Management Buyout Case Study: Kinder Morgan
Kinder Morgan – MOB Richard Kinder and Bill Morgan purchased a master Limited partnership pipeline company from Enron for $40 million in 1997, founding Kinder Morgan, Inc. (KIM) 1 . The primary benefit of an ML comes in the form of tax savings. While shareholders In a corporation face double taxation, owners of a partnership are taxed only once (when receiving distributions). Corporate Income tax does not exist In the partnership. When cash distributions to ML owners exceed partnership the difference is counted as a return of capital to the limited partner and taxed at the UAPITA gains rate when the unit holder sells.
This creates a pass-through entity that Is sustainable as long as 90% of the cash flow Is distributed and certain asset ownership is followed. KIM began amassing energy assets that would generate stable, long-term cash flows. Incentive to allocate capitals and a lower cost of capital due to an absence of taxes drove KIM to grow the business. The profit-sharing structure set up between the general partner KIM and the limited partner Kinder Morgan Energy Partners (KEMP), was done on a sliding scale.
The incentive here was for KIM to raise more money as it loud receive a
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For these reasons, a meeting In early 2006 sparked Ideas of taking the company private. Management was obviously flustered with analysts’ evaluation of Kinder Morgan, as ‘OFF undervalued in the market. As an infrastructure-heavy company, KIM not only had secure future cash flows, but also had also recently generated record earnings while raising its dividend. A select group of managers and investment bankers from Goldman Cash discussed buying out the limited partner KEMP. The board of directors was initially kept out of these talks of prevarication while all due diligence was reformed.
Before bringing in the board, Skim’s senior management (CEO, President and others) began lobbying team members and major shareholders about this potential transaction. It was not until two months had passed, and Goldman had done their due diligence on potential debt ratings, that the management group proposing this leveraged buyout brought the deal before the board of directors. The agency conflict with this LOB is clear, as concern from shareholders that this management-led buyout would enrich management at shareholder expense. The key point of dissension is price.
Management’s incentive to pay the lowest possible price as possible buyers conflicted with their obligation to represent the shareholder interests and receive the best price possible in exchange for the firm. Value Drivers for Prevarication Taking the company private would give Kinder more financial flexibility. Instead of constant Wall Street scrutiny, Kinder could freely allocate capital and quickly take advantage of opportunities that might otherwise be heavily scrutinized. Kinder will be in a position to make long-term bets on market trends without having to worry bout how those bets play out in the short-term.
Despite the loss of liquidity by going private, the transaction would free the firm of tremendous regulatory, administrative and financial reporting pressures, as well as corporate governance bylaws. Kinder recently completed deals for Terrain (oil) and Rocky Mountain (gas) pipelines. Canadian oil sands production was projected to greatly increase and the Terrain pipeline was positioned to capitalize on this. Likewise, the Rocky Mountain pipeline was poised to benefit from new unconventional gas plays. Both of these assets (like cost of Skim’s assets) were exposed to commodity price risk.
However, KIM saw opportunity for long-term gains as they internally projected high commodity prices. Tied in with projections for commodity pricing is the undervaluation of the company. A major incentive for management in this buyout is clearly this undervaluation. KIM had been valued between $100 and 120 a share, yet was trading at only $84. KIM had experienced five years of increasing revenues and its net income was on an upward trend. KIM was financially healthy and its vast infrastructure would only continue to enervate cash flows. It was a perfect buy-low scenario for the investors that knew the firm the best, the managers.
Buy Low, Sell High interest of its shareholders. To try and dispute agency conflict, Kinder established a special committee to make decisions regarding the prevarication proposal. The committee was committed to executing due diligence in finding other alternatives, as well as, negotiating with any buyout group. Mob’s can be stressful on boards as they feel there is no choice. If the board declines, they will be left not only without a deal, but also with displeased management. Moreover, other bidders are less inclined to commit because they do not have management support.
