Bridging the value gap: the takeover of British Energy

Practical Law UK Articles 0-385-2836 (Approx. 13 pages)

Bridging the value gap: the takeover of British Energy

by Michael Shaw, Gavin Davies, Mark Bardell and Sarah Hawes, Herbert Smith LLP

Contingent consideration

Contingent consideration is not uncommon in the context of private company M&A. Retaining some of the purchase monies in escrow subject to conditions, or making part of the consideration subject to earn out arrangements with key members of management, are obvious mechanisms when purchasers are reluctant to pay out all of the consideration immediately and unconditionally upon acquisition.

Both stub equity and, even more so, CVRs have historically featured only sparingly in UK takeovers. However, with current market conditions causing investors to hold widely differing views as to prospects and hence appropriate valuations, the ability to provide target shareholders with an option to roll over all or part of their holding into a form of consideration that allows continuing economic exposure to the performance of the target may be highly attractive to both sides. Cash may be all important for many at present but other shareholders may be keen to share in a possible future recovery in value or at least to hedge their position.

What is stub equity?

Stub equity, as the name suggests, is a form of equity that allows target shareholders to continue to participate, albeit in a limited way, in the performance of the target company following a successful takeover (see News brief, Stub equity: eat your cake and have it, PLC Magazine, May 2007). It is called "stub" equity because the more valuable equity, holding the main rewards including voting control, is in the hands of those parties who put together the offer.

Stub equity may be either quoted or unquoted. In the UK, all of the quoted structures to date have been on the Alternative Investments Market (AIM), rather than the main market, to take advantage of the less onerous listing requirements and continuing obligations. There are various structures that can be adopted, either offering stub equity in the target itself or offering shares in a new company, which may or may not be the bidding vehicle, but which in either case is to own part of the target after the acquisition.

The documentation required and the regulatory steps that need to be taken are dependent on the structure adopted. Admission to AIM for a newly incorporated stub equity company, for example, requires:

An AIM Admission Document.
The production of a prospectus, as the takeover offer constitutes an offer of transferable securities to the public for the purpose of the UK Financial Services and Markets Act 2000 (unless a scheme of arrangement is used, which would not constitute a public offer for these purposes).

There is also typically a shareholders' agreement put in place to regulate certain matters between the holders of the stub equity and the controlling shareholders.

Although the UK City Code on Takeovers and Mergers (Takeover Code) requires that any form of consideration offered be made available to all shareholders, it is normally the case that stub equity appeals most to sophisticated shareholders, who will more readily understand the potential risks and rewards associated with this type of investment.

Why and when is stub equity used?

As can be seen from the UK examples (see box, Stub equity: UK examples), the use of stub equity to date has been confined to large private equity backed transactions. This is for a variety of reasons:

The complexity and cost, especially if the stub equity is quoted, mean that only deals of a significant value are suitable.
There needs to be the expectation of increased future capital returns that would only be capable of being unlocked by virtue of the change of ownership. Private equity structures, geared by high levels of debt, were regarded as meeting this requirement before the onset of the credit crunch.
Because of the nature of private equity bidders, there was unlikely to be an obvious form of alternative equity available. A trade buyer would normally be able to consider including its own equity within the terms of its offer even if, like EDF in relation to British Energy (see below, How the EDF/British Energy deal unfolded), it decided against this, preferring a mechanism that offered exposure only to the performance of the target.

Stub equity therefore became part of the toolkit available to private equity bidders, its deployment becoming relatively more common once institutional investors decided opting for a cash-only exit left them at risk of having sold out too cheaply in the context of rising markets.

However, it need not be confined to these circumstances. In the EDF/British Energy example, for instance, its use was carefully considered by EDF as a means of "bridging the value gap" (see below, How the EDF/British Energy deal unfolded).

Other trade buyers may be similarly interested in the use of stub equity in circumstances where there is disagreement or uncertainty about underlying value. This is particularly likely in the present volatile markets, if it is felt that offering the trade buyer's own equity is not appropriate for some reason. By doing so, stub equity may offer the following benefits:

Provide a hedge mechanism for retaining, in whole or in part, a continuing exposure to the performance of the target, encouraging otherwise reluctant shareholders to accept the offer.
Provide equality of treatment for shareholders even though it is likely that only certain shareholders will want to continue to participate and therefore elect for the stub equity alternative.
Reduce cash outlay and therefore financing costs.

What are CVRs?

A CVR is a generic term covering a variety of mechanisms constituting a commitment from a bidder to pay an additional amount, normally in cash, to the holder of the CVR in certain defined circumstances.

