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Feature

Robert F. Bruner
Dean, Darden Graduate Business School
University of Virginia

LBOs: Questions for the Board

Directors have some explaining to do about all these public companies going private.

By Robert F. Bruner

Leveraged buyouts are booming again. While the improved performance of companies that have gone private commends this wave of activity, it leaves unanswered one enduring and important question: Why can’t CEOs of these firms simply deliver this improvement for public investors?

The answers are as troubling as they are unsatisfying, not least for corporate directors and the private equity industry itself.

There is a small mountain of evidence that private equity investing and LBOs in particular, “pay” — in the sense of enhanced economic efficiency and large risk-adjusted returns. Cash flows increase, asset utilization rises, returns rise. Some have feared that these gains derive from cuts in advertising, maintenance, capital spending, or R&D, but the research does not support this. Kiss a private equity investor today: Our economy is better off as a result of this improvement in efficiency.

In the context of 2006’s heady going-private activity, the big question assumes some urgency. Here’s a sampling of the rationale.

• Escape: CEOs decry the short-term focus on quarterly earnings imposed by public markets and regulatory burdens such as Sarbanes-Oxley. Going private liberates the CEO to focus on longer-term issues and to undertake difficult restructurings without the intrusions of public investors. Yet we have prominent examples of firms that remain public but refuse to play the quarterly earnings game (Berkshire Hathaway and Progressive Insurance) and that undertake major restructurings while in the public eye (Ford and GM). Why not restructure the firm first, then take it private?

Even if it is easier to restructure as a private firm, who should harvest the benefits of this convenience? At present, the benefits of these transactions substantially flow to the entrepreneurial risk-taker -- the private equity investor and the CEO of the gone-private firm. Perhaps this is correct: Let the person with special skill or insight harvest the benefit from his or her special assets in the market. But before the public firm goes private, who owns the special skill and insight of the CEO? There is no escaping the ownership by the public shareholder.

• Skills of Private Equity: Much is made of the skills of KKR and other successful private equity investors — they have the secret recipe that converts the sagging mature firm into a veritable Schwarzenegger. Thus it is argued that firms need to go private to benefit from these special skills. But why don’t the directors of public firms hire some of these boys and girls to learn the secrets? There is no patent on what KKR knows.

• Failed Governance: Michael Jensen and others have argued cogently that LBOs resolve a failure of governance in large corporations by aligning the interests of managers and investors. This speaks to the beneficial effects post-LBO but does not address the apparent conflict ex ante.

• The Devil Made Me Do It: Privately, CEOs will describe the improvement in compensation flowing from LBOs. But this is no defense: It merely underscores the existence of conflicting allegiances.

In the absence of a cogent reply to the big question, we should worry about the implications.

One is that selling shareholders are leaving money on the table that is rightfully theirs. Twenty years ago, Lynn Sharp Paine and I recommended that directors of target firms use a “do-it-yourself” standard to evaluate purchase offers by private equity firms. I have read many shareholder proxies in these deals and rarely see the directors comparing the going-private price to the value of the target firm “as if” they had implemented the operating and financial restructuring while still a public entity.

A second implication is that as corporate directors appraise going-private bids, they may not be trying hard enough to serve the interests of public shareholders. Bad bids can happen to good companies. The venerable case of Smith v. Van Gorkom described in detail the self-serving behavior by a CEO of a public company. The Delaware court found the company’s directors “grossly negligent” to shareholders for approving a sweetheart deal. (The opinion in this case should be required reading for every director contemplating an LBO decision.)

Boards should demand deeply analytical fairness opinions issued by advisers at arm’s length to determine whether an LBO offer is reasonable. Such opinions should include an estimate of the value of the firm as if management were to re-lever it, restructure the company’s operations, and achieve the same kind of capital structure — in public.

Finally, the private equity industry should take pause. In a society that blames McDonald’s for obesity, investors in the LBO arena may be tarred by these actual or perceived conflicts of CEO interest. Lest the good they do become obscured, the private equity industry should demonstrate to public investors that they are ameliorating the conflicts, and that what’s theirs is theirs.

Robert F. Bruner is dean of the Darden Graduate Business School at the University of Virginia. His book, Deals From Hell: M&A Lessons that Rise Above the Ashes, was published by John Wiley & Sons in 2005. He can be contacted at brunerr@darden.virginia.edu.