Conflicts of Interest in Management Buyouts
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 The offer was quickly superseded by a competing offer from KKR and other responding offers from management.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.
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Globalization of LBOs
The leveraged buyout (LBO), or the use of debt to purchase the stock of a corporation has been popular for decades now. In the United States, the value and number of LBOs peaked between 2006 and 2007. After that declined, and then significantly rose again in the following years.
Although there were very few LBOs in Europe in the 1980s, the volume of these deals increased in the 1990s. These had their value exceeding US LBOs’ from 2001 up until 2005.
Europe vis-a-vis the United States
The number of LBOs in Europe was almost double the number in the US by 2005. Also, in many years the average value of European LBOs was below that of the United States,. Indicating that more LBOs were completed in Europe but they were smaller than the LBOs that took place in the US. But although the LBO deal value increased in Europe during 2006-2007, the US was experiencing more dramatic growth.
Considering that 7 of the 10 largest LBOs took place in 2006-2007 and were all American deals, LBOs in both areas declined during the subprime crisis and rebounded afterward. Although the slower European economy dampened somewhat the rebound in Europe. Moreover, some of the LBOs that took place in the United States were significantly larger than in Europe.
From public to private
LBOs occur when the management of a company decides to take a publicly-held company or a division, private is called a management buyout. These are deals where a unit of a public company is bought by managers of that division. In the past ten years, both the volume of the dollar and the number of unit MBOs have risen.
Some trends that are visible in the total LBO data are also visible in the management buyout data. Both numbers and values fell after the fourth merger wave ended but made a comeback while in the fifth wave. But the dollar value of MBOs never returned to the levels witnessed in the fourth wave. While the number of these did come close to the mid 80s levels in 2012.
Greatest buyout in history
One great example, the greatest one in history, is the management buyout of pipeline company Kinder Morgan. This buyout costs $13.5 billion. Management proposed to contribute just under $3 billion of the total acquisition price. This equity contribution was augmented by a $4.5 billion investment by a group of private-equity investors. Investors were led by Goldman Sachs Capital Partners and the Carlyle Group.
The buyers planned to assume over $14.5 billion in debt, giving the deal an enterprise value of over $22 billion. Kinder Morgan was formed in late 1996 by a collection of assets. That was disposed of by Enron for approximately $40 million. These assets rose markedly in value due to its strong acquisition program in 1999, while Enron fell.
Management Investments
Investments may be made by the managers in an MBO using their own capital in the deal. But another equity capital is sometimes provided by investors and the bulk of the funds are borrowed. This deal often entails a sponsor working with the group, providing capital and access with investment banks. All this will work to raise the debt capital. The purchased company becomes separated from its own shareholders, the board of directors, and the management team.
The process is typical when the buying group is insiders in an MBO and the outsiders in an LBO. The former, however, has better access to information about the company’s potential profitability than an outside buying group. This is considered to be one factor that might give a management buyout more chances of being successful than a leveraged buyout. However, better information is still not enough. If the parent company has been seeking to sell the division due to poor performance, the management is assumed to be blamed for this attribute.
MBO vis-a-vis LBO
An MBO leaves the company still in the hands of the same managers, whereas in an LBO the new owners may install their own managers. These new ones may be less tied to prior employees and other assets are more willing to implement the changes that are important to make the company a more profitable one.
Companies should normally sell divest divisions to outside parties when they do and only a few of the time do they sell them to managers. For instance, between 2007–2016, only 2.3% of all divestitures were unit MBOs.
Still, the numbers are significant. On the other hand, the total dollar value of unit MBOs was $769 million in 2016, down from $3 billion in 2015, with the average deal size in 2016 is $154 million. By merger and acquisition standards, these are considered smaller transactions.
Secure Financing
When managers come to a decision of pursuing an MBO, they can work to make sure that they can finance themselves securely, typically with their investment bank’s help or a private equity firm they work with which can offer a fair percentage of the financing.
Fidrmuc, Palandri, Roosenboom, and Van Dijk’s study of 129 PTP transactions from 1997-2003 in the United Kingdom, they were able to present that managers tended to turn the private equity route when they cannot secure the financing by themselves. They do this since managers may give up control in exchange for the assistance of private equity partners.
Thriving Buyout
As previously mentioned, the company Kinder Morgan announced the biggest buyout in history, resulting in the diverging fates of Kinder Morgan and Enron. This all happened because of the strategies they used. Enron, a pipeline company, became a risky energy-trading enterprise. Meanwhile, Kinder Morgan, a company founded in 1927 in Houston as K N Energy, just stayed in the pipeline business and just thrived within the limits of his industry. With its acquisitions, it became an increasingly larger player in the less risky segment of the industry, lowering its risk profile due to the steady performance, and therefore enabling management to attract private equity investors.