The value of CVRs represents the right to a potential payment on some future event and, if they are publicly tradeable, target shareholders may sell them to realise that value immediately.

CVRs have historically been used in takeovers to:

Provide protection against adverse movements in the bidder's share price (but only to target shareholders accepting the share offer) for an agreed period after closing (that is, a form of minimum or "collar" on the value of the share offer).
Give target shareholders an additional one-off payment on the outcome of a certain contingency, for example a substantial piece of litigation or the sale of a particular asset. (Unlike the EDF nuclear power notes (see below, How the EDF/British Energy deal unfolded), this type of CVR normally takes the form of simple unquoted contractual instruments).

There is now also a third option, which is at present unique to the EDF/British Energy deal (see below).

(See boxes, CVRs: UK examples and CVRs: international examples.)

How the EDF/British Energy deal unfolded

The EDF/British Energy deal took place as follows:

10 January 2008. The UK Government announced that new nuclear power stations should have a role to play in the UK's future energy mix alongside other low carbon dioxide sources. British Energy, the largest generator of electricity in the UK and owner of many of the sites expected to be suitable for the construction of new nuclear power plants in the UK, did not have the necessary financial resources to take on alone the task of constructing such new nuclear power plants, even though considerably healthier than at the time of emerging from its financial restructuring in 2005.
In connection with that financial restructuring, the UK Government received a contractual right, convertible at its election, at any time, into British Energy shares representing, by this time, approximately 36% of the enlarged share capital.
17 March 2008. British Energy announced that it was in discussions that might lead to a takeover offer, and conducted an auction in which EDF and a number of other major European energy companies participated.
September 2008. Following tense negotiations, EDF announced its recommended bid by way of a contractual offer, valuing the enlarged share capital of British Energy at about GBP12.5 billion (approximately US$17.5 billion).
An offer was the preferred route because it enabled the convertible interest of the UK Government to play a key role in determining the outcome of EDF's efforts to acquire control of British Energy. By contrast, under a scheme of arrangement, the holding of the UK Government, even once converted into shares, would have constituted a separate class and the UK Government's votes could not be included with those of the general class of shareholders entitled to vote on any proposed scheme of arrangement.
The offer terms included, as an alternative to an all cash offer, a lower cash sum combined with a "nuclear power note", which is a form of CVR linked to the output of British Energy's existing nuclear plants and wholesale UK electricity prices over a ten-year period (see box, Key features of the EDF nuclear power notes). British Energy shareholders opting for the partial CVR alternative could also elect to receive two additional nuclear power notes in lieu of part of the cash to which they would otherwise be entitled.
5 December 2008. To encourage early acceptance, the partial CVR alternative was shut on this, the first, closing date.
5 January 2009. The offers became unconditional in all respects with EDF having control of 94.7% of the British Energy share capital. Elections for nuclear power notes received before the shutting of the partial CVR alternative related to more than 207 million British Energy shares, of which nearly half were also for the additional CVR election. This easily exceeded the 40 million British Energy shares that EDF had set as a minimum threshold condition.

The inclusion of the nuclear power notes in the offer terms was instrumental in obtaining support from some of British Energy's largest institutional shareholders, bridging the value gap and allowing the British Energy board to recommend the proposed acquisition by EDF.

The use of these unique notes demonstrates that there exists a third use for CVRs. This use, which is more akin to stub equity, allows a continued economic exposure to the target's performance. However, unlike stub equity structures, the use of these unique notes avoids the need to provide the holders with certain other features that are associated with an equity investment such as voting or control rights. The nuclear power notes do not pay out only once, linked to a single contingency, but provide a form of ongoing economic interest.

Structural complexities

In accordance with Rule 16 of the Takeover Code, the nuclear power notes were offered to all British Energy shareholders (subject to certain geographical exceptions), although the expectation was that they would only be taken up by sophisticated investors in light of:

The complexities of the instrument.
The expected comparative lack of liquidity relative to British Energy shares.
The inherent uncertainty as to potential value during their lifetime.

The offer documentation, including the form of recommendation by the British Energy directors, sought to ensure that shareholders were made aware of these issues when making their investment decision.

The offering of the nuclear power notes had no impact on the cash confirmation exercise required under the Takeover Code, as for this purpose EDF needed to assume that there might be no elections for the nuclear power note alternative. However, to the extent that such notes were ultimately issued, this decreased the amount of cash needed to be provided, reducing some of the financing costs.

Initially, Lake Acquisitions, a newly incorporated subsidiary of EDF, was considered as the potential issuer of the CVRs offered as part of the transaction. However, this created a problem for those institutional investors classified as collective investment schemes.

