We’ve had accounting fraud, pay that seldom bears any relation to performance, and options backdating. And it appears we aren’t done yet.
The next bit of CEO malfeasance that is getting a bit more press is that CEOs are working in concert with private equity firms to buy the companies they head on the cheap. Not that this hasn’t happened before; CEOs have often gotten themselves in this conflict-ridden role. But there is now evidence that CEOs are helping buyout firms to buy “their” (of course, really the shareholders’) company at low prices, which benefits the CEO at the expense of the shareholders he is supposed to be serving. And the investment banks are also playing both sides of the fence, often jumping from being an M&A advisor to leading a buy-out offer.
This observation has been picked up by the Financial Times as an editorial by John Gapper, “Sleepwalking into a new insider scandal.” And there was a somewhat-related piece on the first page of the second section, “Investors ‘short-changed’ by buy-out groups,” which discussed that the premia to market prices paid by private equity firms averaged only 6% over the previous year’s high, a low level. Although private equity pros attribute the skimpy incentive to high prevailing stock prices, one wonders if higher CEO cooperation might also be playing a role.
Predictably, no interest yet in this story by the New York Times or the Wall Street Journal. Perhaps we are desensitized towards conflicts of interest in this country (after all, Halliburton has not been brought to heel) that we don’t notice when a change in degree becomes a change in kind. But we wonder why New York’s financial industry is losing market share to London. Perhaps it is because they have a greater respect for the rule of law and investor rights there?
There are two types of financial scandal. The first is the Enron kind, where you have to dig hard to realise what is going on. The second involves things such as analysts recommending stocks to get advisory business for their investment banks in the 1990s. Anyone with any knowledge of the sector knew that something vaguely dodgy was going on, but it carried on being tolerated until it blew up.
Given that there is so much money chasing deals and backing new ideas, we must assume that plenty of the first type are brewing. But there are also some of the second in plain view. Perhaps the most visible example is management buy-outs of public companies by executives backed by private equity firms.
To state the obvious, any chief executive who plans to buy the company that he or she leads faces a huge conflict of interest with its shareholders. The job of an executive is to make a company as valuable as possible so that its shares fetch the highest possible price. But any director who bids for a company is eager to pay as little as possible so that he or she can reap the maximum reward in the future.
There are always conflicts of interest between shareholders and managers of public companies, but they escalate when private equity firms hove into view….
Happily, there are already signs of journalists, analysts and investors waking up. The alarm clock has gone off in Australia, where the chairman and senior executives of Alinta, an energy utility, are in trouble for working on a bid for the company while still running it….
Australia is a long way away from America, and the gap in attitudes between the two countries is striking. John Poynton, Alinta’s former chairman, and Bob Browning, its former chief executive, do not seem to have departed from what has become accepted practice in the US in the past couple of years. Nor is Macquarie a more serious sinner than Goldman Sachs or Merrill Lynch, to name two banks that have played both sides of the table in the US.
One of the beauties of US securities laws is that companies that are taken private must file reports on exactly how executives and investment banks came to make bids for the companies they manage and advise. For those seeking enlightenment about markets, I recommend the filings on last year’s $14bn (£7bn) buy-out of HCA, the hospital chain, and $21bn buy-out of Kinder Morgan, the pipeline company.
Kinder Morgan’s executives started to kick around ideas for how to raise the company’s value last March with Goldman Sachs, its adviser. By August, Rich Kinder, chairman and chief executive, had mounted a buy-out that took his stake from 18 to 31 per cent. Goldman had swapped sides to advise the buy-out group and Goldman’s private equity arm had taken a 25 per cent stake.
In the HCA case, its adviser Merrill Lynch discussed the idea of a buy-out with executives last April. The managers contacted KKR and Bain Capital while Merrill, as the filing delicately puts it, “introduced management to Merrill Lynch Global Private Equity”. By July, the three private equity firms had backed a management buy-out that gave Thomas Frist, chairman and chief executive, a 15 per cent stake.
Both sales were handled by special committees of directors – the standard way to curb conflicts of interest – and in both cases executives had to raise their bids a little (7.5 per cent at Kinder Morgan and 4.6 per cent at HCA). Neither company was auctioned although HCA had a “go-shop” clause to allow other bidders to emerge and Kinder Morgan’s advisers contacted other private equity firms.
Compared with Alinta, executives at Kinder Morgan and HCA were treated indulgently. “Ten years ago, if an executive asked me about a buy-out, I would have said: ‘You are not going to break the law but you might get fired,’ ” says one lawyer. “Now, you’re not going to break the law and you’re not going to get fired. All you are going to do is make money.”
But these are troubling transactions for everyone else. It is easy for executives to solicit backers for MBOs without having formally to get the approval of their boards. All they need do is ask their financial advisers to advise them on strategic alternatives for raising the share price. Not only is the topic bound to come up, but the bankers will probably offer to leap on board and finance their buy-out.
This has been so for a while but, at last, directors and shareholders are realising that they should beware of insiders offering cash in return for their equity. At Cablevision and Clear Channel in the US and Country-wide in the UK, investors and boards have resisted bids to take their companies private. Not every MBO is inherently flawed, but when executives attempt to squeeze out their shareholders, it should be a wake-up call.