July 25, 2006
HCA Buyout: A smelly deal
Three private equity firms and the senior executives of HCA have offered to buy the company for over $31 million, the largest buyout in history. This is a classic "management buyout", or MBO, in which the senior executives of the company participate on the buy side, purchasing the firm from its public shareholders. MBOs are rift with potential conflicts of interest and this one is a classic. Since 2001 the senior executives of HCA (the Chairman/CEO and the founder/Director) had as their advisor, Merrill Lynch, now one of the buyout firms. As executives of a publicly traded company the executives and their advisor had a fiduciary duty to the company to maximize its value for its public shareholders. Now they are buyers and maximizing value for themselves. These MBOs have an inherent off-color odor.
It will be a tricky dance for the lawyers to fumigate the smell. The company will create a committee of independent directors who will negotiate the price, ostensibly free of interference from the executives and the one time advisor. The committee, with new advisors and lawyers, will take competing bids, which will likely be non-existent due to HCA's size, and will bargain for a slight increase in price (to show that they are tough). The buyout group will have held back a few dollars a share in its announced price to account for the need to concede a bit to the committee. The buyout group will reform the company and resell it to the public (a "round trip") at a substantial profit. HCA has already done a round trip once.
The question in such deals is always the same. Why did the executives not do for the public company what they now propose to do for the company when they are the owners? Are the executive taking personally a corporate opportunity that they discovered as fiduciaries? [And in this case are their advisers also taking advantage of their inside information.] Have the executives of a publicly traded company "dogged it" to set up the buyout opportunity? Of course, we will hear heated denials (with great umbrage) all around to these questions.
Some of the potential answers are troubling. First, a publicly traded company is so heavily regulated that it cannot move in response to business opportunities. Our regulations are too heavy handed. Second, the executives of a public company have such large agency costs (personal incentive problems) that the elimination of the costs will bring large gains. The only answer that may be positive, a change in investor profile is necessary to accomplish a change in firm structure (the private firms are willing to take higher risks than are public shareholders), is empirically questionable (why the round trip, selling the company back to the public if public shareholders are unwilling to accept and price the new risks??).
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I'm puzzled why you find some of the potential answers troubling. The answers are, frankly, quite valid. Regulation stifles business, plain and simple. Empirical evidence in financial literature ascertaining this fact is replete with ubiquitous examples. Beyond that, I and some of my colleagues have personal business investments -- local restaurants and similar enterprises -- where the ill-effects of regulation even upon private entities is readily apparent. It chokes the life out of all but the most fervently dedicated entrepreneurs.
As a recovering lawyer, and at the risk of being chided, I will point to the legal profession which dominates politics as the general target for blame as the leading cause of bureaucracy within our legislative body -- both locally, and at state and federal levels. Politicians know very little about business and even less about economics, in spite of their overwhelming cognitive dissonance on this matter. As children, we referred to these people as "know-it-alls" who believed they knew better about the lives of others and therefore would interject with their biased opinion as fact in an attempt to redirect the lives of those individuals. Politicians and practicing lawyers make a career of trying to tell others how to live their lives -- what they can and cannot do. A classic example of this is "Hillary-Care" where a lawyer desired to dictate to physicians how to practice medicine. This makes as much sense as a doctor trying to tell an engineer how to build a bridge. (The aside-facts that this individual is now running for President, and has a good chance of winning, is scary beyond comparison.)
In this instance, however, I am qualified to assert my opinion, as an expert in law, economics and finance. Although you inarguably will have the last word since this is your blog and I will not likely stumble upon it again -- in view of the comments in your last paragraph, I felt compelled to respond.
First, you are correct in that publicly traded firms are so heavily regulated that they are often limited in their ability to respond to business opportunities. Gains in free markets and capitalism come from improvements in productivity and efficiency. In these, the U.S. has long been a world-leader because its very foundation was built on the freedoms in which markets thrive, but the overwhelming interference of our government in the past half century has been slowing us like a plow-harness on a raging bull. Aside from the general inefficiency of compliance, the monitoring effects of bureaucracy have killed many businesses. Our voluminous tax code holds itself out as a prime example. Inter-industry self-monitoring is quite simply the best, and possibly only, solution to this problem. Does it have flaws? Sure, but when we attempt to solve all the flaws inherent to regulation, the question then becomes (in the words of Thomas Sowell), "At what cost?" Sarbanes-Oxley is such a nightmare itself, it alone has initiated a resurgence in privatization. Support for this is easily found with numerous working papers and some already-published works in empirical finance literature. In sum, excessive governing stifles productivity and spawns inefficiency.
Second, yes, agency costs are omnipresent whether society and the investing public like it or not. It’s only natural that people look out for themselves first. This is simply derivative of our survival instincts. When firms execute management buyouts, heavily leveraged or not, (such as with the case of HCA, or more recently TXU via KKR and Texas Pacific), they are seeking to maximize their own returns – of course! Who wouldn’t? Those who claim altruism in business are about as believable as those in the legal profession making similar claims. Business is about making money, just like the law profession, just like the medical profession. No matter how you slice it, we were founded as a capitalist country, and many of us would like it to return that direction.
Meanwhile, as long as governments and public monitoring (like SOX) inhibit the ability of businesses to thrive, wise business leaders will simply seek avoidance tactics – the best of which, currently, is privatization. Private firms do not require earnings smoothing, a pretty balance sheet, or nearly as many overwhelmingly burdensome compliance measures. Elimination of external monitoring can make firms much more profitable. So, once that profitable opportunity has been exploited and the buyout initiates no longer see great advantage to being private – that’s when you sell (or re-emerge publicly again). It’s the same basic decision any intelligent investor makes. When you have reaped the profit you expect, you sell the entity (and pay your taxes, unless the lawyers have left a way out of them). This is the reason for the round trip.
How many investors do you know who never sell? Round trips are logical. The company goes back to the public after the mission has been accomplished, so the risks are no longer there. Again, this is the main reason the company is taken private in the first place – because the public would not accept the risks. If executives attempt a risky strategy while public, shareholder fears may drive the price low enough to make the company vulnerable to other dangers, such as a hostile takeover which might expunge the executives who saw the opportunity in the first place.
There is no empirical question here. Everything works as it should.
A conscientious economist, business owner and professor of finance, who happened to stumble on your blog from a Google search,
-- R. Prati
Posted by: R Prati | Mar 3, 2007 8:02:18 AM