Goldman Made Some Preferred Stock Investors Sad

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How shady is this morning's delightful Journal story about the travails of Equity Inns preferred stockholders? I think the answer is "just the right amount of shady," but you might disagree. The gist is that Goldman Sachs real estate private equity funds bought out Equity Inns but left almost $150mm of preferred stock outstanding. Once ENN was no longer a public company (because Goldman owned all its common stock and it had fewer than 300 shareholders), it delisted its preferred stock and stopped providing public financial information.1 This saddened the preferred holders and they expressed their sadness by bidding down the price of the preferred to under 40 cents on the dollar.

Also by complaining to the company, and the SEC, and the Journal, and anyone else who will listen. Also by doing this:

One of the preferred shareholders is responding by creating 300 separate trusts to hold his preferred shares. He argues that should qualify the company for reporting.

Should it? I don't know but I love it. You gotta fight silly formalism with silly formalism.

That's the best part but there's a lot of other stuff going on. For instance here is a fun insider trading problem:

The company has argued that it doesn't need to submit financial reports to the SEC partly because there is a "limited trading interest in the Company's preferred stock."

This frustrates the preferred shareholders who claim that the limited trading is largely because the company makes it so difficult for the public to obtain financial information. For preferred holders to get data, they have to make a written request, pay a small fee and agree that all company information remain confidential.

The amazing thing about the request form is not so much that Equity Inns charges 25 cents a page for its information (2012 financials = $6 for 24 pages), or that you can ask for "Other corporate documents that you believe you are legally entitled to" if you can describe them in detail, but the confidentiality acknowledgment:

Furthermore, except as otherwise authorized by the Company, the Shareholder agrees that he/she/it will not at any time, whether during or after the cessation of the Shareholder’s status as a shareholder, disclose, distribute, disseminate, or make public any information included in the Shareholder Package or other Company Confidential Information, and that the Shareholder will keep strictly confidential all information contained in the Shareholder Package or other Company Confidential Information.

So there you are with your preferred shares and you think you might want to sell them. To make sure I guess you'd want to look at some financial information, so you write to the company, pay your six bucks, get 2012 financials, examine them, and decide that you do in fact want out. And so you go find a buyer. And now you have a problem: you have material information (2012 financials!) that is not publicly available and that you're not allowed to reveal to anyone. So ... what? So you can't sell, I think? If you're a shareholder, your choice is pretty much (1) sell shares without knowing anything about the company or (2) hold on to your shares forever. Or of course sell to an existing holder. Such as:

They're also unhappy because a Goldman affiliate purchased two million preferred shares last year when the shares were trading on the OTC Bulletin Board at around $4 per share. They say that is not fair because Goldman has better access to the company's financial information than they do. ... "When shareholders need to sell, the only buyers are the corporate insiders who know what is actually happening inside the company," Georgetown University finance professor James Angel, a preferred shareholder, wrote to the Securities and Exchange Commission.

There are about 5.85mm shares of these preferreds, with a $25 liquidation preference, a B2 rating at Moody's, and 8.00% and 8.75% coupons, meaning that $4 a share is like a 50% yield. Pretty good! (Now the Journal says they're at $9-ish, or like a 20-25% yield, which ... seems fair for an unlisted junk-rated private REIT preferred?2)

The Journal has this poignant quote:

[S]ome shareholders acknowledge they should have paid closer attention to the reorganization. "Most of the shareholders were inert," Mr. Angel says. "As long as we're being paid dividends, what's there really to worry about?"

Well but what would they have done? The merger did not require the approval of the preferred shareholders, and the merger proxy made clear that "the surviving corporation’s ... preferred stock will not be listed on any securities exchange nor registered under the Securities Act or the Exchange Act." And, as Goldman points out, the preferred stock prospectuses do say that preferred holders will not have any "protection in the event of a highly leveraged or other transaction, including a merger or the sale, lease or conveyance of all or substantially all our assets or business, that might adversely affect the holders of the Series C Preferred Stock." Nothing in the preferred stock, or the disclosure documents, or anywhere else, protected the preferred holders, and Equity Inn and Goldman have no fiduciary duty towards them. They were hosed; all they could really do was sell to some greater fool before the merger. Presumably some of them did.

One theory of how LBOs make money for their investors is that they effectively swipe it from pre-existing creditors.3 A big company is bopping along with $1bn of investment-grade debt, and all of a sudden KKR buys it and levers it up with $4bn of new debt, trashing the credit rating and reducing the value of the existing debt to, say, $800mm. That lost $200 million has to go somewhere,4 and the natural place for it to go is to the new equity holders. The fact that their money could all of a sudden be stolen like that troubles bond investors, so they tend to build protections into their bonds, though only sometimes. Many investment-grade covenant packages don't protect against this, for instance.

And preferred stock doesn't at all: these poor fools who bought Equity Inns preferred stock (look at that 8.75% dividend!) are more or less locked in forever, unless they want to sell to the investors who bought out their company. And those investors would be happy to buy from them, at pennies on the dollar (and at a 50% yield). Which is a nice way to improve the performance of their buyout at the expense of the often-retail buyers who were seduced by high coupons into buying preferred stock even though it left them open to being hosed exactly like this. And then they were.

Hotel Deal Sparks Feud Over Preferred Shares [WSJ]

1.The Securities and Exchange Act of 1934 requires exchange listed companies to make public filings, and Section 15(d) of that Act requires anyone who has ever registered securities to file forever except that:

The duty to file under this subsection shall also be automatically suspended as to any fiscal year, other than the fiscal year within which such registration statement became effective, if, at the beginning of such fiscal year, the securities of each class, other than any class of asset-backed securities, to which the registration statement relates are held of record by less than 300 persons ...

2.I kid, I kid. Random snooping finds me Glimcher Realty Trust's 7.50% preferred stock, which is rated B2/B- and trades with a 7 handle. That's listed, though. And you can get financials. I dunno. Is the not listing worth like 15% a year?

3.Not hugely popular as a main value driver:

Also unsupported is the charge that losses to bondholders finance the shareholder gains from takeovers. Although some shareholder gains have come at the expense of bondholders, banks, and other creditors who financed these deals, Michael Jensen estimates that the aggregate amount of these losses between 1976 and 1990 is not likely to exceed $50 billion, a small fraction of the $650 billion gain to target shareholders.

4.Does it? That's a Modigliani-Miller-ish thing to say.