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In Some Deals, Executives 
Get a Double Payday

Managers Profit When Companies
Are Sold to Private-Equity Firms,
Then Stay on With Big Options

By Henny Sender and Dennis K. Berman, Wall Street Journal

September 8, 2006

Private-equity firms have notched seven of the 10 largest leveraged buyouts of all time this year. For the top executives of the target companies, such deals could be the difference between being rich and being very rich.

That is because in many cases the executives are both buying and selling the company. Consider a trio of massive deals: The bids for HCA Inc., Kinder Morgan Inc. and Aramark Corp., valued at more than $40 billion combined, all have involved top executives teaming up with private-equity firms to buy their own companies and to continue running them.

As increasing numbers of executives heed the siren call of private-equity firms, the dynamic pitting shareholders against management is bound to intensify. (Private-equity firms buy companies or divisions using vast amounts of debt and later sell them or bring them public.)

In such cases, management, with all its detailed knowledge of the company, goes from being a seller striving for a high price to being a buyer looking for an attractive price. Usually the sale of a public company involves an auction or a competitive-bidding process. But when management joins the private-equity buyers, there often isn't such an open procedure, and the process is especially fraught with potential conflicts of interest.

"Every private-equity firm markets itself to its potential investors on the basis of its access to deals, preferably exclusive access to deals" without competitive bidding, says Douglas Cifu, a merger-and-acquisition lawyer with Paul, Weiss, Rifkind, Wharton & Garrison LLP. "But when you are a public company, you have a fiduciary obligation to maximize the value of the company."

"The strength of the private-equity firms is their high-powered compensation," says Josh Lerner, a professor at Harvard Business School. "Can it lead to the temptation of being bought out so management can get the pot of gold?"

There is little that is more important to a private-equity firm than courting the management of a potential target. A critical part of the wooing process is to offer management lavish incentives. Those incentives generally involve as much as a 10% stake in the reorganized company -- far more than managements can usually hope for either as a public company or from a strategic buyer. If management hits financial and operational targets set by the new owners, the executives generally receive stock and options. If the executives exceed those targets, they get more of both. And when the company is recapitalized or goes public, the executives often get windfalls valued at hundreds of millions of dollars.

Teaming up with a private-equity firm isn't without risks. Managements are expected to hold their stakes for a while, so the value could fall, and private-equity masters tend to have a far lower tolerance for mediocre performance than the public markets do.

There are limits on the extent to which management can tilt the scales in favor of a sale. Boards appoint special committees to examine offers, and they in turn hire investment banks to vet the prices and the terms. Shareholders have the ultimate say: They can always vote a deal down.

Consider the case of corporate-data and security company SunGard Data Systems Inc., which was purchased by a group of seven private-equity firms in August 2005. Chief Executive Cristobal Conde wasn't part of the group that originally organized the transaction, but he was persuaded to stay on after the deal closed. That will likely prove a highly profitable move.

Securities and Exchange Commission filings show that, over the course of Mr. Conde's 18-year career, he acquired stock options valued at a total of about $58 million. He kept $22 million invested in the new parent company and cashed out the rest. Overall, pre-existing options for SunGard's top 20 executives were worth $226 million, $110 million of which was reinvested back in the privately held company.

Following the $11.3 billion buyout, SunGard's executives and key employees were given the opportunity to earn as much as 15% of the fully diluted stock of the new company, with more than half of all options going to the company's top 17 employees. In all, the filings estimate that options awarded to Mr. Conde would be valued at $149 million over the years if the company appreciates by 10% annually. At 15%, Mr. Conde's options would be worth $272 million. A SunGard spokesman for Mr. Conde declined to comment.

In the case of Neiman Marcus Group, Texas Pacific Group and Warburg Pincus LLC, which bought out the retailer last year for $5 billion, established an option pool that gives management as much as 7.3% of the common stock "in order to grant appropriate equity incentive awards," according to securities filings. Representatives of TPG and Warburg Pincus declined to comment.

At Sports Authority Inc., a group of top executives increased their equity stakes significantly once the $1.3 billion buyout of their company closed in May. Overall, the company's top six executives own at least 6.5% of the company's common stock, compared with just over 1.5% of the company before the deal. A Sports Authority spokesman didn't immediately comment.

Shareholders sometimes revolt against such largess. In August, some stockholders of Petco Animal Supplies Inc. filed litigation against the company's directors, citing their alleged "attempts to provide certain insiders and directors with preferential treatment in connection with their efforts to complete the sale of Petco to Leonard Green & Partners LP and Texas Pacific Group." This is the second time that the two firms are taking Petco private. TPG and Leonard Green declined to comment. A spokesman for Petco also declined to comment.

Managements that team up with private-equity firms typically make buyout offers that are acceptable -- though not necessarily blowout deals for shareholders. In fact, a rhythm has developed around the classic management buyouts. Managers make their proposal, and a few months later the two sides agree to a slightly higher new price. In the Aramark deal, the per-share price for Aramark ended up at $33.80, up from the original offer of $32.

While some boards are diligent in vetting deals, the process sometimes is skewed in favor of a sale. For example, there usually is a period when other bidders can come forth with offers. But if that window is short, the likelihood of a rival bid emerging isn't large, since potential buyers won't have time to perform due diligence. Special committees charged with weighing deals also can set breakup fees that make rival bidders pay dearly to get rid of the original buyer.

HCA's special committee gave potential rival bidders just 50 days -- not much time to mount a full competing bid to the one that included management. On the other hand, it imposed a breakup fee for the $33 billion deal that was relatively small: The original bidders -- Bain Capital, Kolhlberg Kravis Roberts & Co., and Merrill Lynch & Co.'s private-equity arm -- would get just $300 million from a successful rival. To make sure there was a sufficient pool of potential rival bidders, the committee insisted that the Bain-KKR-Merrill group not take on additional partners.

 


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