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Stung by a neglectful stock market, not-coms are feeling the temptation to go private, and unlock the value they say Wall Street has ignored.
Andrew Osterland, CFO Magazine
November 1, 2000
Last fall, John Perrotti, CFO of Gleason Corp., was in a sour mood. It wasn't his business. Sure, sales and proÞts at the Rochester, New York-based gear-component maker were down from the previous year. The whole machine-tool industry had seen customer orders drop in mid-1998. But the situation was not nearly as bad as the stock market seemed to think.
The company's shares had barely budged since plunging from a peak of $35 to $15 in early 1998. Meanwhile, every week or two, Perrotti could count on another dot-com making its public debut, with little more than an idea and some seed capital, at several times the value of his own business. Indeed, any company with a whiff of technology was either ascending to new heights in the stock market or quickly recovering from a sell-off. Gleason, on the other hand, was being ignored. Its stock, trading at just two to three times earnings before interest, taxes, depreciation, and amortization, was low, even for the downtrodden auto-parts industry.
"When you're an industrial, cyclical manufacturer, it doesn't endear you to Wall Street," says Perrotti, who has spent 14 years at Gleason, the last 5 as CFO. "We weren't getting a fair valuation."
Thousands of senior executives at "Old Economy" companies could make the same complaint. Perrotti decided to do something about it. On December 15, he and most of the senior management team joined CEO Jim Gleason in a bid to buy in the company's stock at $23 per share — a 30 percent premium to the market price.
With equity partner Vestar Capital Partners, a New York-based private equity group, and $180 million in loans from Bankers Trust, Gleason managers decided they would prove the stock market wrong. On February 18, after 72 percent of shareholders tendered their shares, Gleason became a private company with management in voting control.
"We can now devote 100 percent of our energy to making operational and strategic improvements to the business," says Perrotti. No more public filings, no more quarterly hoops to jump through, and no more demoralizing bull sessions with analysts and frustrated shareholders. And if the new owner-managers succeed, they'll reap the rewards themselves.
The case for going private has rarely been more tempting for managers in dozens of sectors of the economy. Manufacturers, retailers, distributors, food companies, restaurant chains, financial services firms — for all the attention they're getting in the public stock market, they may as well trade on the over-the-counter bulletin board. The drubbing of the dot-com stocks this year may have tempered their sense of injustice, but it hasn't improved the situation. "There is a whole set of companies with enormous cash flows trading at four or five times earnings," says Larry Shulman, a senior vice president at Boston Consulting Group. "Their managers think they're doing things right, but the stocks are not responding."
So the managers are. In the first nine months of this year, 189 public companies, with a value of $32 billion, have been bought out by private investors, according to the newsletter Buyouts. And with money still pouring into the private equity market, more undervalued companies will likely choose to leave the public market behind.
"The environment for midmarket buyouts is the best it's been in 10 years," says Dan O'Connell, CEO of Vestar, which has a 50 percent stake in Gleason.
The market for large deals is heating up, too. On October 2, DLJ Merchant Banking Partners, along with food processing company Archer Daniels Midland Co., offered $3.9 billion (including assumed debt) for IBP Inc., the country's largest meat processor. On June 23, Hicks, Muse, Tate & Furst Inc.; Bear Stearns Merchant Banking; and a management team led by Charles "Jerry" Henry, CEO of building-products manufacturer Johns Manville Corp., made a buyout bid of $2.9 billion for Johns Manville — betting that the market has overreacted to the slowdown in the economy.
Be Careful What You Wish For
As liberating and potentially lucrative as a management buyout can be, it is also a very risky transaction. Managers who make a bid for their public companies can see their stock price tank and face lawsuits from angry shareholders if the buyout collapses. Worse, they can be bought out by competitors and lose their jobs. "When you start going private, you're putting the company in play," says William Price, a partner at private investment firm Texas Pacific Group, in Fort Worth.
That's what happened at Acme Electric Corp. Last April, CEO Robert McKenna and equity partner Strategic Investments and Holdings Inc. offered $49 million ($7.65 per share) for the East Aurora, New York-based electronics maker. Activist shareholder Herbert Denton of Providence Capital thought the bid was too low. So, eventually, did the company's largest shareholder, First Carolina Investors Inc.
In May, the board agreed to merge with competitor Key Components LLC, based in Tarrytown, New York, which offered $57 million. McKenna may lose his job if shareholders vote for the merger on November 16.
Given that strategic buyers account for an estimated 95 percent of all changes in control of public companies, there's a very good chance that if managers try to buy their company, a larger competitor will outbid them. That may well be fine for public shareholders, but managers may not be so thrilled with the outcome. "You have to be comfortable with the possibility of losing control of the company," says Boston Consulting's Shulman.
