Private equity: Put up or shut up

James Greenhalgh explains why he loathes private equity firms. And he suggests a way companies can take back control if they receive one of those 'unsolicited, conditional and non-binding' bids.

Imagine you're a shareholder of a $2.0bn company. You march into the chief executive's office and suggest you might - just perhaps - offer $2.5bn for the business.

You demand full access to the accounts, senior management, and long-term forecasts. Oh, and you'd like management to outline its business plan in a detailed presentation to you and a couple of Zegna-suited associates in a month's time.

You can imagine the reaction: you'd be laughed off the premises.

Meddling interlopers?

Yet this is effectively how private equity firms approach their 'bids'. And, rather than dismiss the bidders as meddling interlopers, the target company is expected to drop everything and engage.

Those that don't suffer the consequences. Tracey Horton, the chairman of education company Navitas (ASX:NVT) was almost sacked by shareholders at the recent annual meeting because she refused to grant a bidder due diligence.

Private equity bids are invariably 'conditional' and 'non-binding'. The bidder can walk away at any time before signing an implementation agreement. The private equity bid for Fairfax Media fell over in 2017 after both bidders declined to proceed past the due diligence stage.

Private equity firms can also unilaterally reduce the price. Take KKR's recent bid for accounting software provider MYOB (ASX:MYO). After initially offering $3.70 a share for MYOB, KKR reduced its price to $3.40 after conducting due diligence.

You can see the problem here. The private equity bidder, which has an interest in causing management disruption, gets preferential treatment while causing that disruption.

Management must also inevitably divert time away from managing the business while dealing with the bid. The company will also incur fees from legal advisers and so on.

Unwelcome distraction

'Will they or won't they?' bids of the private equity variety are an unwelcome distraction for shareholders who want to own great businesses for the long term.

I'm quite irritated, for example, that we're likely to lose New Zealand online classifieds company Trade Me (ASX:TME) to a bid agreed with private equity firm Apax Partners. Until the bid, Intelligent Investor had a Buy recommendation on Trade Me almost continuously from 2014 because we believed it was a great business with unrecognised potential. Apax clearly agrees with this assessment, or it would not be paying a 27% takeover premium.

What's especially galling is that we know how Apax's ownership of Trade Me will likely play out.

When the transaction completes in April or May this year, Apax will gear up the business. Trade Me's current enterprise value is about $2.6bn, of which only $200m or so is debt. Apax is likely to add significant debt, which will juice up its equity returns. But you can be sure that when Trade Me is re-listed on the New Zealand stock exchange in five years, its debt levels won't be reduced again to $200m.

This 'loading up a good business with debt' is straight out of the private equity firm's playbook. And if, in the meantime, Trade Me goes belly up for some reason, it's the banks - and their shareholders - who will wear a decent chunk of the losses.

What concerns me most of all, though, is what Apax is likely to do to the Trade Me business. No doubt it will try to minimise costs and improve staff productivity but, most importantly, it will look to exercise Trade Me's pricing power more aggressively.

Boosting revenue this way turbo-charges profits in the short term. But increasing prices irritates customers and encourages new competition in the long term.

Time lags

Private equity firms take advantage of time lags. Measures to boost profitability over Apax's period of ownership will make the business seem more valuable - and guarantee a profitable exit. Five years down the track gullible investors in a newly re-listed, more indebted Trade Me will be impressed because Apax apparently managed it so much better.

We know how this story unfolds because we've seen it many times before. Running a business for an eventual exit means you manage it differently than if you intend to own it for decades. Cutting too many costs or exercising too much pricing power certainly boosts profits - but it can irreparably damage value.

Save for voting against the Trade Me takeover in April - which I'm likely to suggest, not that it will make much difference - there's little shareholders can do now. Our hearts probably wouldn't be in it anyway; our greed means we've already mentally banked the profit and our overconfidence makes us think we'll find an alternative business just as good.

However, one thing we can start demanding of our companies is that they insist private equity bidders 'put up or shut up'. I propose that companies insist that all bidders pay a deposit of between 2-5% of the proposed transaction value before granting due diligence. The deposit would be refunded on a signed implementation agreement.

For one thing, a deposit would prevent private equity firms from making frivolous 'bids'. It would also help compensate other shareholders for the costs and management disruption of assessing a bid.

Most importantly, it would probably act to reduce the number of bids in the first place. And for long-term shareholders who own quality businesses, that can only be a good thing.

Disclaimer
Intelligent Investor provides general financial advice as an authorised representative under the AFSL held by InvestSMART Publishing Pty Limited (Licensee). InvestSMART Funds Management Limited (RE) is the responsible entity of various managed investment schemes and funds and is a related party of the Licensee. The RE may own, buy or sell the shares suggested in this article simultaneous with, or following the release of this article. Any such transaction could affect the price of the share.

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