The Changing World of Equity

1. The Changing World of Equity Charles K. Whitehead Cornell Law School

2. Traditional Construct • Public shareholders are the lowest cost capital providers • Shareholder diversification

3. Traditional Construct • Benefits, including: • Ability to diversify exposure through greater liquidity   • Currency for use in acquisitions • Employee incentive compensation • Prestige and credibility of being public (perhaps declining); publicity • Useful management tool to assist in assessing company strategy • Lower cost financing—alternative funding sources; public shareholders are the lowest-cost risk capital providers

4. Traditional Construct • Costs, including: • Loss of the benefits of control • Risk of takeover (M&A as a governance tool) • Regulatory and legal costs • Greater public scrutiny • Agency costs (between shareholders and managers) • Balanced, in part, by fiduciary duties and voting rights

5. Traditional Construct • Management’s fiduciary duties; maximize shareholder wealth • Duties of Care, Loyalty and Good Faith • Changes in share price • Signal to management (and independent board members) • Risk of takeover • Management compensation • Reputation

6. Traditional Construct But, is the premise underlying common stock, tying risk-bearing to voting, changing? Is the cost-benefit analysis shifting? And, if so, what is the impact on capital structure and governance? What, if any, regulatory changes should be made?

7. Traditional Construct • Benefits > Costs: the company should go/remain public • Growing costs – • Greater regulatory and legal costs • Alternative benefits – • Lower source of funding, and other sources of market feedback (liquid credit market) • Lower cost risk capital (role of derivatives)

8. Derivatives – Swaps Debbie Larry Interest Stock Price (10K) Stock IBM Shares Interest Loan (10K) Debbie Larry Interest Stock

9. Derivatives – Swaps Debbie Larry Interest Stock Price (10K) Stock IBM Shares Interest Loan (10K) Debbie Larry Interest [Stock] Appreciation or depreciation in value Dividends Voting Rights

10. Derivatives – Swaps Debbie Larry Interest Stock Price (10K) Stock IBM Shares Interest Loan (10K) Debbie Larry Interest Depreciation Appreciation IBM Shares Econ Equivalent Interest [+ IBM Voting Rights] Dividends

11. In the Matter of Perry Corp. Mylan King Perry Corp. Buy King Mylan Laboratories King Pharmaceuticals Stock-for-Stock Merger

12. In the Matter of Perry Corp. Mylan TRS on Mylan Stock Counterparties King Perry Corp. Mylan Stock Vote Mylan Stock Dissenting Shareholders Buy King Mylan Laboratories King Pharmaceuticals Stock-for-Stock Merger

13. Leveraged Buyouts & Private Equity • Setting: Set of companies characterized by free cash flow • What should management do with free cash flow? • What are the risks associated with management oversight over cash flow? • Classic agency cost problem

14. Leveraged Buyouts & Private Equity • What is a leveraged buyout?

15. Leveraged Buyouts & Private Equity LBO Proceeds LBO Investment Private Equity Fund

16. Leveraged Buyouts & Private Equity • Publicly-traded company • All equity/no debt • Stock market value of $100 MM • Management owns up to 5% • Private buyout group (e.g., KKR, Clayton Dubilier) acquires it for $140 MM • Borrows $110 MM in high yield debt • Invests $30 MM in equity • Including options, management owns 10% to 30%

17. Leveraged Buyouts & Private Equity • Where do the gains come from? • End the misuse of free cash flow: Free cash flow now goes to pay off debt that financed payout of a premium to the shareholders

18. Leveraged Buyouts & Private Equity • Incentives: • Hard edge debt: If debt/equity ratio is 85/15, a 15% drop in company value will eliminate equity • Management ownership: Large stake to managers, and huge gains if they perform • Intense monitoring: LBO group monitors closely – their fund’s equity at stake, market discipline, and reputation; and so a reduction in the traditional agency costs of public equity

19. Leveraged Buyouts & Private Equity • Jensen: New organizational form • High leverage, intense monitoring, and private ownership should remain

20. Leveraged Buyouts & Private Equity • Rappaport: Too few companies fit the traditional LBO model, requiring a history of consistent cash flows, so the concept is self-limiting • High variance companies are poor candidates for LBOs if bankruptcy is costly • And LBO companies go public again – requires an exit strategy • Role for risk management, hedging, and derivatives?

21. Leveraged Buyouts & Private Equity Diversified Shareholders • Risk capital • Invested by shareholders who manage risk through the purchase and sale of shares • Managed by the board and senior managers, who can fall back on a “catch all” cushion to offset losses • Agency costs • Inexact risk management and the absence of a liquid risk market Costs Managers – Weather – F/X – Oil Prices

22. Enhanced ability to manage risk and increasingly complete capital markets Private owners can purchase risk-bearing and liquidity in discrete slices From risk counterparties, who in turn diversify away their expo-sure Leveraged Buyouts & Private Equity Diversified Shareholders Costs Managers Risk Counterparties – Weather – F/X – Oil Prices

23. Leveraged Buyouts & Private Equity • Additional. real benefits of managing risks at the firm level – • Improved cash flow, and decline in bankruptcy risk • Traditional agency costs > costs of risk transfer

24. Leveraged Buyouts & Private Equity • Recent wave (ending in 2007) of going private transactions, compared to the LBO wave of the 1970s and 1980s

25. Leveraged Buyouts & Private Equity U.S. LBO Deal Value 100% 80 60 40 20 0 03 04 05 06 07 08 09 10 11 Public-to-private Carveout Sponsor-to-sponsor Private Represents control buyout transactions by US-based firms; closed deals only; represents year deals were closed. Source: Bain Capital

26. Leveraged Buyouts & Private Equity • Recent wave (ending in 2007) of going private transactions, compared to the LBO wave of the 1970s and 1980s • Shift in corporate governance in parallel with the shift in risk transfer mechanisms?

27. The Changing World of Equity Charles K. Whitehead Cornell Law School