Private Equity Bashing Circus?

The quality of argument about the benefits of Private Equity investment has reached a dangerously low level when a commentator in a leading British Daily Newspaper can call the discussions a 'private equity bashing circus'.
We would like to point out, however, that two crucial points hardly got mentioned so far.
One concerns the distributive effects the growing presence of private equity. A narrow group of managers in the private equity industry reaps the benefits of ever-growing buy-outs on the back on a compensation structure that has originally been designed for managers of (much smaller) venture capital funds. No one seems to know how much the numbers involved are but the combination of (over?) generous management fees of around 2 % p.a. and a profit sharing of 20 % above (unspecified?) hurdle rates let the compensation available to managers or public companies pale in comparison.
Growing concentration of company ownership in a small number of opaque management companies that are nothing but conglomerate holding companies is also contrary to the aim of a wider spread of company ownership that should be a focus in a democratic society.

No to Super-voting Shares

We reject all types of differentiated voting rights. In most cases they serve to protect the interest of a dominant owner. This does not mean, however, that we subscribe to the simplistic theory of 'one share, one vote' that is currently so popular in corporate governance circles, academia and politics. Super-voting shares are blatant discrimination and an abuse of the privilege that limited and public company status provides.

TXU - how quickly can you raise the white flag?

Towards the end of last week a bid by leveraged investment funds for the US utility company was announced and just one weekend later the board and management are already raising the white flag and agree to the terms of the buy-out offer.

It is surprising - to say the least - that a substantial business in a crucial sector of the economy can be 'taken out' in such a speedy fashion.

Should management and the board only be interested in giving shareholders access to a quick profit or should they manage the business with a longer-term perspective and leave it to the market whether or not control of the company passes to another set of shareholders?

Pro-Gov argues that in many cases the takeover terms on offer to the existing shareholders allow bidders to take control without being forced to pay an adequate premium.

The existing management is also incentivised to accede to buy-out terms too quickly as their golden parachutes and outstanding share options are crystallised in case of a transfer of control. In addition, management may be softened up by the promise of lucrative new terms of employment and share options by the new owners.

Controlling the costs of Public Sector Pensions

The introduction of a simplified Pension System would also solve the problem of skyrocketing Public Sector Pension costs.
The abolishment of pension provision by the employer (and controlled by him) would take the decision about the pension out of political control. After all, the employer does not provide us with our groceries or our housing?
If there is a political majority in favour of a certain amount of state provision the most efficient solution would be a 'Citizen Pension' payable to everyone who is above a certain age.
Additional provision would be made by each person out of his income. There could be provision to give every one an earmarked account in which he would hold his pension pot. Extra relief for hardship could be dealt with by a carefully controlled scheme that prevents abuse by those who wilfully neglect to make provision for old age.

Stop Meddling by Politicians!

That would be our main recommendation for the reform of the pension system in most countries. Most distortions are caused by the arbitrary introduction of piecemeal legislation and tax rules that were intended to favour one or the other political constituency close to the party in power at the time.
It seems to be accepted without further questioning that the citizen should rely on the state for his income in the later part of life. The more the citizen are believing this doctrine, the more the power of the politicians increases and they have little real motive to stop this trend.

One Share, One Vote?

It sounds more than reasonable to apply this formula to the realm of corporate governance. After all, what is seen as the best (or maybe least bad) system of government in the political field, should also be the most appropriate form of shareholder representation.
Never mind that even in politics this principle is only a rough guide to the reality. Various intended and unintended checks and balances exist and lead to a situation where the principle is undermined.
In our opinion, calls by the Association of British Insurers or the EC for the introduction of unified share voting rules should be scrutinised carefully. The founding fathers of the US constitution were deeply suspicious of unfettered democracy and maybe shareholders would be better served if the voting structure in public companies is designed as carefully as the constitution of the United States.
We are certainly not in favour of giving groups of shareholders (often founding families or other controlling owners) different voting rights. But more research is necessary and may well lead to the conclusion that the limitation of voting rights is well-suited to force all stakeholders to focus on the long-term well-being of the enterprise.
Some recent corporate controversies - Deutsche Boerse, Newcorp or Rentokil, to name just the most prominent ones - would have developed differently if there would have been different voting arrangements.

Are public companies sold too cheaply?

Takeovers of public companies make a lot of people happy. Shareholders can sell at a price that seemed out of reach, management gets new - and usually better - incentives or jumps ship thanks to generous golden parachutes. Investment Bankers make fat fees and all in all - thanks to supposed higher efficiencies created by the new owners - everyone is left better off.

Recently, however, some critics argued that buy-outs by Private Equity Investors have some less desirable aspects. In the US there is even a possibility that club-deals by several large buy-out firms may have restricted competition and allowed them to pick up companies for lower prices than would otherwise have been the case.

Other factors pushing companies into the hands of new owners are: managements that are promised cut-price equity stakes or benefit from golden parachutes and option schemes that pay out in the event of a takeover or stake building by investors that have no interest in the long-term future of the business.

We would argue that some simple adjustments to company law might make it possible that the public shareholders would get a higher price in successful takeover attempts. A limit to the number of shares that each holder can vote and a minimum holding period before shareholders can vote with their shares would limit the impact of stake building by hot money that is only to happy to sell out for a small profit.

Conflicts of Interest in Buy-out Vehicles

The booming demand for investing in 'Private' Equity funds allowed a few of the more prominent Buy-out firms to launch listed closed-end funds. One has to assume that the shares on offer were mostly bought by smaller institutions as well as retail investors that would otherwise not have been able to get into the funds that are launched by the major players in the industry.

Apart from the poor aftermarket performance of the shares (not surprisingly they now trade at a discount to net asset value) we are concerned about how large firms like KKR can manage the conflicts of interest if they continue to manage traditional funds that are mostly placed with their regular institutional investors.

The only fair method would be to allocate new holdings between the various funds under management, ideally pro-rata on the basis of the individual fund's total assets.

Do shareholders get fair value in Buyouts?

Today's announcement that Hospital Operator HCA has agreed to be acquired by an investor group again raises the question if public shareholders really are well served by the procedures that are currently applied during these transactions.

When management (which often benefits from takeovers either due to accelerated option vesting, Golden Parachutes or cut-price stakes in the succeeding corporate entity) and the board engage in secret negotiations that lead to a take-out price that is close to the upper end of a decade-long trading range of the company's stock it sets alarm bells ringing.

In our opinion, the price offered to all shareholders should be determined by the highest price that the bidders have to pay to get the required percentage holding that would allow them to control the company.

A proper auction process and clear rules about which shares the bidder may vote in any company meeting are necessary to reduce the 'Bidder's Surplus' as much as possible and minimise the risk that public shareholders sell out at too low a price.

Should Bid targets pay break fees?

We do not think that bid targets should be allowed to enter into binding agreements to pay any indemnity to the bidder until the shareholders have been able to formally vote on the merger/sale proposal.

All too often, the amounts that are agreed are way above any reasonable costs that the bidder may have incurred.

One has to assume that this type of agreement more often than not is intended to discourage competing bids. As such, break-up fees are not in the interest of the company's shareholders.