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Historical Trends in LBOS
Leveraged buyout, a term for a financing technique where a company goes private, has been around since the early ’80s. Despite this, the activity itself has been done for a longer period. Such as in 1919, when the Ford Motor company wanted to be free from public regulations. This is true in terms of manufacturing and selling their Model Ts. It is also significant to note that Ford was affected by some problems that befell the LBOs. For instance, they incurred a cash crunch when the US economy was declining. They thought the company wouldn’t be able to service the huge debt load obtained from the buyout. Their strategic responses were a halt in production, layoffs, and cost-cutting actions.
Henry Ford exercised rights in his agreements with Ford dealers and shipped them the mounting inventory of cars. Even though they did not necessarily need them. The dealers were required to pay and Ford Motor Company was able to cope with the cash infusion it needed. This strategy was done instead of seeking distressed financing.
Start of Deconglomeration
As mentioned earlier, LBOs became prominent in the 1980s than they did in the ‘70s. High stock prices of ‘60s motivated private corporations to go public and allow entrepreneurs to enjoy the profit. Even firms that are not of high quality had their stocks absorbed rapidly by the bull market. But when the stock lowered between 1972 and 1974, so did the low-quality companies and their prices. As a result, managers of some of the companies that went public in the 1960s chose to take their companies private in the 1970s and 1980s. There was a so-called de-conglomeration.
Those that had been built through large-scale acquisitions dissembled through sell-offs. It took place through the sale of divisions of conglomerates through LBOs, ongoing through the 1980s and is partially responsible for the rising trend in divestitures that occurred during that period. The LBOs formed during this decade were Kohlberg Kravis & Roberts, Thomas Lee Partners, and Frostmann Little who created investment pools to benefit from finding undervalued assets and firms, as well as using debt capital to finance their profitable acquisitions. Later on, these became known as LBO firms, and many other firms joined them in the activity.
Peak of LBOs
The 80s were the peak for LBOs, especially during the end of the decade, reaching up to 200, 000 in terms of value worldwide. Larger companies were the target of LBOs, and the average transaction went from $39.42 million in 1981 to $137.45 million in 1987. Despite this, there were still very few LBOs and their value was deemed low. For instance, there were 3701 mergers in 1987 but only 259 LBOs, hence the latter accounts for only 7% of the total number of transactions. You can learn about types of merger in this article “Type of mergers:short-form Mergers”.
It was in 1987 when LBOs made up 21.3% of the total value of transactions. It shows that the typical LBO tends to have a larger dollar value than the typical merger. LBOs were too efficient that many thought it would replace the usual public corporation, but they thought wrong. The fourth merger wave experienced a more limited number of sponsors or LBO dealmakers and also providers of debts. The sponsor was able to pursue deals using high leverage percentages.
The high returns during the ‘80s and the minor barriers attracted many competitors. The barriers to entry were really the access to capital, which proved not that challenging. Given the very large number of pension funds and endowments aggressively seeking diverse investments in the hopes of achieving higher returns. These provided the equity capital, and the access to bank financing and public debt markets provided the rest. As theorized by microeconomics, growth in competition precedes a fall in return.
90’s Drama
The start of the ‘90s was also the start of their dramatic fall. The decrease coincided with the decline in the junk bond market that started in late 1988 and the 1990–1991 recession that followed a few years later. This is proven by Cao and Lerner’s study which reported that the established funds between 1986 and 1999 earned less than 10%. Despite the average buyout firm formed that generated 47% internal rate of return.
The value and the number of worldwide LBOs still increased during the fifth wave of mergers. By 1998, the number reached its highest until 2000. The number of deals in 2000 was approximately double the 1980 level even though the total value was only half. The deals of the fifth merger wave were not the mega-LBOs of the fourth wave but smaller and more numerous.
Decade of Recovery
During the new decade, the number of LBOs fell along with the value. 2001 and 2002 coincided with a recession and an initially weak recovery, so the event was predictable. But by 2004, the LBO volume rose along with mergers and acquisitions until 2007, making it the most robust of all. The growth was strengthened by readily available capital at somewhat modest rates through the collateral debt obligations markets.
Aside from the LBOs increasing, the average size of deals also grew, with 7 out of 10 deals taking place during this period (2006-2007). The instant growth happened because of a combination of a very robust economy, with a rising stock market and a housing-market bubble. The low-interest rates made the cost of debt financing for debt-laden LBOs unusually inexpensive. There were readily available equity and capital, and there were even more of the latter than there were good deals to pursue. This all came to a rapid halt when the subprime crisis took hold and the global economy entered a recession in 2008. This also resulted in low-interest-rate due to the stimulative monetary policy. Whereas pursued by most central banks, credit availability dramatically shrank.
The dealmaking of LBOs fell to a near term low during 2009 and remained below the heady levels of 2004-2007 despite making a rebound in the years that followed. One company affected was RJR Nabisco, which used to be the largest LBO until 2006.
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