25 June 2019

ASIC's overkill on 'stub equity' in private deals

This article was first published in the Australian Financial Review.

This article was written by Mark McNamara, Lee Horan, Mark Vanderneut and Cathy Chan.

The Australian Securities and Investments Commission recently issued a consultation paper on the use of stub equity in public bids by private equity sponsors. It doesn’t like what it is seeing and is looking to clamp down.

For those not familiar, stub equity is a scrip alternative offered by bidders for the sale of your target shares. Target shareholders essentially elect to accept stub equity in the bidder’s holding vehicle as an alternative to taking all cash.

You’ve seen it recently in the successful bids for Healthscope, Scottish Pacific and Pepper, to name a few. It is a feature of Australian schemes that stub equity is offered to all shareholders to avoid class issues, but this means retail holders can take up the stub offer and co-invest alongside the sponsor.

The actual evidence of a real problem here (or of real grievances by those electing the stub offering and taking the private journey) is hard to find. The take up has been tepid, at best.

Our assessment of the 10 most noteworthy deals since 2011 shows seven instances where the stub has been "hit" (that is, the minimum acceptance level has been achieved). Acceptances have averaged around 56 participants. To put that into perspective, those participants represented about 1 per cent of the 30,000 shareholders in those targets (and we suspect a material proportion of those were sophisticated investors and/or target management). Target shareholders have overwhelmingly preferred the cash alternative.

ASIC wants to eliminate the use of proprietary companies and "look through" the custodian position so the public takeover rules and unlisted disclosing entity rules of the Corporations Act can apply.

Imposing these provisions runs contrary to the intended privatisation of these businesses by a sponsor. As the name suggests, it is "private" equity.

Shareholders electing the stub offer clearly understand they will be in a private investment environment and they must agree to a shareholders agreement as part of their election. That agreement will regulate trading of their scrip (including customary "drag" and "tag" requirements to protect everyone, large and small, on an exit).

These are all legitimate commercial requirements for a PE sponsor who, in the ordinary course, will look to guarantee it can achieve a smooth exit for everyone in three to five years. They will not work, however, if the public takeover rules and unlisted disclosing entity rules are imposed.

Sponsors have tended more recently to prefer using an Australian company (proprietary or unlisted public) as their holding vehicle. That’s been a positive development, in our view. Such onshore structures use a professional custodian to hold any stub equity that is issued. The custodian primarily ensures the register doesn’t get too unwieldly to manage. It has also meant the public takeover provisions and the unlisted disclosing entity regime won’t apply.

Somewhat ironically, if ASIC gets its way to "look through" the custodian position, sponsors may well be forced to revert to using foreign holding vehicles not otherwise subject to ASIC’s purview – a perverse and retrograde outcome for Australian shareholders, in our view.

In our experience, sponsors don’t instinctively gravitate to stub equity offers, but will consider them when it makes sense. This might be after initial interactions with a target board (keen to extract additional "benefits" for their shareholders) or having regard to likely preferences for key target shareholders (who might prefer to retain exposure to the underlying investment), or even to assist management roll their shares and incentives over in a tax effective manner.

Sponsors also aren’t, in our experience, actively seeking retail shareholders to accept the stub offer. The risk disclosures in the shareholder materials are extensive and will typically include very explicit warnings about the stub offer. Target directors also generally make no recommendation about stub offers (or recommend against them, as happened in Healthscope). This all seems to be working effectively based on the data we have seen.

Consultation on ASICs proposal has now commenced. No doubt there will be many wishing to express their views. We will be emphasising several aspects of ASIC’s proposal which we consider are overkill. Foremost, we want to understand what data ASIC has used to get it to this point. Regulation driven simply by dislike of a trend or a "sense" of erosion is not the foundation stone from which to build a sensible regulatory position.

ASIC’s current stance has the hallmarks of a solution looking for a problem.

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