‘Suspicious’ valuations tainted Merger, Del Chancery rules
In re El Paso Corp. Shareholders Litigation, 2012 Del. Ch. LEXIS (Feb. 29, 2012)
For the second time in four months, Vice Chancellor Leo Strine of the Delaware Court of Chancery charged Goldman Sachs with using “questionable” and “suspicious” valuations to exert a “troubling” influence. The case, involving Kinder Morgan’s bid to acquire El Paso Corporation, raises valuation issues itself that should interest BVWire readers (if only because USPAP compliance appears to have not been a concern for the principals involved!). In addition, the case seems to open the door to future challenges of questionable i-Banking valuation practices and compliance.
El Paso announces spinoff. El Paso operates a natural gas pipeline business, and also has an exploration and production (E&P) division. In May 2011, El Paso publicly announced that it would spin off the E&P business. In an attempt to preempt other bidders for the spinoff, Kinder Morgan offered El Paso $25.50 per share for the entire company. After consulting with its longtime financial advisors, Goldman Sachs, as well as an independent bank (Morgan Stanley), the El Paso board countered with an offer of $28.00 per share, and sent its CEO to negotiate the deal directly with the Kinder CEO. By late September 2001, the chief executives had agreed on a $27.55 merger price, subject to due diligence by Kinder Morgan.
Just one day after setting the deal terms, however—as V.C. Strine recounts it— “Kinder said, ‘oops, we made a mistake. We relied on a bullish set of analyst projections in order to make our bid. Our bad.” The El Paso CEO backed down, but continued to take the deal on a “downward spiral,” according to Strine, compromised by “debatable negotiation tactics” including:
- Goldman stood on both sides of the transaction, ostensibly advising the El Paso board on the financial soundness of the Kinder bid (for a $20 million fee) while also owning roughly 19% of Kinder Morgan stock (worth nearly $4 billion).
- Goldman also occupied two seats on the Kinder board, and was part of the control group that collectively held over 78%.of the voting power of Kinder stock.
- More troubling still, the lead Goldman advisor to the El Paso board failed to disclose that he personally owned $340,000 worth of Kinder holdings.
- After Morgan Stanley was brought on to “cleanse” any perceived conflicts, Goldman was able to accomplish the “remarkable feat,” Strine said, of giving the new bankers an incentive to favor the merger by tying their fees to the completion of the deal.
- On the executive side, the El Paso CEO failed to disclose his “secret motive” for closing the deal, which involved making a post-merger management buyout of the E&P division.
In less than a month after Kinder reneged on its original terms, El Paso ended up taking a package that was valued at $26.87 per share as of the signing date (Oct. 16, 2011). The merger price, comprised of $25.91 in cash and stock and a warrant with a strike price of $40 per share, was $13 above Kinder’s then-current stock price and failed to protect against ordinary dividends. The merger agreement also contained a “no shop” provision, preventing El Paso from soliciting other bids, permitting it only to take a “superior offer” for over 50% of its assets, on payment of a $650 million termination fee. This effectively precluded El Paso from spinning off its E&P division to a third party, because it comprised less than 50% of the consolidated assets and the substantial termination fee made the prospect even of selling of its weaker pipeline division prohibitively expensive.
Despite these conditions on the deal, the proposed merger price was at a 37% premium to El Paso’s market value. In fact, after the agreement went public, the price of Kinder’s share rose, thus increasing the merger price to $30.37 per share, or a 47.8% premium over El Paso’s then-trading price. Nevertheless, a group of El Paso stockholders sued to enjoin the merger, asserting numerous breaches of fiduciary duty based on the alleged conflicts of interest.
Questionable decisions based on questionable values. The court agreed that the El Paso board made “numerous decisions” during the negotiations that “could be seen as questionable.” These included the board’s failure to:
- Shop the company its two divisions separately to any other bidder after Kinder’s first overtures, despite knowing that Kinder wanted to deflect other buyers from the attractive E&P division;
- Force Kinder to go public and face market pressure to raise its bid in a hostile takeover;
- Object when Kinder reneged on its original deal, based on the “arguably ludicrous” assertion that it relied on forecasts by one of the “most bullish analysts” covering El Paso’s stock;
- Negotiate deal protections that would permit a post-signing market check for better bids for the separate divisions; and
- Negotiate a deal that at least equaled the value of Kinder’s original offer.
As a result of these failures, the Board was basically down to two options: sell the entire company to Kinder or spin-off its E&P assets. Importantly, although the Board attempted to “wall-off” its conflicted Goldman advisors by bringing in Morgan Stanley, it still permitted Goldman to remain as lead advisor on any spinoff. Thus, Goldman “was in a position to continue to exert influence over the merger,” Strine explained, by revising its valuations of the spinoff downward during the Kinder negotiations.
For instance, using a comparable companies analysis and based on enterprise value to earnings multiples, Goldman valued the E&P assets at $8 billion to $10 billion in May 2011, when El Paso first announced its spinoff plan. By September 2011, when Kinder negotiations were well underway, Goldman said that declining EV/EBITDA multiples caused the E&P assets to lose another $1 billion in value; by October and the closing of the deal terms, their range of value had bottomed out at $6 billion to $8 billion.
By comparison, Kinder Morgan’s advisors valued the same assets as of late September 2011 at $7.86 billion. Moreover, aspects of Goldman’s valuations were “questionable,” Strine noted, because short-term volatility in commodity prices had depressed the market multiples, making them inadequate indicators of long-term value. Further, “solely looking to market multiples to generate a hypothetical trading value fails to take into account the control premium that could be achieved on the sale of the E&P business,” he said.
“Even worse, Goldman tainted the cleansing effect of Morgan Stanley” be refusing to permit Morgan to collect a fee should only the spinoff be consummated. In other words, if Morgan approved a deal (in which Goldman owned 19% of the acquiring entity), it received a $25 million fee. If it counseled the board to go with the spinoff or another option, Morgan got “zilch, nada, zero,” Strine said.
This fee incentive led to “odd” valuations by Morgan Stanley. For example, evidence suggested that Morgan used an unreasonably low terminal value for a portion of its discounted cash flow analysis of the El Paso pipeline business. That is, rather than use a perpetual growth model to calculate this terminal value, the Morgan analysts used a mid-point exit EV/EBITDA multiple of 10x, which resulted in a long-term growth rate of only 0.7%: “a rate less than half of the estimated rate of inflation (2%),” Strine emphasized. This assumption conflicted directly with testimony from the El Paso CEO, who insisted the pipeline business had strong growth potential. It also conflicted with the management forecasts, used by Morgan Stanley, which included capital expenditures for both maintenance and growth.
The record also revealed that Morgan may have used internally inconsistent values for Kinder’s cost of equity, using a higher rate (11.8%) when benchmarking El Paso’s COE but using a substantially lower rate (7.5%) when valuing Kinder directly.