In light of my recent investments in management buyouts (MBO), I wanted to put together a quick “hitlist” of why I think they’re so interesting. As a heads up, there are no investment ideas here; just something for future article reference / linkback, but I still think many will find it interesting.
The most important reason I think MBOs are interesting is because they are inherently extremely conflicted. Before approving a sale, a board must ensure that shareholders are receiving a fair price. The acquirer, in order to bid, must feel that the “fair” shareholder price represents a bargain for the acquiring company. If the acquirer is a competing company, the bargain purchase may make sense, as the synergies between the two businesses may be worth more than the “fair” value of the standalone business. For private equity companies, again the bargain purchase argument may make sense. Perhaps they disagree with the board’s assessment of fair value, or they believe they can take different strategies than management that may create value.
However, for MBOs, this “fair/bargain” argument makes no sense. Management can create no value from taking the company private. They can’t exactly argue they can create value from changing their current strategies, as that effectively argues they’re currently mismanaging the business. They can’t argue for synergies, as they’re bringing nothing new to the table. And they can’t even argue for a difference in value assessments, as boards rely on management projections in assessing fair value!
That last point is important to me. When assessing fair values, boards generally hire a financial advisor. The financial advisor does a few things. First, they look at peers to assessing trading multiple values. Second, they take management projections and do a DCF on them. Both processes rely on management input, but the second is generally considered the most relevant and obviously relies on heavy management input.
Does it seem a like a small conflict of interest that management can have input into how boards decide the company’s value in an MBO? Does it seem like there may be some small incentive for management to low ball estimates in order to lower the “fair value” of the company and purchase it on the cheap? As I’ve argued before, incentives matter. And an MBO gives management incentive to lowball estimates and undervalue the company to enrich themselves.
Then there comes the issue of proper shopping. One of the great things about a merger is the company is normally fully shopped .This shopping process, much like an auction, ensures that shareholders receive a full and fair price for their company. But this may not be the case for MBOs. First, in some MBOs (for example, American Greetings) management and the board may not even bother to shop the business. Perhaps there was a competitor willing to pay a much higher price for the business, but if the company wasn’t shopped shareholders will never know.
Even if the company is fully shopped, it doesn’t mean the process is fair. For example, Barbarians at the Gate has some tremendous scenes where KKR tries to do due diligence on RJR in order to put a bid together to compete against the MBO. Management is downright hostile, refusing to discuss the numbers, provide industry overview, or even provide proper numbers for due diligence. Much like in the fairness opinion, wouldn’t a rational management team provide extremely pessimistic numbers that discourage bidders and make their bid look expensive, not cheap? Wouldn’t they hold their cards close to their vests and refuse to discuss strategies or opportunities with a potential competing bidder? I know I certainly would.
All of these conflicts, however, are exactly what make MBOs so interesting. Management has put the company in play by offering to take it over. Once the company is in play, boards legally must respond to superior offers. And now that management’s purchase price has been revealed, a lot of their cards are on the table.
Consider this: if company X is getting MBO’d for $20 a share, than competitor Y knows that management thinks the company is a bargain at $20 a share. They also know they there are likely serious synergies between the two competitors. While X may not look like a bargain on management’s forecast numbers, Y can now take a bit of comfort knowing what price X’s management thinks the company makes sense at. Thus, they could consider coming back and paying $22 per share and feeling confident that the synergies + fact management thought the company was a buy at $20 will result in a bargain purchase at $22.
And the public bid also resolves the problem of company X not getting shopped. Maybe competitor Z was interested in buying X but didn’t know they were for sale. Well, there’s a simple solution for company Z: the bid is public now, and company X is effectively in play. Z can do some due diligence and put together a competing bid.
Are there other issues involved with MBOs? Sure. There are plenty of other risks, opportunities, and conflicts of interest. But I wanted to put this little primer together for reference when writing up future MBOs.
Disclosure- Long AM. I actively research and consider investing in a variety of MBOs.
The most important reason I think MBOs are interesting is because they are inherently extremely conflicted. Before approving a sale, a board must ensure that shareholders are receiving a fair price. The acquirer, in order to bid, must feel that the “fair” shareholder price represents a bargain for the acquiring company. If the acquirer is a competing company, the bargain purchase may make sense, as the synergies between the two businesses may be worth more than the “fair” value of the standalone business. For private equity companies, again the bargain purchase argument may make sense. Perhaps they disagree with the board’s assessment of fair value, or they believe they can take different strategies than management that may create value.
However, for MBOs, this “fair/bargain” argument makes no sense. Management can create no value from taking the company private. They can’t exactly argue they can create value from changing their current strategies, as that effectively argues they’re currently mismanaging the business. They can’t argue for synergies, as they’re bringing nothing new to the table. And they can’t even argue for a difference in value assessments, as boards rely on management projections in assessing fair value!
That last point is important to me. When assessing fair values, boards generally hire a financial advisor. The financial advisor does a few things. First, they look at peers to assessing trading multiple values. Second, they take management projections and do a DCF on them. Both processes rely on management input, but the second is generally considered the most relevant and obviously relies on heavy management input.
Does it seem a like a small conflict of interest that management can have input into how boards decide the company’s value in an MBO? Does it seem like there may be some small incentive for management to low ball estimates in order to lower the “fair value” of the company and purchase it on the cheap? As I’ve argued before, incentives matter. And an MBO gives management incentive to lowball estimates and undervalue the company to enrich themselves.
Then there comes the issue of proper shopping. One of the great things about a merger is the company is normally fully shopped .This shopping process, much like an auction, ensures that shareholders receive a full and fair price for their company. But this may not be the case for MBOs. First, in some MBOs (for example, American Greetings) management and the board may not even bother to shop the business. Perhaps there was a competitor willing to pay a much higher price for the business, but if the company wasn’t shopped shareholders will never know.
Even if the company is fully shopped, it doesn’t mean the process is fair. For example, Barbarians at the Gate has some tremendous scenes where KKR tries to do due diligence on RJR in order to put a bid together to compete against the MBO. Management is downright hostile, refusing to discuss the numbers, provide industry overview, or even provide proper numbers for due diligence. Much like in the fairness opinion, wouldn’t a rational management team provide extremely pessimistic numbers that discourage bidders and make their bid look expensive, not cheap? Wouldn’t they hold their cards close to their vests and refuse to discuss strategies or opportunities with a potential competing bidder? I know I certainly would.
All of these conflicts, however, are exactly what make MBOs so interesting. Management has put the company in play by offering to take it over. Once the company is in play, boards legally must respond to superior offers. And now that management’s purchase price has been revealed, a lot of their cards are on the table.
Consider this: if company X is getting MBO’d for $20 a share, than competitor Y knows that management thinks the company is a bargain at $20 a share. They also know they there are likely serious synergies between the two competitors. While X may not look like a bargain on management’s forecast numbers, Y can now take a bit of comfort knowing what price X’s management thinks the company makes sense at. Thus, they could consider coming back and paying $22 per share and feeling confident that the synergies + fact management thought the company was a buy at $20 will result in a bargain purchase at $22.
And the public bid also resolves the problem of company X not getting shopped. Maybe competitor Z was interested in buying X but didn’t know they were for sale. Well, there’s a simple solution for company Z: the bid is public now, and company X is effectively in play. Z can do some due diligence and put together a competing bid.
Are there other issues involved with MBOs? Sure. There are plenty of other risks, opportunities, and conflicts of interest. But I wanted to put this little primer together for reference when writing up future MBOs.
Disclosure- Long AM. I actively research and consider investing in a variety of MBOs.
