Private Equity's Advantage

Private equity can have a competitive edge over strategic acquirers because selling firms are more willing to let a private equity fund perform due diligence than a rival. In case the transaction does not occur, there is less risk if a private equity fund has proprietary information and a deep insight in the business than a competitor. Even the best nondisclosure agreement is of only limited utility once a deal has collapsed. Even though private equity firms may own other firms in the same business, the perceived risk of divulging information to a financial investor is lower than releasing it to a competitor.

Private equity prides itself in its ability to take the long view and its ability to structure privately negotiated transactions quickly. The decision-making process is indeed simpler in private equity firms, where only a few partners need to agree on the viability of a transaction. The decision makers are all deal professionals who have experience putting transactions together. The situation is different with corporate buyers, where the board of directors must sign off on a transaction after multiple internal committees have given their blessing. Unless a firm is a serial acquirer, many decision makers are not familiar with the procedures for acquisition.

Public companies often complain about the pressure to manage quarterly earnings, which impedes management's ability to take long-term decisions. Private equity contrasts its ability to take a long-term approach to investing that looks over short-term fluctuations in earnings, especially when they are caused by investments into the future of the enterprise. Private equity folklore claims that buyouts benefit companies because they can reinvigorate firms, invest in their growth, and reposition them as stronger and more competitive enterprises. This may well happen in some cases, but many buyouts are done simply with the benefit of cheap debt and constitute little operational improvement. They are simply financial maneuvers.

An entire group of private equity fund made private investments in public equity, abbreviated PIPE. Because the Securities and Exchange Commission (SEC) requires that stock acquired in a private transaction be resold only under stringent restrictions, it lacks liquidity and is worth less than regular stock. Therefore, a private equity investor gets to buy the PIPE stock for less than the shares trade at in the market and can make an extra return. Put differently, private equity can buy into public companies at a lower price than the investing public. What is even more significant is that these investments often come with board representation. Private equity firms can familiarize themselves through this channel with the firm and its industry. Then, when the firm is willing to be bought out, the private equity funds have an advantage over other potential buyers because they already know the firm.

Private equity funds do not always invest in common stock. Frequently used instruments are convertible debt or preferred securities that can be converted into common stock. The advantage is that when things work out well, the funds will convert their holdings into common stock, and they will be as well off as if they had invested in common stock from the outset. However, when there are problems, debt and preferred stock get paid first, and private equity funds end up better than the holders of common stock. When venture capital or private equity funds are present with such securities, problems can arise when companies are taken private, as we will see in the example of Aegis Communications.

Aegis Communications was a small operator of call centers and offered its clients related services that fall under the customer relationship management (CRM) label. It had acquired several other firms and was saddled with significant amounts of debt. In 1999, Aegis conducted a strategic review of its activities and issued new preferred shares to a group of investors involving turnaround firm Thayer and private equity fund Questar in order to reduce its bank debt.

Aegis continued to suffer losses, but only half of these losses were due to operations. The other half came from the preferred dividends paid to its majority shareholder, the private equity group, on its preferred shares. To make matters worse for the holders of common shares, the interest on the preferred dividends was paid in additional shares of preferred stock. Thus, the interest-on-interest effect kept diluting shareholders and increasing the burden of preferred dividends. Even though the private equity shareholders owned only 36 percent of the common stock, the convertible preferred shares gave them a 72.8 percent majority.

In March 2001, the same group of investors proposed acquiring the remaining shares from minority investors for $1 per share, representing a total of about $33 million. The board formed a special committee of independent directors to evaluate the proposal. The special committee consisted of two independent directors, one of whom had been appointed on the same day the committee had been formed after one director affiliated with the buyout group had resigned. Had he not resigned, not enough independent directors would have been on the board to form a committee. A committee of one would have been too much of a farce.

Three months later, the private equity investors changed their mind and decided not to proceed with the buyout.

Another two years of losses ensued. For practical purposes, Aegis was all but bankrupt. The principal goal of the private equity funds now became the limitation of their losses. As owners of preferred stock, they were in a strong position, which was reinforced further by their control of the board. Outside shareholders were faced with the typical problems that minority shareholders encounter once the going gets tough: They get squeezed by insiders.

In July 2003, Aegis planned a sale to AllServe Systems plc, a British firm in the same sector. The payment of $22.75 million that AllServe was to make was sufficient for the repayment of debt and some of the preferred stock. Common shareholders would have received nothing.

