Locked into a Spotless strategy

Spotless Group's creativity in responding to PEP’s overtures hints at pressure from institutional shareholders, whose response to today's announcement will be crucial.

The Spotless board, under pressure from recalcitrant institutional shareholders, have nominated their threshold price for a change of control in the face of the bear hug being enforced by private equity group Pacific Equity Partners.

Late last month Spotless provided PEP – and the market at large – with an upbeat presentation of its position, strategy and prospects that depicted a significant structural uplift in its earnings over the next few years.

That was a response to the unsolicited approach from PEP, which foreshadowed an indicative price of $2.68 a share if the Spotless board granted it access to due diligence and ultimately unanimously endorsed a scheme of arrangement offer at that level, if one were made.

Today the board told PEP (and, maintaining its commitment to a full informed market, the ASX) that it would give the group non-exclusive access to due diligence, and commit to unanimously recommending an offer, provided it was not less than $2.80 a share.

It’s not common for a defending board to nominate the price at which they will support a change of control but Spotless has been forced to be creative in responding to PEP’s overtures because a substantial proportion of its investor base – perhaps 40 per cent, if not more – wants a transaction and the cash and investment profits it would release in an environment where fund managers are struggling to generate any positive performance.

In theory Spotless could have simply dismissed the $2.68 a share indicative and very conditional approach from PEP and, by denying the group access to its books and refusing to recommend an offer, seen the private equity firm off. Without due diligence and the directors’ support for a scheme, private equity can’t arrange the debt funding required for a bid.

Today’s response, however, hints at the pressure being exerted on the board by its institutional shareholders, with some suggestions that the institutions have threatened to call an extraordinary general meeting, presumably to re-make the board to their liking if Spotless tried to stare down PEP.

Those shareholders’ responses to today’s developments will obviously be crucial for Spotless.

If the group could deliver on the projections in last month’s presentation, which depicted the group generating $140 million to $150 million of earnings before interest, tax, depreciation and amortisation in three or four years’ time, against the $90 million to $94 million it expects this financial year, the $2.80 a share base level of value the board has placed on the group wouldn’t appear unreasonable.

The $2.80 a share level isn’t that distant from where PEP has pitched its approach that it can be characterised as a deal-stopper or as evidence that the board is opposed to any offer at any price. PEP has already signalled its willingness to outlay about $1 billion (in enterprise value terms) for Spotless, so an extra $32 million to get both access to Spotless’s books and lock in the board’s support isn’t prohibitive.

The board has effectively locked itself in. If PEP – or some other party – takes up its invitation the fate of Spotless is out of the board’s hands. Alternatively, if PEP isn’t willing to foreshadow and ultimately make a $2.80 a share offer, the board’s statement that "this is the lowest price at which the Spotless board would be willing to unanimously recommend a scheme of arrangement" doesn’t leave it much wriggle room, other than the qualifying phrase "in the current circumstances."

PEP now has a choice of how to respond.

It can take control of the process by indicating a willingness to make a $2.80 a share offer, while still having an exit path by making it clear that any offer would be subject to the outcome of the due diligence investigation.

Alternatively, it could rely on the restlessness of Spotless’ institutions, ignore the board’s invitation and wait for the institutions to deliver Spotless to it at $2.68 a share.

That would be an aggressive strategy, which private equity firms generally aren’t comfortable with, and relative to the straightforward path of dealing with the board on its terms, might involve some risk given the resolve and creativity Spotless and its advisers have demonstrated in responding to PEP so far.