Value for whom?

Over the past few years, there has been a marked increase in public-to-private transactions (PTPs) sponsored by private equity funds in the UK and Europe. Many private equity groups flush with cash and trawling around for investment opportunities struck gold in the public markets, where depressed valuations of small and mid-size listed companies in particular meant these companies were unable to raise fresh capital, and their shareholders were looking for a way out.

In such a situation a PTP offers a neat solution: shareholders can obtain liquidity at a premium, company management regain access to funding while financial sponsors seize control of assets that they can work with away from the glare of the public markets. Everbody wins – or do they?

Recently a number of private equity funded UK PTPs have been subject to institutional criticism. A number of public shareholders have rejected offers for their holdings, insisting the proposed valuations of the companies in question were too low, and questioning whether management participating in a take-private really did (or do) have the equity holders' best interest at heart.

Much attention has been paid to three transactions in particular:

• the £278m takeover by London-based private equity group TDR Capital and South African house Capricorn Ventures International of restaurant chain Pizza Express, which was completed in June of this year;

• Cinven's £403m bid for health club operator Fitness First, which was completed in May 2003;

• the recommended, conditional £1.54bn offer by Permira, The Blackstone Group and a private equity fund sponsored by Goldman Sachs for Debenhams, the department store chain, officially launched in late July.

In each of these cases, leading institutional shareholders are refusing to tender to offers that they feel undervalue their respective targets. As a result, fund managers Fidelity and M&G Investment Management between them still hold around 10 per cent of Pizza Express, while Deutsche Asset Management retains a 10.29 per cent stake in Fitness First, increased from an original 7.2 per cent interest. In the case of Debenhams, Standard Life Investments has already stated that it will reject Permira's offer.

Debenhams is the most high-profile of these three test cases of investor resolve. There, shareholder unease has led to a situation where the company, whose management has pledged its support to the Permira-led consortium, is paying two other private equity funds to carry out due diligence which may yet lead to a counter-bid. Debenhams, in an effort to persuade shareholders that at the end of the bidding process a competitive offer will be on the table, agreed to pay CVC Capital Partners and Texas Pacific Group £1m a week over a period of six weeks, regardless of whether the pair will ultimately make an offer.

However, investors have also been irked by management's decision earlier on in the process to proceed with a potentially lucrative MBO, without looking at other alternatives to create value such as a share buyback.

Some were also unhappy with the fees the company will have to pay if in the end there is no successful bid at all. Debenhams has also agreed to pay Permira a £8.5m break fee in the event of management withdrawing its recommendation of their offer and throwing its weight behind a rival approach from CVC and Texas Pacific instead. When fees to advisers are taken into account, it is estimated that the lowest total transaction cost to the company, if it is sold, will be around £21m. If neither bid succeeds, the tab is thought to still mount to a hefty £12m.

Staying put
Allianz Dresdner Asset Management is one of the institutions that have gone on the record recently about PTP bids that in their view undervalue shares. There is a perception that in the past, institutional investors have taken too short term a view on their shareholdings, particularly in smaller-cap stocks. There now appears to be a growing realisation amongst fund managers that they can do more to obtain the best value from a public-to-private and in so doing protect the interest of their clients.

Mark Lovett, head of UK and Europe for Allianz Dresdner Asset Management, says: “We are now seeing a bit of a harder line in terms of [investors] not being prepared to accept valuations put on PTP transactions that do not reflect long-term value expectations. Short-term sen timent can drive shares above and below this long-term value. Historically, houses have not taken a unilateral stance if they were unhappy with a particular situation, but there is now a greater recognition that we can vote against an offer even if we end up as minority equity holders within a business.”

Holding an illiquid stake in a business that has been taken private is not without risk for a fund manager. For a start, it may require permission from its clients to alter the terms of their investment management agreements. But Lovett at Allianz Dresdner does not feel that this is not an insurmountable obstacle. “This should not be an impediment to acting in the perceived best interests of the client,” he says.

And while the fund manager may end up with an illiquid asset and little ability to influence how it is managed, some commentators believe it may not be a bad strategy for an institution that has faith in a company. For the potential reward is the benefit of a private equity investment without having to pay the fees normally associated with such an investment. Since a private equity investor, once an investment has run its course, will invariably seek to sell 100 per cent of a company, a minority shareholder can be confident of benefiting at the point of exit, too.

There is now a greater recognition that investors can vote against an offer even if they end up as minority equity holders within a business

Some institutions are less keen on the idea of an unlisted stake though. An insider at another fund manager that has also publicly opposed an offer recently feels that the relative ease with which UK companies can be taken private puts undue pressure on institutions to tender. “If a board can decide to de-list when it has taken a simple majority of the shares, that puts pressure on other investors to tender at a price they may feel is unsatisfactory. The alternative may be to ask permission from hundreds of clients to continue to hold the de-listed shares.”

Although it is unclear how the de-listing procedure could be changed to make this part of the PTP process more equitable, the regulators appear to have taken this complaint on board. UK watchdog the FSA has just completed a consultation process on proposed changes to the listing rules. One proposal stipulates that company directors should not be allowed to de-list without shareholder approval.

