Going Private
from
Autumn 2001
by Julie Connelly
It
is the most arduous experience you will ever go through as an outside
director—and chances are you will have brought it on yourself. The
company’s stock price has been languishing for a year or two, and your
CEO, whose options are so far underwater they’ll never see daylight
again, mentions at a board meeting that he just happens to have been
approached by the partner of a leveraged-buyout firm who can’t
understand why the investment community has lost interest in such a
fabulous company. You can’t understand it either, and so you authorize
the CEO to see what the buyout firm has in mind.
From that point on, you and the other outside directors have stepped into a corporate film noir where the issues are murky and it’s tough to know who the good guys are. The transaction that results from the CEO’s little confab with the buyout firm is likely to split the interests of management from those of the shareholders and pit inside directors against outside directors, and might result in an avalanche of shareholder suits alleging that all the directors were derelict in their duties of care and loyalty. Then, if the deal gets done, the shareholders, having been jettisoned like so much ballast, may get to watch the company prosper and make a new set of owners rich.
The seductive proposition that the buyout firm has in mind, of course, is to take the company private, usually at a 30% to 40% premium above its current market price and with the current management as equity partners. This means that you, as a director, have just set yourself up for the ultimate conflict of interest. Says Charles Elson, director of the Center for Corporate Governance at the University of Delaware: “Management is saying, ‘We think the company has a better future under us than under the shareholders.’ Why is that? What do they know that I don’t know?”
Although the environment for going private is nothing like it was in the 1980s, when Michael Milken’s junk bonds fueled an enormous buy-’em-and-bust-’em-up boom, it is starting to heat up as share prices cool down. So who should go from public to private? The ideal candidate for a P2P, as Wall Street’s Net-heads call these deals, is a company with a market cap of $250 million to $1 billion, excellent management, superb growth prospects, and market leadership in its industry—and one that is out of favor with investors.
The last of these criteria is what counts, of course. Directors of such companies no longer have high-multiple stock to use as currency for acquisitions, their access to capital has declined with the stock prices, and they can’t use worthless options to hang on to top-performing managers.
Meanwhile, private equity firms (the classier name that the LBO shops prefer) have raised immense war chests to finance management buyouts of orphaned corporate divisions, private businesses whose owners want to cash out, and undervalued public companies. Depending on who’s doing the estimating, somewhere between $100 billion and $200 billion of uninvested private equity money is sloshing around looking for deals.
The action is already picking up. At the end of May, private equity firms were at work on 38 leveraged buyouts, according to Fred Jager, president of Hunter Wise Financial Group, an investment banking firm in Newport Beach, California. If that figure is annualized, LBO firms are on track to do more than 90 deals in 2001, compared with 77 last year, 74 in 1999, and 70 in 1998. These numbers would probably be bigger but for the difficulty of raising the debt needed to finance the deals. Default rates have climbed to between 8% and 9%, compared with 4% in 1999, and are scaring off even risk-taking investors. And banks have turned tight-fisted because they’re trying to recoup from their telecom lending excesses of the past several years. Private equity firms typically contribute 35% to 40% of the capitalization to their buyouts—the norm was 5% to 15% in the really leveraged ’80s—and the rest comes from a combination of high-yield and bank debt.
Few directors are willing to talk about going private on—or even off—the record. One of the few who will is William E. Mayer, a director of Johns Manville, the building-products company that was forced into bankruptcy by asbestos litigation in the early 1980s. In 1998, the company began to look for a buyer. Says Mayer, who is also the founder of Park Avenue Equity Partners, a New York City buyout firm: “My responsibility as a director is to the shareholders, and I can’t protect them without a motivated management. But I’m not supposed to deal with management, because they’re potential adversaries in the deal. If I can’t sell the company in the end, I know how this process will upset managers and customers.” The process is so loaded with pitfalls and the complexities are so enormous, he concludes, that going private “is, I think, even more difficult than firing a CEO.”
It was particularly difficult for the Manville board, which took 18 months to find a buyer. In June 2000, one emerged in the form of a partnership between Bear Stearns & Co., the investment bank, and Hicks Muse Tate & Furst Inc., a leading LBO firm. But then the junk-bond market and Manville’s earnings began falling apart, and the two firms were unable to round up the financing they needed. That became front-page fodder for the financial sections of newspapers all over the country, leaving everyone involved red-faced.
