Mall REITs: Unibail-Westfield and the Retail Segment
An out of the blue multi-billion dollar acquisition, history has shown, has a tendency to kick start an otherwise dormant segment of the real estate market and provide the boost needed for a turn-around. In fact, last month, we wrote about the merger between LaSalle Hotel Properties and Blackstone which was responsible, in large part, for the 11.9% returns posted by the Lodging REIT sector in the month of May. Typically, such an acquisition inspires institutional investors or changes the collective perception of the market, but the mall REIT sector seemed largely unaffected by the closing of the largest retail real estate acquisition ever, the acquisition of Westfield Corp. by Unibail-Rodamco SE. Unibail’s portfolio is now valued at roughly $72 billion, consisting of 102 shopping malls, 13 properties and 10 convention centers in Europe and the U.S.
The agreement for Unibail to purchase Westfield for $15 billion was announced in December 2017, approved by shareholders in May 2018, and closed in June 2018. While the consideration offered to Westfield shareholders represented a slight premium over market prices, there was some doubt cast on whether the deal would be finalized. Following the deal announcement in December, Unibail shares steadily declined, reducing the original purchase price by more than $1 billion.
Capital markets seemed to disfavor the merger, largely because of the debt position that Unibail needed to pull it off. Before the acquisition, Unibail maintained a 33% loan-to-value ratio. Following the merger, Peter Papadakos of Green Street Advisors puts that number at close to 43%. In buying Westfield, Unibail’s debt will grow to 11 times EBITDA, up from 9 times, according to Green Street. The CEO of Unibail acknowledged as much, noting that the company will need to sell non-core assets from the existing Unibail portfolio and the recently acquired Westfield properties in order to shore up the company’s balance sheet.
If Unibail’s debt load wasn't enough, markets didn't ignite over the news of the Unibail-Westfield merger because of the obvious global threats faced by Mall REITs and retail centers, generally. The rise of e-commerce and digital technologies are fundamentally reshaping consumer expectations and shifting the function of stores toward useful and entertaining customer experiences. Fortunately, Westfield had been reducing its retail exposure in favor of residential and entertainment properties focused in high-income areas with strong population density. Westfield’s former CEO Peter Lowy believes that the real challenge going forward will be to “keep the mall relevant.” A nod, no doubt, to the unyielding market concerns about the health of the mall business.
As valuations for class-B and class-C properties have declined, REITs holding mainly class-A space for malls have suffered in the downdraft. One theory is that institutional investors have been too quick to lump class-A mall assets into the class-B and class-C category such that the entire asset class now suffers from the indelible mark that e-commerce has left on the broader mall and retail segment.
Amidst the doom and gloom, there may be an upside to the Unibail-Westfield merger. For months now, market commentators have been trying to parse the distinction between class-A malls and the less attractive class-B and class-C malls, which tend to be located in semi-rural or suburban areas and suffer from over-reliance on anchor tenants and exposure to box-store failure. Nora Creedon, a managing director at Goldman Sachs observes that “within various sectors, there are some opportunities emerging worth watching, such as the insufficient differentiation between high-quality [specifically naming class-A malls] and low-quality assets. We believe this is an evolution of retail, not the death of retail and that negative sentiment has made valuations very attractive for high-quality retail REITs.” Fortunately for Unibail, 85% of the assets in the Westfield portfolio are considered flagship, class-A properties.
This makes for an interesting position for Unibail. Unibail’s strategy, as both a buyer and a seller, may be difficult to achieve in the current market given the lack of appetite for lower-quality retail assets. Because of its debt-heavy balance sheet, it will be dumping its under-performing assets into a market that is buying exclusively class-A, if at all. On the other hand, if retail real estate has been overly generalized as a tainted asset class due to the specter of e-commerce, Unibail may be cashing in on Westfield’s profusion of class-A malls at an ideal time.
Fifth Circuit Vacates U.S. Department of Labor's Fiduciary Rule
On June 21, 2018, the United States Court of Appeals for the Fifth Circuit officially vacated the Department of Labor’s (the “DOL’s”) Fiduciary Rule. This decision was somewhat expected after the DOL indicated that it would not challenge the court’s March 15 decision in which it found the rule “unreasonable.”
The 2016 Fiduciary Rule expanded the category of advisers who were considered fiduciaries with respect to plans subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and individual retirement accounts (“IRAs”). The Fiduciary Rule generally required that financial services advisers act in the best interests of their clients by applying a higher standard than the rule that previously applied to investment advisers. It also established prohibited transaction exemptions (“PTEs”), including the “best interest contract” or “BIC” exemption, in order to allow service providers who became investment advice fiduciaries under the new rule to continue receiving compensation. Since President Trump took office, the Fiduciary Rule has been the focus of significant attention, and several court cases challenging its validity were filed.
The Fifth Circuit’s decision to vacate the Fiduciary Rule has created legal ambiguity as to who qualifies as a fiduciary with respect to ERISA plans and IRAs. Until further guidance is provided, the pre-Fiduciary Rule “five-part test” devised by the DOL in 1975 must now be followed for purposes of determining who is a fiduciary. [Providers] that previously relied on the BIC exemption are now faced with the options of either withdrawing from fiduciary status or to rely on the Field Assistance Bulletin 2018-02 (the “FAB”). In the FAB issued on May 7, 2018, the DOL took the position that investment advisers can continue to follow its prior advice in the rule entitled “Definition of the Term ‘Fiduciary’; Conflict of Interest Rule -- Retirement Investment Advice,” where the DOL stated that it “would not pursue claims against fiduciaries who were working in good faith to comply with the fiduciary rule and applicable provisions of the PTEs, or treat those fiduciaries as being in violation of the fiduciary rule and PTEs.”
