The Alinta management buy-out proposal (MBO) has focused attention on the conflicts that arise in MBOs.
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The Alinta management buy-out proposal (MBO) has focused attention on the conflicts that arise in MBOs. One day, the chairman and CEO were the shareholders’ champions; the next they had changed sides and were leading an attempt to buy the company from those same shareholders.
Alinta’s board did not seem to immediately be able to work out the ‘them’ and the ‘us’. It sought to deal with the issue by switching John Poynton from chairman to non-executive director and excluding him and Bob Browning from discussions on the MBO.
The whole thing was just too chummy: Bob can keep working here while he works on his MBO; Pete (Peter Magarry) can cover Bob’s job; Poynters can swap jobs with Akers (John Akehurst); the other blokes can stay on the payroll. At least that how it looks from the outside.
In the end, Messrs Browning and Poynton, who were working for the other side, resigned only after days of public criticism.
It was hardly corporate governance at its finest.
Private equity firms often bid for companies without any pre-existing agreements with management and this involves much less conflict of interest, especially if two or more private equity firms are bidding against each other.
In these cases, management works with the board to secure the best deal for shareholders.
But in an MBO, management works with a private equity firm to secure the best deal for each party.
There is no doubt that the modern CEO is motivated by money. Company chairmen seem to be spending an increasing amount of time at AGMs justifying executive remuneration packages, usually on the grounds of the need to hire and motivate the best managers.
However, no matter how well a CEO is remunerated, they can make much more money in an MBO; much, much more.
Boards should, therefore, not be surprised when their expensively hired and motivated CEO switches loyalty to a private equity proposal.
At some point in the course an MBO, usually at a very early stage and sometimes before the board is aware that an MBO is being formulated, the CEO becomes the enemy. His interests become aligned with the bidder.
CEOs in this position should resign, as Mr Browning has now done, and they should not be allowed to resume normal duties if the MBO fails.
A board is placed in a difficult position when it receives an MBO proposal because the people who know the most about the company’s operations and finances are the CEO and CFO; and they take all this knowledge with them.
The MBO group therefore has a lot of information about the company while the board knows little about the MBO.
It is like playing cards with a person who can see your hand while you can’t see theirs.
To assess the MBO proposal the board must find people in the company who can provide information on the business and its prospects.
It would be against human nature for a CEO, CFO or any executive who is involved in an MBO to represent their company’s prospects to the board with the same enthusiasm as if they were working with the board to sell the company for the best possible price.
Their MBO financing model will show clearly that the cheaper they buy the company, the richer they’ll become.
The problem goes beyond the company’s senior management.
The company’s executives who are not part of the MBO team will probably be loyal to the CEO and, even if they are not, they will be aware that they will have to work for that CEO if the MBO is successful. So they will tread carefully.
They may pass information to the MBO team and they may hold back in helping the board evaluate the company’s value.
Fortunately for its shareholders, the Alinta board has demonstrated that it is aware of these issues and it has taken steps to mitigate them, with the appointment of Mr Akehurst as chairman and ring-fencing dealings with bidders to the directors independent of the bids.
Where the Alinta board may have let down its shareholders is in preventing the situation from arising in the first place.
Private equity transactions are becoming commonplace and boards must take steps to ensure that management is prohibited from aligning itself with a single private equity bidder and negotiating against the company.
In particular, non-executive directors should be prohibited from participating in any MBO and senior management should be prohibited from passing information to or having discussions with private equity funds without board approval.
Some would say that this should already be the case under the existing regulatory and contractual environment, but current practice suggests otherwise.
• Simon Withers worked in London for 19 years in mergers and acquisitions and advised on many private equity transactions.
What's a board to do?
• Become sceptical. Review recent downgrades in internal profit projections (short and long term). Examine projects that have been put on hold.
• Create competition between private equity funds. Tell management they can join a bid but they are not to align themselves with a bid until a winner is chosen and a price agreed.This is common in the US and Europe.
All private equity funds have access to the same sources of funding and effectively work from the same spreadsheet. The private equity market is very competitive and this is a board’s best chance of achieving full value.
• Open the books to industry bidders. Industrial buyers may have synergies or strategic objectives that would enable them to outbid private equity funds.
In these situations there is often talk about an MBO being in the best interests of the company, as if the company was your auntie, but the purpose of this may be to take attention from the paramount interests in a bid situation – shareholders’ interests.
In the case of the proposed MBO, the Alinta board has said: “The board also intends to ensure that all information which is available to the MBO group and its advisers, and which is used in the preparation of the proposal, is made available to others who may wish to make a bona fide proposal.”
• Require transparency and warranties. As Alinta shareholders are to likely to be offered shares in the bid vehicle, the board and its advisers will have to value those shares. To do so, they will need a full understanding of the MBO's financing proposals.
In these situations the question always arises as to which version of the financing proposals is being shown to the board. Private equity funds seek to make large profits from their transactions but disclosing too high a return in the financing model may lead to board to believe that the offer is too low.
So how does the board ensure that it is being shown the same information that is being used by the bidder? One way would be to obtain warranties to this effect from the management team and private equity fund. The warranties would be in favour of a trust set up for the benefit of shareholders accepting the offer. This would be unusual, but the practice of dealing with MBOs in Australia is still developing, and obtaining warranties from the bidder may level the playing field.
• Consider whether the company should gear up and/or restructure on the same basis as the proposed MBO. If the capital structure of the MBO is so appropriate and attractive that the chairman and CEO are investing their own funds in it, it begs the question, should the same structure be put to shareholders as an option?
This is particularly pertinent in Alinta’s case because its shareholders would know and accept that Alinta has an aggressive policy in relation to optimising its capital structure.
• Best of all, have guidelines in place. Private equity deals are becoming commonplace and boards should have policies for dealing with such approaches (to both executives and non-executive directors) and for dealing with them following an approach. The primary objective of the guidelines should be to prevent management from aligning itself with a single private equity bidder and negotiating against the company.
In particular, the company chairman and non-executive directors should be prohibited from participating in any MBO, and senior management should be prohibited from passing information to or having discussions with private equity funds (other than preliminary probative discussions) without board approval.
This will allow the board to take control of the process, including whether or not an MBO proposal will be entertained. For Alinta, it is too late. The horse has bolted.
-Simon Withers