Management buyouts can encounter a clear conflict of interest. Running the corporation is the manager’s responsibility. This is to maximize the value of stockholders’ investment and provide them with the highest return possible. They also take on a very different role when they have to offer stockholders to purchase something. When RJR Nabisco presented an offer to stockholders to take Nabisco private in an MBO, for instance. The offer was quickly superseded by a competing offer from KKR and other responding offers from management.
Some argue that managers cannot perform this dual and contradicting role as an agent for the buyer and seller. Why does management advocate an offer that was not in the stockholders’ best interest? Is it trying to make the most out of the stockholders’ investments?
Earning management to conflict management
Additionally, a conflict in management buyouts involves “earning management”. Before the activity, interested managers who are planning to buy the company from the shareholders could have an incentive. This is to pay less for the acquisition and to lower reported profitability. Discretionary accruals were manipulated in the predicted direction prior to the public announcement of the MBO. Perry and Williams found in the study of 175 management buyouts from 1981-1988.
The researchers developed a control sample wherein matched firms for each bought company were selected. The accruals were found to be associated with a reduction of income in the MBO group. These pieces of evidence should be causes of concern and extra vigilance. Such are increases in depreciation expenses or decreases in noncash working capital.
Neutralized voting
A possible solution that is commonly proposed is neutralized voting. This happens when proponents of a deal do not participate in the approval process. If these proponents are stockholders, their votes would not be counted. Still, they have to participate in the voting because of state laws. The quorum may not be possible without the participation of those who hold a certain number of shares.
The appointment of an independent financial advisor is a common second step in the process. It is meant to help reduce the conflicts of interest and render a fair opinion. It should be noted that certain practical considerations may limit their effectiveness even if precautionary measures are adopted. The members of the board of directors who may profit from the LBO may not vote for its approval. Other members of the board may have a close relationship with them and consider themselves obligated to support the deal.
Stockholders filing lawsuits to sue directors for breach of fiduciary duty have places limits on this tendency. Investment bankers who have done much business with management or may have financial interests in the deal. This put fair opinions forward but are usually of questionable value. Despite these steps in trying to reduce conflicts that are innate in the MBO process, for instance. The issues of the manager being both the buyer’s and seller’s agents are not yet addressed. To have mandated auctions of corporations presented with an MBO is one proposed solution by many.
Prohibited bid
According to current case law, directors are prohibited from favoring their own bid over another bid once the bidding process has begun. In addition, they are not allowed to do so since it is deemed unfair bidding. This was set forth by a number of important court decisions. Such as in Revlon, Inc b. Forbes & MacAndrew Holdings, Inc., PLC Hanson Trust v. SCM Corporation, and in Edelman v. Fruehauf.
The Revlon, Inc v. MacAndrews & Forbes Holdings, Inc. case, the court came to a decision of ruling that Revlon’s directors breached their fiduciary duty. Granting a lockup option to white knight Forstmann Little & Co. Considering the bid as an unfair process that favored the latter over hostile bidder Pantry Pride.
As for Hanson Trust PLC v. SCM Corporation, the Second Circuit Court took a similar position on the use of lockup. Options to favor an LBO by Merrill Lynch instead of a hostile bid by Hanson Trust PLC. Hanson Trust firs. This made a tender offer for SCM at $60 per share. They upped the bid to $72 as a response to Merrill Lynch’s LBO offer at $70 per share. The final ruling of the court stated that SCM gave preferential treatment to Merrill Lynch by granting lockup options on two SCM divisions to Merrill Lynch.
The last example is the case of Edelman v. Fruehauf, where the circuit court concluded that the board of directors had decided to make a deal with management. And did not properly consider other bids, such as the all-cash tender offer by Asher Edelman. They ruled that the Fruehauf board of directors did not conduct a fair auction for the company.
Prebuyout and post buyout
Even if the initial decisions establish a precedent that an auction for a firm must be conducted fairly, the courts stop short of spelling out the rules for conducting or ending the bidding process. Furthermore, the law is also vague to when or if there is an action required that will be facilitated by the independent directors’ committee. This process is often used when management has proposed a buyout. Similarly, they will usually respond by creating a special committee. When faced with a management proposal to take the firm private in order to endure that shareholders are fair value for their investment.
Moreover, another equity is provided by outsiders even when management is the buyer of the business unit. That is why management may not be in control of the post-buyout business. This depends on how much equity capital is needed. And how much capital the managers have and are willing to invest in the deal.
One study by Kaplan in 1980-1986 used a sample of 76 management buyouts. It showed the median to compare the pre and post buyout share ownership percentages of the CEOs and all management. He concluded that these percentages rose from 1.4% and 5.9% to 6.4% and 22.6%. In conclusion, management ownership tripled after the buyout. In theory, it motivated the company to guarantee and moves closer to maximizing efficiency levels for profit.
© Image credits to Steve Johnson