicted controlling stockholder transaction to avoid entire fairness scrutiny:
(i) The controller conditions the procession of the transaction on the approval of both a special committee and a majority of the minority stockholders
(ii) The special committee is independent
(iii) The special committee is empowered to freely select its own advisors and to say no definitively
(iv) The special committee meets its duty of care in negotiating a fair price
(v) The vote of the minority is informed; and
(vi) There is no coercion of the minority.
The plaintiff challenging TTD's amendment alleged that defendants failed to satisfy elements (ii) and (v) of the MFW framework. The plaintiff argued that the special committee was not independent and that the stockholder vote was not informed. While the plaintiff alleged six material disclosure deficiencies with respect to the proxy for the stockholder vote, the Court ultimately found that they did not, individually and collectively, result in an uninformed stockholder vote. With respect to the independence of the special committee, the Court found that the plaintiff failed to allege facts supporting a reasonable inference that a majority of the special committee members were not disinterested and independent. In particular, the Court rejected the argument that the special committee's lack of independence was self-evident because it decided to maintain the dual-class structure. The Court ultimately found the plaintiff's challenge to the special committee to be grounded in the belief that maintaining the dual-class structure was a bad deal for TTD. The Court made clear, however, that its role in applying the MFW framework is limited to a process analysis, "not second guessing the ultimate 'give' and 'get'." The Trade Desk decision should reassure controlling stockholders that if they appropriately subject their transactions to the MFW conditions, courts will grant business judgment rule deference.
In one of an increasing number of breach of the duty of oversight claims, the Delaware Court of Chancery dismissed breach of fiduciary duty claims against directors of a software company, SolarWinds Corporation, in connection with a 2020 cyberattack by Russian hackers. In Construction Industry Laborers Pension Fund v. Bingle, plaintiffs alleged that the directors failed to adequately oversee the risk of criminal cyberattacks. The Court noted that duty of oversight claims (Caremark claims) have recently "bloomed like dandelions after a warm spring rain," but reaffirmed that they remain one of the most difficult claims to prevail upon. Because Section 102(b)(7) of the Delaware General Corporation Law exculpates directors (and due to a recent amendment, officers as well) for breach of duty of care claims, a lack of oversight "must be so extreme that it represents a breach of a duty of loyalty," which "in turn requires a pleading of scienter, demonstrating bad faith." While the Court determined that cybersecurity is "mission critical" for a company like SolarWinds, and that the directors failed to prevent a significant corporate debacle, the Court ruled that plaintiffs failed to plead specific facts from which to infer bad faith on the part of a majority of the directors. Interestingly, the Court distinguished a cyberattack, a crime by a third party, from recent successful Caremark claim cases that involved alleged violations of law by the corporation (e.g., Marchand food safety regulations and Boeing air safety regulations). While the Court questioned whether incidents involving crimes by third parties were appropriate to implicate oversight liability, it ultimately determined it need not resolve that issue. While plaintiffs alleged that SolarWinds' nominating and corporate governance committee ignored a cybersecurity presentation, the Court found that such briefing did not indicate an imminent threat and was not a red flag but actually "an instance of oversight." While the committee did not report to the full board during the two years after it was delegated responsibility for cybersecurity, the Court held that "Without a pleading about the committee's awareness of a particular threat, or understanding of actions the Board should take, the passage of time alone under these particular facts does not implicate bad faith." The Court ultimately ruled that plaintiffs failed to plead sufficient facts for the Court to infer scienter on the part of the directors. The decision in Bingle reaffirms the high bar for successful Caremark claims.
In re P3 Health Group Holdings, LLC: Carve-out in non-reliance provision allows fraud claims to proceed
While finding that its complaint contained "the barest minimum of allegations," the Delaware Court of Chancery failed to dismiss, at the pleading stage, a fraud claim brought by Hudson Vegas Investment SPV, LLC in connection with its 2019 investment in P3 Health Group Holdings, LLC. The decision highlights that even projections can be the subject of a fraud claim, as well as the importance of carefully drafting non-reliance and no-recourse provisions meant to eliminate (or at least limit) fraud claims in the first place.
