Management-Led Buyouts: Ethical and Legal Issues Can Cloud Outcome

Management-led buyouts, in which company managers partner with investors to take a company private and then - usually several years later - take the business public again have made many managers and families rich. They have also enriched lots of lawyers as the deals are often perceived to favor management and insiders over other investors. The benefit of these deals is that they reward managers handsomely for their efforts. The downside is that ethical questions frequently arise, which turn into legal challenges as the aggrieved investors take their case to court.

In the following article from the New York Times' Dealbook, Steven Davidoff provides the cautionary tale of two deals that will go public soon:


Private equity firms are in a celebratory mood.

The impending initial public offerings of Kinder Morgan and HCA are the latest I.P.O.’s that are about to shower riches on their private equity backers. In the case of Kinder Morgan and HCA, the party will include the companies’ managers, who had partnered with the private equity firms to take their companies private.

The two buyouts, however, are a cautionary tale for other boards considering a sale to a management team.

The $22 billion Kinder Morgan buyout was completed in 2007. Richard Kinder, the chief executive, teamed up with four private equity firms and orchestrated a buyout to his advantage. Mr. Kinder planned the buyout for more than two months before presenting a proposal to the board. His group eventually bought the company with Mr. Kinder receiving a 31 percent stake. Shareholder litigation over the buyout was eventually settled for $200 million, one of the largest-ever such sums. With the I.P.O. this week, it appears that Mr. Kinder and his private equity partners have almost tripled their money in four years during a terrible market.

$31.7 billion buyout of HCA in 2006 was led by the Frist family and three private equity firms. It also included HCA’s chief executive, Jack O. Bovender Jr. In the deal, Thomas F. Frist Jr., a founder of HCA and a director, and his son Thomas F. Frist III raised their ownership of HCA to 18.8 percent of the now private company from 6.8 percent.

The senior Frist also received a payout of more than $134 million in the acquisition. This type of simultaneous cash-out while actually raising an ownership stake is a tactic of management-led buyouts that is commonly criticized. And this was the second time the Frists had taken the company private. The buyers are also looking to triple their money in an I.P.O., which is expected to occur in the coming months.

These two deals highlight the potential risks in management-led buyouts. Managers are often friends with the directors and can use this influence to push through a buyout. At the same time, a board faces a quandary. If it says no, the board might effectively be firing treasured management. There is also the issue of planning a buyout at a low point in the company’s stock price; is that doing shareholders any favor?

The debate over management-led buyouts goes back years. In the 1980s, proposed management-led buyouts for RJR Nabisco and Macmillan were criticized. Management was viewed as trying to use its position to push through low-priced deals. There was a fierce debate at the time about regulating these transactions to prevent abuses, and Louis Lowenstein, a professor at Columbia Law School, even called for banning them.

Yet management-led buyouts can be economically beneficial, others argue. The primary justification is that a private company can be more efficient than a public one because of the capacity for an increased debt load, lower regulatory costs and diminished public scrutiny. And management is best positioned to reap these gains. After all, this is what private equity is about — creating benefits by taking companies private.

Courts and lawyers have focused on improving the sale process to cure these defects.

They focus on creating an independent committee of directors to negotiate a buyout. A “go-shop” provision is typically added to allow the target to solicit other bidders after announcement of the transaction. The goal is to ensure that there is independent bargaining and that other bidders have a real chance to buy the company.

These devices have mixed results. One study found that empowering shareholders to reject these transactions did encourage more third-party bidding. But this same study also found that management’s head start gave it the ability to pay a lower premium on deals. And go-shops with management involvement have been found to be mostly cosmetic and do not result in competing bids.

The reason for the lack of competition is not surprising. Many bidders believe that current management is necessary to run the company. They will not bid unless management is on their side.

These issues are coming to the fore in a number of recently announced buyouts. The J. Crew buyout has been criticized over how the company’s chief executive, Millard S. Drexler, and his private equity partners disclosed their initial approach. Mr. Drexler waited seven weeks to inform the board he was discussing a buyout with the private equity firms TPG Capital and Leonard Green & Partners.

In addition, the buyout group dropped its price at the last minute, and Mr. Drexler initially refused to consider partnering with any other buyers. Last week, Del Monte’s private equity buyout group announced that Del Monte’s management would be allowed to participate in the buyout. Del Monte also disclosed that in putting the company up for sale, it decided to speak only to private equity firms.

This is a common problem in many buyouts. Management is tempted to steer the process to private equity firms over strategic buyers. The reason is simple: If a private equity firm is the buyer, it will often decide to retain management and let managers invest in the deal.

So what should boards do?

Boards represent shareholders in these deals and should bargain hard. The board of Exco has recently taken just such a position in response to a management buyout proposal. Boards should also respond to a management bid by demanding that management negotiate with any other bidders and facilitate all bids, not just management’s. Boards should also open up the process as much as possible to ensure subsequent bidders can feasibly bid.

The goal is to ensure that there is an open process to reap a fair price.

And courts should consider their responsibilities to protect shareholders. Banning management-led buyouts is a step too far, but if there are signs of unfairness, a court should strictly scrutinize these transactions and not be afraid to award damages. This will provide boards a strong hand to argue for appropriate procedures.

Boards need to negotiate to ensure that shareholders don’t rue the day their own managers buy the company.