You've found a great share. Sit back and wait; what could possibly go wrong?
So you've done your research. The share looks excellent value. You've checked out the financial statements and they meet all your criteria for investment. You've looked at the risks affecting the company and they seem well covered. All the signs are that this is an under-valued share and you can, in time, look forward to a handsome return. What could possibly go wrong?
Management buy out
Companies are run by real people; people whose decisions hugely influence the value creation on which investors depend for their returns. The more motivated management are to deliver these returns, surely it's better for investors.
However, if you've been able to spot the company is a bargain, you can be sure that management have too. After all they work in the business day after day and have access to far more information about it. For that reason most investors look upon the buying of shares by management as a positive confirmation of value in the company.
However sometimes management don't just want a share in the company, they want it all! The management buyout (MBO) is the means by which they try to get it. That's fine if management are prepared to pay a fair value for the company. However some management seem to be taking advantage of the economic cycle and weakness in the stock market to try and buy companies at knock down prices.
Having seen their shares collapse by around 90% in two years from 480p, private shareholders were outraged when management at recruitment firm OPD Group (LSE: OPD) took the opportunity to launch an opportunistic bid for the company at 57p. The offer followed a downbeat trading update and the threat of a potentially dilutive fund-raising, despite management having recently paid themselves substantial cash bonuses.
Shareholders in undervalued IT services outfit FDM Group (LSE: FDMG) were also taken aback when management revealed a possible 120p bid for the Group. Adjusting for its substantial cash balance this values the Group at little more than five times earnings.
De-listing
Of course shareholders don't have to sell their shares, if the offer is less than they want. Only when a management buyout team hold 90% of the shares in the company can they force the remaining shareholders to sell. Unfortunately some management teams have identified a neat little way to get round this obstacle.
When a management buyout team hold 75% of the shares they can de-list the company. A stock market quotation is a substantial cost to small companies, so it's an easy expense for management buyout teams to save. However for remaining shareholders, de-listing significantly reduces their ability to sell shares and consequently to obtain full value for them. No wonder investors often reluctantly accept the offer.
Indeed some management teams which hold substantial stakes in their companies have taken this a step further. Rather than a straight offer for the shares of other shareholders, they've used their large holdings to push through a de-listing of the company at the same time as using the company's funds to offer to buy out the remaining shareholders. This effectively delivers the company into their hands.
Last year Northern Recruitment Group (LSE: NRG), announced a proposed de-listing and tender offer at 40p. With management holding 57% of the shares the outcome was a formality, despite the shares having traded at over 100p only two years earlier. With other investors scrambling to take the offer, management end up with 90% of the company.
Software provider Touchstone (LSE: TSE) also recently announced it was considering de-listing and a limited share buyback for those not wishing to remain a shareholder in what would essentially become a private company. Having lost 90% of its value over the last two years, the shares now trade at bargain levels. However with the Birch family holding 33% of the shares, it seems there is little that private investors can do to stop this happening.
Even worse, when facilities and energy management specialist GSH Group (LSE: GSH) announced it was delisting, 84% shareholder Ian Scarr-Hall informed the company that he would vote down any proposal to buy back shares from minority holders. Although he eventually relented, after adjusting for the company's substantial cash pile the buy-back price of 190p was little more than 3 times earnings.
Where management hold substantial shareholders, the risk always exists that private shareholders will end up forced into selling their shares at less than they want.
Big shareholders
Of course it's not only management buyout teams that private investors have to worry about. Other large shareholders are just as capable of using their dominant positions to the detriment of private investors.
Earlier this year, as part of the refinancing of troubled property group Mapeley (LSE: MAY), 66% shareholder, Fortress, effectively pushed through a de-listing of the company.
Elektron, a major shareholder in scientific equipment maker Hartest Holdings (LSE: HTH), revealed last week it was considering a 25p joint bid for the company, despite the share price being 30p at the time of the announcement. With Elektron and private investor Peter Gyllenhammar owning 53% of the shares, private investors could end up powerless to prevent the acquisition.
The common thread in all these situations is large dominant shareholders. In situations like this private investors need to take into account the risk that they are not investing on a level playing field and consequently may never realise the value they have identified.
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