Two ideas at the heart of modern financial economics are the efficient markets hypothesis, which says that investing doesn’t work, and the Modigliani-Miller theorem, which says that corporate finance doesn’t work.1 Also there is a financial industry which is pretty much organized around ignoring those ideas. Hahaha how stupid of David Einhorn to think that he could make Apple more valuable just by issuing some preferred stock! But also how stupid of David Einhorn to think he should invest in Apple rather than a market-cap weighted index of all the companies! I mean, stock picking, so last century, just index.
Management buyouts are one place where those two efficiency hypotheses break down in obvious ways. Of course management knows more about a company’s prospects than public shareholders do, and so will be able to buy when the company is undervalued.2 And of course adding giant gobs of debt to the balance sheet, with the attendant tax benefits, will make the stock more valuable. This doesn’t always work out – managements have their own problems estimating their company’s prospects, and leverage is risky – but it’s a perfectly plausible theory.
Or so I think but I come from a corporate finance background. Neil Irwin is an economics guy so he is puzzled:
There can be any of several theories behind a buyout offer for a company. One is that current management is incompetent, and new managers will run the company better. Another is that the publicly traded governance structure is a poor fit for the company—that having to answer to impatient shareholders is leading management to be unable to make good decisions for the longer-term, for example. A third possibility is that the acquirer is a competitor or in a related field, and they will be a better company through the combination.
These are efficient-markets stories for buyouts, which means that they omit the actual main reasons for LBOs,3 viz. the buyer thinks the company is undervalued and wants to buy low (and, later, sell high), or the buyer thinks larding the company with debt to juice equity returns is a good idea (and institutionally that’s easier to do in an LBO than in a public company).
Like, here is why Michael Dell wants to buy Dell for $13.65: he thinks Dell is cheap at $13.65. So does everyone, now, but in his defense when he made the offer the marginal buyer of Dell stock was paying $10.88, so he really was ahead of the curve on that one. But of course he can’t say that, because he happens to be the CEO and so has inside information and fiduciary duties to the shareholders, so it’s awkward for him to just say “based on all my inside info I think you guys are dopes for selling to me at $13.65 and I will lift that offer all day long.” Instead he has to say a bunch of pretty obvious nonsense like “Under a new, private company structure, we will have the time and flexibility to fully pursue and realize our end-to-end solutions strategy and pursue organic and inorganic investment, without the scrutiny associated with a publicly traded stock, quarterly targets, and other limitations of operating as a public company.”4
But while the marginal pre-bid seller of Dell was happy to sell at $10.88, the marginal seller now has a $14 handle, and so there’s competition, with Blackstone bidding, and Carl Icahn sort-of-bidding, for Dell.5 Here’s Irwin on those two:
They are both envisioning keeping the company public, taking over the majority of shares but leaving a “stub company” of remaining public shareholders. In other words, all the burdens that come with being public—the SEC disclosures, the short-termism that can result from public markets, the need to deal with investor relations—wouldn’t go away under Blackstone or Icahn. Only the existing management team would; that’s right, by trying to fully take over the company he founded, Michael Dell might end up losing control of it entirely.
Except that it turns out that Blackstone, at least, would be perfectly happy to keep Michael Dell around as CEO, and it seems that Michael Dell would be perfectly happy to stick around with Blackstone.
So what is Blackstone’s plan? Their proposal for Dell is clear enough on the basics: borrow a lot of money, cash out anyone who wants to sell at $14.25, keep around anyone who wants to stay (albeit subject to a cap on the total number of public shares) in shares that “would continue to be publicly traded on the Nasdaq.” Not so much on what, if anything, would change in Dell’s operations; keeping Michael Dell – whose plan, remember, was to “continue the execution of our long-term strategy and focus on delivering best-in-class solutions to our customers as a private enterprise” – suggests that the answer is not much.
Basically Blackstone wants a leveraged recap of Dell, kind of like Icahn Take 1, or Southeastern. (Also – just a guess – like some future revised Silver Lake proposal that will allow some of the complainier shareholders to keep equity too.) Also Blackstone thinks Dell stock is cheap at $14.25, and doesn’t own any, so would like to buy from anyone who wants to sell. And, if there aren’t enough people willing to sell at $14.25, it would prefer to force some – not all! – of them to sell too.6
So … that all seems fine? Except the last part? Like, go buy stock if you think it’s undervalued, plenty of people think the opposite. At the end of the day Silver Lake, Blackstone, Icahn, Southeastern, and Michael Dell all pretty much agree: Dell should take on more debt, and they should own more of it. But it’s awkward because, again, under most of the proposed deals the CEO, the biggest shareholders, and a private-equity firm with access to due diligence are teaming up to buy a lot of shares from public shareholders just because they think those shares are cheap, without even a shred of “we need to be private to realize our end-to-end solutions strategy and pursue organic and inorganic literally no one is still reading by this point.” YOU ARE STEALING OUR COMPANY, someone might shout.
It’s got to be a little embarrassing for Dell’s special committee. Not because they agreed to what now looks like a somewhat lowball bid from Michael Dell and Sliver Lake: the go-shop clause worked, flushing out additional bidders (err, potential bidders), and given that Blackstone’s offer is only 5% above Silver Lake’s it doesn’t really look like management was getting a sweetheart deal. But because they talked such a big game about having considered and rejected a leveraged recap where all the public shareholders could participate – and now may end up recommending a similar transaction where certain shareholders get to participate and others are cashed out. If they thought there was no way to get more than $13.65 worth of value as a more levered public company under its current management team, why doesn’t Blackstone agree with them? Why doesn’t Michael Dell?
Dude, get a Dell, and then get a coherent model of corporate governance [WaPo / WonkBlog / Neil Irwin]
Blackstone Is Open to Keeping Michael Dell as CEO [WSJ]
Michael Dell Considers Blackstone Offer “Management Friendly” [WSJ]
1. Oh I mean obviously all of that is wrong.
2. This is called “semi-strong-form market efficiency,” or something.
3. I’ll grant that a lot of strategic deals are synergy-flavored (his option 3), but that’s not relevant to all that many LBOs.
4. Honestly Michael Dell, what’s gonna happen if you stop publishing quarterly targets? Will, like, Carl Icahn buy a stake and try to push you out in favor of a more shareholder-friendly management? Heh.
5. Ooh btw there’s a theory out there that Blackstone is only sort-of-bidding too: that they’re jumping Silver Lake’s deal in order to prove to a Federal judge “see? we jump each others’ deals all the time! no conspiracy in restraint of trade here!” This theory is obviously a little silly but I like it, it’s delightfully conspiratorial.
6. Actually it’s a two-tier thing where (1) some big shareholders (Southeastern, etc.) get invited to join the Blackstone group and keep (presumably) all of their shares and (2) the remaining public shareholders get invited to choose cash or shares, subject to a cap on the number of shares. So technically forcing all of the (non-insider) shareholders to give up some of their shares, rather than forcing some to give up all.