Closing the Gap – Use of Contingent Value Rights as a Tool to Get Deals Done
While there has been an increase in bank M&A activity over the past year as the economy and real estate markets continue to improve, the slow pace of the recovery and uncertainty in the real estate market continue to make M&A deals difficult. Disagreement over expected loan portfolio performance and a general lack of appetite on the part of buyers to take on much risk with respect thereto has become one of the largest sticking points in getting to “yes” on a transaction. Contingent value rights, or CVRs, are a tool increasingly being used within the industry to help bridge this gap.
CVRs are rights that pay additional consideration to target shareholders in the event certain conditions are met. Essentially they work as a structured form of post-closing adjustment. CVRs have historically been used in other industries, such as pharmaceuticals, where the value of a company is highly dependent on the outcome of a future event, which may not be known for several years. CVRs represent a way for target shareholders to realize, albeit on a delayed basis, the additional value that they believe exists in the enterprise while reducing the potential risk for the buyer in the event such value never comes to fruition. The flexibility in structuring CVRs makes them attractive in the bank M&A context as they offer a way for buyers and sellers to resolve their differences regarding expected loan portfolio performance.
Payment on a CVR can be linked to a specified group of loans or to the performance of the acquired loan portfolio as a whole. The delayed payment aspect of the CVR gives a buyer protection against paying for losses that it believes may develop in the loan portfolio. At the same time, CVRs present a target with the opportunity to get a deal done sooner, and at a higher price, by agreeing to put a portion of the consideration its shareholders receive at risk. In addition, payment on the CVRs can be tiered so that as the loans in question get paid off, partial payment is made on the CVRs.
An additional advantage of the CVR is that it can be structured as either a “security” or a “contract right.” Structuring the CVR as a security allows transferability, giving CVR holders that do not want to wait to receive CVR payments the ability to sell the CVR and receive immediate value. Depending on the number of holders and other factors, CVRs structured as securities can also be listed on an exchange, such as NASDAQ, to increase the marketability of the rights.
The downside, however, is that like any other security, structuring the CVR in this way will likely require registration with the SEC. For private institutions or those that want to avoid the time and expense of SEC registration for a transaction, the ability to structure the CVR as a contract right means that it remains a tool available for all institutions that want to use it. However, to be treated as a contract right, the CVR must meet the criteria established through a series of SEC no-action letters, including, most notably, that it not be transferrable by the holder.
The flexibility in structuring CVRs also raises a number of issues that must be considered and negotiated. These include, among others: determining the payment triggers; the amount of the premium, if any, associated with the delayed delivery of consideration under the CVR; the timing of future payments; how future performance will be monitored and who will be responsible for determining if payment triggers have been met. These issues must be carefully considered and can ultimately impact the “value” of the CVR in terms of the overall deal.
For buyers and targets that are finding it difficult to get deals done in the current uncertain economic environment, CVRs represent an alternative that should be considered. The flexibility they provide in structuring for future consideration based on future performance may help close the gap between buyers and sellers and help to further accelerate the pace of M&A activity.