DEAL MECHANIC

Public-to-private buyouts, such as that involving UK repair service the Automobile Association, have not been short on controversy given that financial sponsors have frequently reaped substantial profits within a short space of time. This has encouraged the search for an equitable solution to facilitate take-private bids, in situations where private equity bidders and public market sellers cannot agree on price. The fashionable option du jour is stub equity, which allows shareholders to retain a stake in a company following a take-private, despite the company now being in the private domain.

Buyout firms Bain Capital Partners and Thomas H Lee Partners' $19.6 billion (€14.2 billion) bid for San Antonio, Texas-based Clear Channel Communications is a key test case for the concept. The buyout firms initially had an offer accepted by the company's board in November last year. However, the strong opposition they experienced from shareholders meant they have needed to sweeten the offer three times subsequently.

The valuation of the company was upped in the final offer from $39.00 to $39.20 share, not prima facie an enormous increase. However, key to assuaging shareholder doubt was the provision that 30 percent of the company's shares could be issued as stub equity. Shareholders can subscribe for as much or as little equity as they choose, although the final stake issued will be 30 percent should there be sufficient interest, or below if there is limited uptake. This is in contrast to some structures used in the past, which issued stub equity in direct proportion to a seller's stake in the company.

Asset manager Fidelity Investments, with a 10 percent stake in Clear Channel, publicly rejected the buyout firms' original offer last year, which arguably began the process that led ultimately to the stub equity solution. Alongside Highfields Capital Management, with a 5 percent stake, and other shareholders, a blocking stake was assembled against the deal on the basis that the offer undervalued the company. Under Texan law, a buyout needs to be sanctioned by 65 percent of the shareholders, so the high-profile opposition placed the offer in doubt.

According to a source close to the bidding, Highfields led the pressure for a stub equity component to the deal. With a sweetened offer duly submitted, the asset manager agreed to accept the bid in June. Others such as Fidelity had publicly declined to comment at the time of going to press, although the view was widely expressed by those canvassed for this article that the vote will now go through in favour of the take-private.

A source said: “Some felt it was a very full cash offer; other investors said they had a longer-term outlook and now they can elect for cash or retaining an interest.” The deal's solution allows the buyout firms to complete the deal without changing the price structure dramatically, but also allows the original investors to benefit from a future rise in the value of the company.

The stub equity component has been praised as a way of persuading resistant shareholders to yield up shares in public companies and many expect it to be used in future public-toprivates in the US. However, Scott Sperling, co-president of TH Lee, expresses caution on this point. He says: “Whether the structure is employed more widely in the US is something we'll need to wait and see.”

SCHMUCK INSURANCE
Spencer Summerfield, head of corporate finance in the London office of law firm Travers Smith, which has advised on deals using stub equity, says: “Institutional shareholders will always choose cash over stub equity but it is a solution to bridge the gap when a buyer is unwilling to match the level demanded in cash terms.”

Stub equity is called “schmuck insurance” by some, he says. This is because in the UK, its popularity has increased after the returns made by public-to-privates such as Debenhams were announced. “Lo and behold the deals revealed numbers that made original institutional shareholders look bloody silly,” says Summerfield.

A brand of stub equity used in deals advised by Travers Smith is the so-called partial-private structure, which enables stub equity to be listed on a public exchange in order to provide liquidity for shareholders. It was a structure successfully employed in Ferrovial's recent bid for BAA and Morgan Stanley Real Estate Funds' (MSREF) purchase of Canary Wharf.

However, in the case of Clear Channel, investors will need to trade the shares on banks' so-called “pink sheets” or private exchanges, because no listing has been set up for the stock on a public exchange. Doug Warner, a partner in the New York office of law firm Weil, Gotshal and Manges, says: “Shareholders will have limited liquidity for their unlisted shares and will depend upon the willingness of brokers to make a market in the shares.” Because Clear Channel shares will not be available to buy and sell on public markets, shareholders will have to trade privately or await the buyout firms' exit from the company.

Clear Channel shareholders will also have to accept a lack of visibility of their investments. If there are fewer than 300 shareholders with stakes in Clear Channel after two years, the buyout firms can choose not to file SEC reports. This will likely affect the pricing of the investments until the buyout firms exit.

Warner argues stub equity is a traditional bull market play and that times may have changed for shareholders following turmoil in the credit markets. “It will be interesting to see the level of interest from Clear Channel's shareholders in taking up the stub equity, given current market conditions,” he says. Many shareholders may, after all, decide to take cash option.

that times may have changed for shareholders following turmoil in the credit markets. “It will be interesting to see the level of interest from Clear Channel's shareholders in taking up the stub equity, given current market conditions,” he says. Many shareholders may, after all, decide to take cash option.

PUBLIC LIMITATIONS ON THE PRIVATE
The buyout firms will be faced with having to submit SEC reports for at least two years following the take-private. “Having public shareholders as minority shareholders increases the costs and risks to the sponsors as they will have to remain an SEC reporting company and they can't control who holds their shares,” Warner says. Given the private equity model arguably benefits from less scrutiny and legal responsibility compared with public markets, this may be considered somewhat restrictive. The shareholders have also negotiated the right to appoint two independent directors to the board of the acquisition vehicle.

Buyout firms and public investors will be watching to see how the deal plays out over the long term. There are, however, precedents to consider. “The structure is not that new, you just have to have been in the business for more than a decade,” says TH Lee's Sperling. Before good will accounting rules were changed in the 1990s, stub equity was a common obligatory component in bids – Thomas H Lee, for example, having used the technique in its buyout of Fisher Scientific in 1997.

The noises emanating from those involved in the deal are bullish. “The stub equity doesn't change the fundamental capital structure of the deal. The financing is locked in and was signed up in 2006 when prices were dramatically different. A 10-10.5 times earnings multiple at a company like Clear Channel should ensure demand for the equity,” said one source.

If this assessment is correct, TH Lee and Bain will almost certainly be pleased with the compromise they have struck to keep public shareholders on board. The structure's enduring popularity may depend on how all parties to such deals end up feeling a few years down the line.