Conflicts of interest can lurk at every corner with management buyouts (MBOs) – the scenario where a group of people within the company acquires the business, or a division, from its existing owners or shareholders.
While the management buyers have a fiduciary duty to deliver the best possible deal for outside shareholders, they also clearly would like to pick up a bargain if possible.
"There is this inherent kind of mismatch because obviously they're going to want to get the lowest price possible," says Jared Stanfield, a senior lecturer in the school of banking and finance at UNSW Business School.
In the paper,
Are Target Shareholders Systematically Exploited in Management Buyouts and Freezeouts?, Stanfield and his fellow authors – Jarrad Harford from the Foster School of Business at the University of Washington and Feng Zhang from the David Eccles School of Business at the University of Utah – examine this vexing issue.
They find evidence that managers and controlling shareholders "time MBOs and freezeout transactions (a merger deal that seeks to eliminate unwanted minority shareholders) to take advantage of industry-wide undervaluation".
Their research indicates that portfolios of industry peers of such transactions show significant alphas – a measure of the active return on an investment while accounting for risk factors – of about 1% a month during the first 12 months after the transaction.
Stanfield concedes that MBOs are complicated and that buyers and shareholders will sometimes win or lose.
"So we are not pushing the idea of the 'bad guy manager' coming in and stealing money from the poor shareholder," he says. "But it does seem that a firm being undervalued is a significant source of value for managers and controlling shareholders."
'Why do shareholders and courts not see the potential for exploitation and stop it?'
– JARED STANFIELD
Deriving lower value
Andrew Jones, head of corporate finance at accounting and business advisory firm PKF Australia, says MBOs can be an effective way for a founder or other business owners to realise wealth without significant disruption to their business's management, staff and customers.
However, he thinks MBOs are an option that "often derives a lower value".
"Typically, the highest value is ordinarily paid by a trade buyer who may have synergies with the business, or if the public markets are running well then an IPO (initial public offering) is attractive," Jones says.
"If the shareholders or owners of the business are definitely wanting to sell and are pressured on time frame, it may be that circumstances dictate that an MBO or succession to management in some form is the only available option."
Jones says in most cases stakeholders will prefer an IPO or selling to a competitor or trade buyer so they can benefit from control premium (the amount a buyer may be willing to pay over the current market price in order to gain a controlling share in the business) and synergy value (the amount by which the value of the combined firm exceeds the sum value of the two individual firms).
"That's the case nine times out of 10," Jones says.
Stanfield and his co-authors suggest there is little doubt that when insiders choose the timing of a buyout, the process is open to potential abuse.
"In this study we conclude that, on average, managers time these bids to take advantage of industry-level undervaluation. In this way, not only do the deal valuations appear fair, but the managers can capture the difference between the target's true value and its bid price.
"Across a battery of tests, including long-run abnormal returns, counterfactual tests, and industry valuation and operating performance, the results are consistent with our hypothesis. Our results suggest, but do not prove, systematic exploitations by managers and controlling shareholders around MBOs and freezeouts."
Yet Stanfield notes it is difficult to prove that a deal is definitively exploitative.
"Remember that the shareholders have agreed to sell. No one is forcing shareholders."
Jones agrees that power rests ultimately in the hands of shareholders and adds that there is inevitably tension between the price and value of a business.
"I don't think there's a huge conspiracy out there. It's just too competitive a landscape for that to happen. It's a matter of when these deals come to market – if there's a lack of options, then the market is generally depressed," Jones says.
'Still a good deal'
A good example of the complexities of MBOs and freezeouts is computer magnate Michael Dell's 2013 purchase of Dell Inc, with private equity firm Silver Lake, at a time when the company's core personal computer business was in decline.
The final price negotiated was US$13.96 a share, including a special dividend. This put the value of the business in excess of US$24.5 billion and represented a 28% premium over Dell's stock price in January of that year.
Most analysts felt Michael Dell had paid way too much. However, in the year following the announcement of the deal, Dell Inc's industry peers experienced a significant resurgence, with industry returns at 38%.
On the back of Dell Inc's rising fortunes, a legal spat ensued over the original valuation of the deal. The ruling was that the transaction was undervalued to the tune of US$4 billion (A$5.34 billion), but Dell and his co-investors only had to pay out hundreds of millions of dollars.
"So it was still a good deal for Dell," says Stanfield.
'If you don’t have a clear mechanism in place, there’s invariably a dispute and you get advisers at 20 paces and mediation around valuations'
– ANDREW JONES
Existing research has focused on MBO deals and their success or otherwise, whereas Stanfield and his co-authors wanted to explore the source of value for managers with such transactions and how to measure it.
In the paper, they note that MBOs and freezeouts are typically announced "at the trough of industry profitability".
"Specifically, we show both declining firm profitability and profit margin before MBOs and freezeouts, as well as increasing profitability and profit margin after the deal."
While the researchers found the mean target industry's market-to-book ratio at the time of MBO and freezeout announcements was significantly below its long-term historic average, they "do not observe a similar pattern for arm's length mergers and acquisitions".
The authors say there are at least three possible explanations for the positive abnormal returns to industry peers of MBO and freezeout targets: data mining, omitted risk factors, or managers and controlling shareholders successfully timing the acquisition when the industry is undervalued.
According to Jones, there should always be shareholder agreements in place to protect parties participating in an MBO, adding that values are typically based on a fixed-value mechanism or a multiple of earnings. Clarity around the valuation process is crucial.
"If you don't have a clear mechanism in place, there's invariably a dispute and you get advisers at 20 paces and mediation around valuations," he says.
In all MBOs, Jones believes it is vital to carefully select investment partners and ensure that legal and financial advice is sound: "Get the right advisers around you."
Stanfield notes that safeguards around MBOs have been in place for many years, with courts and regulators setting procedural rules to protect a target firm's shareholders. These safeguards include the formation of special committees of non-interested directors and the necessity of majority approval by minority shareholders.
Nevertheless, anomalies can and do occur, prompting Stanfield to suggest that his paper begs an answer to a broader question:
"Why do shareholders and courts not see the potential for exploitation and stop it?"
As for a definitive answer to that, the jury is still out.