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May 31, 2008

Anatomy of a takeover

Sun Capital’s hostile takeover of Kellwood was gradual but dramatic

All happy companies might be alike, but all unhappy companies are unhappy in their own way. Kellwood Company, a Saint Louis-based maker of high-end women’s apparel, had posted a $66 million quarterly loss on September 6, 2007, sending its share price plummeting just 11 days before Sun Capital Partners made an all-cash tender offer for the company’s shares. Immediate challenges notwithstanding, Kellwood’s management and board were convinced that the five-year plan they had drafted would return enormous value to shareholders, says Howard Steinberg, a partner at McDermott Will & Emery in Manhattan. They opposed Sun’s offer, setting in motion what would be a lengthy period of negotiation eventually resulting in a deal. The many twists and turns of the transaction can serve as a good lesson for others in similar positions.

Perhaps the most dramatic event that can rock a board and management team is a hostile takeover attempt. But even wildly disruptive events such as takeovers unfold gradually over time. Sun’s takeover of Kellwood lasted nine months. It began in May 2007, when Sun filed its first 13D, and ended on February 6, 2008, when Sun sent a letter to all Kellwood investors asking them to tender their holdings for $21 per share.

The Kellwood deal – initially opposed by management and the board – follows a fairly standard script for tender offers. ‘With a tender offer, you really don’t need management’s okay because you’re going straight to the shareholders,’ says John Laide, product manager for FactSet SharkWatch. That said, Laide observes that ‘if the board doesn’t think the company should be bought at that price, it doesn’t make it any easier for the acquirer.’

A series of talks

According to Steinberg, whose firm represented Kellwood, there was no great concern when Sun filed a Schedule 13D in May 2007, reporting that it owned 5.5 percent of Kellwood’s stock: ‘At the time that it filed its first 13D, Sun said it didn’t have any particular plans or proposals with respect to Kellwood.’

Sun, a Boca Raton-based company with nearly $10 billion in equity capital under management, describes itself as a ‘hybrid’ private equity firm and operating management company. Historically, Sun has invested in underperformers and turnarounds, and 36 of its total 77 portfolio companies prior to the Kellwood acquisition had a consumer-retail orientation. Jason Bernzweig, vice president at Sun, did not return numerous calls for comment.

So what does a public company do when faced with an investor accumulating shares while denying any desire to acquire the company? On June 28, 2007 Kellwood’s senior management met with representatives from Sun. ‘That was a  get-acquainted introduction meeting,’ Steinberg says. ‘It wasn’t a meeting to discuss the sale of Kellwood but a chance for Kellwood to introduce itself to Sun on an investor relations basis.’

On July 26 Sun filed an amended 13D saying that its stock ownership now had hit 9.3 percent. ‘As the situation progressed and Sun made known its intentions to acquire Kellwood, the board really led the process,’ Steinberg says. ‘At some companies, the CEO and senior management lead the process with the board merely following along. In this case, the board was actively driving the bus.’

Kellwood did not welcome Sun’s acquisition proposal. It argued it could ‘create greater value for shareholders by being independent,’ Steinberg says, referring to Kellwood’s five-year plan to transform the business, which included selling operations such as its Smart Shirts division. As part of Kellwood’s strategic plan, it acquired Hanna Andersson, a popular designer of high-end children’s fashion, and Vince, a women’s sportswear line that sells at prestigious stores including Saks Fifth Avenue and Barneys.

When Sun finally sent a written acquisition proposal on September 18, 2007, ‘the company had been dealing with the presence of Sun since May and so it wasn’t a shock,’ Steinberg recalls. Sun made an all-cash offer of $21 per share for 100 percent of Kellwood’s stock. Sun emphasized that the offer represented a 38 percent premium over Kellwood’s closing price on September 18, the last trading day before Sun’s public disclosure of its acquisition proposal to Kellwood’s board of directors.

Cutting out the middle man

Next Sun established a website, www.kellwoodvalue.com, with the specific aim of ‘taking our proposal directly to [Kellwood’s] shareholders.’ The ‘welcome’ letter on the site noted ‘Kellwood’s continued unwillingness to enter into a constructive dialogue with us regarding our interest in acquiring control of Kellwood.’

Sun also voiced its opinion that shareholders should ultimately ‘have a say in how best to maximize value and choose for themselves between our offer, which delivers substantial, immediate and certain value, and Kellwood’s highly speculative five-year plan being pushed by management with a well-established track record of missing expectations.’ Specifically, Sun noted that Kellwood had lowered its guidance for sales and earnings in each of the last five years and that results still fell ‘consistently’ short of stated goals.

Putting up the defenses

Before Sun began acquiring shares, Kellwood had put provisions in place to protect the company in the event of a hostile takeover. ‘Most public companies, including Kellwood, give thought to protecting shareholders in advance of anybody showing up and making a potentially hostile, unwelcome or unsolicited offer,’ Steinberg explains. For Kellwood, these measures included a poison pill, a classified board and a super-majority provision for the approval of mergers or acquisitions.

Over the past few years provisions like these increasingly have raised red flags for shareholders. At Kellwood’s 2007 annual meeting, 88 percent of investors voted in favor of CalPERS’ board-declassification proposal, according to CtW Investment Group, which works with pension funds sponsored by unions affiliated with Change to Win (CtW). Kellwood had indicated a willingness to respect shareholders’ desires and to declassify the board, but not until after the 2008 director election.

CtW, which sent Kellwood a letter and posted it on the web on December 18, 2007, believes that Kellwood manifested a ‘constellation’ of troubling practices, says Michael Garland, CtW’s director of value strategies. In addition to Kellwood’s classified board, CtW cited a lack of independence among its advisers, chiefly Banc of America Securities, which had enjoyed a long-term business relationship with Kellwood. Because Banc of America and its affiliates derived considerable income from their relationships with Kellwood, CtW noted that these ‘relationships could be jeopardized by a change in control.’ Therefore, Banc of America, which declined to comment on record, would be unlikely to support a transaction.

