The classic private equity (PE) playbook has traditionally involved mature, stable cash flow businesses and the “magic dust” of leverage to ensure appropriately high levels of returns. Recently, there has been a strong shift into a new frontier of acquiring listed growth businesses – companies whose rapid scalability and growth profiles are incredibly attractive, despite these businesses often being unprofitable. PE is starting to take a view on these businesses, that with the right management and board, they can deliver huge returns on the back of strong top line growth. While most public market shareholders have a short-term investment horizon, private equity is increasingly adept at using market conditions and legislation to ensure their longer-term vision for the business can be realised under their private ownership.
PE firms, like all investors, love a bargain and a happy hunting ground of late for this ‘growth’ savvy group of PE firms has been the US stock exchanges. The US regulatory environment of quarterly reporting naturally lends itself to share price volatility – one slight slip up by management in not meeting guidance can cause a drastic share price reaction.
This paper aims to not only shed light on how PE firms cleverly shape their takeover bids to ensure success, but more importantly provide some views on how boards can mitigate the risk of a PE takeover that doesn’t reflect the full long-term value of the company. There is no doubt PE has a role to play in public markets, but we think there is a more collaborative model for the future, whereby both PE and current shareholders can realise long-term value together.
1/ Play the game in times of market volatility
When it comes to making a takeover bid, market volatility creates a particularly attractive environment in which to play. A sudden and short term softening of the market allows PE to dress up their offer with a lofty market premium, making it sound incredibly attractive and hard to refuse in a regulatory environment only requiring 51% of shareholders to agree to the offer (more on that later). A recent example perhaps illustrates this best;
Vista Equity Partners recently acquired US listed software business Mindbody Inc, promoting their offer as the second highest 1-day premium (68%) paid in a SaaS transaction. It didn’t mention that MindBody had been trading above the offer price for eight months prior to a short-term market wide 30% decline. With no change in long-term fundamentals or strong growth prospects, MindBody was a sitting duck for a PE firm with an eye for a bargain. For any investor with an investment horizon longer than a couple of quarters, the Vista offer was not attractive in any sense (it was in fact a 4% discount to the six month average). Yet by marketing it as a 68% premium over a 1 day period, the offer preyed upon the short termism of shareholders and the board beholden to them – the thought of litigation if they didn’t accept the offer in the ‘interest of shareholders’ certainly aids the case for an accepted bid, specifically serving the interests of those with a short term investment horizon. As an aside, the major 20% shareholder (a long-term investor) is currently in court over the acceptance of the deal, alleging the board sold too cheaply.
2/ Use a friendly regulatory environment to your advantage
The US has the lowest threshold of shareholder approval for a takeover bid to be accepted (51%). By comparison, the UK and Australia have a legislative threshold of 75% or 90% depending on the nature of the transaction. Not only does this lower threshold provide a friendly environment for a PE offer, the proliferation of dual class share structures means that the offer may not be in the best interest of a majority of shareholders and yet still be accepted with little friction. The result is that large, long term, public market investors, who have taken a view on the medium to long term opportunity for the business, are held over a barrel, as they possess very little voting impact on the result of a bid.
Why is this environment not conducive to ensuring an equitable outcome for shareholders? Without dual class share structures, shareholder economic interest is commensurate with voting power. However particularly as with the case of fast growing founder-led businesses, the founder may have been diluted to a much smaller equity holding over the course of multiple funding rounds, but still control the voting rights – that is, their voting power exceeds their economic interest. Why is this important? A PE offer is then very hard to block if the voting power rests in the hands of a small few.
This too can of course be of benefit if the founder is strong willed and passionate about the long-term vision and value of the business. When Realpage was bid by Vista opportunistically in 2014, it took great strength to reject the bid under the threat of litigation. The stock is up 3x since the bid. It could easily have been another win for PE.
3/ Speed as a competitive advantage
In conjunction with a buyout offer, PE often provide a brief 30 or 35 day “go- shop” period for the business to elicit a higher price, knowing full well that very few can move with the pace to meet this time line. Other PE firms have little chance of moving that fast unless the target company was already on their radar, but are still better equipped to run at the speed required than any potential strategic acquirer, who by this point do not have the time to do the appropriate due diligence required to make a bid. This virtually ensures the bidder is working against low or no competition. While the agility of PE firms can only be admired, it is imperative boards are not sucked into a PE timeline, and run a full and transparent process prior to a signed deal and a formal ‘go shop’ period – more on this later.
