Reasons to Be Suspicious of Buyouts Led by Management

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Michael Dell, chairman and chief executive officer of Dell Inc.

With the help of the private equity firm Silver Lake and Microsoft, Michael S. Dell, the founder and chief executive, is buying back his computer company.

And that is cause for concern.

Many management-led buyouts have been successful enriching management at shareholder expense. A look at some of the worst ones shows why.

The first issue is price. In such a buyout, a company's executives have an incentive to pay the lowest price possible, yet they are also supposed to represent the interests of shareholders. That's a fundamental conflict.

As a result, there is almost always a lingering suspicion that the top executives are timing the buyout to pay a discounted price or are otherwise taking advantage of their unique knowledge to underpay.

There are lots of examples. In 2007, both HCA and Kinder Morgan were taken private by management and a number of private equity firms in huge buyouts. At the time, management teams at both companies were criticized for the timing and the low price paid. In the case of HCA, this was the second time the founding Frist family had taken the company private.

Sure enough, four years later both companies went public, making hundreds of millions for management. More recently, Kenneth Cole used a timely drop in the stock market to complete a $280 million buyout of his own company. Mr. Cole had to raise his bid by only 25 cents a share from the initial price offered.

In those cases, the issue was whether an appropriate price was being paid. In some recent deals, management actually lowered the offer price after announcing a higher one.

Take J. Crew, whose buyout group included the company's chief executive, Millard Drexler. At the last minute, his bidding group dropped the price it was willing to pay by $2 a share. The J. Crew board still went ahead with the deal, probably because the directors felt they had no choice.

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Still, the J. Crew shareholders were treated much better than those of Landrys, which was taken private by its C.E.O., Tilman J. Fertitta, after a two-year ordeal. In 2008, he initially offered $23.50 a share. Then, as Mr. Fertitta's financing fell apart, he dropped the offer to $21 and subsequently to $13.50 a share. He was ultimately pushed into paying $24.50 a share after the hedge fund Pershing Square Capital Management took a significant stake in the company.

At least the Landrys shareholders ended up with a better price when a hedge fund stepped in. This did not happen with CKX, the owner of the "American Idol" franchise.

Robert F.X. Sillerman, CKX's chief and major stockholder, tried to take the company private for years, initially offering a deal that valued the company at $13.75 a share in 2007. The board let him do this despite not having financing. That deal unraveled. But he came back for more, teaming up with Apollo in 2011 to finally buy his company at $5.50 a share.

Why do boards allow this to happen? Directors often feel there is no choice and that if the board says no they will be left not only without a deal but with very unhappy management. And many times other bidders are not willing to jump in because they do not have management on their side.

The sentiment was aptly summarized back in 2007, when Institutional Shareholders Services recommended that its clients vote for the management buyout of OSI Restaurant Partners, the owner of Outback Steakhouse. I.S.S. stated:

We recognize the shortcomings in the process and the conflicts of interest of management and founders … but given the downside of a failed transaction resulting in a loss of premium and likely continued deterioration of fundamentals, support for the transaction is warranted.

In other words, the transaction is preferred because it is the best of bad choices. And at least one study has found that when management preannounces a deal it results in lower premiums presumably because it scares off other bidders.

The J. Crew buyout goes to another issue: process. Management can use its control of a company to manipulate the sale process to its own benefit.

In the buyout of RJR Nabisco – made famous by "Barbarians at the Gate" – the chief executive of the company, F. Ross Johnson, tried to organize his own buyout without knowledge of his board. He ultimately lost the frenzied bidding for the company in part because the board thought he was trying to to manipulate the directors into selling on the cheap.

Unfortunately, Mr. Johnson's conduct is not some 1980s relic. In the case of J. Crew, Mr. Drexler planned a buyout with his partners for weeks without telling the board, using company information in the process.

To help prevent these problems, special committees of independent directors are formed to consider a buyout. The directors are supposed to have an independent voice, but sometimes they are unable to stand up to management. Then there are the cases where they try and say no, and clash with management.

In a 2007 buyout attempt of Affiliated Computer Services by Darwin Deason with Cerberus Capital Management, board members heavily criticized the deal. Mr. Deason's response was to attack the board. Five Affiliated Computer directors resigned in protest and Mr. Deason was faulted for trying to manipulate them. The company was ultimately sold to Xerox for $6.4 billion in a deal in which Mr. Deason pocketed an extra $300 million. Shareholder litigation over that extra payment eventually yielded a $69 million settlement.

Then there is the Bankrate buyout, where the managers simply did not bother with a special committee. Bankrate's management and two of its directors bought the company pursuant to a sale process that also came under heavy criticism by Institutional Shareholder Services. The board contacted only one other potential buyer and failed to form a special committee. The directors then negotiated exclusively with the management team.

Again, the buyout group reduced the price offered at the last minute. The takeover only succeeded because interested management owned 26 percent of the shares and voted for the transaction. Only two years later, Bankrate went public again.

Finally, management-led buyouts have come under criticism when management joins with a private equity firm. The reason is that managers can simultaneously cash out some of their stock in the buyout while receiving yet more stock in the newly private company. It is a great opportunity that regular shareholders do not have. One study has found that in the average buyout, management receives $52.2 million by selling stock, and then reloads with stock in the newly private company, which on average represents 21.9 percent of the new company.

While some management-led buyouts no doubt serve both shareholders and management, there are clear perils. Dell will need to file documents with the Securities and Exchange Commission describing its sale process and negotiations with its buyout group.

These past deals show why Dell shareholders will be scrutinizing these documents very carefully to learn about Mr. Dell's involvement in the buyout process and whether they are getting a good deal.