In November 2019, Hudson invested US$50 million in P3 Health, a healthcare management company, in exchange for 20 percent of its equity. Hudson's investment made it P3 Health's second-largest equity holder. Hudson's lawsuit alleged that while it was considering its investment, the founders of P3 Health, as well as its private equity sponsor, provided materially incorrect financial information—including projections—regarding P3 Health. In particular, while these projections indicated EBITDA was estimated to be greater than US$12.7 million for 2020, the company actually reported a loss of US$40 million for the year—a US$52 million swing. Hudson alleged that the founders and members of the private equity sponsor who crafted and provided financial materials to Hudson knew that they were materially false and misleading, and that they were material to Hudson's decision to invest in P3 Health.
Importantly, the Court found that while fraudulent statements generally involve assertions of fact, the fact that Hudson's claim involved projections "does not doom it." According to the Court, "[a] projection can be actionable if it is sufficiently specific and if the plaintiff pleads that the projection was fraudulently conceived." In this case, the Court found that the projection was a specific financial figure that addressed EBITDA for the upcoming year. "The statement did not involve puffery about the business, nor was it a projection about the firm's performance stretching across multiple years into the future." With respect to whether sufficient facts were alleged to support an inference that the defendants either knew that the projections could not be achieved or were recklessly indifferent to their truth and accuracy, the Court found that "the timing, magnitude and surrounding circumstances support a pleading-stage inference of scienter." While the Court acknowledged that missing a near-term projection by a large margin supports several possible inferences, "at least one possible inference is that the near-term projection was knowingly false." Therefore, according to the Court, at the pleading stage, Hudson is entitled to the inference that is favorable to its claim.
Defendants argued that Hudson's fraud claim should be dismissed because Hudson agreed in its purchase agreement that it was not relying on any representations about P3 Health, including the projections. The Court confirmed that Delaware law will enforce "a clear non-reliance clause by which the plaintiff has contractually promised that it did not rely upon statements outside the contract's four corners." However, the Court found that the non-reliance clause agreed to by Hudson contained a fraud carve-out. As a result, the non-reliance clause did not foreclose Hudson's fraud claim with respect to P3 Health's EBITDA projections.
Finally, defendants argued that the purchase agreement's no-recourse provision prohibited Hudson from suing them, as they were not parties to the purchase agreement. The Court, however, found that Delaware public policy does not permit parties to use a no-recourse provision to insulate themselves from fraud.
The Court's decision serves as a reminder that financial information prepared by sellers and target companies and provided to buyers should be carefully prepared and that projections should be supported by reasonable facts and assumptions; otherwise such information may form the basis of a fraud claim. In addition, parties should appreciate that the inclusion of a fraud carve-out in a non-reliance provision—which is a common feature of many purchase agreements—could expose sellers (and potentially their principals) to liability for statements made outside the four corners of the agreement.
Bandera: Delaware Supreme Court reverses US$690 million Court of Chancery award
The Delaware Supreme Court reversed last year's Court of Chancery decision awarding US$690 million in damages for breach of a partnership agreement in connection with Lowes Corp.'s acquisition of limited partnership interests in Boardwalk Pipeline Partners, LP. In finding a breach of the partnership agreement, the Court of Chancery determined that a legal opinion (delivery of which was a condition to Lowes exercising its call right) was not delivered in good faith and that the protective provisions of the partnership agreement with respect to the general partner's reliance on legal opinions were not available. In Boardwalk Pipeline Partners, LP v. Bandera Master Fund LP, the Delaware Supreme Court disagreed with this decision, finding that the general partner had the right to rely on a second legal opinion (delivered by another firm) that the original opinion was reasonable. Importantly, the Court of Chancery did not find, and plaintiffs did not argue, that the second opinion was given in bad faith. By relying on the second opinion, the general partner triggered a provision of the partnership agreement providing that the general partner was "conclusively presumed" to have acted in good faith when it relies on advice of counsel "as to matters that the general partner reasonably believes to be within [counsel's] professional or expert competence."
As a result, the Supreme Court found the general partner was exculpated from damages. The Bandera decision confirms that Delaware courts will give full effect to protective provisions contained in limited partnership agreements when the parties properly complied with them.