The astute Going Private reader will recognize, on behalf of the private equity audience at the Shakespearian play of the marketplace, the character of Polonius. Loud, distracting, full of unsolicited advice that issues forth almost constantly from his mouth no matter the circumstance, often appearing in places he is decidedly not wanted, always determined to become the center of the stage, usually bearing evil tidings, typically meddling in the affairs of the other characters and, just occasionally, hiding behind the wrong draperies at exactly the wrong time. So tedious does his intrusive toiling become that it is not long before the audience wishes him a speedy, and preferably painful, exit. For the private equity world Poloious is, of course, the activist investor.
Increasingly, activists and private equity have become at odds. This is particularly so in going private transactions. Activists have begun to ask serious questions about auction processes as well as the prices being paid for publicly held firms. "Why," the question goes, "should we sell you this firm cheaply today so you and your private equity partners can make hundreds of millions later when you re-offer it publicly? We are leaving a lot of value on the table. We, and the other public shareholders," (activism can be a highly populist pursuit, but only when the institutional shares are already a tight proxy race) "are being cheated."
While I am generally sympathetic with the activist cause and I believe shareholder activism serves important (nay, critical) purposes in the public and private capital markets, this argument is about as compelling as Martin Short playing in the role of Stalin.
A close friend of Going Private and activism manager at a fund with activist tendencies points to the latest Clear Channel spat as a case in point. Bain Capital and Thomas H. Lee Partners have posted a $39.00 per share bid for Clear Channel, up from their original bid of $37.60 per share. ISS opposed the original bid as have a number of large shareholders, of which Fidelity seems the be the loudest.
Clear Channel makes an attractive target for a bit of modern day greenmail. Under Texas law two thirds of the shareholders must approve the transaction. Distinguish this from two thirds of the votes cast. Uncast votes will cut against the merger. This gives minority holders a strong position and makes for a particularly retail-oriented campaign.
The problem with these kinds of battles, however, is more about risk than price. Or, rather, while price is the public face of the issue, the more important and latent issue is risk. In order to pay $40 per share (the rumored "magic number" for Clear Channel) Bain and Thomas H. Lee will have to pile on more debt. This being the fourth serious bid for the company, one might imagine that a lot of pencil sharpening has already gone between the debt capital markets guys and whoever the Debt Bitch over at Bain is. (Hope she doesn't have rug burns yet). As should be obvious, default risk increases as the debt load gets higher. Bets on the company's future performance are, in effect, being leveraged to pay current shareholders.
Let's go back, for a moment, to the basic scenario. Public shareholders lose confidence in a company, let's call it "Opaque Channel." Opaque Channel (not to be confused with "The OC"), a communications company and once great purveyor of obscure, Kafkaesque commentary, Byzantine news analysis and spin of such magnitude that the headquarters (gyroscope like) slowly wobble about their central axis, has had a difficult run recently. Over the course of a year, the shareholders bid the stock, which was sitting at $25 a share a year ago, down to $10 per share. It doesn't really matter why. Perhaps they don't believe in management anymore. Perhaps they believe the market for the company's twisted informational products is shrinking amid the increasing stupidity of media consumers and the consummate boost in demand for short, shallow news and commentary. (CNN.com has deftly avoided this problem by leading their stories with a prominent, red colored "Story Highlights" section with the 4-6 bullet points that summarize their already curt 500 word articles). Perhaps margins are low. Perhaps the company has issued depressing guidance. Whatever the case, the market does not believe in the prospects for the company. The market has set the price for the firm at $10.
Now, some guys and gals who think they are pretty smart (the private equity locusts) do their homework and decide that, with some changes, they can make some money by buying the company in a leveraged deal, holding it for a period of time, improving the operations, and, perhaps, eventually reissuing it to the public market for substantial profits. Let us pause for a second and reflect upon what this really means.
The private equity locusts are willing to take the company private, forgo any real liquidity (and therefore opportunity to exit the investment easily if things go south) and, further, will add debt such that there is little room for error. They are, in effect, signing a contract to hold the company for 5 years even if it sinks down the tubes the entire time. Their only early exit would be to find another buyer eariler. Either the public, or another private firm that sees the value in deeply miasmal content providers.
Not only this, but the private equity locusts who think they are smart, have also managed to convince some debt market leeches (who also think themselves smart) that they are smart, and that their plan for the resurrection of Opaque Communications can work.
Moreover, the private equity locusts are willing to provide the public shareholders with a premium to do so. They put their money where their mouth is. They bid $11.50 per share. 15% over the company's currently trading price. This is pure surprise and purely found money for the public shareholders, who, two days ago and as a group, couldn't imagine the company was presently worth more than $10.
