Private Equity Buyouts: The Fairness Question

A few months ago, I wrote a post about private equity buyouts, triggered by the Kinder Morgan deal.
In that post, I discussed the larger trend of private equity buyouts as they may effect the larger pool of equities, the S&P500 Index, and, lastly, my equity portfolio strategy.

Last week, my partner and I were discussing this phenomenon again, as HCA is being taken private. And, further, a flurry of Wall Street Journal articles have focused on this trend, plus the trend of hedge funds to turn to private equity as a tool for asset allocation.

Whereas in my prior post, I deliberately chose to omit any discussion of the ethics of buyouts, and the multiple roles of investment banks, plus the question of fees charged to the buyouts. In this post, I will comment on those aspects of modern private equity buyouts.

First, it does seem, frankly, grossly unfair that a small group of managers of a firm like HCA, or Kinder Morgan, who clearly know more about the future prospects of a company than the average shareholder, would tender to take out those other owners at a price which, by definition, has to be below that felt to be attainable by the internal management leading the buyout.

It is inconceivable that a veteran management group would get into bed with a private equity group or a hedge fund, and then offer the remaining (soon to be ex-) shareholders a "fair" price for the latter's interest in the firm.

If there were ever to be legislation to clean up this ethical loophole, my partner and I reasoned something like the following would work. A sort of reverse greenmail. If a management tendered to take the firm private, regulation should provide for the offering of a similar ownership share in the newly-private firm, without voting rights, but with equity rights equal to that of the management's holdings. In effect, whatever management deals itself in for would be available to any shareholders who wished to stay on board for the ride. It would be interesting to see how such a change in the law to mitigate gross underpayment to existing shareholders by the buyout group would affect future private equity deals.

Another popular recent topic regarding private equity buyouts is the weight and number of fees connected with the deals which are ultimately charged back to the company being taken private. Add to this the multiple roles of some investment banks- advisor, participant, and perhaps even competitor to finance the deal- and you have another ethical mess.

I had to laugh recently when John Mack, CEO of Morgan Stanley, deadpanned that there would be 'some potential conflicts' as he planned to move his firm heavily into financing and participating in the private equity business in order to sustain and increase fee revenues at his firm.

The Journal ran a long piece on July 25th, providing some examples of he egregious fees with which the target companies are saddled during and after a buyout. Cash is looted to repay legal and financing fees, plus generous dividends, "just because." Now, mind you, as the new owners, the buyout firm and management team are perfectly within their rights to do this. However, one has to wonder, for a firm such as Burger King, if the company will have much of a chance of ever becoming a consistently superior total return company, post-IPO, when it has to incur all these questionable, largely non-economic costs on behalf of the short-term buyout owners.

I don't have information pertaining to this question, but I wonder how many private buyouts of size, when taken public again via IPOs, become reasonably attractive on the basis of total returns. It could well be that, my earlier legislative suggestion notwithstanding, prior shareholders are actually better off to take the cash and run before the buyout. Unless, of course, their receipts of the many rich fee and cash streams, as part of the new ownership class, make up for post-IPO weakness in the company's share price and returns.

Adding hedge funds to this mix seems to be like pouring gasoline on a fire. These guys are even shorter-term oriented than the buyout firms and their accomplices, the target firms' managements. One can just imagine the kind of explosions that could result from letting money managers who are essentially day-traders, self-privatized from Wall Street banks, play around with private equity buyouts lasting even as little as 18-24 months.

As my partner and I discussed these various aspects of the newly-popular private equity buyout trend, we reminded ourselves that our equity strategy will be largely unaffected. Managers take firms private when they feel that their company's stock price is 'getting no respect.' That doesn't typically describe our selections. So, fortunately, we will be watching this circus continue from the sidelines.