With Milton Friedman dead what else would we expect to but encounter all manner of schemes now afoot to defuse the market. The scene suggests the death of a long-hated and aged dictator after a long illness or quick coup, given the number of parties vying for thought leadership and the demagogy involved. I suppose that would equate the subject of the latest round, management buyouts, to Italian fascism. Andrew Ross Sorkin seems to have jumped onto the bandwagon Ben Stein has been piloting in this capacity. Michael Kinsley of Slate.com seems to have been relegated to the position of navigator, though given the position he recently penned for Slate on capitalism he should perhaps be sitting way out on the left wing. Sorkin outlined his own four point plan to make management buyouts "fair" again. I am reminded of the communists emerging once again, dusty faced, but bright eyed, from the ruins of Stalingrad, emboldened by the receding shadows of vanquished fascism. You will see, I think, that the communists have always proved much better propagandists than the fascists. Their lies are far more enticing as they are wrapped in the cloak of populism and contrasted to fascism's intrinsic elitist strain. The reality is that communism is centered around its own elitism, it is just far more adroitly camouflaged. Either way you go, you can smell the sickly sweet stench of lies.
Loyal Going Private readers will already be aware of my feelings about the word "fair," but for the uninitiated, it seems pretty clear to me that whenever someone calls for change to make things "fair," what they usually mean is that they plan to take someone else's hard work and hand it out to someone who hasn't gotten their hands dirty yet- in the interest of "fairness," you understand.
Sorkin begins:
Management led buyouts, by their very nature, are meant to benefit management and their private equity backers,” Stephen Lowey, a lawyer who often represents institutional investors, said to me last week.
No? You mean they aren't meant to benefit starving African children? Who knew? Hard not to point out that Sorkin's foot dips into the water this way- with the assumption that these transactions are presumptively zero-sum games- and that this is somewhat concerning. Just wait, dear readers. Just wait.
The trip continues:
He contended that public investors almost always get cheated, and it’s not hard to see what he’s talking about. Every day, it seems, some stock that has been battered is being picked off by its own management and private equity firms at a paltry premium.
Watch carefully, this is the magic that is at the root of all these anti-MBO arguments, be they Steinisms or Sorkinettes. Did you catch it? It was a pretty quick slight of hand there, but it only took twenty words or so to point to an asset that is being traded in one of the most liquid and efficient markets on the planet and claim that it has been mispriced. And this, dear readers, is the conceit at the heart of these arguments. That we have to protect the market from itself. That the very shareholders who have bid the company down need to be protected from the pricing action they, themselves created, by preventing interested parties from buying the asset at the quoted price. You see, it's really worth more. Damn the market, full speed ahead!
And even that isn't the whole story, as apparently these same shareholders deserve a premium. Not just a "paltry premium," mind you, but a substantial premium. Let's ignore for a moment that this would have the effect of rewarding the kind of short-term speculation that hangs on every fraction of a penny in earnings for this quarter to determine if the stock should be battered or not.
What we have quickly said here, is that because someone might, possibly, benefit in future, albeit at greater risk, and despite the fact that the shareholders as a whole don't see the value (if they did why is the stock price so depressed) we cannot possibly allow third parties to pay above market price for a company, undertake a risky (to themselves) plan to improve value and put their own reputation and capital on the line to do it. In the interests of fairness, they need to share those "windfalls." Please. Where is Muffie Benson-Perella when you need her?
I cannot imagine we would feel the same way if a farmer, who had leased land from a landowner for years, paying via a portion of his crops, suddenly offered to buy it with a loan from the bank, and thereafter, following a systematic improvement of the soil, doubled his profits. Even if he found oil one day we'd cheer him on and produce a half-hour comedy about his new life in Beverley Hills Greenwich.
In the United States we generally do not tax contingent, unrealized gains. Why do shareholder's think they are entitled to them?
But, cry the masses, shareholders have no say in the company. They cannot easily change management or challenge/force the deal effectively because (proxy contests are expensive/boards are staggered/there are poison pill arrangements in place). Such masses often forget the purpose of the separation of ownership and control, of capital and competence- to permit management specialization generally unmolested by the old widow who wants to paint the plant pink.
It is also easily forgotten that shareholders knew or should have known full well how much power they had or didn't have when they bought the shares. It is not as if such matters are opaque. Arguing for more control (absent paying a premium for it) after purchasing shares you knew lacked such control strikes me as awfully disingenuous. Not that that surprises anyone.
"Aren't managers who mount MBOs guilty of a conflict of interest?" wonders one commentator. Here, I cannot help but be amused. Despite what you might hear on CNN, one is not "guilty of a conflict of interest." A conflict of interest is not, of itself, a crime. Think on this long and hard. It is easy to get another impression in this day and age. A conflict of interest simply exists, or does not exist. The solution to one that exists is simple. Disclosure, additional scrutiny. I don't think anyone observing an MBO will fail to recognize the various roles of the parties involved. The danger of hidden self-dealing is actually quite low in a public transaction. And, frankly given the transparency of the process, if outright fraud, (say, non disclosure of good news or dumbing down of the numbers pending the MBO) occurs you can well bet that the plaintiff's bar will be on it like white on rice, that is unless you want to take the somewhat dense position that there aren't enough shareholder lawsuits in the United States.