What motivates management?
Part of what the Debenhams transaction has brought to the fore, in addition to shareholders worrying about valuations, are questions about whether the involvement of incumbent management in a proposed takeover may prevent them from acting in the best interests of shareholders to maximise the offer price.

In the UK, where bid regulation is more advanced than elsewhere in Europe, principal protections offered to shareholders in a bid situation are set by the Takeover Code. The Code was originally formulated in reaction to the mistrust that can arise between shareholders and management while a transaction is underway, which is when shareholders find it hard not to wonder if management know something about the company that they do not. The Takeover Code requires that relevant information be disclosed equally to all shareholders; the disclosure of the same information to rival bidders; and regular consideration of market abuse and insider dealing issues. In addition, all information relevant to the target must be given to its independent directors so they can advise shareholders on how they should respond.

It is also worth noting that the Takeover Code is a flexible regime and its rules are constantly under review by the Takeover Panel. If a perception of abuse arises, the regime has the flexibility to address it.

Many practitioners feel that the rules work reasonably well. Robert Easton, a managing director at Carlyle's buyout group in London, says: “The conflict issue is pretty well established and if the independent directors and the advisers are behaving correctly, the protections are there.”

But not everyone agrees. The head of private equity at one investment bank feels the protections offered by the Takeover Code are not necessarily watertight. “It is one thing for the MBO team to have to share formal information with other bidders, but another is that there are things that people who are close can speak about informally.” However legitimate these concerns may be, Debenhams' attempt to maintain a competitive process by incentivising CVC and Texas Pacific to conduct due diligence indicates a desire to provide assurances beyond those given by the Takeover Code.

It is worth reminding oneself that while topical, the fact that shareholders, managers and private equity investors do not necessarily see eye to eye during a privatisation process is not new. Guy Weldon, a partner at Bridgepoint, says: “The issues surrounding PTPs are the same as they were five years ago. Lots of PTPs never take place despite extensive discussions as the bidder and the independent directors' committee never agree. For each PTP that takes place there are probably six where terms are not agreed.”

Nevertheless, what the unusually intense public debate surrounding recent PTPs in the UK indicates is a new willingness among institutional investors to grapple with issues that they feel should have been addressed earlier. It certainly appears that institutional shareholders, partly because they feel under pressure from disappointed clients to improve performance, have come out of their shell determined to stick by their perceptions of short- and long-term value. Should this become a trend, financial sponsors will in future have to prepare the ground for delistings of public companies even more carefully.

Intriguingly though, and this may well play a reconciliatory role in the continuation of the public-to-private argument, in the final analysis the interests of private and public equity fund managers may not be that divergent. “Very often,” says Robert Easton at Carlyle, “the exact same investors are behind the scenes in both communities.” So even in the event that a private equity company succeeds in buying a listed company on the cheap, the sellers may still have something to cheer about a few years down the line.

Privacy concerns
You tell your GP about a public company you know that would make a great acquisition target. He rolls his eyes. Why? Alex J. Stockham explores the pitfalls and potential rewards of public-to-private deals in the US.

In the United States, public-to-private transactions loom large for private equity firms because of the widely held belief that there are so many good public companies that would be better still if they didn't have to bear the burden of being publicly traded entities.

That said, many of these potential transactions have been passed over because of the onerous process required to actually complete a privatisation.

Taking a public company private in the US is fraught with difficulties and expenses. Limited partners whose GPs pursue going-private deals should know that because of the higher level of public involvement, these transactions are time-consuming and complicated, which means plenty of lawyers and investment bankers tend to be involved.

There are two main groups whose anxieties must be assuaged when taking a company private – the government and the public shareholders. Both are hard masters to please.

Not that the many complications of public-to-privates are insurmountable. Several such transactions have recently been completed with the help of private equity investors. Most have been in the middle-market, where transaction values are less than $100m. In April, New York investor Kohlberg & Co. acquired membership-based campground owner and operator Thousand Trails in a privatisation valued at approximately $113m. In March, Denver-based KRG Capital acquired publicly traded medical imaging product supplier Colorado MEDtech through its CIVCO Holdings portfolio company for approximately $62.5m. In January, Thomas Cressey Equity Partners teamed with Philadelphia-based LLR Partners to acquire publicly traded business technology software company Prophet 21 for $76m.

Lawsuits come up cynically because there can be a settlement to close the eal

Nevertheless, like death and taxes, stumbling blocks on the path to privatisations are almost inevitable. Best practice for public-to-privates is time-consuming, expensive, and when properly executed results in the highest possible price being paid for a company – not attributes that private equity firms look for.

One consistent feature of a going-private transaction is the shareholder lawsuit, which usually claims that management is selling the business for too low a price. “It's almost like a transaction cost,” John LeClaire, co-chair of the private equity group for law firm Goodwin Procter. “Lawsuits come up cynically because there can be a settlement to close the deal.”

However, the shareholder suits that frequently accompany going-private proposals point to a facet of these transactions that cannot be overlooked – in most cases, the management of publicly traded companies that are going private are essentially acting as both buyer and seller.