Under the UK Financial Services Authority Collective Investment Schemes Sourcebook (the COLL Rules), collective investment schemes are subject to a number of restrictions, some of which affect only transferable debt securities, including not holding more than 10% of any one company's debt capital. As Lake Acquisitions had no debt securities in issue, this would have prevented certain of British Energy's shareholders from electing for the maximum number of nuclear power notes to which they would have been entitled. (For any single collective investment scheme, the most that it would be able to hold of the nuclear power notes would be 10% of the total issued by Lake Acquisitions, even if its shareholding represented more than 10% of the total issued shares and it wanted to elect for as many nuclear power notes as it could.)

To resolve this issue, EDF looked for an alternative issuer that had a substantial existing debt issue. While this would not remove the restriction, it meant that in practice it was no longer an obstacle.

Ultimately, Barclays Bank PLC (Barclays) agreed to issue the nuclear power notes to British Energy shareholders, in consideration for which it received equivalent CVRs issued by Lake Acquisitions. The linking of the nuclear power notes to the underlying CVRs issued by Lake Acquisitions in this way enabled Barclays to act as a mere conduit in the structure and thereby reduce its exposure and risk.

It was considered important from the outset, in order to ensure the attractiveness of nuclear power notes to British Energy shareholders, that the notes be admitted to trading on a suitable exchange, preferably in the UK. While stub equity deals are often unlisted (see box, Stub equity: UK examples), it was felt that this would not be appropriate for the nuclear power notes, as key shareholders would demand that there be a market for the nuclear power notes and therefore that the nuclear power notes should be quoted.

Unfortunately this proved to be less than straightforward. The listing requirements for the Official List of the UK Listing Authority and of AIM were not compatible with the proposed terms and structure of nuclear power notes. However, admission to trading on the PLUS-quoted market operated by PLUS Markets Group was possible and trading liquidity, whether on or off market, will be greatly assisted by the agreement of each of Merrill Lynch, BNP Paribas and JPMorgan Cazenove to act as market makers.

The offer of the nuclear power notes required the preparation of a prospectus. Although it is not unusual for shareholders of a target company to receive both an offer document and a prospectus in connection with a takeover offer where the choice of consideration includes securities, British Energy shareholders may initially have been somewhat surprised to receive an offer document from Lake Acquisitions, a subsidiary of EDF, and a prospectus from Barclays.

Behind the scenes, there was the need for contractual arrangements between Lake Acquisitions, EDF and Barclays to enable this to happen. These addressed issues such as:

Responsibility and liability for contents of the prospectus itself as well as for other documents and acts related to the takeover offer.
Undertakings in connection with the issue of the nuclear power notes and the CVRs issued by Lake Acquisitions.
The sorts of things that would normally be expected in any contract governing the issue of listed debt securities such as fees and expenses, conditionality, selling restrictions and termination.

The nuclear power notes themselves were issued by Barclays, which entered into a fiscal agency agreement with Computershare Investor Services PLC as registrar and paying agent. The nuclear power notes are linked to CVRs, which were constituted and issued by Lake Acquisitions with the benefit of a trust deed, and were guaranteed by another member of the EDF group. In addition, certain ancillary arrangements also needed to be entered into with a listing agent and other service providers.

The unique nature of the circumstances meant that such documentation was necessarily bespoke to the transaction. However, some of the complexities encountered arose solely as a result of the transaction's novelty and, as they have now been faced, solutions will be more readily available on future occasions.

Why EDF used CVRs

There are three key reasons why EDF ultimately preferred to offer CVRs rather than stub equity.

First, quoted CVRs, unlike their stub equity counterpart, need not provide the holder with any voting or control rights in relation to the business. As EDF adopted a contractual offer rather than a scheme of arrangement for the reasons described above, in order to increase the attractiveness of this proposal, EDF agreed, as part of the negotiations with the British Energy board, that the acceptance condition would be set at 75% rather than the customary 90%.

This meant that, at the time of making its offer, EDF could not be certain that it would be able to implement the statutory squeeze-out procedure and therefore, although it might successfully acquire majority control of British Energy, it might not be able to achieve 100% ownership. Offering stub equity would bring with it the possibility that EDF would face equity holder minorities at two levels in the target group:

First, at the Lake Acquisitions level in the form of holders of the stub equity.
Second, at the level of British Energy itself.

This would have meant that there were two potential levels at which issues of control rights and dividend leakage could have been relevant. The creation of the nuclear power notes meant that the possibility of these issues arising at the first of these levels was removed.