Thomas Shattan, managing director of New York investment banking firm The Shattan Group, argues that if a company is simply looking for capital that it can't raise in the public market, there are less-risky and potentially less-expensive alternatives. "Companies don't have to go private. They can raise cash by just going to institutional investors," says Shattan, who has raised more than $600 million in private equity for small and midsize companies over the past three and a half years.
Indeed, wider swaths of the investment community have been pumping money into the private equity market, no doubt hoping to capture the kind of returns that venture capitalists had been enjoying in the technology sector. Even control-oriented buyout firms have been more willing to make minority investments in public companies. "There's less of a fetish for control," says Shattan.
For many companies with beaten-down stocks, however, raising capital is not the issue. Gleason, for example, generates more than enough cash flow to finance its own growth. In fact, the founding Gleason family took the company public in 1968 for tax purposes only, says Perrotti. "The company never really used the market to raise capital." The real issue is whether or not there is any value in remaining a public company.
Selling the Deal
From the public shareholders' perspective, only one thing matters when control of the company changes hands: price. They don't care whether a private investor or another public company is making the offer. They don't care what role management will have in the resulting financial structure. They care about getting as a big a premium as they can get.
Of course, price is equally important to a management team contemplating a buyout. Managers want to pay as small a premium to the market price as possible. "There's a huge conflict of interest right up front," says Jim Decker, director of Houlihan Lokey Howard & Zukin, a Los Angeles-based investment banking firm. And if public shareholders don't feel they're getting a fair shake in the deal, a management buyout can deteriorate into recrimination, lawsuits, and executive turnover.
Shareholders have reason to be wary of buyout bids from company insiders, says analyst Patrick McGurn, director of Institutional Shareholder Services, a proxy advisory services firm in Rockville, Maryland. "They remember the end of the 1980s, when they saw buyouts happen at small premiums, and then saw those companies come back public in the early 1990s with management pocketing the rewards," he says.
Returns on private buyouts, which may occur when the company is subsequently sold or returns to the public market, have been rich. The Cambridge Associates's U.S. Private Equity Index has a 10-year return of 20.2 percent — 27.5 percent in the last 5 years. This time around, investors are quicker to fight for a larger share of those potential rewards.
There is no avoiding conflict. Shareholders that bought into the company at a higher price than the buyout offer are unlikely to support it. Brandes Investment Partners LP, the second-largest shareholder of IBP, has very publicly questioned the fairness of the $3.9 billion bid made by DLJ, ADM, and management.
In Gleason's case, the recalcitrant shareholder was the largest, Artisan Capital Partners, which held a 12 percent stake in the company. "We believe the board is abrogating its fiduciary responsibilities to its shareholders through these actions," said Scott Satterwhite, portfolio co-manager of the Artisan Small Cap Value Fund, in a Securities and Exchange Commission filing last February. "We have expressed to the board our belief that, to ensure a full and fair price for the company, an open auction process must be undertaken."
In general, shareholders show less resistance to management buyouts when the company has already been shopped around unsuccessfully to potential strategic buyers. "After a failed auction, if management can find a financial backer — public or private — it becomes a white knight," says Decker. In many cases, however, managers don't want to risk losing control of the company in an open auction.
Technically, the board has no legal obligation to conduct one after a buyout proposal is made, says Stephen Opler, a partner with Alston & Bird LLP, of Atlanta. The so-called Revlon duties of corporate directors — established as precedent in a lawsuit when Revlon attempted to thwart a takeover by Ron Perelman in 1985 — require the board to maximize public shareholder value. Thus, the board must consider all bids that emerge for the company. It does not, however, have to solicit them.
Most public shareholders want them to. And if shareholders believe a board is biased toward the interests of management, a buyout proposal can quickly founder. "You're the ultimate insider," says Paul Song, chairman of IT consulting firm Aris Corp., in Bellevue, Washington. Song recently bought the software division of Aris, a company he founded nine years ago, for $2.6 million in cash and stock.
"You have to avoid the appearance of a non-arm's-length transaction," he says. The easiest way to do that is to establish a special committee of independent directors to consider the management bid and other possible alternatives for the company. In Aris's case, the company actively sought interested buyers for a software division that was not receiving the resources and attention it needed. After no interest was expressed, Song's bid drew less suspicion from outside shareholders — particularly since Aris maintained a 15 percent holding in Noetix Corp., the new company, with the option of increasing its stake to 45 percent.
