Ben Stein (who I enjoy reading and watching) wrote an interesting piece in the latest Barron's and argued that managements and directors who implement LBOs often act contrary to their fiduciary duties. Of course, the case on everyone's mind right now is Dell Computer (DELL) - a company I identified as a likely takeover candidate in an article on January 1 when it was trading at $9.97 a share.
Stein's point is that LBOs are implemented because the perpetrators believe a company is worth considerably more than its share price in the market and more than the price they offer to shareholders. Since directors and officers have a duty to put shareholder interests first, they should take action to reap this windfall for the shareholders rather than for themselves. While I generally agree, I do believe that there are a few factors Mr. Stein ignores.
A company may be worth more as a private entity than as a public company and that value may be hard to realize for the shareholders. In addition, the relevant time frame for the LBO investors may be quite different from the relevant time frame for the shareholders and the impatient stock market may not be the best place to capture the premium value. That said, I think Ben is generally correct. As a long term value investor, I think that DELL is worth more than $13.65 a share and I have explained why in an earlier article. I think that balance sheet cash is understated and underappreciated in the market and, if correctly calculated, reveals that DELL is trading at an absurdly low multiple.
A more difficult question is - what is to be done? While Ben is eloquent in this description of the problem, he doesn't really describe a solution other than a directional change in human nature toward greater altruism. Some of us investors are not inclined to be optimistic about the probabilities of this kind of development - at least not in our lifetimes. Is there a mechanism which could protect shareholders in this kind of situation? Prohibiting LBOs would be too drastic and would remove a valuable corrective to the pessimism which often afflicts the stock market. I am going to list some mechanisms which have been used and suggest a new one which I believe could be more effective.
1. Fairness Opinions - In most LBOs, a "fairness" opinion is obtained from a reputable investment banking firm (I do not believe this is an oxymoron but I am open to argument on this point) stating that the consideration offered to shareholders is fair. I have several problems with this. One is that there is likely to be a "selection bias" is favor of entities which offer favorable "fairness" opinions. A more basic objection is that as a value investor I would like to be able to make my own decision about what is and isn't a fair price. I am not aware of LBOs that have been canceled or revised because of unfavorable "fairness" opinions (I am sure there have been some) but this is not the mechanism I would like to rely upon.
2. Auctions - Like a bankruptcy trustee or a foreclosing lender, management implementing an LBO can orchestrate an "auction." Frequently, a "disclosure room" is set up with confidential information available only to qualified bidders who sign non-disclosure agreements. This process lends at least some objectivity to the process. For large companies like DELL, the number of potential buyers is small and an auction may not be useful. It should at least be considered before the acceptance of an initial offer.
3. Shareholder Choice - I would propose a third alternative which would preserve shareholder rights. I would give shareholders the right to participate in the LBO. Because one objective of the LBO is generally to take the company private, I would preserve the private nature of the new company and therefore could not simply allow shareholders to "opt out" and continue owning their shares. Instead, I would create a new entity designed to facilitate shareholder participation. Here's how it could work. DELL would go private and would be acquired primarily by a private equity entity - let's call the new private company NewDell. Existing shareholders would be given the option of receiving cash for their shares or instead receiving shares in a completely new company - DHC (Dell Holding Company) whose sole function would be to own shares in NewDell.
The only shareholders of NewDell would be the private equity entity and DHC and so NewDell could be private and would not be a public company. DHC would presumably share in any appreciation in NewDell and the shareholders who converted to DHC would benefit as well. There would inevitably be some uncertainty until shareholders made their elections and the payment date could be significantly subsequent to the election date allowing the private equity entity to respond to the results of the shareholders' election. Under some circumstances, it is possible that shareholders might be required to take a certain percentage of cash to assure that the private equity entity could obtain control of the new entity. On the other hand, if the election revealed that the overwhelming majority of shareholders wanted DHC stock rather than cash, this might lead to an increase in the offer price.
I believe that a mechanism of this type is necessary to allow markets to function in such a way as to preserve shareholder value. Shareholders could begin to agitate for the enactment of amendments to corporate charters requiring these kind of provisions in the event of LBOs in the future.
Needless to say, I am an owner of DELL stock and would elect to take DHC shares if offered the option.