Second, as CVRs do not constitute equity (see box, Stub equity and CVRs: key similarities and differences), payments to holders are not dependent on the availability of distributable profits. It may also be the case that constructing a complex payment mechanism, particularly one that is restricted by reference to a particular aspect of the business or to specified assets, is easier for CVRs (for which it is merely a contractual matter). In the case of stub equity it would be more difficult, as the mechanism would constitute part of the share rights contained in the articles of association of the relevant company.

This is, however, a question of degree as it would be possible to devise tracker shares to achieve the same result, although there have not been any examples of quoted stub equity taking this form to date.

Third, EDF was concerned about the potential conflicts that could arise between the interests of itself as the main shareholder and those of the stub equity holders. Conflicts might, for example, arise in relation to the approach adopted on issues of safety of the nuclear plants, which could require substantial investment to be made or material shutdowns of the plant to occur, but which would be prejudicial to anyone holding an investment with an objective to maximise short term profits.

Directors of the relevant group company would be faced with having to reconcile such conflicting interests and potentially be exposed to claims by aggrieved shareholders for breach of duty. This risk is increased by the changes introduced in the UK Companies Act 2006, which have expanded the circumstances in which a derivative action may be brought by a shareholder on behalf of a company and have codified, and in some cases widened, the duties of a director of a company incorporated in the UK.

The issue of the nuclear power notes, as opposed to stub equity, avoids such problems as directors are only required to pay heed to the interests of creditors in situations where a company is on the brink of insolvency.

What next?

The success of EDF's nuclear power notes may lead other potential bidders to weigh up the respective merits of stub equity and CVR structures if they face a need to "bridge the gap" between their valuation and that of target shareholders or management.

It will of course be some years before the full impact on EDF of the nuclear power notes is known, that is, whether or not EDF is required to make significant payments under the notes. However, it is clear that, on this transaction, CVRs were the key to the success of the deal and without them the UK Government's policy objective of introducing a programme of new nuclear build in the UK might never have been met.

The authors advised EDF in connection with its recommended takeover of British Energy and the associated issue of CVRs.

Stub equity: UK examples

In the UK, the use of stub equity has a short but noteworthy history.

In many of the cases shown below, whether or not the stub equity was ultimately issued, the tactic of including it as part of the offer terms almost certainly enabled the successful bidder to win its battle for the target because those terms enabled it to count on the support of management or key institutional shareholders.

Date	Bidder	Target	Features of stub equity	Comment
October 2003	Grapeclose (Permira/Apax consortium)	Inmarsat	"Partial unit alternative" offered in an indirect parent of BidCo. Unlisted.	Bid was successful and stub was issued.
January 2004	Duelguide (Elliot Bernerd led consortium)	Chelsfield	Similar to Grapeclose offer above.	Bid was successful and stub was issued.
February 2004	Songbird (Morgan Stanley fund-led consortium)	Canary Wharf	Class B shares in parent of BidCo offered. AIM admission.	Bid was successful after auction process and stub was issued.
February 2004	CWG Acquisitions (Brascan Corporation led consortium)	Canary Wharf	Shares in vehicle, which was to be 100% owned by target shareholders and a shareholder in BidCo offered. AIM admission envisaged.	Unsuccessful competing bid against Songbird (above).
May 2004	Revival Acquisitions (Philip Green, Goldman, Barcap and HBOS consortium)	Marks & Spencer	Shares in BidCo to be offered. AIM admission envisaged.	The offer was pre-conditional on the recommendation of the M&S board, which was not forthcoming. The bid did not proceed to a Rule 2.5 announcement (an announcement of a firm intention to make an offer, as required under Rule 2.5 of the Takeover Code).
February 2006	Greg Dyke, Apax, Blackstone and Goldman Sachs consortium	ITV	ITV to retain listing and target shareholders to remain co-investors along with the consortium. Retention of existing listing envisaged.	The bid did not proceed to a Rule 2.5 announcement.
June 2006	Airport Development (Grupo Ferrovial led consortium)	BAA	Shares in parent investment company of BidCo offered. AIM admission envisaged.	Bid successful (in a competitive situation) but stub alternative lapsed as an insufficient number of shareholders elected to receive it.
Septem-ber 2006	Apax	Incisive Media	"Summer Partnership Interests" offered, indirect parent of BidCo. Unlisted.	Scheme was passed and partnership interests were issued.
May 2007	Apollo	Country-wide	Shares offered in an indirect parent of BidCo. Unlisted.	Scheme was passed and stub was issued (in a competitive situation).

