Reading the Fine Print in the Heinz-Kraft Deal
The $70 billion combination of Kraft and Heinz is a big, big deal, but it is perhaps most interesting for how the parties have agreed to run the combined company.
It is also an odd deal from the start.
Kraft shareholders will receive one share of Heinz stock for each share of Kraft stock. This is par for the course. The unusual part is that Heinz is private and will publicly list its shares in connection with this transaction.
This immediately raises valuation issues.
Because Heinz shares do not trade in the market, their value is uncertain. Kraft, therefore, took a leap of faith in accepting the offer. This may not have been a huge leap since you can pretty much assume that Heinz would be priced similarly to Kraft in terms of multiples to earnings and revenue. In fact, since Heinz is better-run, it may even be priced higher. These are numbers that the investment bankers can easily compute.
Still, the owners of Heinz — Berkshire Hathaway and the Brazilian private investment group 3G Capital — are notoriously good bargainers. And
Warren E. Buffett, the head of Berkshire, has always complained that offering stock to buy companies is foolish since it dilutes your own interest. He has said that it only makes sense if you are getting a good deal and the company is valued at least as much as the stock being given. Not only that, but Heinz is private and so Mr. Buffett and 3G have the best knowledge, and in some cases, the only knowledge, on Heinz’s value.
This may make you queasy about the deal Kraft struck, but the market seems comfortable with it. Kraft’s stock surged 36 percent on Wednesday, the day of announcement. We’ll see if the market is right as Heinz will have to disclose significant amounts of operating information in connection with the listing of its shares and completion of this deal.
The Heinz-Kraft combo is also notable in that it is specifically structured to keep Berkshire and 3G in control.
If Heinz had paid all stock, then 3G and Berkshire Hathaway would have lost control of the combined company by owning less than 50 percent. That’s the reason for the added $10 billion, or $16.50 a share, dividend, financed by Berkshire Hathaway and 3G. This kept 3G’s and Berkshire’s combined ownership of the new company at 51 percent.
Why is the cash paid as a dividend and not just directly to Kraft shareholders as cash? I am not sure why. But it may have to do with the fact that about 30 percent of the offer price is being paid in cash. Kraft does not want to trigger a buyback of its debt. But a very technical tax and structuring point is that you can’t pay that much cash in the merger and not trigger the debt buyback.
(If you are a deal lawyer, here are the even more technical details. Heinz is acquiring Kraft through a merger of Kraft with a Heinz subsidiary. When the subsidiary and Kraft merge, only one survives. The other’s assets and liabilities are transferred to the survivor. But under the tax rules, if Heinz pays this much cash and Kraft is the surviving company in the merger, then the stock portion being paid to Kraft stockholders is taxable. If, however, the money is paid as a dividend, the merger can still be structured so that Kraft is the surviving company and the stock part is tax-free. And Kraft needs to be the surviving company, otherwise it will have to refinance its debt at a significant cost.)
Once the transaction closes, 3G and Berkshire will have control over the company. According to reports, Mr. Buffett will appoint three directors and 3G another three. Five other directors will be appointed by Kraft. But don’t be fooled. Berkshire and 3G can simply act together and replace the Kraft directors at whim.
This control can be exercised at any time. The certificate of incorporation of the new company is being amended to allow shareholders to act by written consent. Under the certificate, 3G and Berkshire acting alone as majority shareholders can remove directors at any time if the majority of the board approves it. Without board approval, directors can be replaced by 3G and Berkshire at any annual meeting.
With 3G and Berkshire in control, this might leave Kraft shareholders wondering what protections they have. Sometimes, in a case like this you will see minority protections in the certificate of the surviving company. These can include minimum pricing requirements if the controlling shareholder tries to purchase their shares. It can also include a requirement that the board include independent directors. But in this case, there are none of these included. Shareholders will instead have to rely on the basic protections afforded by Delaware, where the combined company will be incorporated.
The bottom line is that this will be a company run by 3G and Berkshire with little input from Kraft shareholders. Expect huge cost cuts to get that$1.5 billion in annual cost savings that Heinz expects. And remember, Kraft executives — 3G executives fly coach. Enjoy!
To appeal to Kraft, the parties have agreed that the headquarters for the combined company will be in both Pittsburgh and Chicago for the time being, something that is not bound to last given the cost-cutting penchant of 3G. The combination agreement among the parties states that the two headquarters approach will take effect when the deal closes and ”following” that time. But what does following mean? A day? A year? Forever? And who would complain? Since the merger agreement doesn’t allow anyone to enforce the two headquarters provision, no one can complain if Heinz moves everything to Pittsburgh (or vice versa). Additionally, companies will sometimes make a contractual commitment to continue to support charities in their hometowns, as occurred when Berkshire Hathaway bought Wrigley. This is not the case here. Instead, Heinz and Kraft said they remain “committed” to their community charities, but did not contractually commit to anything.
Still, 3G and Mr. Buffett did not move Heinz abroad. Mr. Buffett would not want to be seen as arbitraging tax too much. (He did participate in the Tim Hortons deal that moved Burger King to Canada, though that could be explained by the fact Tim Hortons was the bigger company.)
Both companies are in the packaged food business, so antitrust issues may arise in this transaction. Heinz has agreed to take all steps to clear the transaction with the antitrust authorities, including divestitures, except as would have a “material adverse effect” on the combined company. This is what is known in the industry as a modified hell-or-high-water provision since it requires Heinz to take some steps, but not every step, to satisfy the authorities. The merger agreement does not define a material adverse effect. But based on precedent, we are talking about the possibility of billions in divestitures before the company is materially harmed. This provides Kraft with a lot of cover to get the deal done without the antitrust authorities blocking it or Heinz refusing to settle. Still, there is no termination fee to be paid to Kraft if this deal is blocked.
The fact there is no termination fee payable by Heinz didn’t stop the parties from negotiating a $1.2 billion termination fee paid by Kraft if another bidder steps in. This is a high fee — 4 percent of the transaction value — particularly since it appears that Kraft was not shopped to other potential bidders before the transaction with Heinz. But Kraft is incorporated in Virginia. Presumably, the judges there are a bit more lenient than in Delaware, which probably would have approved this. Chalk it up to Mr. Buffett’s magic touch in negotiating deals that are almost never trumped.
Finally, on Wednesday, Kraft amended its bylaws to ensure that all litigation is filed in Virginia. This is a response to the fact that according to at least one study, 95 percent of the deals last year attracted litigation.) And this one is likely to draw lots of suits since it is so big. Additionally, it is unclear how much the two sides negotiated over price.
This type of bylaw is common these days, but doing it in anticipation of litigation is risky. According to Deal Point Data, 24 companies about to be acquired have done so over the past three years. But at least one court has struck down this type of forum selection provision when it was done in anticipation of lawsuits.
Still, while litigation is likely, it won’t stop the transaction. And with Mr. Buffett’s magic touch, nothing else probably will. Kraft shareholders should get ready for life under their new leaders.
Correction: March 27, 2015
An earlier version of this post referred incorrectly to the action Kraft took to ensure that all litigation is filed in Virginia. It amended its bylaws, not its certificate of incorporation.
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