Occasionally, PE will be a little cheeky, and make an offer over a holiday period, which provides no opportunity during the go shop period to elicit competing bids. When playing the game, why not stack the odds of winning in your favour?!
We believe that the Board of Directors have a critical role to play in protecting their companies from opportunistic PE offers. No doubt, boards operating in environments as litigious as the US are always fearful of the threat of being sued by shareholders if they reject an offer, and this pressure plays to their short-term desire for self-preservation, rather than any long term capital growth objective for the business.
At the core, it is imperative that board members fully understand the five year forecasts of the business and the long term value proposition that exists. While this sounds simple enough, it is not at the heart of many board members thought processes, particularly in a market with a cadence of quarterly reporting. If they did this, they would understand the reason PE is knocking at their door – they are interested in compounding their capital at 25-30% pa and can sense a compelling investment opportunity, at a very attractive price.
While deeply understanding the business requires the use of some quantitative skills of the director, there are several very simple methods boards could adopt to ensure they are not next on the PE shopping list;
1/ Be more open to supporting the share price in times of weakness with structures such as stock buy backs.
2/ Constantly engage large shareholders to get feedback on the long-term value of the business, rather than rely on advisors once a takeover bid has been made. The incentives of advisors are completely mis-aligned to those of long-term shareholders.
3/ Work hard to attract the right type of investor – a stable and strong shareholder register has significant benefits well beyond that of takeover defences. By promoting a best of breed IR strategy and clearly communicating the long-term vision and framework for the company, long-term investors will naturally gravitate to ownership of the business. Spotify and Zillow are great examples of this. The key point regarding opportunistic takeover defences, is that having firmly and consistently communicated that management and board have a long-term focus, there will be no surprises amongst the shareholder base if the offer is rejected.
Perhaps most importantly, we believe that if the company has received a bid by PE it is the board’s duty to ensure a transparent and full process is run. Historically, before a formal bid was announced, boards would run private and often slow, unofficial ‘go shop’ periods to illicit a full spectrum of potential alternate bids. It has been increasingly popular for boards to play at the same pace that PE dictates and often investment bankers advise – move with urgency to avoid leaks, sign the deal presented to them and then run a window dressed ‘go shop’ period to ensure you are not sued. At the bare minimum they should insist on a longer 60-day go shop period, as was the case with Ultimate Software deal earlier this year. While this may sound incredibly cynical, having witnessed this first hand, it is our strong view that boards must be stronger willed to slow the process down, and run a full and transparent process for the benefit of all shareholders before signing a deal with PE.
There is of course a middle ground. Private equity firms can bring a huge raft of experience and expertise (particularly operationally) to businesses that cannot be underestimated in creating value. There is an opportunity for this to happen within the public markets. A future of private equity collaboration with founders and boards to realise and share in long term value creation provides much fairer outcomes for both public market share holders and the PE investors. This also promotes long term benefits for the public markets more generally.
There are of course numerous examples of this – the Cornerstone OnDemand Inc management team believed deeply in the long-term value of their business but realised they needed operational and strategic grunt. Rather than selling wholly to Silverlake and taking the company private, they entered a partial ownership structure involving the issuing of convertible notes. They believed this was the best way to maximise shareholder value over the long term.
Other examples also serve as guidance of a new wave of supportive private capital; Advent Partners bought half the founder’s stock in Lululemon to help fund continued growth, and while working hand in hand, the company has been slowly repurchasing these shares ever since. Value Act have been incredibly successful taking chunky minority positions in public companies and, regardless of position size, attempt to actively assist – they previously held only a c 1% position in Microsoft, but possessed a board seat and were actively engaged in growing the business. TCV successfully used their capital to help transition Netflix from a mail order DVD business to the streaming beast it is today. All of these transactions respect current shareholders and are attempting to be accretive to the long-term value of the business, without changing the ownership structure of the business. The greater point is that an active and engaged long-term shareholder, regardless of holding a board seat or not, can play a crucial role in helping management navigate the public markets. This principle is central to TDM’s investment philosophy and one we are proud to have executed with businesses such as Ellie Mae and LogMeIn.
It is our belief that private equity and fast-growing businesses can co-exist in partnership within the public market eco-system, it is just up to founders and boards to be willing to stand up to them to ensure that this is the case.
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