CVRs: UK examples

Contingent value rights (CVRs) have been used in the UK relatively rarely, with only the CVRs issued by Publicis (in connection with its bid for Saatchi & Saatchi) being an example of the first type of traditional CVRs (see main text, What are CVRs?). The others, before EDF's bid for British Energy, have all belonged to the second category of traditional CVRs (see main text, What are CVRs?).

Date	Bidder	Target	Contingency
July 2000	Publicis	Saatchi & Saatchi	Changes in the market price of the bidder shares and/or the Euro/GBP exchange rate.
March 2003	Kondar	ENIC	Sale of the target's interest in Tottenham Hotspurs to a third party.
July 2003	First Group	GB Railways Group	Success of ongoing bids for various railway franchises.
January 2004	Pendragon	CD Bramall	Recovery on an application to HM Customs & Excise of overpaid VAT.
February 2005	Great Hill Partners	QXL Ricardo	Success of ongoing litigation.
September 2007	Venture Productions	WHAM Energy	Receipt of regulatory approval for certain projects.
September 2008	EDF	British Energy	Output of British Energy's existing nuclear generation fleet and UK wholesale electricity prices.

CVRs: international examples

Contingent value rights (CVRs) of both traditional types (see main text, What are CVRs?) have been used beyond the UK (see box, CVRs: UK examples). However, even in those jurisdictions where CVRs initially may have found some favour (mainly, the US and France) their usage to provide a collar on the value (that is, set a minimum value) of the bidder's share offer has dwindled. History has shown that they attract adverse trading behaviour of the very type they seek to provide protection against. The Lufthansa example, concerning the acquisition of Swiss Airlines, is an interesting variant of a CVR, using a basket of comparators as a means of seeking to curb such adverse effects.

Date	Country	Bidder	Target	Contingency
October 1989	US	Dow Chemical	Marion Laboratories	Bidder share price.
June 1994	US	Viacom	Paramount Communications	Bidder share price.
October 1994	US	Viacom	Blockbuster Entertainment	Bidder share price (but instead of cash, issue of further shares).
November 1996	France	AXA	UAP	Bidder share price.
November 2000	France/ Netherlands	France Télécom	Equant	Bidder share price.
September 2001	US/ Netherlands/Germany	Hewlett-Packard	Indigo NV	Increase in revenues over a set period.
March 2003	US	OSI Pharmaceut-ical	Cell Pathways	Approval by drug regulatory body.
July 2003	US	Symphony Technology	Capital Resources	Success of anti-trust litigation.
May 2005	Germany/ Switzerland	Lufthansa	Swiss International Airlines	Referenced to the performance of a basket of comparable airlines.
July 2008	Canada	Suroco Energy	Acquisition of oil fields owned by Alentar Holdings	Receipt of regulatory authorisation for oil fields.
September 2008	US	Ligand Pharmaceut-icals	Pharamacopeia	Licence, sale, development, marketing or option agreement in respect of a certain drug programme.

Stub equity and CVRs: key similarities and differences

There are a number of similarities but also important differences between stub equity and contingent value rights (CVRs). In terms of similarities, both stub equity and CVRs can:

"Bridge the value gap" between bidders and target shareholders.
Give target shareholders continuing economic exposure to the target.
Be quoted or unquoted (but a quotation adds further complexity and the burden of ongoing disclosure).

The differences between the two are set out below.

Stub equity	CVRs
Equity, therefore needs to carry some form of voting right/control unless unquoted.	Not equity, therefore freedom as to what rights provided.
Equity, therefore potential for dividend leakage. In addition, payments dependent not only on triggering the mechanism payment contained in the articles of association but also on availability of distributable profits.	Payment mechanism can be drafted flexibly and is not dependent on the availability of distributable profits.
Directors' duties: must have regard to all shareholders.	Directors' duties: only applicable to creditors when company on the verge of insolvency.
Generally relatively few restrictions preventing institutions from holding stub equity, particularly if quoted.	Ability of institutions to hold CVRs may require more analysis (see main text, Structural complexities).

Key features of the EDF nuclear power notes

The nuclear power notes used in the British Energy/EDF deal had the following key features:

A maturity of ten years.
In relation to contingencies, payments may be made annually on the basis of a formula linked to:
- the output of British Energy's existing nuclear fleet;
- UK wholesale power prices, subject to minimum, maximum and cumulative constraints (minimum payment may be zero).
The issuer was Barclays Bank PLC (back to back with the issue of equivalent instruments by EDF's bidding vehicle, Lake Acquisitions, to Barclays).
The notes were quoted on the PLUS-quoted market of PLUS Markets Group.

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