LET’S assume it’s not a deliberate conspiracy, but the three-way tag team now operating between private equity, hedge funds and transaction-based investment banks is devastatingly effective.
Nowhere is it better illustrated than with Coates Hire Ltd.
A mysterious bear raid hit the company’s shares in mid-February, even though it reported a 61 per cent lift in interim profit at the same time and was looking ahead optimistically. The share price fell from above $6, where it had been for a year, to below $5 in a couple of days.
In April, an unnamed private equity fund approached the board seeking access to due diligence to make a bid.
On May 1, the board announced that it would conduct a review of strategic options — code for deciding whether to put the company up for sale — and had appointed Macquarie Bank to conduct it.
From May 1 onwards, hedge funds moved into the stock and the daily volume jumped from the usual 500,000 to 5 million. In the past month, about 80 million shares have changed hands.
On Thursday this week, Coates announced the most minor of profit downgrades — that profit would be 5 per cent below forecast. That’s usually regarded as a rounding error and not reported, but the directors felt that with the sharks circling they should report it.
The share price fell back from $6.10 to $5.90 amid heavy turnover, as a changing of the guard took place among the hedge funds: lower risk funds sold to higher risk funds.
Meanwhile, Macquarie Bank, which has been advising Coates on acquisitions for about four years, continues its strategic review, and several other potential bidders have taken their place in the queue.
Macquarie’s job is to put a value on the company, come up with a list of possible bidders, give the directors a step-by-step guide for dealing with the takeover and come up with other options for adding value for shareholders.
The actions taken by the Coates board over the past two months will probably be seen by most corporate governance experts as a textbook example of how to deal with a private-equity approach.
Except that here is a perfectly good, 100-year-old company in a boom industry, earning a 16 per cent return on equity and growing profit by 50 per cent a year, that is now locked in the warm embrace of the banker’s tag team: private equity, hedge fund and investment bank.
Hedge funds and leveraged buy-out (LBO) funds were the catalysts for putting the company into play, and now Macquarie Bank will deliver it up.
That’s because while Macquarie is paid a retainer to cover costs, it will get a transaction fee — a success fee — if the company is sold. The size of the fee is confidential (wrongly, in my view), but investment banking transaction fees are usually 1 to 1.5 per cent. For Coates, that would mean $100 million to $150 million.
In other words, Macquarie has a very big incentive to ensure the company is sold. There is nothing unusual about this: Carnegie Wylie & Co had a similar arrangement as adviser to Qantas, and again as adviser in the sale of Coles.
The various performance fee funds — hedge and LBO — are also very keen to see the company sold: the hedgies make a quick profit selling to the LBO funds, and the LBO funds start earning base fees on the investment and then performance fees when it goes back to the market.
And management doesn’t mind one bit: most senior executive contracts these days pay out handsomely in the event of a takeover, and there is no shortage of jobs around (after a few months in Europe, of course).
Lately, traditional fund managers have been pushing back at the performance fee tag team, not because they don’t want the quick profits for their own quarterly performance stats, but because they are running out of things in which to invest the proceeds.
In my view, there are three big problems with the way investment banks have now got things stitched up: due diligence, break fees and success fees.
Bidders now routinely demand a formal and detailed examination of non-public accounts and forecasts to reduce their risk.
What they give in return for this is virtually nothing — merely the nomination of a conditional price — and they don’t risk their costs because they generally get a break fee as well.
The directors are put in an impossible position by the request for due diligence: if they refuse and tell the suitor to go make a public bid based on public information, they can stand accused of blocking an opportunity for shareholders.
So they bring in an investment bank to advise them, which puts its hand out for a retainer to cover costs, plus 1 per cent or more of transaction — if the bid occurs.
So naturally, it occurs. After due diligence (that is, having got information the shareholders don’t possess), the bidder nominates a price, and the company’s adviser sagely nods its approval. Directors recommend the bid and fees fly in all directions — including a break fee for the bidder if there is an auction and they lose.
Whether this is what will happen in Coates, only time will tell.
And as for Coles — well, an auction is still likely with a successful conclusion, by which I mean the sale of the company along with a fee orgy for the investment banks, hedge funds and private equity.
As opposed to the board knuckling down, finding a new chief executive and running the company properly.