Steinberg points out that Kellwood eventually hired Morgan Stanley and Sonnenschein Nath & Rosenthal for second opinions on financial and legal matters, respectively. ‘Bringing in financial and legal advisers without any history with the company made the board feel any decision was that much more independent,’ Steinberg says. On the other hand, he emphasizes that there were no ‘significant differences’ in the second advisers’ analyses.

CtW also criticized Kellwood for granting golden parachutes on July 17, 2007 to four senior executives who were not executive officers. The change-in-control agreements came just 39 days after Sun disclosed its 8 percent ownership.

Finally, Garland underscores that any one aspect of Kellwood’s behavior would have been acceptable, but that it was the combination that spurred CtW to air its concerns. ‘It’s a set of circumstances that paints a picture of an entrenched board going into the bunker to do everything it can to avoid being taken over,’ Garland maintains.

The role of the board

Although CtW faults Kellwood’s board for many of its governance practices, Steinberg sees the situation differently. He praises Kellwood’s directors for their involvement, noting that during the entire process anywhere from 15 to 20 board meetings took place. He strongly endorses such a hands-on approach: ‘What it does is it removes any connotation that somehow management might be acting in a way to protect itself rather than looking after the interests of shareholders.’ He continues: ‘There was never a time since I was involved with the company that the board was in a catch-up position. They never had to be brought up to speed. They were involved the whole way.’

Steinberg, who began working with Kellwood roughly 18 months prior to Sun’s arrival but whose law firm had a relationship with Kellwood that dates back to when it was founded by former Sears executives in 1961, says that his role was to give independent advice to the board. ‘In a situation like this, the role of outside counsel gravitates much more toward advising the board,’ Steinberg explains. ‘That becomes the focus as opposed to dealing day-to-day with management.’

According to Steinberg, Thomas Pollihan, Kellwood’s general counsel and corporate secretary, was involved closely as events unfolded. As a company employee, Pollihan dealt primarily with management, while Steinberg worked with the directors: ‘The board expects that outside counsel is going to be giving different kinds of judgments, even if in a particular situation those judgments may be different from what operating management might like to hear.’ Pollihan has since announced his retirement from the company.

Bringing up old wounds

One moral of the Kellwood-Sun story is that a hostile takeover means old controversies will almost certainly be rehashed. While Steinberg admired the caliber of talent on Kellwood’s board, CtW found conflicts of interest here as well. Prior to Sun’s acquisition proposal, CtW had taken Kellwood to task for its decision to reseat director Jerry Hunter after shareholders withheld 51 percent of their votes for his reelection at the 2005 annual meeting; the controversy originated over the fact that Hunter’s law firm provided legal services to Kellwood while Hunter served as chairman of Kellwood’s corporate governance committee.

Although Kellwood and its shareholders might not always have been on the same page, management and the board usually found agreement, observes Steinberg. ‘I’ve seen situations where there are strong differences of opinion between management and the board,’ he says, noting that ‘in this case there was no real dissension,’ as ‘management understood its role. It understood that as this situation developed it had to defer to the board. And the board took control of the process.’

A change in direction

Kellwood initially adopted an officially ‘neutral’ stance on Sun’s tender offer, while at the same time making it clear that it believed its five-year plan presented by management was the wiser course. After a long series of negotiations, Kellwood dropped its neutrality, endorsed the deal and a merger agreement was signed.

How does an acrimonious situation suddenly resolve itself? Like many aspects of the story, there are at least two sides of the tale.

Garland says he was surprised at the outcome: ‘Kellwood seemed to be headed in one direction so resolutely, and then threw up the white flag.’ He speculates that ‘pressure from shareholders,’ including CtW and others who might have weighed in behind the scenes, tipped the balance. ‘I don’t know if one of their advisers gave them religion, but something definitely happened,’ Garland says. ‘It may have been the cumulative effect of shareholder opposition; it may have been better legal or financial advice; or [it may have been] all of those things combined.’ 

Steinberg paints a more prosaic picture of Kellwood’s decision to endorse Sun’s offer. He notes that many practical details had to be ironed out before an agreement could be reached, including Sun’s due diligence request, which ultimately was dropped.

More importantly, though, Steinberg denies that shareholder opposition had any influence on the ultimate recommendation of either management or the board, an assertion arguably supported by research. Though shareholder activism has garnered a great deal of media attention recently, Jim Mallea, product manager at FactSet MergerMetrics, says it rarely squelches – or even forces through – a deal. In fact, year after year, he maintains, there is approximately a 95 percent chance of a deal closing after a definitive agreement has been signed. And even if the deal is killed, shareholder opposition is usually not the reason, he says.

Meanwhile, Pavel Savor, assistant professor of finance in the University of Pennsylvania’s Wharton School of Management, also shares in the opinion that the denouement of the Kellwood acquisition was fairly typical. ‘It’s not that uncommon for a firm to initially resist a deal and then negotiate over the fine points and go with it,’ he says. ‘Very often the target company changes its mind.’

In the end, no one knows whether Kellwood’s five-year plan would have created meteoric success or fizzled completely. Like many takeovers, all that is clear is that Kellwood’s directors resigned, its corporate secretary retired, shareholders walked off with $21 per share and Sun expanded its portfolio of companies under management. And even though Steinberg and Garland put a different spin on events surrounding the Kellwood acquisition, both would agree that ultimately, a good conclusion was reached.

Elizabeth Judd

Elizabeth Judd, a graduate of Yale and University of Michigan, regularly writes about investor relations, corporate governance and new fiction