A couple of shareholders, and it is not clear if they are new or old shareholders, but this really doesn't matter as share certificates are not wine, nor are they cheese, and therefore do not somehow gain nobility with age, start making noise.
"How can you expect us to sit here and let you take this company private and make hundreds of millions of dollars and not cut us in on it. You are cheating us."
Consider the assumptions being made here by the complaining shareholders.
1. That a 15% premium over the value that the shareholders themselves have set is somehow unfair.
2. That, de facto, the private equity guys and gals will make hundreds of millions of dollars.
2. That, if left to its own devices, Opaque Channel could make shareholders hundreds of millions of dollars if only left on the public markets long enough. Management, about to be out of a job, doubtlessly feeds these delusions eagerly. "We need just a few more quarters for our strategic obfuscated media product to catch hold in the market place."
2a. Note the inconsistency in 2 above. Namely that, if shareholders believed in management and felt that Opaque was only a few quarters away from greatness, why isn't their confidence reflected in the stock price? This is an important attitude to look for. The hope for a windfall which is not backed up by the resolve to pay more for the stock in the first place is quite telling.
3. That the shareholders today should enjoy the potential future benefits of the LBO today (undiscounted) and without assuming the risks (liquidity, default risks, time frame) that the private equity locusts assume.
Consider point 3 carefully. This is the essence of the "we are being cheated" argument. Please note that "We are being cheated," really boils down to "We want you to pay us for the right to take a risk with this company. And, actually, we want to boost the risk you take after you finally buy us off. We want you to be paid less for more risk because we, deserving public citizens, are being cheated of our entitlement to a windfall of more than 15%."
In this connection, consider a subtle nuance of point 2. By definition, what I will call a "pure" going private LBO (one that relies on actual top line and operational improvement to drive return rather than just clever debt loads) is a contrarian investment. Private equity groups plan to make money by finding value that others have forsaken, and taking risks on these investment theses. That's the point. If you doubt this, all you have to do is watch what happens when an buyout firm withdraws the only bid from a public firm. Anyone in risk arbitrage will tell you that the stock price quickly descends back to its original level in the absence of bidders. Once again, the public shareholders show their colors. The shareprice sinks back to $10. The stock is worth $10 to them in the absence of a cash bid for their shares. How can it be anything other than obvious to the impartial observer that the "entitlement" to more for these fickle shareholders is a fantasy?
Of course, in the political and economic climate that is the United States today, these fantasies are drawn as reality. Giving someone 25% of what they ever imagined it was worth, and in the process piling additional risk onto the purchaser, is somehow transformed into "fraud." Pretending that capital markets are anything but broken for these firms, and that therefore some enterprising group trying to unlock value is some kind of con job, seems to be a hobby.
So what are buyout groups to do? Certainly, as prices are driven up by purely political (and I include both legislative and capital markets politics here) pressures they will have to, increasingly, bow out of otherwise useful and value-creating transactions. They cannot, in good faith to their limited partners, assume the risks associated with these sorts of price elevations.
So how does one quiet unruly shareholders to consummate these transactions? KKR and Goldman Sachs Capital Partners may have the answer in the structure we find attached to their purchase of Harmon International.
Here, KKR and Goldman give existing, public shareholders the option to convert up to 12.5% of the firm into 27.0% of the new. The new firm will be registered under the Securities Exchange Act of 1934, and therefore, while not listed, will issue financial statements but trade over the counter only. That keeps out the retail investors but gives institutional the opportunity to play along.
Consider the many problems this solves for the private equity buyers:
1. Noisy public shareholders are (we assume) silenced because they can participate in the LBO and its subsequent success (or failure).
2. The short term pressure of "the mob" and the "tyranny of the quarterlies" is suppressed.
3. The populist argument against the transaction is (mostly) neutralized.
4. The above are accomplished without the addition of more risk (debt).
Consider the problems it creates for the rest of the market:
1. Specious, populist arguments against going private transactions are bolstered.
2. Going private transactions (which I believe act as a "do-over" for firms which the public markets are not mature enough to serve) will see reduced returns and, accordingly, this particular public market safety valve for value will be damaged.
What is, at least from my perspective, sad, is that the reason buyout shops are resorting to this sort of tactic is because they have not been able to convincingly make the anti-populist case in their going private transactions. This is probably because private equity as an industry is PR brain dead. This, in turn, is because private equity is dominated by massive and myopic egos. Private equity is about as accomplished at PR as Larry Ellison when separated from his handlers.
Activists will continue to make these arguments, because they make money by doing so, as they will, quite rightly, criticize poorly run auctions and conflicts of interest in "sweetheart deal" buyout transactions with the tacit complicity of management. This latest development, however, is a sad reaction to overreaching by public shareholders.