Really worried about some manager making too much in an MBO that you don't have the power to prevent? Don't buy the stock in the first place. Stick to firms with corporate governance policies that make MBOs nearly impossible, or slates of directors unlikely to approve such measures. One public company director I know responds to MBO proposals by asking the manager to quit first, and then mount the bid if she wants the board's support. Are all directors so tough? Probably not. If that's important to you as a shareholder, find out and vote with your wallet.
Let's take Sorkin's suggestions one by one:
Let minority shareholders decide, too. While it’s understood that a
controlling shareholder has the right to steer the company, that
investor shouldn’t be able to do so at the expense of minority
shareholders. You should be irate to hear Isadore Sharp, the chief
executive and controlling shareholder of Four Seasons Hotels, tell
shareholders that his offer for the company “is the only one I am
prepared to pursue.” The Dolans of Cablevision pulled the same stunt.
That’s fine, but transactions like this should then require a
majority of the minority shareholders to approve the deal. It’s not
enough to have an independent committee of board members and an
investment bank’s fairness opinion bless a deal that is clearly below
market value simply because the controlling shareholder won’t allow a
true market for the company.
Why should you, or anyone else be irate? It was the daft shareholder that did not make herself aware of the corporate governance nuances of the company she just bought a piece of. I have no sympathy for shareholders who willingly buy into Class B shares when there is a Class A with supermajority voting rights and then complain that they are being "oppressed" and file a minority shareholder oppression lawsuit as if we were dealing with a closely held firm. These shareholders neither paid for control nor should they have it after having acquired the shares at a discount to what control bearing shares would have called for. Again, they knew full well the nature of the transaction they were entering into. Changing the rules now, particularly with regulation, is folly.
The reality is that if corporate governance is actually worth something to shareholders they will bid up or down based on their ability to oust management or block a transaction. This is what gives rise to things like the "Dolan Factor," at Cablevision. Even the New York Post is in touch with this effect. When you recognize this you see that these shareholders want a free lunch. Non-control prices for controlling shares. Poor shareholders. Even assuming our shareholders were a sympathetic bunch, why should this sort of thing be regulated, rather than left to each firm to decide via its public by-laws so that the market can price control accordingly?
Sorkin continues:
Use truly independent advisors. The investment bankers that run these
auctions have a huge hand in shaping their outcome. Since management is
part of the buying group, it already feels like an inside job. When an
adviser has a longtime relationship with the family or company, it
feels even more that way.
Again, one is not "guilty" of a conflict of interest. And absent some actual showing of wrongdoing, which would, once again, garner the wrath of the plaintiff's bar, I am not particularly sympathetic. This is, however, the more compelling of Sorkin's issues (for whatever that's worth).
More from Sorkin:
Give public shareholders a stake. One reason shareholders are so
suspicious of take-private deals is that they see private equity firms
quickly flipping companies they just bought onto the public market and
making a multiple of their original investment. Here’s a solution:
Offer shareholders as much as a 10 percent stake in the deal. That way,
shareholders who see long-term value — and are willing to have illiquid
shares — can go along for the ride and won’t feel ripped off if the
deal turns out to be a grand slam.
How to structure this would be a little tricky, however. It should
be available only to shareholders who held the company before it
announced its sale, so that you don’t have arbitrageurs and other fast
money jumping into the fray.
A little tricky? I'll say. Now we are classifying shareholders based on their corporate structure and proposing regulations that say who can purchase public shares when. Enforcement of this clause would require the SEC to develop a set of "shareholder thought police" to divine the intent of shareholders before permitting them to buy. We can't let those evil fast-money shareholders get involved. Instead, we have to give, not sell mind you, but give, shares away to existing shareholders because... well because they are existing shareholders. Are they going to share in the risk going forward? Not really. The premium they were paid on their existing shares means that they were effectively paid to take 10% of their prior holdings. That's about as backwards a plan as I have seen. It is also pretty obvious that Sorkin doesn't understand the important role arbitrageurs play in markets. That's not really surprising though, is it?
What is surprising, a little surprising anyhow, is the hypocrisy of Sorkin here. Of course, this part of his plan screws shareholders by artificially depressing the price. Hopefully, these shareholders will be able to sue Sorkin for the difference. Wasn't it the same Sorkin that was moaning over supermajority holders who prevent a "real market for shares" just a few paragraphs back? Looks to me like Sorkin has just become what he despises- one of those fascists who doesn't permit a "real market" for public shares.