However, instead of the sale, a consortium of Deutsche Bank and Esser injected additional capital into Aegis in return for warrants. Simultaneously, the conversion ratio of the preferred stock held by the private equity funds was adjusted in their favor, diluting common shareholders.

Amid continuing losses and accounting deficiencies, working capital was raised by the sale of receivables and issuance of notes to Essar and Deutsche Bank. The debt was eventually assigned to World Focus and converted to equity. World Focus also acquired the common shares of Questar for $0.0268 per share and committed to paying Questar the difference in case it were to acquire the publicly held shares at a higher price.

In the fall of 2006, World Focus bought out the shareholders for $0.05 per share. The private equity funds were paid additional funds to compensate them for the difference. Series B preferred stockholders were paid $3.60 per share.

This Aegis saga shows how private equity funds can protect their interests even in cases where a company is de facto bankrupt. Public shareholders bore proportionately much worse losses than the private equity funds that controlled the board and were able to invest through privately placed preferred stock.

CEOs Don't Want to Sell to the Highest Bidder

The principal problem with management buyouts is that management deals on both sides of the transaction. As managers of the firm, they coordinate the sales process and have privileged access to confidential corporate information; as buyers, they have an interest in acquiring the company for the lowest possible price. This was discussed in more detail in Chapter 9.

Picture yourself as the CEO of a company whose stock price is depressed even though you are aware that the company will do very well in the near future. For example, you may have invested in new equipment that will lower the cost of production and increase your company's profitability once it is running in production mode. The stock price may not reflect the future benefits of the investment. Efficient market theorists will claim that the market will incorporate this information into the stock price. The reality is, however, that management frequently complains that the market fails to recognize the benefits of long-term investments, and indeed this is one of the arguments used to justify private equity buyouts. As the CEO, if you want to benefit from the upside, you could either get the board to issue more options or get involved even more deeply into the firm by teaming up with a private equity firm and take the company private.

In short, imagine you are CEO Evans of Macmillan, whom we encountered in Chapter 7. His principal motivation was probably to acquire Macmillan for himself. The auction only started because Evans himself initiated the sale of Macmillan with a $64 per share recapitalization proposal. It was only after this proposal that Maxwell became interested.

Management buyouts are the flip side of private equity buyouts. Managers must rely on private equity to fund the acquisition, and private equity funds often rely on management's knowledge of the firm, its markets, and its customers for the success of the transaction. A strategic acquirer, however, already has a management team of its own and has no use for duplicate overhead. In fact, eliminating the managers of the target firm is one of the first and easiest steps to achieve the very synergies that justify the transaction.

As a result, managers often have little incentive to sell to strategic acquirers and instead prefer financial buyers who will keep them employed. For example, candy and baseball card maker Topps received two acquisition proposals, one from its rival Upper Deck for $10.75 per share and another from Disney CEO Michael Eisner for $9.75 per share. Eisner acted as a pure financial buyer and indicated from the outset that he intended to keep CEO Arthur T. Shorin and his son-in-law, chief operating officer Scott Silverstein, to manage Topps. In their desire to sell to Eisner and retain their jobs, Shorin and Silverstein went to great lengths.

Details of attempts to prevent Upper Deck from buying Topps became public during a trial in Delaware's chancery court, where Upper Deck sued Topps. Upper Deck had signed a confidentiality agreement with Topps when doing its due diligence, as part of which it had agreed not to make a tender offer for Topps shares without Topps's management approval. Given management's conflicted incentives, they had little reason to help Upper Deck make a proposal and worked actively to prevent it. Management refused to approve Upper Deck's tender offer but supported Eisner's, so Upper Deck had no choice but to sue to invalidate this provision of the confidentiality agreement.

In its regulatory filings, Topps misrepresented to its shareholders Upper Deck's acquisition proposal, claiming that there was a financing contingency. In fact, Upper Deck had already arranged financing through CIBC, subject to certain conditions. These conditions, however, all related to information about Topps, and exactly the information that Topps had refused to provide to Upper Deck under the confidentiality excuse.

Similarly, Topps overestimated the antitrust aspect of a combination of the two firms. Upper Deck's own lawyers estimated that there was little antitrust risk in a buyout, and it is difficult to see why Upper Deck would want to buy Topps just to be rebuffed by regulators. Baseball trading cards are not a competitive market, where consolidation would pose a risk to consumers. If regulators were concerned about competition in the trading card market, they would have blocked the 2004 purchase of Fleer Corporation by Upper Deck. The antitrust risk in Upper Deck's tender offer is therefore negligible.