The disclosure rules that Mayer refers to are onerous because there are so many conflicts. In most corporate transactions, directors are covered by the business-judgment rule that assumes you knew what you were doing and acted in the shareholders’ best interests. Not so in a going-private transaction. You must show that the price you have accepted is a fair one and the best price obtainable under the circumstances. Then, as certainly as night follows day, when the press release announcing the deal goes out on the wires, enterprising class-action lawyers will line up to sue you for breaching your fiduciary duty and failing to maximize value for shareholders.
“Companies that don’t do a lot of deals are not necessarily prepared for going private,” says Christian Oberbeck of Saratoga Partners, a New York City LBO firm that has taken a number of companies private, among them Formica Corp. “The boards weren’t selected with the idea that their companies are going to go private one day.”
For the outside directors, the film noir cameras start rolling when management and its private equity partner put an offer for the company in writing. Sometimes this is the only offer on the table; other times it may be one of several resulting from a discreet auction that the company’s investment banker has conducted among potential financial buyers like private equity firms and strategic buyers such as competitors.
For example, Buffets Inc., a Minnesota restaurant chain, asked its investment banker, US Bancorp Piper Jaffray, to find ways of pumping new life into the company, including a possible sale. Of 88 prospective buyers, only two, both LBO firms and both interested in making management part of their bids, came up with firm offers. The directors turned down a deal that would have required them to line up financing, preferring the all-cash $650 million bid by Caxton-Iseman Capital Inc.
Once there is an offer, the board appoints a special committee of three or more independent directors to advise it on whether to accept the deal that the full board will in turn recommend to the shareholders. Prime yourself for another conflict. A high standard of independence is demanded of special-committee directors, because they are the ones who will negotiate on behalf of the board with however many buyers ultimately show up. Obviously these directors should have no other affiliation with the company or management. Yet in a smaller outfit, directors may well have business relations with the CEO or other management members. Perhaps they’re joint owners of a Jiffy Lube franchise. But since you can draw the special committee only from the existing pool of outside directors, you may have to live with such an affiliation. If so, make sure everyone on the board is aware of it. “If a director’s brother-in-law is a significant supplier to the company, these things come out in litigation,” warns James M. Hill, managing partner at the Cleveland law firm Benesch Friedlander Coplan & Aronoff.
Sometimes a conflict cannot be tolerated. At Buffets, independent director Michael T. Sweeney was excluded from special-committee membership when he revealed that he was in discussions about going to work for a private equity firm that was a potential bidder for the company.
Legally, these transactions are all about process, about building a record and documenting every step the directors take to get the best price they can for the company. “The courts judge these things on process, and the process is almost as important as the outcome,” says the director of a company that is going private now.
To reassure the courts that you went through the process correctly, you must document that the directors met several times to discuss the offer, and that the meetings were not just pro forma quickies. Did you receive independent financial and legal advice about the deal? Did you try to get the bidder to up the ante? “Courts like to see bargaining,” says a lawyer who advises special committees.
It’s best if all your decisions are unanimous; otherwise you are inviting lawsuits. So you’ll spend a lot of time on tangential matters raised by directors with bees in their bonnets about issues that turn out to be negligible. But when you file the deal with the Securities and Exchange Commission, the papers must show that you considered every aspect of the transaction in the light of its effect on shareholders and that the special committee spoke with one voice.
Before you can begin your deliberations as a committee, you must appoint a financial adviser—usually an investment banker—to counsel you about the fairness of the offers and the likelihood that they can be financed. You’ll also need a legal adviser to apprise you of your fiduciary duties as you negotiate with the buyers. Neither the individuals you deal with nor their firms should be receiving any other fee income from the company or any of the purchasers. If they are, the minutes of your meetings had better show that it was disclosed, discussed, and, for whatever reasons, determined not to be meaningful.
Deputize the committee’s legal counsel to keep meticulous minutes of all your deliberations. Remember, you’re going to have to prove that the price was fair to the shareholders. But don’t indulge your own penchant for note-taking; your little pensées can be subpoenaed. A lawyer who has advised special committees tells of an industrious director who wrote “Price too low” on his copy of the offer. Well, wouldn’t you know that turned out to be the final price? Of course there was a lawsuit. It never amounted to anything, but the director “had a painful two hours in deposition,” the lawyer recalls.
