Kinder Morgan's Private Buyout: Some Thoughts on the Larger Trend

This week saw the well-regarded energy firm Kinder Morgan become the object of a private equity buyout by its senior managers. The last information I saw had them offering something like a 16% premium to the firm's current market value.

Rather than discuss the pros and cons of this particular buyout, and the ethics of internal management, who know more about a company's prospects than anyone else, "offering to buy" a firm from other shareholders, I'd like to discuss the larger phenomenon of which this is the most recent example.

What may be the long term effects of a continuing series of private equity buyouts of publicly-held large-cap US firms? What does this mean for equity strategy managers, and investors in general?

First, consider why some firms are doing these buyouts. Sarbanes-Oxley has been mentioned as being both a source of the movement offshore of significant amounts of new business capital formation. A variant of that is to move business capital beyond the reach of the law by remaining in America, but going private.

If this continues, it's possible that one result is a near-term decline in the average return of indices of publicly-held companies, such as the S&P500. As the index replaces firms going private, one has to wonder if the replacements represent a pool of lesser-performing firms.

For an equity strategy like mine, the dynamic of outperforming the index doesn't really change. No matter what the average of the index, there will always be "above average" firms. Whether many of them are consistently superior is another question, but my expectation is that there will still be some which fit that criteria.

However, if the overall rates of returns available to public shareholders falls, it does nothing good for investors in general.

On the other hand, one has to wonder for how long private equity stays private. Isn't the ultimate goal to buy undervalued assets, improve their value, and spin them back out? If so, one would expect that these firms will begin to come out "the other end" of the buyout process, and release higher-valued firms into the publicly-held universe.

As higher-valued firms, one might expect their future returns to be less, since the value was built and taken out by the private equity groups. If this happens with sufficient frequency, perhaps buyout premiums will rise to clear the market of these deals in the first place.

If not, there is another phenomenon which may occur. I believe KKR was rumored, or is, structuring a sort of derivative cash-flow security based upon some of their gone-private entities. It seems that they are planning to slice up value of some of their private deals much like the way in which collateralized mortgage obligations slice the income streams from mortgage pools into differently performing tranches.

If this happens, we would see some elements of the publicly-held sector transformed into a sort of non-voting, non-operational claim on cash flows, and perhaps, value of businesses, without "shareholder" votes.

It's an interesting new development in long-term finance. It would also settle, in those cases, the issue of so-called "shareholder democracy" and "corporate governance." In a sense, it would be a modern twist on the "B shares" approach used by family companies gone public, such as Wrigley, Murdoch/Newscorp, and Dow Jones.