Even when large controlling investors back a buyout proposal, as was the case with Gleason, it isn't necessarily a slam dunk. Consider Neff Corp., a Miami-based equipment rental company approximately 50 percent owned by the Mas brothers — sons of Jorge Mas Canosa, founder of the Cuban American National Foundation. Last May, the company announced it was looking for a strategic buyer for the company, causing the stock to surge to $18 by summer. When it became clear that no serious buyer had emerged, the stock fell back down below $5. On February 28, CEO Kevin Fitzgerald, backed by GE Capital, which held a 24 percent stake in the company, made a buyout bid for the company. At $9 per share, the bid was less than two-thirds the price at which Neff had gone public just two years earlier. Investors cried foul, and six separate lawsuits were quickly filed to prevent the board from accepting the offer. The uproar and a rise in interest rates killed the deal, although GE Capital may be contemplating another bid. Meanwhile, CEO Fitzgerald, his credibility with shareholders shot, resigned in June.
The buyout not only fizzled, but it also took a toll on employee morale. "It had a detrimental effect on the company," admits Neff CFO Mark Irion. He says the company experienced high turnover in its sales force because of the fiasco. "We lost a lot of employees, and this was not a good message to recruit on."
The Lure of the Deal
As considerable as the short-term execution risks in a private buyout are, corporate managers fed up with depressed stock prices are increasingly willing to take their chances. And buyout firms and Wall Street merchant banking operations, flush with cash, are increasingly eager to help them.
The big sticking point is the moribund debt markets. Since the Federal Reserve began raising interest rates last year, the spreads on junk bonds have widened significantly, forcing buyout investors to either put up more equity or seek other sources of capital. Mezzanine debt from investment bank funds and providers such as Heller Financial Inc. is filling the gap, but to a limited extent.
Industry insiders have their eyes trained on the Johns Manville deal. "It's a litmus test of the health of the high-yield market," says one private equity investor. Hicks, Muse, Tate & Furst, which has recently suffered large losses on telecommunications and theater-chain investments, is trying to engineer a transaction reminiscent of the LBOs of the late 1980s. Along with Bear, Stearns, it plans to use $1.75 billion of senior debt and $600 million in junk bonds to finance the $2.9 billion takeover.
The bankers are reportedly alarmed over the degree of leverage. Building-materials manufacturing, after all, is as cyclical a business as there is. Manville's earnings are already suffering from a slowdown in the economy. And if the slowdown becomes a bona fide recession, the company's debt load could drag it into bankruptcy — a consideration that all managers contemplating a buyout of their public companies have to weigh.
Clearly, the public market anticipates tough times for economically sensitive businesses in the future. Just as clearly, corporate managers think investors have overreacted. Here's to proving the market wrong.
Andrew Osterland is a senior editor at CFO.
Picking Your Partner
The first and probably most important decision of a buyout transaction is which partner to use. With the junk bond market in the tank and banks tightening their purse strings, the days of highly leveraged buyouts are over: You need a serious equity partner.
The good news is there's plenty of money looking for a home. Not only are buyout firms launching new funds at a near-record pace, but the merchant banking arms of investment houses such as Goldman, Sachs and Bear, Stearns, as well as the commercial banks, are also pouring money into the market. As a result, managers have more opportunity to pick and choose.
Some firms are known for their creative financial engineering. Texas Pacific Group and Silver Lake Partners, for example, helped Seagate Technology Inc. managers take the company's disk-drive business private for $2 billion — generally seen as a low price for the dominant player in the industry. They pulled it off with little protest because they simultaneously worked a tax-free distribution of Seagate's approximately $18 billion stake in software maker Veritas Software Corp. to shareholders.
Other firms, such as Clayton, Dubilier & Rice and Kohlberg Kravis Roberts & Co., have experienced, if heavy, hands when it comes to making operations more profitable.
A significant number of private equity funds focus on specific industries. Some, like Aurora Capital Group, which took auto- and medical-parts manufacturer Autocam Corp. private last February, have been building manufacturing and distribution platforms into which they can add new businesses. Others have simply acquired an expertise with certain kinds of businesses. Investcorp, for example, has a way with retailers, taking companies like Saks Fifth Avenue private. Lake Pacific Partners and Horizon Partners concentrate on food companies. Heartland Industrial Partners, a $1 billion fund, looks for industrial manufacturers such as MascoTech Inc., a diversified industrial products company it took private in August. These funds have essentially become strategic buyers, able to build economies of scale and squeeze out costs. They are long on management talent and typically expect to be involved in the day-to-day operations of acquired businesses.
If that prospect isn't particularly appealing, there are alternatives. "Managers may not want to partner with experts in the industry," says Vestar Capital Partners CEO Dan O'Connell. Vestar sells itself as a kinder, gentler buyout firm, eager to help its portfolio companies, but only to the extent that they want help.
To that end, Vestar took a minority investment in an IT consulting business to help its companies develop E-commerce strategies. It also opened an office in Paris to facilitate its companies' European investments.
Gleason Corp. CFO John Perrotti says Vestar's flexibility and willingness to take a minority ownership stake in his company were the major reasons Gleason chose to partner with Vestar. —A.O.