Unfortunately, as a special-committee member you are going to be without the one set of advisers you habitually consulted in the past: top management. Even though the future of the company is at stake, you can’t talk to the men and women who know the most about it, because they’re involved in the deal. “Instead of approving the recommendations of people you relied on, you have to make decisions without them,” says Robert L. Friedman, who’s a managing director at the Blackstone Group, a private equity firm in New York City that has taken many companies private.
In fact, far from being able to advise you, management is starting to pressure you like a Sopranos representative looking for the vig. They want their deal closed as fast as possible. The company is hanging out there flapping like a pair of scarlet long johns on a clothesline. The buyers don’t want someone else to come in with a higher offer that they will have to top. You will be pressured to move quickly to negotiate a deal, and to hold off making any announcement until you have signed on the dotted line.
Says one beleaguered director: “I’m the chairman of the special committee for a company that is going private right now. The buyer complains that I’m too careful, too methodical. Managers are exasperated: Why can’t I just make up my mind? People are calling me on the phone and writing nasty letters complaining that we should have closed this deal weeks ago, that I’m going through a process instead of getting a deal done. It’s not making me popular. I hope I’ll be on good terms with the other directors at the end of this.”
The buyers will try to force your hand by saying that if you shop their offer, they’ll withdraw it. This is a standard private equity threat, and one you shouldn’t fall for. If the offer is that good, why would anyone top it? “The board has to say, ‘That’s an exposure we’ll risk.’ You can’t be bullied. Ultimately, the courts won’t let you be bullied,” says John K. Castle, CEO of Castle Harlan, a private equity firm in New York City.
The directors of IBP Inc., formerly Iowa Beef Processors Inc., were threatened in just this fashion last October and yielded, with predictable results. Management, backed by DLJ Merchant Banking Partners, offered $22.25 a share for the company. The buyers told the special committee that if it solicited other offers, they would withdraw theirs. The directors dutifully kept mum, even though a year earlier IBP had held inconclusive talks with Smithfield Foods Inc., a competitor, about a combination. Then, while the special committee was negotiating terms with DLJ, Smithfield bought a 6% stake in IBP. Again, not a peep to Smithfield from the directors about the LBO discussions.
When the deal with DLJ was announced, however, Wall Street analysts greeted it with outrage. Not only was it below the $27 to $28 a share they deemed a fair price, it also fell short of the company’s 52-week high of $25. Fifteen shareholder suits rained down on IBP.
A complicating factor was that John Chalsty, DLJ’s chairman, was on the IBP board of directors. Though he did not participate in board deliberations on the merger, Chalsty and DLJ bankers met with two members of IBP’s special committee and their advisers to talk about the deal. “There was a real conflict of interest in IBP, even though Chalsty recused himself,” says Charles Elson. “It put the other directors in a difficult position.”
In November, Smithfield offered $25 a share for the company and DLJ bowed out. The shareholder suits enjoining the DLJ offer were dropped. Smithfield’s bid was ultimately topped by a $30 offer from Tyson Foods, which the IBP directors accepted. A messy transaction became even messier when Tyson tried to back out of the deal after IBP, under SEC pressure, had to restate its earnings. A Delaware court oiled the shotgun and ruled that Tyson must take its walk down the aisle.
Obviously the IBP committee came embarrassingly close to selling the company way too cheap. As Michael D. Madden of Questor, a New York City private equity firm that specializes in turnarounds, points out, “The biggest mistake directors make is not being informed about the value of the company initially, and then not keeping up-to-date about it.” Unless you can establish a frame of reference for the price the buyer is offering, you’ll leave a lot of money on the table.
You can use an auction to set a true price, but there are disadvantages to this strategy. For one thing, you don’t know what big bad wolf is going to show up to huff and puff and blow the house down. Would you want to sell the company to a financial buyer who offered an adequate price but planned to install Al Dunlap as CEO? And if strategic buyers show up but don’t win the company, you have just shared your trade secrets with your chief competitors. Auctions can also be very distracting to managers. James Hill says, “An auction could cost you 10% to 20% off your profits” while managers are chatting up buyers instead of running the company.
Besides, “the Delaware courts have consistently stated that there is no blueprint for attempting to get the best price,” says Philip Garon, a partner at the Minneapolis law firm Faegre & Benson. So when a company decides to sell itself, a single buyer whose price is supported by a fairness opinion from the special committee’s investment banker will do. Revlon Inc. v. MacAndrews & Forbes Holdings Inc. is the decision that guides going-private transactions, and it says only that when the directors have determined to put a company up for sale, their fiduciary obligation is to get the best price for the shareholders. It doesn’t say how they should go about doing this. (For more on the Revlon case, see the box on page 30.)