The committee was notified of the offer (from senior management, SSP, Carlyle, Alga Global Asset Management and Reversions) Just two weeks after being informed of such a possible transaction. There was not much the committee could do as they essentially Joined a game already in progress. Kinder Mooring’s management and Goldman Cash had a two- month head start on them. Goldman Cash had already approached the biggest and most logical buyers to Join their team. The likelihood of someone willing to bid against a well-financed proposal, that already included the company’s founders, was slim to none.
Although the board presented the LOB offer to over thirty parties, not a single one expressed interest in having involvement in this deal. This limited the committee’s bidding options and after valuing the company at over $100 a share, they returned to the buyout group. With more advanced notice, the special committee may have had an easier time seeking out other offers. The board also faces additional pressures from outside forces. First, pressure in the Oromo of class-action lawsuits were filed to stop this potential deal. Most Loco’s have more than one company offering to buy them out.
This creates an auction and drives up the price of the company. The absence of a bidding process, teamed with an attempt by the Buyout group wielding its control to force out the public shareholders, fostered this litigation. The credit rating agencies, Moody’s and S&P, levied credit watch pressure on the firm since the transaction would create high levels of debt and could lower the company credit rating making it difficult for the privatized company to operate. A lower credit rating would greatly increase the cost of capital, which funded the firm’s primary growth mechanism, acquisition.
Finally, there is considerable pressure from management to accept the deal. Directors may be influenced into approving the MOB because they feel there is no other choice. If the board says no, they will be left not only without a deal, but with very dissatisfied management or may possibly lose key members of management. In the eyes of the board, the long-term pros may outweigh the short-term cons that come from bending to management’s will. Dealing with an ML Mills are designed to increase distribution payouts to the GAP as the ML increases cash distributions to its LAP.
This can disproportionately benefit the GAP (KIM) when the ML (KEMP) increases cash flows and raises distributions to reach higher incentive distribution tiers payable to the GAP. This can create a conflict of interest, as the GAP may be tempted to add ample assets with a high upside to the ML, but in return, may add higher risk assets to the LAP to meet the next threshold, even though those assets may not be what are in the best interests of the LAP. This can be problematic in sustainable infrastructure-focused industry like what Kinder operates in, as cash flows are long-term minded.
Understanding the associated time frames with companies of this nature, management’s proposal is surprising. It is apparent that the company is drastically undervalued and is poised to take off. Richard Kinder proposes to sell the company to himself (buy the company) by taking the company private. With public shareholders out of the way, his ownership stake in the company will rise from 17 percent to 31 percent. It is a unique situation where he is involved in both sides of he transaction. In the short-term, the LOB is a positive move for shareholders.
As a target in this acquisition, KIM would be offered a price at a significant premium to the market. The initial premium offered was at 18. 5 percent to the share price, but eventually Jumped to 27 percent. By increasing shareholder wealth, this deal is a windfall for investors and it would appear that the board is acting in the best interests of the shareholders by agreeing to this privation. However, even with guaranteed increased wealth that would be generated through his deal, the board is not acting in the best interests of its shareholders, and thus, should not carry through.
For starters, the company is being sold at $107. 5 a share, which is within its valued estimates (without any premium factored in for a buyout). Market pressures drove KIM down to a price point that made this premium sale at 27 percent to market value seem better than it was, as the stock should have already been trading between $100 and 120. Kinder and his investors were also the only group placing a bid on the company. To create the best outcomes for shareholders amputation needs to be stimulated during a sell-off.
Having a management backed bid that spoke with investors prior to communicating with the board, reduced the chances of the board to find suitors. The board failed to find bidders, and thus failed its shareholders by leaving money on the table. Other than negative reactions from the market (1 5% drop in last four months) the company was booming. The management seemed to be using their unique knowledge and influence to pay a discounted price. By the time the board finally knew of the deal (months after management had established contacts with Goldman and talked with other Bibs), they were essentially powerless to stop it.