MBOs Dirty Little Secret

Several of my recent posts have focused on the issues of fiduciary duty and affiliation, and no sooner do I wake up this morning that I read Ben Stein's piece on Management Buy-Outs (MBO). I mean, Ben is a brilliant thinker and a wonderful writer, but the arguments he lays out for why MBOs are so wrong are so cogent and so powerful as to render the counter-arguments almost moot. He gets right to the point of the matter very quickly, and I'd like to briefly review them for readers who may have missed his piece.

The reason why MBOs have flourished at certain periods (including the current period) is outlined as follows:

I wrote about many other deals, and helped to stop some of them. The deals were happening because the market swooned in the mid- and late 1980’s, but asset values remained high, and so there was a major arbitrage to be realized between asset value and stock price. To me, it seems that this arbitrage belonged to us stockholders and not in any way to our trustees, the managers. But the managers wanted that money, and if they wanted it, they usually got it. There was not much of anyone to stop them.

I think it was both interesting and accurate that Ben chose to use the word "arbitrage" to describe the manner in which managements profited from public shareholders. To refresh people's memories, per Wikipedia:

In economics, arbitrage is the practice of taking advantage of a state of imbalance between two or more markets: a combination of matching deals are struck that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state. A person who engages in arbitrage is called an arbitrageur. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives and currencies.

In other words, managements are taking advantage of an imbalance, and this imbalance is in the realm of information - get it, Information Arbitrage. Management knows stuff that the public shareholders do not, and they parlay this information asymmetry for their own personal gain. There is a word that describes this, what is that word? - WRONG. There is another word that should describe this given the breaches in ethics and, truly, law, that go into the MBO process - CRIMINAL.

Ben cites five specific reasons why MBOs should be illegal, which I believe hit on all the key points I can think of:

• Management self-interest
• Breach of fiduciary duty
• Conflicts-of-interest
• Lack of full disclosure
• Insider trading

Each of these reasons, to my way of thinking, constitutes a criminal offense. Yet somehow, due to the presence of a "fairness opinion" from a Wall Street firm, these reasons fall by the wayside and these deals get done. Now, for those who know Wall Street know that fairness opinions are a bunch of garbage, scarcely worth the paper they're written on. What self-respecting Wall Street firm is going to tell their corporate client for whom they've done stock offerings, bond underwritings, provided merger advice, gone to each other's golf clubs, etc. that they won't write a fairness opinion because, well, the deal is unfair to the public shareholders? My honest opinion? Zero.

So here we are. We have a break-down in the system, this thing called a fairness opinion, that seems to let self-dealing and all the unfairness listed above to occur. I disagree with Ben that we should make MBOs illegal. I believe the pieces are already in place to squeeze this false arbitrage opportunity out of existence.

I think that we simply need to apply the legal standards which already exist to deal with the reasons above (I mean, rules against things like insider trading already exist, no?) and not let managements and Boards off the hook simply because of a fairness opinion. Further, we should hold Wall Street firms to the same standards that we (should) hold managements in these situations. By tightening the standards around what constitutes a fairness opinion and to ensure that managements and public shareholders each have access to the same set of information (basically stripping out the information arbitrage that structurally exists between managements and public shareholders), this should go a long way towards ameliorating the management-only arbitrage opportunity that sometimes exists and leveling the playing field.

So, if the legal standards exist and are consistently applied, and if the whole deal of fairness opinions are strengthened (via Wall Street firm accountability and liability) to really make them fair, and to institute a mechanism for forcing disclosure of managements views, models, memos and plans relating to a proposed MBO, the share price should begin to resemble fair value and the virtually riskless arbitrage profits that have historically been garnered via MBOs should evaporate. This, I think, is the essence of what Ben was saying - it is all about the public shareholders, and it is both mind-boggling and disturbing that such inequities have been allowed to fester in our capital markets. These fundamental breaches of duty to public shareholders have been going on for decades and they need to end - now.

Thanks, Ben, for bringing this critical issue to the fore yet again. It is a worthy cause and it absolutely needs to be addressed.

Comments

[mike]

Yaser;

Your comments need to be predicated on the type of institutional investor. Investors managing their own accounts are more worried about the stock being properly priced. A large pension, for example, couldn't care less about a "quick pop." The assets need to be reinvested and this type of anomolous return doesn't help the portfolio.

[robpas]

After reading this post, I immediately thought about George Akerloff and "The Market for Lemons"; He analyses a market for a good where the seller has more information than the buyer regarding the quality of the product. It's that asymmetric information thing. Management always knows more and in this case has a selfish economic reason for profiting in direct opposition its role as a trustee for the shareholder. As my old friends on the street would say --"always remember there is somebody on the other side of a trade, and what do they know that I don't". Nice post Roger.

[Crazy Jim Smith]

MBO's should always raise an investors suspicions that something is up.

It's a no brainer that if management want to buy the stock then it is worth something and yeah maybe they are hiding something from the shareholders.

Great write up.

[Roger]

Yaser, I hear you but I think you are missing the point. The point is that if management is self-dealing, and if this self-dealing impacts (and of course it impacts) public shareholders, then money is being left on the table which is being unfairly grabbed by management. Institutional shareholders themselves have a fiduciary responsibility to their investors, and simply accepting a "quick pop" and moving on is NOT effectively discharging their responsibilities. So in this case there are two bad actors, not just one. Just my two cents.

[Yaser Anwar]

Although I agree with Mr. Stein's premise, that management should be working for shareholders & not themselves, its not always possible.

Institutional Investors hold majority stock in most companies & sometimes a quick payout is the way to go for them. Is this right? Maybe or maybe not, but if they can get a quick pop in the stock, say 20-30%, why not? Institutional Investors would be all for it, all they care about is their performance & not having to wait for a rise in stock's price by 20-30% in the next 5 or 10 years.

Management I believe plays on this "quick buck" ideology of Institutional Investors, where the IIs get their pop and management gets to sell their stake well beyond their dreams.

As Mr. Stein pointed out in his NYT article, these MBOs do not always work out & once again we will see a slow down in merger-mania once the corporate raiders realize that the debt load is just too heavy.

All this happens in a 8-10 year cycle & will keep happening over and over again, until it is blocked by the SEC.