Topps's investment bank, Lehman Brothers, was rendering advice that was clearly partial to Topps's management. Lehman's first fairness opinion used management's five-year projection, exit multiples between 9 and 10, and a cost of capital of 11 to 12 percent (actual: 11.6 percent) and found a range of values for the stock of $9.67 to $12.99 per share. In a subsequent opinion, Lehman eliminated the last two years of management projections, reduced exit multiples to between 8.5 and 10, and increased the cost of capital to 11.5 to 13.5 percent. These changes had the effect of reducing the theoretical value of Topps's shares to $8.76 to $12.57. Eisner's then proposal of $9.75 was no longer near the low end of the range and made the price look somewhat less undervalued.

The court enjoined the Eisner transaction, which in itself is unusual, forcing Topps to make additional disclosures and to allow Upper Deck to make a tender offer. Despite its victory in court, Upper Deck eventually withdrew its tender offer, blaming it on Topps's unwillingness to provide it with crucial due diligence information.

Private Equity Funds Have Their Own Agenda

In some instances, there can be a large disconnect between the interests of private equity funds and those of public investors. Merisel, Inc., is an example of a transaction that got into trouble when a large investor, private equity fund Stonington Partners, L.P., needed to exit its investment.

Private equity funds are structured as partnerships with a limited duration, typically 10 years. In their early stages, the managers identify investment opportunities and draw on capital commitments from their limited partners. In the middle of their life, managers restructure the business they acquired and seek to maximize value. Toward the end of the life of the fund, managers liquidate their investments by either selling the companies to other firms or funds or by taking them public in an initial public offering (IPO) if market conditions permit. Alternatively, the funds can distribute shares of the investments to the limited partners. The latter option has several disadvantages. First, the value of the shares can be difficult to establish. This can be a problem for the manager, whose incentive fee is based on 20 percent of the profits generated. If cash is distributed to the limited partners, there is no discussion about the profit generated. However, in the case of a distribution of shares, the profit depends on the value assigned to the shares. In the case of illiquid investments, there is likely to be disagreement between the manager and the limited partners about valuation.

Second, the limited partners may have no interest in holding the shares that have been distributed to them, but want to invest the proceeds from the Stonington liquidation elsewhere. This will lead to selling pressure and depress the value of the shares. If market participants anticipate a distribution and an associated selling pressure, the stock price will decline already in advance of the distribution and depress the stock price, which in turn reduces the valuation and the profit share allocated to the manager.

For these reasons, managers of private equity funds prefer to sell rather than distribute shares.

In the case of Merisel, it was exactly this problem that convinced management to sell the firm. Stonington Partners held 60 percent of the company and were in the process of winding down their fund. Merisel's board was concerned that many of Stonington's limited partners would be unwilling to hold shares for Merisel. After all, despite being fully SEC reporting, Merisel was a micro-cap company traded on the Pink Sheets, and many investors still have an aversion to companies traded on that platform. The proxy statement for the merger states this logic very bluntly:

In September 2006, two members of the board of directors of Merisel (which we refer to as the “Board”) who represent Stonington Capital Appreciation 1994 Fund, L.P., a privately-held investment fund (which we refer to as the “Fund”) and the majority stockholder of Merisel, informed the Board that it believed that Merisel should preliminarily explore the feasibility and advisability of strategic alternatives that would enable the Fund to liquidate all or a significant portion of its holdings of Merisel. According to the representatives of the Fund, termination of the Fund, which was supposed to take place at the end of 2007, would require the Fund to liquidate its security holdings, including its majority common stock interest and preferred stock in Merisel, or distribute such holdings to its limited partners. […] the Board determined that Merisel should consider the impact on Merisel and its stockholders of the Fund selling or distributing its Merisel shares and begin evaluating strategic alternatives to maximize stockholder value.

Merisel DEFM14A, May 9, 2008, p. 25

The threat of a liquidation of the private equity fund put significant pressure on the board to sell Merisel, and one wonders whether potential buyers would use knowledge of the situation to depress the price.

The board did eventually find an interested buyer, business development company American Capital Strategies (ACAS), which agreed to acquire Merisel for $5.75 per share in cash. However, when Merisel announced results for the first quarter of 2008 that were below its forecasts, ACAS declared a material adverse effect and sought to renegotiate the price.

