Conflicts of Interest in Management Buyouts

It is common for conflicts of interest to occur when it comes to management buyouts. Managers have the job to maximize the value of investment of stockholders and give them the highest return possible. They also have the job to present an offer to stockholders to buy the company. This is the case when the management of RJR Nabisco gave an offer to stockholders to take Nabisco private in a management buyout.

This offer was quickly supplanted by a contending offer made by KKR and other responding offers from management. Why did the management choose to advocate an offer that it knew was not in the interests of their stockholders if their actual goal is to maximize their investments? Researchers hypothesize that managers cannot serve in these dual and conflicting roles as agents for buyers and sellers.

MBOs can be more successful than LBOs because better access to information about the profitability of the company is given than an outside buying group has. When managers decide to pursue a management buyout, they can opt to secure the financing themselves. With the aid of their investment bank, or they can work with a private equity firm that offers to finance.

Earnings Management

“Earnings management” is another important issue and potential conflict before a management buyout occurs. It typically involves a meticulous process of changing financial reports. This is done to mislead shareholders about the organization’s elemental performance. Sometimes. It is also done to prompt contractual results that usually depend on reported accounting numbers.

If the managers are interested in buying a company from the shareholders, they could have an incentive. That will lower their reported profitability to pay less for the acquisition. In Perry and Williams’ analysis of 175 management buyouts between the years 1981–1988. They found evidence that discretionary accruals were manipulated. These were done in the predicted direction in the year prior to the public announcement of the MBO.

The researchers also developed a control sample where matched firms for each bought-out company were chosen. There is an association between accruals like increases in depreciation expenses or decreases in noncash working capital with a reduction in income in the MBO group. These results show a cause for concern and extra carefulness.

One proposed answer for these contentions is neutralized casting a ballot. Whereby the defenders of an arrangement don’t take part in the endorsement procedure. If the defenders or proponents are stockholders, then their votes will not be counted in the approval process. They might be allowed to participate in the voting because it goes by the law.

Important Steps to Reduce Conflict

The next step is usually the appointment of an independent financial advisor to render a fairness opinion. This helps reduce contentions in terms of interests. Regardless of whether these precautionary steps are embraced, specific practical considerations may restrict their viability. And even if the members of the board of directors who may profit from the LBO may not vote for its approval. Other members of the board with close relationships to them may consider themselves required to support the deal.

Stockholders’ lawsuits for suing directors for breach of fiduciary duty have placed limits on this tendency. The investment bankers who have put fairness opinions forward may also have much business with management. Or may have a financial interest in the deal, leaving them of questionable value.

Even if these steps are important in trying to reduce the conflicts inherent in the management buyout process. One solution that has been proposed is to have mandated auctions of corporations presented with an MBO.

US Court on LB Conflicts

Current case law states that directors are not permitted to favor their own bid over another once the bidding has started. This prohibition was set forth by different court decisions, such as in Revlon, Inc. versus MacAndrews & Forbes Holdings, etc. In this case, the Delaware Supreme Court ruled that the directors of Revlon breached their fiduciary duty in granting a lockup option to white knight Forstmann Little & Co. The court ruled that this constituted an unfair bidding process that favored Forstmann Little & Co. over hostile bidder Pantry Pride.

In another example of Hanson Trust PLC v. SCM Corporation, the Second Circuit Court had the same position regarding the use of lockup options to favor an LBO made by Meryll Lynch instead of a hostile bid by Hanson Trust PLC. Hanson Trust had initially made a tender offer for SCM at $60 per share. In response to Merrill Lynch’s LBO offer at $70 per share, Hanson Trust upped its bid to $72.

According to the Court, SCM gave preferential treatment to Merrill Lynch by granting lockup options on two SCM divisions to Merrill Lynch. The board of directors will usually respond by creating a special committee of independent when they are faced with a management proposal to take the firm private.

Meanwhile, nonmanagement directors have the job to ensure that shareholders receive fair, if not maximal, value for their investment. The committee may then choose to have its own valuation produced, hire an independent counsel, and conduct an auction.

Post-Buyout Managerial Ownership

It should be noted that even when the management is the buyer of the business, outsiders still provide other equity. So they cannot be in full control of the post-buyout business. This is dependent on the amount of equity capital needed and how much capital the managers have and are willing to invest in the deal.

In a study by Kaplan, he used a sample of 76 management buyouts over the period of 1980–1986 and compared the median pre-buyout and post-buyout share ownership percentages of the CEOs and all management. The results of the study show that these percentages rose from 1.4% and 5.9% to 6.4% and 22.6%, respectively.

Management ownership more than tripled after the buyout. In theory, the managers are required to be better motivated considering their much higher ownership interest. This will help ensure that the company moves closer to efficiency levels that can help them maximize their profit.

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