REITs should be aware that, as a result of the Fifth Circuit vacating the Fiduciary Rule, exemptions such as the BIC exemption as well as certain other protections may no longer be available. We will continue to monitor developments and are happy to assist you with any questions you have about the Fiduciary Rule and the new state of affairs following the Fifth Circuit’s decision.
REIT Going-Private Transactions
Spencer Johnson, Tony Rothermel, Audrey Rogers
Current market conditions have set the stage for a wave of REIT public-to-private transactions. For private equity funds, flush with record levels of cash, REITs trading at a discount to net asset value represent an attractive investment opportunity. This article provides an overview of a REIT take-private transaction, highlighting key considerations that shape the process.
Take-Private Process – Overview. The take-private transaction begins with either the target board’s decision to sell or an initial approach by a potential acquiror. During the pre-financial crisis wave of REIT activity, most targets ran a traditional auction process, hiring an investment bank and contacting potential bidders. In 2018, we have seen an increase in the number of take-private transactions initiated by an unsolicited bid or initial approach from a private equity fund.
For both the target and potential acquiror, moving quickly at this phase is critical, regardless of how the decision to sell is initiated. Information leakage and rumors are likely to result in the target inadvertently or prematurely placing itself “in play”. Once the target is in play, it is often difficult to pull back as a practical or market matter.
Market Check – Auction vs. Negotiated Sale. In response to an unsolicited bid, the target board may choose to negotiate with the unsolicited bidder or instead solicit other bidders in a pre-signing auction. Fiduciary obligations imposed on the target board means that the sale of every public company will include a market check, whether pre- or post-signing, including through the absence of preclusive lock-up arrangements.
In this context, a key factor in the board’s decision is the universe of potential acquirors, which may be quite small depending on the size of the target and the diversification of its portfolio.
In some instances, the target board may choose to actively shop the company after signing a definitive agreement through the means of a “go-shop” provision. Go-shop provisions empower the target and its advisors to actively solicit a superior bid for target shareholders for a specified period immediately after signing a deal. This approach is customary in the context of a related-party transaction, such as an external manager buying its managed REIT, where the related acquiror has intimate knowledge of the target and its assets.
Even without a go-shop provision, the target board is provided with a “fiduciary out” that would allow it to terminate the initial agreement if presented with a superior offer. Accordingly, the acquiror will negotiate certain deal protection devices, including a “break fee”, or an agreed-upon percentage of the overall transaction value payable by the target if the target terminates the proposed transaction. What constitutes a superior proposal will be heavily negotiated by the parties. In addition, “matching rights” granted to the original acquiror will be heavily scrutinized.
There is no one-size fits all process for take-private transactions. Delaware and Maryland courts give the board broad discretion to implement the process which they judge best to maximize shareholder value. Target boards will carefully consider the full range of alternatives, including a pre-signing full auction, limited auction, accepting a preemptive bid, go-shop provisions, and low break-fee deals, to determine which option is most likely to maximize shareholder value under the circumstances.
Negotiating the Definitive Agreement – Special Committees. Typically, a take-private transaction involves a controlling shareholder or management insider acquiring the target it controls. To avoid any perceived conflict of interest, the target board typically establishes a special committee of independent directors, or non-management directors unaffiliated with the controlling shareholder, to retain advisers and negotiate the transaction.
Once the target board or special committee decides to pursue a transaction, the target and successful bidder will conduct due diligence and negotiate the definitive transaction agreement.
Many buyers, private equity funds in particular, seek to retain the target REIT’s senior management. The target board or special committee should insist that management be excluded from negotiating the potential transaction, or discussing future employment arrangements with the private equity fund, until the parties have reached a definitive agreement on the economic terms of the deal.
Post-Signing – Shareholder Approval. The vast majority of REIT take-private transactions are structured as a one-step merger. For these transactions, the target will prepare and file a proxy statement with the SEC and mail to target shareholders ahead of the annual shareholder meeting. For a Delaware target, a one-step merger must be approved by a majority of outstanding shares (or a higher threshold if specified in the certificate of incorporation). For a Maryland target, the merger must be approved by holders of two-thirds of outstanding shares (or the threshold specified in the REIT’s declaration of trust, but never less than a majority). This post-signing process will generally take three to four months.
The majority of take-private transactions are challenged by shareholders, on claims that the target board breached its fiduciary duties and that insufficient disclosure was provided to shareholders to make an informed decision to approve the proposed deal. Shareholder litigation may require payment in the form of settlement or could result in additional disclosures in the proxy statement, delaying the closing. Courts in Delaware and Maryland will generally respect the board’s decision if the record demonstrates that an appropriate and thorough process was followed, including with respect to addressing any conflicts of interest. The target board and special committee processes should be well-documented, which will allow all parties to minimize the risk and cost of litigation.
There is no single process by which REIT take-private transactions are initiated and negotiated. However, so long as REITs trade at a discount to net asset value and private equity groups are fully capitalized and searching for investment opportunities, the trend of unsolicited privatizations of publicly-traded REITs is certain to continue.