On May 4 and May 6, 2008, representatives of ACAS informed Merisel's financial and legal advisors that ACAS currently does not intend to proceed with the acquisition of Merisel at $5.75 per share in cash in accordance with the terms of the Merger Agreement. According to the representatives of ACAS, ACAS desires to renegotiate the terms of the transaction (specifically, the per share purchase price) in light of ACAS' view of the performance of Merisel's business during the first quarter of 2008.

Merisel DEFM14A, May 9, 2008, cover letter

Merisel's stock price reacted vigorously (see Figure 10.1) and dropped from $5.50 just before ACAS's announcement to $2.61. Several factors player a role in this drastic drop:

• The deterioration in Merisel's business itself would have justified a lower price absent the pending merger.
• The threat of a collapse led to significant selling.
• The risk that Stonington's limited partners would sell their shares in the market should the merger not happen led to selling.

Nevertheless, the underlying reason for the collapse was the potential overhang of sell orders in Merisel's stock should Stonington's distribute shares to its limited partners. ACAS was well aware of this problem, and it can be assumed that the pressure that Merisel was under was factored into the decision to seek a renegotiation of the merger.

The moral of this experience is that private equity funds can have interests that are opposed to those of other shareholders not only when they take firms private but also when they are investors and want to sell. Arbitrageurs must be vigilant about the agenda of these investors.

Buyouts as Financial Engineering

Private equity returns can be attributed to a large extent to financial maneuvering rather than managerial skill. Increasing leverage of the acquired firm by adding debt and paying out the proceeds from the debt offering to the private equity funds is a popular method for achieving a fast payout. This can be done more quickly and requires less effort than a sale. Nevertheless, a sale of a portfolio company also can be attractive for private equity funds if they can sell it for a valuation that is much higher than that of the original firm when it was acquired originally.

For shareholders, the principal problem with these types of transaction is that there is no reason why they should be performed by a private equity fund rather than the management of a public firm. In that sense, financial engineering is tantamount to theft from the former shareholders. The gains from this maneuvering should have accrued to the public shareholders. When the same managers who helped take a firm private then manage it under a dividend recapitalization, the insult to the public shareholders is complete.

Dividend recapitalizations are a form of financial leverage where a company, after it has been acquired by a private equity firm, issues additional debt and then pays out the proceeds from the debt offering to the private equity funds as a dividend. A survey of private equity firms² found that most firms are comfortable with a debt/equity ratio of 4:1 following a dividend recap. The sooner a dividend payout is made after the buyout of a public firm, the higher the rate of return of the private equity fund will be. Therefore, private equity funds have an incentive to make a dividend recap as soon as possible after the buyout. Most see a time frame of 12 to 24 months as appropriate. A dividend recap is also an attractive alternative to an IPO: It is faster to accomplish, it can yield comparable returns, and the private equity fund continues to hold the equity for potential future upside.

The downside of dividend recaps is the high debt burden that can crush a portfolio company and drive it into bankruptcy. If this happens too quickly after the dividend recap, the private equity fund faces liability under fraudulent conveyance. As long as the portfolio company survives for an extended period of time after a dividend recap, there is little risk of legal liability for the private equity fund should the firm end up in bankruptcy. In addition, if enough procedural safeguards are in place, such as board review and independent legal and solvency opinions, private equity funds can limit their exposure to liability from recaps.

Multiple arbitrage is another egregious form of financial maneuvering that allows private equity funds to capture gains that normally would belong to shareholders. “Multiple arbitrage” refers to acquiring a firm at a low multiple and selling it at a higher multiple—for example, a purchase at a low price/earnings (P/E) ratio, and a subsequent sale at a higher P/E ratio. One case of multiple arbitrage was the acquisition of Celanese AG by Blackstone in April 2004. Celanese was listed on the Frankfurt stock exchange, where it traded at a relatively low multiple. When Hoechst and Rhône-Poulenc merged in the 1990s to form life sciences conglomerate Aventis, their chemicals businesses were spun off as a separate firm, Celanese. It became a takeover candidate when Kuwait Petroleum Corporation wanted to sell its 29 percent stake. Blackstone acquired 84 percent of the shares for €32.50 for a multiple of 6.4 times earnings. Although this represented a 10 percent premium to the most recent trading price, the book value of Celanese was €42, or almost one-third higher.³ However, arguably Celanese was partly a U.S. company, because 60 percent of its assets were located in the United States. Blackstone benefited from the disconnect between the location of the assets and the trading market by reincorporating Celanese in Delaware, complete with a classified board and poison pill shortly after the buyout. Only nine months after the buyout, Blackstone sold Celanese Corp. in an IPO to U.S. investors. The buyout required only a cash outlay of $650 million, but Blackstone ended up owning $1.7 billion worth of stock and making $1.4 billion in cash, including $111 million in management fees that Celanese paid to Blackstone as its owners. Why management could not have reincorporated Celanese AG in the United States itself and let the original shareholders reap the benefits of a higher multiple stateside can be explained only by the large payments that management made from the buyout. Chairman Claudio Sonder made €7 million in change of control payments, which is uncharacteristically large by European standards. Also, Celanese managers participated with Blackstone in the transaction and benefited directly from a lower buyout price.

