Polonius is (Posthumously) Avenged

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.

Comments

[Angry investor]

I agree that private equity firms should not be disparaged for trying to buy companies at attractive prices, improving them, and then reselling them. As you point out, they are taking on risk and deserve to be rewarded for that risk if they do their jobs correctly.

However, I disagree with your comment, "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." Public shareholders would not (or should not, at least) own shares in a company that they think is fairly valued. The act of owning the shares implies that they think the shares are worth more than where they are currently trading. Similar to private equity, many shareholders buy stock in companies that are temporarily out of favor in the hope that fundamentals/appearances will improve over time. The fact that a stock is trading at $10 does not mean that the company will not be worth significantly more in the future, even without the Midas touch of a private equity firm.

Public equity holders resent having stocks that they believe are worth $20 in a few years being taken out for $12.50 now. Sure, the $12.50 beats $10, but I'd rather get my $20 down the line. There's no guarantee I'll get it, but that's the risk an investor takes. I'm not saying private equity buyers are committing "fraud," to quote your piece, but many times a takeout is not a desirable outcome for a public shareholder and they have a right to voice their displeasure in such circumstances.

[miami]

As the convergence of PE and Hedge Funds continue, how do you think these types of battles will be resolved as these investing styles [say, shorter v longer] intersect more often?

Will PE be able to co-op Hedge Funds? Will enough Hedge Funds open private 'side pockets' that they will co-opt themselves?

Will activist HF managers start to incur a penalty as less LBOs occur in their holdings?

[Unknown Professor]

I think you're right that you'll have increasingly more cases of buyout offers being withdrawn. Following this, we'll see continued increases in do-it-themself recaps.

Of course, if this doesn't work (and I doubt they'll have near the appetite for risk that the PE firms have), we'll have some very unhappy shareholders looking for CEO scalps.

Alternately, they'll demonize the recalcitrant buyers. And then, hopefully (but I doubt it) they'll realize they've just engaged in an autoscrewing.

Like we learn in Finance 101: it's return AND RISK.

In any case, it'll make for good financial drama (and a case or two for my corp fin classes).

BTW - a short and very unscientific poll of my friends concludes you need more stories about the Debt Bitch. We're just sayin...

[dc]

The grant of additional equity seems a particularly expensive way to buy the cooperation of a minority shareholders, given the historically strong performance of KKR's and GS's acquisitions (as measured by fund gross returns).

Maybe Goldman and KKR are trying to keep the constant escalation of acquisition premia out of the mainstream press/public domain by using sleight-of-hand in deal structuring. If deal-specific returns are the only criteria for the structure, there should be some cheaper, simpler way to make the deal go through (an elevated -- yet less damaging to sponsor IRR than the equity grant -- acquisition premium for example)

[Efficient Market]

I don't understand the comments from "Angry Investor". If the intrinsic value of these shares is $20 in the future, that will be reflected in the current price. If a $20 stock is trading at $10, why wouldn't investors keep buying it until it is bid up to $20 (or PV of $20 discounted back "a few years")? Or if it was so clear that the stock is undervalued, why would the majority of investors vote for a buyout that undervalues their shares?

Clearly the PE shops are adding some value and they deserve to enjoy the gains. They are paying a premium to current market price, so current shareholders should stop crying about being ripped off.

[Equity Private]

"The grant of additional equity seems a particularly expensive way to buy the cooperation of a minority shareholders, given the historically strong performance of KKR's and GS's acquisitions (as measured by fund gross returns)."

Yes, perhaps, but it does pull risk out of the deal in that you minimize debt. How expensive is using the debt to pay a higher price going to look if the company defaults?

"I don't understand the comments from "Angry Investor". If the intrinsic value of these shares is $20 in the future, that will be reflected in the current price. If a $20 stock is trading at $10, why wouldn't investors keep buying it until it is bid up to $20 (or PV of $20 discounted back "a few years")? Or if it was so clear that the stock is undervalued, why would the majority of investors vote for a buyout that undervalues their shares?"

Of course, what is at work here is the HOPE of a windfall versus a committed position on price (by bidding the stock up). Hope of gains that isn't reflected in the stock price is, of course, irrelevant. If we are going to use "hope" as a metric to determine what is "fair" to give existing shareholders than what limits our scope to a 15% or a 20% premium? Do we doubt that existing investors hope for 500% premiums? Clearly, as a group, they could not have believed the shares worth more because the marginal investors have not bid up the stock.

[Angry investor]

You may choose to call the difference between a $10 share price and $20 intrinsic value “hope.” I call it time arbitrage. Unlike what is taught in business schools, the market is not perfectly efficient. To paraphrase Ben Graham, in the short run the market is a voting machine, in the long term it’s a weighing machine.

Many investors focus far too much on near term results and not nearly enough on the long term, what you may call “intrinsic,” value of a company. It is common for a stock to trade for far below its intrinsic value for temporary reasons. Maybe it’s an industry downturn, maybe a stock option scandal, maybe value is obscured because of a complex operating structure. Sometimes value is recognized but investors aren’t patient enough to wait for it to unfold (the phrase “dead money” is often heard in these situations). Whatever the problem, it’s often clear that the problems will pass. However, investors overlook the long term value of a company because they are worried about what will happen in the near term. That’s how you get a chance to buy $20 worth of future value for $10.

Why would an investor approve a 15% premium when he/she thinks it’s worth $20? Not all investors have the same time horizon. Hedge funds that get paid bonuses on annual (or even quarterly) performance, are going to be much more interested in the near term premium from a private equity buyer than a long term investor patient enough to wait for the true value to be revealed and then recognized by the market. Other investors may not have the stomach or the incentive to wage a proxy battle. They take the near term pop and move on. The recent success of activists has changed things so that now more investors are likely to fight a take out they think is unfair.

Owning a company that is trading at a discount to its intrinsic value isn’t “hope” to me--it’s value investing. I’m not hoping for a pie in the sky 500% premium as you suggest. I want fair value, or at least my best guess at what fair value is. When private equity comes along and tries to take advantage of near term issues to buy a company at a discount to that value I get unhappy. Telling me that I should stop crying because I got a 15% premium to a depressed stock price is insulting. If you think the market price of a stock is its true value then there’s really no reason to invest in publicly traded stocks. In that case, we’ll just have to agree to disagree because my whole investment process is based on taking advantage of short term issues to buy stocks at a discount to their intrinsic value. The “group” may be voting that the stock is worth $10 now, but that doesn’t mean that true value isn’t $20.

[Equity Private]

Angry Investor Says: "Unlike what is taught in business schools, the market is not perfectly efficient."

And that, ladies and gentlemen, concludes Going Private's experiment with comments.