A long-standing theme of the Abnormal Returns blog has been that hedge funds and private equity were substantially altering the capital markets. It would therefore behoove investors of all stripes to track the goings on in these industries so as to be better informed.
The proposed acquisition of stereo equipment maker Harman International (HAR) by a partnership of Kohlberg Kravis Roberts and Goldman Sachs (GS) is yet another example of how private equity is transforming the market for corporate control. How so?
KKR and Goldman are proposing to leave a portion of the newly private Harman in the hands of today’s existing public equity holders. This so-called ‘stub equity’ provides investors a chance to piggyback alongside the private equity investors. (Although DealBook thinks the roughly 27% stake implied by the deal is “hardly a stub.”)
Dennis K. Berman at WSJ.com outlines the deal and its implications:
The Harman deal provides another example of how privately managed capital is reshaping public markets, and how they, in turn, are reshaping private equity. If successful, the deal could be a landmark, putting pressure on other private-equity firms to offer small investors a stake in their multibillion-dollar investments.
Of course any sort of new structure comes with its own complications. Michael J. de la Merced and Jeremy W. Peters at the New York Times write:
Private equity deals often take several years to realize a profit, and investors must be willing to have their holdings locked up in the interim. Moreover, not all deals make a profit, leaving buyout firms and stub holders with a loss. At the same time, the public shareholders would be at the whim of the private equity holders with little or no say in the business.
In addition, stub equity shareholders in the new entity will have no voting power or say in how the company is run. Nor is it likely that the stub equity will be liquid or trade on an established exchange.
Stub equity is by no means a one-way deal for existing shareholders. This allows private equity firms the ability to stretch their own equity stakes. In addition it mutes the criticism that current shareholders are ‘leaving too much on the table’ in the most recent wave of private equity-led buyouts. One additional implication is raised by breakingviews.com:
[T]he strategy has another advantage. It could mitigate concerns that the big windfalls executives reap when taking their companies private create a conflict of interest that could put them at odds with their shareholders. In this case, Mr. Harman says he will cash out half of his 5% stake in the company and roll over as much as he can of the rest. So he is being treated the same as other shareholders.
As one can see stub equity raises a number of issues, but also open up opportunities for a class of investors currently shut out of the private equity game. If ‘stub equity’ achieves some level of critical mass, have no doubt that it will set-off a whole new trend: the “Stub Equity Fund.”*
*An investment fund that exists to invest in stub equity in order to replicate private equity returns absent the high fees (and carry) of traditional private equity funds.