It should be noted that a small group of arbitrageurs, including Paulson & Co. and Arnhold & S. Bleichroeder, held out for a higher bid.⁴ The arbitrageurs obtained an independent valuation of Celanese AG that initially valued the shares at €42. A third valuation that was done during court proceedings found a value of €65 per share, which was subsequently adjusted upward to €73. Paulson & Co. attributes the low valuation of €32.50 in the original buyout to the “coziness” between Blackstone and the financial adviser that opined on the value, Goldman Sachs. Goldman was an investor in the Blackstone funds that acquired Celanese and therefore had an interest in obtaining a low price. The litigation between Paulson and Celanese was settled in August 2005 for €53 per share. This represents 63 percent more than the original price. Other shareholders who did not tender their shares received €51 per share.

Activists Replace Private Equity

In recent years, activist investors have attracted considerable interest among investors and the financial press. Some activists trace their roots back to the same origins as private equity: the corporate raiders of the 1980s. Although many of the techniques used by shareholder activists are similar to those of private equity their approach is dramatically different. They take minority stakes in companies that continue to be traded publicly and then press for operational and financial changes while the company remains public. Whereas in private equity buyouts only the investors in private equity fund benefit shareholder activism has the advantage that they benefit from the value that can be unlocked.

Typical requests of activists investors are:

• the shedding of noncore divisions and the focus of the enterprise on its core business, either through a sale or a spin-off;
• changes to management compensation, as management is sometimes incentivized to grow a business even though it may have moved to a stage where it has become a cash cow;
• monetization of assets such as real estate or intellectual property;
• changes in capital allocation, which means special dividends, share buybacks or dividend recapitalizations; and/or
• a sale of the company.

Activist investors sometimes have a background in private equity or are hybrid public equity/private equity investors. The latter gives them extra leverage because they have the ability to purchase the company outright should the sale to a third party not materialize.

Between the years 2011 and 2014, the number of activist funds has grown from 19 to 162. Their assets have increased from $68 billion to $205 billion over the same period.

With the growth in activist investing in recent years it can be argued that the need for private equity has diminished greatly. Although there will remain valid reasons for the existence of private equity—in particular, its ability to acquire upon short notice large businesses in private sales—buyout activity by private equity should continue to decrease as companies will either adopt many of the tricks of private equity themselves or come under pressure from activist investors or even traditional investors to optimize their corporate structures and operations.

In the early 2000s, large institutional investors were reluctant to back activist campaigns. The perception of activists at the time was overwhelmingly negative: Activist investors were viewed as a disruptive force. Many institutions feared losing access to management or mandates to manage corporate pension assets if they were known to have supported activist campaigns. These fears persist today but are mitigated by the realization that successful activists can turn underperforming companies around and thus add value overall.

The style of many activist investors has also changed over the last decade. Some of the most successful activists are not the ones who begin a campaign with a poison letter sent to management and made public instantly. Instead, activists today seek to work behind the scenes first and, although they may be required to disclose their investment early on, go public only relatively late with their grievances when management refuses to engage in serious discussions.

Numerous examples exist of where activist investors have exerted pressure on companies in recent years and implemented what is essentially a private equity agenda. Even large companies such as eBay, Mondelez, or Canadian Pacific Railway have seen activist investors influence management successfully and help the firms become more focused and efficient. Private equity is likely to become a narrower niche strategy while activist investors will assume the role previously played by private equity in making corporate structures more efficient and catalyzing mergers of companies.

One area in which activist investors have become more vocal recently is when companies sell themselves below their true value. Activist investors have achieved price increases in roughly half the cases in which they agitated for higher prices. Prominent successes include the acquisition of Dell by Michael Dell and private equity group Silverlake or the acquisition of Celesio by McKesson.