Will Bain-Huawei abandon its takeover of 3Com?

3Com yesterday announced that, along with Bain Capital and Huawei Technologies, it has withdrawn its filing to the US Committee on Foreign Investment (CFIUS), putting the outcome of the $2.2 billion joint takeover of 3Com by Bain and Huawei in question.

CFIUS has the right ôto suspend or prohibit any foreign acquisition, merger or takeover of a US corporation that is determined to threaten the national security of the United Statesö. The CFIUS approval was considered key for the acquisition of networking company 3Com, which was announced in September, to move ahead.

Under the takeover proposal tabled for CFIUS approval, Bain was to own 83.5% of 3Com and Shenzhen-headquartered Huawei was to own 16.5%, with an option to increase its ownership by another 5%. Bain will appoint eight of the 11 members of the board and Huawei will appoint three. On both parameters it seems clear that Bain will be in control of 3Com.

However, the objections being raised were not only about control, but about access. If the deal goes through, Huawei will have access to information with regard to 3ComÆs TippingPoint division, which sells anti-intrusion software to, among others, the US department of defence.

"We are very disappointed that we were unable to reach a mitigation agreement with CFIUS for this transaction," says Edgar Masri, president and CEO of 3Com Corporation in a written statement yesterday. It is not clear what the next steps will be, although 3Com also said: ôthe parties remain committed to continuing discussionsö.

David Trout, owner and publisher of The M&A Researcher, feel differently. ôIt is now abundantly clear that this transaction will not succeed with Huawei involved as a partner, regardless of concessions offered by the companies,ö he says. Trout suggests the only way to move the deal forward is for another investor to step in and buy HuaweiÆs interest and suggests that if this does not happen ôthe chances of this transaction being successfully completed appear to be virtually nilö.

The withdrawal follows supplementary information sent by 3Com to its shareholders on February 19, which added to its January 25 shareholder notification about terms of the deal. 3Com wrote that Bain and Huawei had, in June, indicated a valuation of 3Com without the TippingPoint division. In this scenario, the price being offered would fall from $5.30 per share to a $4.50-$5.00 range, making the total value of the deal (at 3Com's current equity base) worth between $1.8 billion and $2 billion. At the bottom end of that range, the valuation would be 17.5% lower than the $2.2 billion originally offered by the buying consortium.

3Com shareholders are scheduled to vote on the deal on February 29.

The takeover proposal has been mired in controversy in the US, where 3Com is headquartered and listed, ever since it was announced.

ôThis deal endangers our military and our security,ö said House of Representatives member Thaddeus McCotter in October in a clip broadcast on YouTube. ôIf CFIUS approves this sale and its accompanying sensitive defence technologies to Huawei, it will place in Communist ChinaÆs cyber-hacking hands some of the most sensitive technologies employed for our high-tech defence.ö

McCotter was voicing an opinion shared by a number of people in the US.

But Bain has compelling reasons to choose Huawei as a co-investor. The deal is a bailout of sorts for 3Com and HuaweiÆs presence would strengthen the combined entity. 3ComÆs China subsidiary, H3C, accounted for the US firmÆs entire 2007 profit. Huawei will be less inclined to compete with H3C if it is invested in the firm, via an equity stake in the parent. Further, analysts suggest HuaweiÆs partnership is critical for Bain to effectively create value.

ôNational security, real or hypothetical, is the hot button political issue at the moment,ö says Trout, commenting on why the Bain-Huawei investment has become so politicised.

And the way events have unfolded since the deal was announced have reinforced how high sensitivity runs in the US to perceived security threats.

"Bain Capital has the utmost respect for the mission of CFIUS to promote international investment while protecting our national security, and we continue to cooperate with CFIUS,ö Bain said as recently as last week.

Bain voluntarily submitted the deal to CFIUS for approval. Typically, deals are reviewed by CFIUS within 30 days. If questions still remain, CFIUS begins a secondary review which lasts 45 days. The M&A Researcher estimates the deal was submitted in early December and entered the second review period in early January. If CFIUS cannot resolve the outstanding issues and approve the deal, it will need to be referred to the US President himself for approval.

ôCFIUS will not approve the transaction as long as Huawei is involved,ö is TroutÆs view. ôThe White House will ultimately make the final decision.ö

Bain had been examining alternatives to secure the necessary approvals.

ôWe have put on the table robust mitigation proposals that offer significant structural and security safeguards to American national security interests,ö continued Bain in its statement last week. ôAt this sensitive time for the US and global economies, we think it is critical that responsible cross-border investments like the 3Com transaction be permitted to move forward on sound economic terms."

Specialists suggested that the ômitigation proposalsö could be an IPO of Tipping Point. But the markets arenÆt favourable for a listing. The Dow Jones index has dropped from around 14,000 points when Bain first announced the deal, to about 12,000 now. Any valuation estimates assumed for TippingPoint when the deal was contemplated would have to be scaled back, which in some sense penalises Bain and Huawei.

ôFrom the regulatory/political perspective it will not be considered æpenalisingÆ as it will be considered taking the appropriate measures,ö says Trout, while agreeing there is a financial implication.

And as 3ComÆs SEC filing indicates, the buyers had considered a scenario without TippingPoint, in which case 3Com shareholders will bear the brunt of the pain.

3ComÆs shares traded up to $4.90 in September but have been falling thereafter as the deal got stuck. 3Com fell 16% in early trading on Wednesday to $3.14 as shareholders got wind of the latest piece of bad news and traded down further during the course of the day to $2.87 at closing.

3ComÆs SEC filing details that a comprehensive sell-side process was run by Goldman Sachs on behalf of 3Com and the only concrete bid was from the Bain-Huawei consortium. In current market conditions, it seems unlikely that other bidders will be more aggressive. Even the indicative $4.50-$5.00 per share price range without TippingPoint is considerably higher than the current traded price.

The M&A Researcher has been among those suggesting that the deal may not sail through even without TippingPoint. In a deal update on February 13, The M&A Researcher called the sale of TippingPoint an ôinteresting gestureö but went on to say: ôwhether or not this proposal will convince the White House to consent to the transaction (assuming CFIUS defers the case upwards) remains somewhat of a difficult development to predictö.

Goldman Sachs has worked closely with 3Com since 2004 when it advised the US firm on the acquisition of TippingPoint. It continued with a buy-side role on 3Com's acquisition of a 49% stake in H3C for $882 million in 2006, then raised $430 million of debt financing for H3C in 2007 and is now advising 3Com on the current deal.

In an SEC filing, 3Com disclosed that it is paying Goldman Sachs $24 million for the current deal, a principal portion of which is payable on completion. Bain and Huawei are being advised by Citi and UBS. As the fees payable to all advisers will be significantly success-weighted, they are all invested in ensuring the deal gets done. None of the advisers agreed to comment.

ôEnsuring markets remain open to investment is every bit as important as ensuring that they remain open to trade, so we are also committed to focusing on maintaining and expanding investment flows between our two countries,ö said David McCormick, the US treasury under-secretary for international affairs, on January 30, referring to Sino-US relations.

China Inc is probably asking whether this commitment is a two-way street.