But the courts don’t like to see you take the first offer. So if you don’t do any hard bargaining, there had better be a good reason—as there was when Johns Manville’s directors finally found a buyer. What the Manville directors never noticed in all the upset was that someone in Omaha had been accumulating the stock. The deal with Hicks Muse officially fell apart on December 8. Three days later Charles T. Munger, vice chairman of Berkshire Hathaway, called Robert A. Falise, a Manville director, to say that Warren Buffett had been buying the company’s stock, which was then trading at $10. Buffett was prepared to pay $13 a share for the entire company, Munger said, adding, “and don’t worry, the check will clear.”
Falise and William Mayer made an effort to get a better price out of Buffett in a conversation with him and Munger later that day, but Buffett didn’t get to be Buffett by overpaying for companies. He refused to budge, and got the company at his price.
Directors should remember that even though a deal is signed and announced, the bidding for the company isn’t necessarily over. Most contracts include a little clause known as the fiduciary out, which means that while the buyer is bound to complete the purchase of the company, the board is not bound to sell it to him. In return for paying the buyer a termination fee, usually about 3% of the value of the sale, you are free to consider and accept a superior offer, provided it is unsolicited. In other words, you can’t go looking for richer offers, but you can stand on the street corner and swing your purse. Directors should make sure that a fiduciary-out clause is part of every contract with a would-be acquirer or merger partner.
And don’t worry about paying that termination fee. It’s money well spent if a subsequent offer significantly enriches shareholders—and it’s a fair payment to whoever stimulated the market. “A contracting buyer generally incurs substantial out-of-pocket expenses and lost-opportunity costs,” says Garon. “He has also performed a valuable service for the seller by acting as a stalking-horse for a third party.”
So are the board’s worries over once you have a signed deal that you can recommend to the shareholders? Nope. Now is the time for you to start fretting about whether the deal can close. The buyer has to be able to round up his financing, and in this market that’s no certain thing, as the Manville directors discovered. Hunter Wise Financial’s Fred Jager estimates that 10% of announced going-private deals don’t close and only half of those that are taken to the board but not announced actually get done.
A deal that craters has a bad effect on the company. The negotiations were disruptive to employees, customers, and shareholders, but you assured everybody that they’d be better off in a private company. Now you’ve got to sell them on remaining public. Worse, your undervalued stock, which propelled you into this process in the first place and which rose on the announcement of the deal, drops like a rock. Now it’s trading below where it was before you decided to sell the company to management. John Castle warns, “A higher price where the execution is uncertain is not necessarily a better price.” Fortunately, the Revlon rule does not prevent you from factoring in the buyer’s ability to close as you decide what the best price is.
The going-private process finally ends in a tender agreement or cash merger when the shareholders accept the deal. From start to finish, the time commitment that directors who serve on the special committee must be prepared to make is substantial. The typical transaction takes about six months to complete and involves four or five l-o-n-g meetings of two to three hours or more, in addition to regular board meetings and lots of phone calls. Since you have a day job, most of those phone calls are going to be at night. “You need to multiply by a factor of five the considerable time you normally spend as a director,” says James McCann, CEO of 1-800-FLOWERS.com, who served on the special committee when Petco Animal Supplies Inc. went private last year. Even though McCann actually enjoyed the experience, he says, “Right now, if asked, I wouldn’t serve again on a special committee because of the time considerations.”
Once the deal is done, it can still come back and bite you. Opportunistic shareholder suits will allege “crimes against humanity,” as Christian Oberbeck puts it, in the hope of a fast settlement. Most suits, he says, are negotiated away for an amount between $300,000 and your directors’ and officers’ liability insurance maximum. But directors feel tarnished by these suits, and with reason. They’ll surface every time someone does a Nexis search on your name.
Is going private worth it? It depends on whom you ask. Managers who are also owners of the new company often work harder because “you’ve altered the incentive structure,” says David Ikenberry, a professor of finance at Rice University’s Jones School of Management. “That’s a real gain, to make the same widgets and use less capital.” From the shareholders’ perspective—the directors’ only consideration—finding an alternative to frozen, undervalued stock invariably makes sense. Getting $100 per share now is always better than being promised $120 sometime in the future. After all, whatever a director recommends still ends up as a decision to be taken by the shareholders, by way of a vote.
