In In re Appraisal of PetSmart, one of Delaware's largest appraisal litigations in history, the Delaware Court of Chancery held that the deal price in PetSmart Inc.'s going-private transaction was the best evidence of fair value. This decision, along with the Court of Chancery's recent decision in In re Appraisal of SWS Group, where the court held that fair value was less than the deal price, will likely bring joy to deal lawyers across the country while confounding the plaintiffs bar.
In PetSmart, Vice Chancellor Joseph R. Slights III was faced with petitioners seeking appraisal from a private equity acquirer's acquisition of PetSmart, which cashed the public stockholders out for $83 per share. PetSmart's merger with BC Partners came after the company analyzed its strategic alternatives and ran a sale process that included contact with 27 potential bidders. BC Partners made the best "final" offer to acquire the company, originally at $82.50 per share, but was subsequently increased to $83 per share. The merger closed in March 2015. The petitioners declined the merger consideration, instead opting to pursue their appraisal rights. During a four-day trial, petitioners submitted their discounted cash flow analysis which stated that fair value of the company was $128.78 per share. That represented a total acquisition cost of $4.5 billion and was approximately 45 percent greater than the merger price. In contrast, the company contended that the deal price was the best evidence of fair value.
In analyzing the parties' disparate valuations of PetSmart, the court considered three issues at the outset. First, the court asked whether "the transactional process leading to the merger fair, well-functioning and free of structural impediments to achieving fair value for PetSmart." Second, the court considered whether "the requisite foundations for the proper performance of a DCF analysis sufficiently reliable to produce a trustworthy indicator of fair value." And third, the court inquired whether there was "an evidentiary basis in the trial record for the court to depart from the two proffered methodologies for determining fair value by constructing its own valuation structure."
Regarding the first issue, the court held that the auction process was fair and generated a fair value for the company. In support of its finding that the sale process generated fair value, the court noted that PetSmart's board considered a sale of the company as a potential outcome in its strategic alternatives analysis, not a fait accompli. The board did not rush the sale process, hearing from 27 potential bidders, entering into nondisclosure agreements with 15 parties, entertaining bids from five parties with four bidders topping $80 per share and the company was even receptive to bids from its market competitor. Finally, the company's banker was able to negotiate an increased offer from the highest bidder. These factors allowed the court to find that the process was well-functioning and achieved fair value for the company's stockholders.
In consideration of the parties' DCF analyses, the court found management's projections unreliable, rendering the DCF analyses "meaningless." While the DCF is widely utilized in appraisal proceedings, it is only as useful as its inputs. Where, as was the case in PetSmart, the management projections are deemed unreliable, the court will look to other metrics to determine fair value. In its decision, the court discussed prior cases in which management projections were deemed unreliable where "'the company's use of such projections was unprecedented, where the projections were created in anticipation of litigation, where the projections were created for the purpose of obtaining benefits outside the company's ordinary course of business,' where the projections were inconsistent with a corporation's recent performance, or where the company had a poor history of meeting its projections." Those issues were all present in this case. Reliable projections should reflect a company's "expected cash flows" and not simply "hoped for" results. Of particular note, the court looked to post-closing evidence in analyzing the reasonableness of management's projections. While this court historically relies upon information "known or knowable" at the time of the merger, the court analyzed the post-closing comparable stores sales growth and EBITDA and compared those figures to the projections used in the sales process, finding that the company was "massively underperforming" in certain areas. This analysis led the court to reject the petitioners' contention that post-closing evidence demonstrated the reliability of the projections. The court also held that the DCF analyses offered by the parties that relied on nonmanagement projections were also unreliable. The court held that a DCF utilizing projections reflecting assumptions on how PetSmart would be run after the merger did not reflect fair value at the time of the merger.
As to the last issue, the court held that there was no evidentiary basis necessitating the court to construct its own valuation structure. Based on the frailties of the management projections, the court did not believe it could credibly adjust those projections in order to arrive at a reliable and useful DCF analysis. Interestingly, in the court's analysis of fair value, it rejected the argument that a financial buyer's price, which was a product of an LBO pricing model, cannot represent fair value.
The key takeaway from PetSmart appears to be that the Court of Chancery will still defer to the deal price where the evidence indicates that the merger was a product of a robust sale process that led to a third party acquisition. The DCF, while remaining the gold standard in the Court of Chancery, is only as useful as the projections it relies upon. This decision provides helpful guidance to practitioners in determining whether issues relating to projections will render the projections unreliable in the court's eyes.