What about regulation? Does Sorkin propose that these shareholders who keep a stake will also be entitled to public disclosure of financials? Will the company still have to file with the SEC? Comply with SarOx? How exactly will shareholders be convinced to forgo their rights to SEC regulation and disclosure in the shares? If so, will the shareholders have to be "qualified persons" as if it were a private placement? If not, what assurance does the SEC have that they are sophisticated enough to hold what amounts to private placement shares? The SEC would never permit such an offering in other contexts, why are shareholders now suddenly smart enough to take advantage of a QP-type deal without being QPs? What company would ever embark on a buyout in that circumstance in any event? Few, if any. It has the effect of locking effectively all companies into the public equity markets and the burdensome disclosure regimes for eternity or breaking safe-harbor laws. Sorry, I just don't see it.
Next genius idea:
Show us the business plan. ...shareholders should have a chance to see
the company’s future business plan so they can judge for themselves
whether the same strategy could be accomplished if the company remained
public. Companies shouldn’t have to give away all their secrets, but
they should make available the same business plan that they provide to
the banks and debt holders that are financing the transaction.
Shareholders should either take their premium and go on to other things or protest the deal. Car dealers do not ask for a statement of use for a car before selling it to someone in order to determine the price. Why are shareholders different exactly?
The reality is that the public equity markets are just not the place for many companies. The public markets and public shareholders have failed, perhaps because they have become intensely short-term in the last 40 years, any number of companies that could prosper if they were free to manage their balance sheet aggressively (but not too aggressively), adopt long-term strategies that might well result in break-even returns for several years before bearing fruit. The kinds of strategies that the public markets simply have no patience for. Why should we look askance at the move to more efficient allocation of capital? Because it is not "fair?" And who's "fair" is it?
Sorkin's approach has the common thread I see quite a bit with the neo-marxists who struggle to redistribute "windfalls" to other segments of society who cannot be bothered to think long term or otherwise create wealth. It is the thermodynamic theory of collectivism:
First, make sure they cannot win. (e.g., a windfall profits tax).
Second, make sure they cannot break even. (minority shareholder oppression suits, compulsory disclosure of post-transaction plans).
Third, make sure they cannot get out of the game (compulsory public equity markets participation).
This is the sure sign of a scheme that is failing, its death rattle gurgling. I am reminded of the music industry, desperately trying to legislate themselves into insulation, any sort of insulation, from any sort of progress that forces them to rethink their ancient and now flawed business model.
Those seeking to improve "fairness" (ahem, Dr. Mark Klein) would do well instead to concentrate on understanding the concept of risk adjusted returns and get out of the way. I'm not holding my breath.
Today, Financial Rounds posted this entertaining cartoon about executive pay (one assumes the target is CEOs of public companies). Notice, however, that the Professor doesn't necessarily advocate the position taken by the cartoon. At the risk of being branded a republican (trust me, I'm not), and though I think the cartoon is actually quite funny, I don't actually see the issue. I cannot for the moment think of a market for talent with more transparency, liquidity, or velocity than the market for CEO of publicly held corporations in the United States. They can bolt at any moment to competition. Foreign firms are always looking to supplement their access to and knowledge of lucrative American markets. Private equity firms are prowling around for anyone who wants to come over to "the Dark Side."
The
most interesting to me is shown in this chart. It is the significant dip from 2001
to 2002 and the tiny gain in 2003 in total direct compensation. Even 2004 has barely recovered from 2001. Can we really believe that risk
adjusted returns for CEOs facing Sarbanes Oxley, which could damn them, destroy their career and trash any future earnings potential
for the acts of a few rogue subordinates, could show a net gain during
the interim before and after SarOx's passage? Don't get me wrong, I like SarOx on many levels, but in conjunction with reduced CEO compensation, it is a disaster.
Not
only that, but CEOs in the United States have had the beta of their
compensation substantially increased insofar as it has been shifted
heavily into contingent bonuses and long-term compensation, which is
often tied to stock performance. The odd terrorist event could eliminate massive portions of CEO compensation even if they were the best manager the known universe had yet seen.
Listen to the howls that have been eminating from anyone who was paying attention. It is totally outrageous and shocking that Exxon's Lee Raymond got 
The Economist 
My favorite reader and Bain Capital guru, sent me an interesting missive on executive pay. With all the mewing about the payment of decades of accumulated long-term compensation to Exxon's former CEO Lee Raymond, have we looked at what private equity compensation structures look like? Perhaps we should.
Just after an outstanding 
Readers of Going Private will be familiar with my many critiques of the critics of executive pay. Hardly a week passes without another bit of hand wringing over the W2 forms of public company CEOs. These are usually accompanied by cute little graphics of fat cats with overflowing bags of money. Any number of sound bites pointing to the rising inequity in CEO pay are cited by plastic "financial reporters." Never mind what scholars on the subject say. A loose connection to the facts seems a required line on the resume of executive pay critics. So it doesn't surprise me that it is only the Economist that has managed to pick up on the rather compelling view on the subject of no less a luminary than Steven Kaplan, the University of Chicago professor and economist.
