The Law and Other Anomalies

The US economy in 2023 was not really soft, but it was perceived as such and market valuations of enterprises held by PE funds were depressed.  PE Fund refrained from cashing out their investments, hoping that values would rise in the future, that  buyers next year would be more willing to spend,  and that disposition of fund investments at 2024 higher prices would create better returns for fund investors.

According to Dealogic, PE exits in 2023 totaled c $333B; exits in the prior two years were c$6B and over c$893B.  2023 exits were the lowest since 2013.

Now comes 2024 and there will be greater pressure to exit as time will be running out on some funds and since hopefully valuations of positions to be sold will have increased.  Further, companies seeking acquisitions likely have enjoyed profitable 2023s and have not expended acquisition dollars last year, so it seems that fund managers may find willing and solvent buyers for the investments that the funds need to sell.

Strategic buyers looking to purchase PE fund assets may try to balance possibly higher market valuations by careful shopping, in light of the fact that there may be something of a glut of companies for sale given lack of company sales last year.

Interest rates have stabilized and may tick downward during the course of the year, also a factor which may lead to acquisition activity.

Finally, noting the overlay of greater anti-trust enforcement particularly against roll-ups, anti-trust clearance may take a long time to achieve, particularly in markets where there is product/customer overlap and/or in regulator-targeted industry sectors such as med-tech. (See prior anti-trust post to this blog site, dated December 20)

Overall, commentators expect a pretty interesting 2024 acquisition year.

Last week the SEC promulgated two new rules which are of great impact on large-scale securities investors and the firms that advise them.  The below merely touches certain highlights and, I must emphasize, as with all things posted here, does not constitute legal advice.  The regulations and releases are vast (the adopting release for the regulation redefining securities dealers is 247 pages long, has 805 footnotes and is subject to well-reasoned dissents by the two outvoted Republican SEC Commissioners).  Thus forewarned (and if you a registered RIA or a large investment vehicle please call your attorney), here is the broadest of outlines:

DEALERS: A dealer under federal law is defined as an entity or person in the business of buying and selling securities for its own account through a broker or otherwise. BUT it excludes those for which such activity is NOT part of a “regular business.”   We  used to refer to such excluded entities as “investors” or “customers,” who had certain protections under law.  The new Rule requires certain customers, those which regularly invest and trade in securities for its own account with frequency at large scale, to register as a dealer.  The reason is that, according to the SEC, such a trader fulfills the same function as a traditional dealer, funding in the marketplace by creating liquidity for others in the trading markets.

The result of being a dealer is that you must register with the SEC and FINRA (the self-regulatory dealer organization) and file reports with the SEC and comply with regulations that are largely  irrelevant.  While registered investment companies are exempt (they would otherwise have to register with the SEC twice), the new Rule covers private funds and pension funds.  In ways not yet clear at least to me, coverage also does not exclude investment advisers.

In an interesting aside, the SEC Release makes clear that a crypto automated market maker might have to register, which as Commissioner Peirce points out seems tantamount to registering a software protocol.

RIAs: Starting in about a year, registered investment advisers which advise PRIVATE unregistered fund vehicles must  include, in their SEC filings on Form PF, private information about the strategies that such advisers and funds utilize in their securities transactions.  The purpose is better to understand and thus regulate the trading markets, the same rationale for the above dealer regulatory rule.

To review: a SPAC is an entity formed with the intent of acquiring an emerging private company which it will then operate, paying for that acquisition in stock.  The cash previously raised from investors in the empty (shell) SPAC is retained to finance the operations of that acquired business.  For years prior to the pandemic, SPACs were a way quickly to make acquired early-stage companies solvent and public, with less cost and regulation than going through a full SEC registration process (IPO).

The principal problems with prior SPAC practice: promoters of the SPAC took a lot of equity, diluting public investors; the regulatory structure controlling the SPAC process by which public investors ended up owning a public operating company were not as rigorous (relative to accounting and disclosure of the nature of the operating company) as would obtain if that company filed its own IPO (a lack of consistent regulation being applied to two transactions ending up with the same result once the dust settled); historically high compensation for the deal promoters–all against a backdrop that a disproportionately large number of SPACs performed poorly or went bust.  This last important point, not surprising given that early stage companies were financed via SPACs when they would not be commercially acceptable to investors in an IPO, caught the attention of the SEC, which is concerned with protection of the retail investor.

This past Wednesday, the SEC issued new regulations designed to make the SPAC process substantively equal in terms of disclosure to that which the public would receive in an IPO.  Not intending here to summarize over 500 pages of SEC output, suffice it to say that these new regulations require SPACs to: make clear the dilution suffered by public investors at the hands of the promoters; disclose the detailed bases of financial projections; and, remove an SEC rule that previously protected SPACs from all liability even if financial projections proved massively over-optimistic.

Preliminary lawyer reaction from the SPAC bar is that these new regulations (effective in about four months) will make SPAC deals slower and more expensive, but will not destroy the practice; in the future, only larger SPAC transactions will make economic sense.

Note: yet again the two Republican SEC Commissioners (out of five) voted against tightening SEC regulations. While no doubt the Democratic majority on the Commission is activist and thus seemingly always in favor of more regulation, it is hard in this instance to agree that regulation here is not warranted; past inconsistent regulation of similar business transactions is facially difficult to justify, and there is no doubt but that the failure rate (from the standpoint of the public investor) in SPAC companies was significantly worse than with IPO offerings.  You can rationally believe that IPO procedures are expensive and disadvantage small emerging companies, as seems to be the Republican viewpoint, but absent reform of the IPO process (which is not going to happen during a Democratic administration), the SPAC really was just an end-run around the regular standards for raising public equity.

Two days ago, the Federal Trade Commission and the Department of Justice issued new and more restrictive guidelines for when the government will challenge business combinations in various categories.  These new guidelines define when the government will take action, and do not constitute law, but the government hopes they will impress the courts as the expression of agency expertise which the courts should follow.  These guidelines certainly define cases where businesses will find themselves being investigated and sued.

The new guidelines are extensive and nuanced; below are just a few highlights. Generally, the new guidelines shift some focus from protecting the consumer from high prices set by monopolies to a goal of both nipping that risk in the bud while considering impact of business concentration on the labor force (which has never been seen as a goal of anti-trust enforcement before).

High points:

*Focus on healthcare and roll-ups generally, with an eye on PE firm platform models (see prior post foreshadowing this focus, December 13, 2023)

*Lowering the level of concentration in a relevant market that will trigger either an investigation of a deal OR declaration of presumption of violation (and increased risk of litigation)

*Focus on coordination between competitors by reason of use of AI such as  pricing algorithms which will lead competitors to the same pricing decision (the risks of such an approach are interesting–what if independent examination of  available facts does lead to similar pricing?)

*How will a deal affect labor when competitors merge (a good question of public policy, but not contained in anti-trust laws which were mostly crafted at a time when even the legitimacy of unions themselves was being questioned)?

*Concerns over, or presumption of, illegality when a deal eliminates a potential competitor, or ties up access to a key component used by competitors

*Examination of effect of acquisition of partial or minority stakes in other companies

*Removal of several statements suggesting lack of problem with certain defined  mergers; now the focus can be based on a series of small deals, and a new deal can open inquiry into prior completed and presumable acceptable deals.

Final observation: anti-trust risk disappeared on many fronts over the last few decades, but has come roaring back in this Administration.  While it is a pleasure for a lawyer to say that companies doing deals need to consult anti-trust counsel, it is also correct advice in an increased number of cases, even of relatively small size.  Deals no longer need to be “big” to be “bad.”