Closing valuation gaps, unlocking value

The use of special dividends in public M&A 10 min read

The current Australian M&A landscape continues to be marked by a tough valuation environment, with bid-ask spreads, interest rate uncertainty and an uncertain macroeconomic backdrop making the completion of transactions difficult. The traditional tools available in private deals to address these issues (think earnouts, deferred consideration) are not so simply implemented in public transactions. Amidst these complexities, we are observing bidders and targets increasingly turn to the use of special dividends in their dealmaking toolkit to bridge that valuation gap. The use of special dividends may improve the value proposition of a bidder's offer by releasing accumulated profits and franking credits to existing shareholders prior to the sale completing.

In this Insight, we consider the use of special dividends in public transactions in providing parties with price flexibility and delivering greater value to shareholders, ultimately, to bridge valuation gaps and deliver successful transactions.

Where and how have they been used in practice?

Special dividends are increasingly being utilised by bidders and targets. We call out below some of the more recent cash and scrip transactions in the market that have included special dividends.¹

Navigating special dividends

With these use cases in mind, we set out below certain key issues and considerations that bidders and targets alike must grapple with when adopting special dividends in transactions.

Conditionally

The attractiveness of a bidder's offer to target shareholders can be correlated with the degree of certainty bidders and targets can afford shareholders at announcement that a special dividend will be declared and paid. Equally, target boards should not fetter their discretion, or commit at announcement to declaring a special dividend (particularly where the period between announcement and payment of a special dividend may be significant, eg a number of months). This is a balancing of competing interests. By way of example, Invocare's announcement of its non-binding indicative offer and exclusivity arrangements with TPG suggested the amount, declaration and frankability of any special dividend are only 'expected'. While certainty may have its allure, conditionality should be preserved to navigate the risk of the unexpected between announcement and declaration. Simply put: directors should exercise caution when committing to the payment of future dividends that may at that time put them in breach of their directors' duties or at law.

Form of funding

Target company liquidity may be a concern when committing to the payment of special dividends. However, in meeting these concerns, target boards may consider utilising forms of bidder financing. Such funding waylays the potentially significant outlay of funds associated with a target-funded dividend and can assist to avoid any apparent risk of material prejudice to the company, its shareholders or creditors. A bidder-funded dividend, as in the Uniti scheme, by way of consideration in advance or unsecured loan and which can be provided on desirable terms (eg interest-free, unsecured and subordinated to the target's other debt facilities) is a desirable option (and by no means the only option) for target boards to consider. But, beware the tax pitfalls with bidder-funded special dividends, as discussed below.

Whether special dividends are a form of prohibited 'financial assistance' by targets to bidders remains an open question that needs to be considered. Even so, various structuring methods can and do navigate the threshold issue of whether special dividends are prohibited 'financial assistance.' Indeed, prior agreement with target boards that officeholders provide evidence as to financial health, adequate target board resolutions or the adoption of a target shareholder approval 'whitewash' are means by which parties can obtain comfort.

Tax considerations

Typically, target companies attach franking credits to the special dividend so that it is fully or partly franked. The use of special dividends can improve the bidder's offer by allowing qualifying Australian tax resident shareholders to obtain the benefit of franking credits in the target.

ATO ruling

Target companies will usually apply to the ATO to confirm (by way of a class ruling) how a franked special dividend paid in connection with the scheme would be subject to tax for target shareholders. In particular, the ruling would usually consider the following key issues:

• First, does the special dividend form part of the 'capital proceeds' received by a shareholder for the disposal of their shares in the target company?
• Second, do the franking credits attaching to the special dividend pass to target shareholders?

Indicative timetable for a scheme

An indicative scheme timetable for the payment of a special dividend in the context of a scheme (taking into account the key dates described above) could be as follows:

Tax reform: new tax integrity rule

Whilst the ATO has issued class rulings in favour of the use of special dividends in M&A in recent times, it is an area to watch. The Government's proposed new integrity measure—which applies to special dividends funded by capital raising—could treat a special dividend paid in connection with a scheme as ‘unfrankable’ where the special dividend is funded directly or indirectly by a ‘capital raising’.

The key question in this context will be: how is the special dividend funded? Does the funding involve the issue of an ‘equity interest’ (for tax purposes) by any entity—eg the target, the bidder or anybody else? The ATO has previously flagged the possibility of applying the new integrity rule in this context.⁹

The proposed integrity measure is currently being reviewed by the Senate and may be subject to change. The Senate Economics Legislation Committee released a report indicating that while the Senate was supportive of the policy rationale behind the measure, it recommended the Government review the scope of the measure to ensure its targeted application.

ATO consultation: capital management

The ATO recently announced a public consultation process in relation to public listed companies undertaking certain capital management activities.

Relevantly, the ATO has asked for submissions on the utility of existing public guidance materials for dividends paid in connection with a scheme of arrangement, including whether there are other issues for which public guidance should be provided by the ATO.

Takeaway

Bidders and targets are looking for additional ways to unlock value for shareholders and to bridge bid-ask spreads in public transactions. Too often, we are observing transactions go cold, whether because of opportunistic bids being rebuffed by target boards, the increasing cost of debt or bidder boards/investment committees unable or unwilling to hit a target board's view on value. In these circumstances, special dividends and the value they can deliver in cash and franking credits may be the additional value you need.