Guns drawn in a Spotless stand-off

Pacific Equity Partners' attempt to pressure Spotless group into embracing a takeover is at an impasse, with only three obvious mechanisms for resolving it.

On Monday Spotless surprised, and angered, PEP by telling it, at a meeting that PEP thought was to discuss further engagement between the parties, that it would provide the private equity group with access to due diligence and commit to unanimously recommending a PEP offer – but only if it was at not less than $2.80 a share rather than the $2.68 a share PEP had indicated it might be prepared to pay. Without an indicative offer of at least $2.80 a share, there would be no due diligence, no recommendation and no meaningful engagement.

PEP responded yesterday by saying that despite the voluminous presentation Spotless' management provided to it and the market last month, it had been provided with no information that would justify a valuation above its $2.68 a share. It said it was unable to progress the proposal without access to due diligence.

Today Spotless focused on its medium-term outlook and its belief that it has the ability to lift earnings before interest, tax, depreciation and amortisation from the $90 million to $94 million expected this financial year to about $140 million to $150 million within three or four years as its transformation program is completed.

The Spotless view is that the PEP price is based on today's circumstance and market relativities rather than acknowledging the existence of a major restructuring that, if successful, will create a structural uplift in margins and profitability as Spotless evolves into an integrated multi-service business. It says its determination that $2.80 a share was an appropriate price is based on the group's medium and long-term prospects.

PEP can't bid, it appears, without conducting a due diligence process. Generally lenders to private equity won't advance funds unless there has been a due diligence investigation and the target company's board have been locked into supporting a scheme of arrangement, ensuring a 100 per cent ownership outcome.

Spotless has made it clear there will be no due diligence without a $2.80 a share indicative offer. Unless there is a significant change of heart – and the Spotless board would find it hard to reconcile a view that the minimum acceptable price is $2.80 a share with a decision to grant due diligence at something less – there will be no due diligence and no offer from PEP unless either PEP budges and raises the price it is prepared to pay or there is a different Spotless board.

PEP is displaying no obvious signs of any willingness to bid against itself again (it views an earlier decision to alter the proposed offer from $2.63, which was essentially a decision to allow Spotless shareholders to keep their interim dividend of up to five cents a share) as an increase in the offer.

With that option for breaking the deadlock apparently closed, that leaves the potential for a challenge to the board as the other way in which the impasse might be broken.

There are Spotless institutional shareholders that are very vocal about their frustration that Spotless hasn't thrown open the door to PEP and which have threatened to call an extraordinary general meeting to try to change the boardroom.

Apart from the controversy and hostility that would generate, which private equity firms usually try to avoid, and the uncertainty over the eventual outcome, any prospective replacement directors would face some rather awkward issues.

It would appear a reasonable assumption that Spotless didn't pluck the $2.80 a share number out of the air – that it has a significant amount of analysis and valuations to support the board's view of the group's baseline worth.

Presented with that kind of material, there would be some rather interesting questions relating to fiduciary obligations that new directors would need to consider before they committed to any offer below that level.

In fact, while there has been some criticism of the incumbent directors for denying PEP due diligence and an endorsement unless it is prepared to pay at least $2.80 a share, it is arguable that they would compromise their fiduciary obligations – and their own integrity – if they had a strong and evidence-based belief that $2.80 a share was the absolute minimum the company was worth if the interest of all shareholders were taken into account and then committed their unanimous support and their co-operation to a bid at a lower price.

The third option for resolving the situation would be for PEP to simply walk away, which is quite feasible, although having locked up the support of a number of the key institutional shareholders PEP will be reluctant to let the opportunity pass.

Spotless focus on the medium to long term – and PEP's interest in acquiring the group – are almost certainly because both the incumbents and PEP see the same future for the group.

The Spotless transformation project isn't an attempt to reinvent any wheels. There are a number of integrated services groups offshore that provide a template for what Spotless is trying to create.

If it is successful in replicating their model it will not only get a big uplift in margins and profitability but because it, uniquely, has a broad enough portfolio of complementary service businesses to pursue the strategy, a very significant competitive advantage as well.

The issue shouldn't be whether the strategy is right, or whether or not Spotless will get a significant structural uplift in profitability once the new model is in place, but whether the current management can execute the change program effectively.

At this point Spotless believes it is on track and the changes are already delivering benefit. If it executes the remainder of the project effectively, it should eventually be worth a lot more than $2.80 a share.

PEP might believe it could manage the changes better, or that it would be easier to undertake the costly investment required to create the new model within an unlisted environment, or perhaps just that the current difficult sharemarket conditions and the institutional hunger for whatever positive returns are available have created an opportunity. It wouldn't be prepared to make an offer if it didn't think there were substantial gains to be had in the medium term.

The notable thing about the stand-off is that, despite some of the sillier things said about the Spotless tactics, the board hasn't simply stared down PEP, denied it due diligence and waited for it to go away.

Perhaps as a response to the pressure from the institutions, the board has actually nominated a price at which it will not only open the group's books to PEP (or anyone else) but also committed to recommending an offer at that price, unanimously. The directors have left themselves no wriggle room if someone puts a $2.80 a share proposal on their table.

That price is only about 4.5 per cent above the price PEP has already indicated it is willing to pay – the board hasn't put an outrageous price-tag on the company that would effectively be akin to saying Spotless wasn't for sale at any price. It would cost PEP only an extra $32 million, in an offer that places an enterprise value of more than $1 billion on Spotless, to guarantee itself a bloodless and successful outcome (in the absence of competition).

In theory there is a fourth option for ending the stalemate. PEP could simply make a conventional bid. For the same reason – its bankers – as it is unable to commit itself to a scheme without due diligence and the unanimous support of the target board, however, PEP would find it very difficult in today's environment to find anyone willing to lend it the funds for a hostile bid.

PEP hasn't said it won't increase its offer, so that option remains open. Neither has it threatened to walk. It appears to be hoping the shareholder pressure, or perhaps actual shareholder action and a board spill, will either cause the board to crack or see the directors replaced by a more co-operative bunch. The impasse could be a lengthy one.