Conflicts of interest
“Obviously, management, if they participate in the deal, has an inherent conflict with the public stockholders because they're a buyer in the deal,” John Ayer, a partner at law firm Ropes & Gray, says. “But the market has developed a number of practices that, in many situations, will dramatically reduce the practical risk of a lawsuit.”

In brief, a public company management team that wishes to avoid a shareholder suit should immediately appoint an independent board of directors to run the sale process. That committee will hire its own advisors, lawyers and investment banking firms to help sell the company. It is the duty of the independent committee to sell to the highest bidder, which may not be the private equity firm who approached the company with the deal in the first place. “These deals get done, it's just an arduous process,” Paul Schaye, a managing director of New York investment bank Chestnut Hill Partners, says.

The process can be so arduous, in fact, that small buyout firms often shy away from going-private transactions because a collapsed deal can be such a drain on limited resources. For example, in May Bear Stearns Merchant Banking and Trimaran Capital Partners privatised ice packaging and distribution company Packaged Ice in a transaction valued at roughly $450m. Only a large firm like Bear Stearns Merchant Banking has the resources, capital and manpower to work on a deal that could take almost a year to complete – with no guarantee the transaction will actually close.

“Many middle-market firms aren't used to doing deals where they could lose the deal,” Ropes & Gray's Ayer says. “They could spend six months or more while a company is being shopped and they can get outbid. They don't like that.”

One general partner with extensive experience doing privatisations is Ira Kleinman, a senior managing director at New York-based buyout veteran Harvest Partners. Harvest Partners recently agreed to take private vinyl siding and window manufacturer Gentek Holdings for approximately $118m in cash. The transaction was done through Harvest Partners' portfolio company Associated Materials, which the firm had delisted in March 2002 for a total of $436m. Despite the firm's track record of successful privatisations, Kleinman says the potential of such transactions tends to be overrated. “In the private equity world, we're always looking for less auction deals,” Kleinman says. “The problem is, it's hard to get a transaction done that way in a public-to-private deal. You have to go through a process.”

Uncle Sam
Another part of the process that can be discouraging to private equity firms seeking to take a company private is dealing with government organisations such as the US Securities and Exchange Commission. The SEC, whose mandate is to serve as a watchdog for the public shareholder, takes a cautious view of these types of transactions because of the fact that private equity firms are typically backing a management bid to buy the business.

“The SEC, like the shareholders, might be suspicious and want to look at a proposed transaction, look at the extensive disclosure that is required and ask a lot of questions,” William Sawyers, a partner in the San Francisco office of law firm Orrick, Herrington & Sutcliffe, says. “They see themselves as protecting the minority shareholders.”

Middle-market firms aren't used to doing deals where they can spend six months and then get outbid

And of course, sometimes there is indeed something to protect the shareholders from. Larry Fisher, another partner at Orrick, Herrington & Sutcliffe, recounts a rumour circulating in legal and financial circles about a recent going-private transaction where management appeared to be deferring revenues to make it appear that the company was in worse shape than it actually was so it could be bought for a lower price.

The transaction went through, Fisher stresses, and no wrongdoing was ever proven. But improprieties, or even the appearance of improprieties, can and have plagued going-private transactions, spelling trouble for their financial sponsors.

Private appeal
The distractions of the shareholders and the governmental organisations are standard annoyances that need to be dealt with when a private equity firm is trying to close a privatisation. But despite the lengthy, expensive and potentially fruitless process, these types of transaction are on the rise, according to MergerStat. There were less than 200 privatisations in 2000, but MergerStat estimates that there will be around 375 in 2003.

There are several reasons for a company to consider going private, chief among them a desire to grow the business outside of the constraints of the public eye – a situation made more strenuous by the recently passed Sarbanes-Oxley Act. The act increases the requirements surrounding corporate reporting and disclosure and makes CEOs personally responsible for oversights.

In theory, privatisations should be occurring at a rapid clip. In practice, this has not happened to the extent that some market observers had predicted.

Harvest Partners' Kleinman says privatisations won't ever become overly popular because being a public company still holds some cache. His assertion runs counter to a notion among many in the private equity market that public-company management teams are itching to go private. “Companies still like being public -it's an ego thing,” he notes. “CEOs hesitate when you talk about going private.”

A legal source says that public companies heads may also feel a duty not to sell below the price their stock had during the glory days of the late 1990s. Ropes & Gray's Ayer agrees. He notes that valuations of many public companies are far from rock bottom, which has prevented more privatisations from being done. “While there has been some activity, it hasn't reached the levels that many people have been predicting,” Ayer says. “The valuation and the expense of doing them are factors.”

Chestnut Hill Partners' Schaye believes it to be a pity that more privatisations have not occurred, because every party involved receives something of value in the process. “The shareholders will get some value and the management team in many cases gets a bit of the apple as it goes private,” Schaye says. “They also don't have the scrutiny of operating as a public company.”

Of course, for the private equity sponsor the prospect of acquiring a company already attuned to the rigors of regular reporting and enhancing shareholder value is attractive. General partners just have to put up with a taxing acquisition process in order to reap the benefits.