Private equity mania tests funds' resolve ::

Author: Simon Hoyle
Date: 10/03/2007
Words: 1498
Source: SMH
Publication: Sydney Morning Herald
Section: Business
Page: 47

Lazard's stand against the attempted buyout of Flight Centre should not be an exception, writes Simon Hoyle.

LAST month, the New York fund manager Pzena Investment Management wrote to the independent directors of Fortune 500 company Lear Corporation, expressing alarm about the possible sale of Lear to a private equity investor.

"It is our fear that the [Lear's] management may have lost sight of the long-term value inherent in the company and that their personal interest in the transaction may create an inherent conflict," Pzena's co-chief investment officers, Richard Pzena and John Goetz, wrote.

"We are well aware of Wall Street's short-term mentality and the pressure it can bring on companies. It is our hope that Lear does not succumb to that pressure and sell the business for less than it is worth over the long term.

"We would like to remind the board of its fiduciary obligation to shareholders, and urge you to seek other offers for the firm. We think it is incumbent on the board to exclude the management from this process since preserving their jobs and/or enriching themselves can come at the expense of shareholders. The trend towards private equity firms teaming up with management to 'steal' companies from their owners is alarming, and we urge you to take a stand to ensure this does not happen at Lear."

Pzena neatly sums up many of the challenges, frustrations and anger that an increasing number of private equity deals engender in "traditional" fund managers. Some managers oppose private equity investors outright, claiming they do not play by the same rules as "traditional" managers. They say that investors often don't realise that private equity investors can pay what seems like a lot of money for an asset because of how they use debt (see breakout).

Others do not oppose private equity deals per se but are concerned that an increasing number of buyouts are not being structured in the best interests of all shareholders, but in the interests of a company's management and only a select group of shareholders.

Either way, the private equity mania sweeping the local sharemarket can produce an exquisite conundrum for a fund manager: should it grab the short-term return on offer, or hang in and back its judgement that a company's true long-term worth is greater than the proposed buyout price?

How a manager responds to these competing pressures is crucial for any of us whose money - particularly our superannuation money - is invested with them. No one likes to see their super fund lose value, but we all want to maximise our long-term returns.

It would seem that fund managers are damned whatever they do. If they are not being criticised for taking too short-term a view, they're being berated for failing to make a quick buck when they get the chance.

When Pacific Equity Partners launched a bid to buy Flight Centre, one fund manager faced precisely this conundrum. Lazard Asset Management held about 12 per cent of the company, mainly on behalf of superannuation funds, and believed the long-term value of the Flight Centre business was higher than the bid price. Lazard rejected the bid, PEP didn't raise its offer, and the bid failed.

Inevitably, there was a short-term fall in the share price. Speculators and traders had bought into the stock in expectation of a deal happening and making a quick buck. When that didn't happen, they sold out and went trawling elsewhere.

Lazard copped a lot of flak from parties associated with the deal who, for a range of reasons (principally, no doubt, making a lot of money very quickly), wanted it to go ahead. Lazard's problems were compounded by the sharemarket correction that started at the end of last month.

This problem - it could be called the Lazard Contradiction - is becoming bigger for all fund managers, simply because there are more private equity deals, management buyouts (MBOs) and the like being hatched. Many managers, and the investors in their funds, are grappling with these issues for the first time.

Others have more experience, but still find the situation frustrating. Clime Asset Management has seen at least two companies it had invested in - Colorado and OAMPS - subject to private equity bids.

"The first thing we do is ask ourselves if a bid is significantly above our valuation for the business," says Roger Montgomery, managing director of Clime Asset Management. "When a bid is significantly above what we think the business is worth, we sell. "What ticks us off is the all too common situation where it's an uneven playing field, when minority shareholders are not being treated the same way [as large shareholders]."

Montgomery says bids like this leave small shareholders quite powerless. "There's not much you can do," he says. "I'd say small investors could contact Stuart Wilson at the Australian Shareholders' Association. Because this is a full-time job for us, we are probably better placed to analyse these takeover bids. It's a lot harder for a private investor to do that. There's always the possibility that investors with a fund manager can lobby that fund manager. That's an option, asking the fund manager to quantify and qualify what their response is going to be and explain it."

Chris Condon, chief investment officer at MLC, says managers must have a clear idea of how they will respond to private equity proposals. He says it should be simple: a fund manager's clients are its investors; everything the manager does should be aimed at serving those investors. If a manager is hired on a mandate, as MLC's are, then the mandate should make it clear how private equity proposals will be assessed.

"We vote the shares in our portfolios, not our investment managers," Condon says. "But we expect them to be active in giving us guidance on how to vote those shares. If they tell us that they bought this share, they think it's worth X, the private equity firm think it's worth less than X and they suggest we vote against it, we generally will.

"That was a very effective approach to stopping a company being sold to a private equity firm for a price that one of the dominant managers in our portfolios thought was undervalued - that [manager] was Lazard.

"The relationship we have with [Lazard] is one that, going into it, we had a very clear understanding of what they do, and they had a very clear understanding of what we were asking them to do. I would suspect ... that the way they have worked with their clientele would mean that the people who are hitting them on the head [over Flight Centre] are not their clients."

Condon says MLC expects the managers it hires to maximise long-term returns, and to "use the whole toolbox of value-adding tools, such as being able to vote shares or stymie inappropriate takeovers where there are inappropriate valuations".

"There can only be one client in mind, and that's the investor in their funds," he says. "It comes down to the personal integrity of the people involved. I cannot speak for any fund managers who aren't in our stable, but I am confident that every fund manager in our stable is looking at only one thing."

Private equity funds have an important role to play in equity markets, and help to keep the management of listed companies on their toes. "I do want to say that this whole notion of private equity firms buying companies is one that provides some excellent tension in the markets, and can quite often be a very good thing," Condon says. "[However] it's incumbent on the agents that are operating for the current owners of the companies to extract as good a price as possible."

John Kightley, managing director of Maple-Brown Abbott, says, "We've seen this before, if you go back to 1986, 1987. This is something that often happens when the level of risk appetite is high and there's a lot of liquidity around, and it generally happens at the end of a bull market.

"The level of gearing seems to be somewhat higher than it was in the past, and the multiples that people are prepared to pay are somewhat higher. And some of the targets have been stocks that one wouldn't normally associate with steady cashflow.

"The issue for us is the potential conflict of interest, and the real conflict of interest when management gets involved, when there's a weak board or the board is only half-involved, and a lack of appropriate independent directors, which means it's difficult for us and our clients, as shareholders, to know who is batting for us.

"We have always had a long-term view.

Back to articles...