Going Private Transactions (LBOs and Minority Squeeze-outs)

Minority Squeeze-Outs

A minority squeeze-out is essentially another form of merger. In the classic squeeze-out scenario, a subsidiary corporation is majority-owned by its parent, but there remains a substantial group of minority shareholders. By virtue of its majority interest in the company, the parent has control over all corporate matters of the subsidiary, including the election of directors and business combinations. Because of the power of the bidder to assure the outcome of any vote to approve its offer, such situations have the characteristics of self-dealing. [1] Fear of being squeezed out on terms less favorable than those initially offered strongly influences shareholders to approve offers.

However, recognizing the vulnerability of minority shareholders, the Securities and Exchange Commission has promulgated regulations (Rule 13e-3 and Rule 14A and 14C) that govern certain going-private transactions. These regulations require that minority shareholders be given detailed information about the transaction, including why the offer is deemed fair to those shareholders, as well as their appraisal rights, if any.[2] Moreover, the Delaware courts have ruled that there is a fiduciary duty to treat minority shareholders fairly in such transactions.

As a result, most bidders in minority squeeze-outs establish special committees of independent directors to negotiate on behalf of the minority, and the company is likely to have a fairness opinion prepared by its investment banker. These developments appear to have achieved their objective. There have been several instances of special committees rejecting a majority shareholder's initial offer. Furthermore, at least one statistical study has concluded that squeeze-outs do not, on average, exploit minority shareholders.[3]

While votes against such a transaction may appear meaningless, it is important to note that there have been successful lawsuits for breach of fiduciary duty related to squeeze-out transactions.[4] To the extent such offers are abusive, it would strengthen the position of shareholders in a potential lawsuit if they were to resoundingly vote against the transaction.

Minority shareholders faced with a squeeze-out situation should evaluate the fairness of the offer price much the same as they would any other merger transaction. In addition, they should look for indications that their interests were adequately represented by an independent special committee, and that the offer was reviewed and found adequate by financial experts. Fairness opinions should be scrutinized as in merger situations.

“Going Dark”

“Going dark” transactions are intended to reduce the number of shareholders below 300 and are typically achieved via: (1) a reverse split at a very high ratio with fractional shares resulting from the reverse split being cashed out, (2) a reverse/forward split with fractional shares resulting from the reverse split being cashed out, or (3) a cash buyout of shares from shareholders owning less than a designated number of shares (tender offer or odd-lot stock repurchase).

Such transactions allow listed companies to de-list from their particular stock exchange and to terminate the registration of their common stock under the Exchange Act, so that, among other things, they do not have to comply with the requirements of the Sarbanes-Oxley Act of 2002.

Reasons for “going dark” include:

• A company derives no material benefit from its status as a public reporting company;
• The low trading volume in its common stock has not provided significant liquidity to shareholders;
• A company does not expect that it will use its common shares as consideration for acquisitions or other transactions in the foreseeable future and has no present intention of raising capital through a public offering;
• The low trading volume in the common stock results in an inefficient trading market causing substantial spikes in the trading price when actual trades are made;
• The direct and indirect costs of remaining a public company (principally compliance with section 404 of Sarbanes-Oxley) will be unduly burdensome and costly in relation to a company's size;
• The common stock has attracted only limited market research attention and the company has not enjoyed the appreciable enhancement in image that usually results from having listed company status.

The benefits of de-listing and de-registering include:

• Eliminating the costs associated with filing documents under the Exchange Act with the SEC;
• Eliminating the costs of compliance with Sarbanes-Oxley and related regulations;
• Reducing the direct and indirect costs of administering shareholder accounts responding to shareholder requests;
• Affording shareholders who hold fewer than a designated number of shares the opportunity to receive cash for their shares without having to pay brokerage commissions and other transaction costs; and
• Permitting management to focus its time and resources on the company's long-term business goals and objectives.

Some of the disadvantages of de-listing and de-registration include:

• Shareholders owning fewer than a designated number of shares immediately before the transaction would not have an opportunity to liquidate their shares after the transaction at a time and for a price of their own choosing. Instead, they would be cashed out and would no longer be shareholders and would not have the opportunity to participate in or benefit from any future potential appreciation in the company's value.
• Continuing shareholders would no longer have available all of the information regarding a company's operations and results that is currently available in filings with the SEC.
• Following the transaction, shareholders would no longer be able to trade their securities, except in the pink sheets (if at all) or in privately negotiated transactions; the effect of this may be a significant reduction in liquidity.
• A company may have less flexibility in attracting and retaining executives and other employees because equity-based incentives (such as stock options) tend not to be viewed as having the same value in a non-listed company.
• A company will be less likely to be able to use its common shares to acquire other companies.

Recommendations on “going dark” transactions should be considered on a CASE-BY-CASE basis, determining whether the transaction enhances shareholder value by giving consideration to:

• Whether company has attained benefits from being publicly-traded (examination of trading volume, liquidity, and market research of the stock);
• Cash-out value;
• Balanced interests of continuing vs. cashed-out shareholders;

Market reaction to public announcement of transaction.

Management-Sponsored Leveraged Buyouts (LBOs)

Another means of going private is a management-sponsored leveraged buyout. In such transactions, management, with the financial assistance of an investment advisor or LBO firm, raises funds through the issuance of high-yield debt securities in order to buy the outstanding shares and take the company private. LBO proponents argue that owner-managers have a greater incentive to manage a company more efficiently and profitably.

Furthermore, it is argued that the burdensome debt hoisted onto the shoulders of such companies forces managers to manage cash and cut costs in order to handle the high interest payments required as a result of the debt financing that facilitated the LBO. Finally, the substantial increase in annual interest payments serves as a substantial tax shield for future taxable income.

LBOs raise a host of controversial issues, but the pros and cons of LBOs will not be argued here. Once paid off in cash for their holdings, shareholders of the target company no longer have an equity interest in the company's future prospects.

However, shareholders are justified in asking why their company could not be run as productively before the business was entirely owned by management. Whatever the answer may be, shareholders are entitled to a substantial premium that reflects the value created by the transfer of control from agents to principals.5]

In evaluating the premium offer price from an LBO, shareholders should compare a proposal with similar precedent transactions. Shareholders also should be alert to the various sources of value present in LBOs compared to merger transactions.

For example, a substantial portion of the premium paid to shareholders may be explained by the interest tax shield caused by the debt financing of the transaction. Therefore, when the investment banker or LBO promoter presents data in proxy material to shareholders, such as a range of multiples to estimated future earnings, shareholders should be alert to whether such figures include the tax shield benefits.

A complicating factor in evaluating shareholder decisions on LBOs is the cost of a failure to consummate the transaction. LBOs are notorious for the wasted capital they expend even when they are unsuccessful. These expenses have a direct bearing on the bottom line and are translated into per share costs by shareholders. In other words, in addition to assessing the premium offered in an LBO, shareholders should also weigh the costs of not approving the transaction.