American Capital Strategies Illustrates Private Equity Risks in Merisel Pull Out

Another addition to the graveyard of busted mergers: business development company American Capital Strategies (ACAS) has terminated its agreement to buy Merisel (MSEL.PK) under the “material adverse change” clause that has become a standard excuse for buyer’s remorse. After the exchange 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 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 (TSN) 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 (FINL), which tried to invoke the material adverse change clause during its acquisition of Genesco (GCO). 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 Tuesday’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.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund [PAEDX], which owns shares of Trans World Entertainment (TWMC).

Comments

[GregY:]

Very interesting analysis. Thank you.

2008 Jun 11 10:52 AM

[inthewings:]

So what if ACAS tried to get a bargain? Don't we all? And if it really is a forced sale of an illiquid company, isn't a bargain price appropriate? Things are tight all the way around. Long ACAS.

2008 Jun 11 01:41 PM

[chagrinned1:]

Unfortunately you are second guessing the reason ACAS is
rejecting the deal at this time. Could you be related to David Einhorn or his good friends on CNBC?? There is a tendency to tear down bus development companies at a disasterous time in the market. Up to now I have kept/added to long positions except in disasterous banks. Now with all these critics I have to rethink my posture. THis possibly could be a time for your restraint when you limit discussion to your navel?? And yes I am long ACAS.

2008 Jun 11 03:29 PM

[jjason:]

Thomas, You seem to have a little bit of knowledge of ACAS's strategy and from that knowledge you suppose you know more than Malon Wilkes ( CEO of ACAS ). I disagree with your premise that a poor quarter is not significant. A poor quarter can knock down the market price of a companies stock.

I would wonder why, after the news about not buying MSEL.PK, the share price dropped? What's MSEL.Pk worth?

Anyway, I'll leave it up to the folks at ACAS to decide what is best for us shareholders.

Long ACAS.

2008 Jun 12 01:16 PM

[nyka:]

Despite the accusatory tone of this report, I remain long ACAS.

2008 Jun 13 02:03 PM

[DirtyD:]

Where do you come up with Merisel having $2.50/sh cash? According to its latest filing, it ended with $13,664,000 cash or $1.70/sh. This would definitely keep it out of the deeply-undervalued range if you ask me, especially with no future deals out there and declining revs.

2008 Jun 19 03:43 PM

[fxtrader07:]

i wonder how the author arrives at the conclusion that it#s a one quarter only affair. from where does he know or guess that the next quarter will be a good one again? After all, every trend starts with a first step. Given Malon's and ACAS' track recoprd and history the author#s assumptions make zero sense. ACAS has no reason to risk its hard and well-earned reputation just to get a somewhat lower price for merisel. They are precisely not like wall street and the big banks which have no issues risking dollars to make pennies.
In short, the author suggests that crooked and unfair ACAS tries to rob the 'poor' folks at Stonington. But there are quite some contradictions here. just to point out one: if the "one quarter" didn't materially impact the value of merisel - why then is the stock price dropping so hard and why then are no other buyers lining up to bid? and why should acas risk to lose the deal to someone else, if the one quarter was a meaningless episode? and why would they not try to renegotiate behind closed doors?

2008 Jun 20 07:48 AM

[jonathan:]

Guys you may want to ease up a bit. The author did not accuse ACAS of anything, nor did he state or imply that they were acting in a crooked or unfair manner. All he did is lay out a pretty well-structured view of the deal and some of the risks on both sides.
If I were making the decisions at ACAS I might have done the same thing (pulled out looking to take advantage of Merisel's situation). That's just doing business. ACAS has a duty to it's own shareholders, not to Merisel's. I am sure they weighed/are weighing the potential damage to reputation as part of that.

I appreciate Thomas' analysis but I would come to a different end. I doubt that ACAS' tactic will be seen as scorched earth. Everyone knows the market is rough right now so I doubt this return-maximizing is considered anything more than hard-core business.

I also doubt Merisel will have an easy time finding another buyer. There are not many out there at the moment. That will probably change end of the year but for now ACAS is probably their only easy option.

2008 Jul 11 09:58 AM

[Jaded Consumer:]

Onlookers likely overestimate the litigation cost and liability risk of ACAS in the transaction, or they read bad news about Merisel (which ACAS didn't buy) and conclude there must be more cockroaches in the ACAS kitchen. I think the deal collapse represents an indication that ACAS takes due diligence seriously and really doesn't want to own duds if it can be helped -- and it's willing to take short-term lumps to achieve this.
I've commented on this previously here:
jadedconsumer.blogspot...

I don't think the take-home story on Merisel is that at ACAS, Homer nodded -- but that someone at ACAS was awake at the wheel and averted a disaster that actually materialized later on.

Good show, I say.

2008 Sep 30 12:29 PM