A lesson for all management buy-outs

Alliance Boots’ shareholders are worried that Stefano Pessina is underpricing his proposed £9.7bn management buy-out for the retail and wholesale chemist, where he is deputy chairman. How can Mr Pessina prove that if he makes a formal offer, it fully reflects his assessment of the company’s fair value?

One elegant solution was mooted in a lecture on management buy-outs this week by Paul Myners, the former chairman of Marks and Spencer.

Mr Myners suggests that whenever managers want to buy a company in which they own a big stake, they should make a final offer and agree to sell their shares to any higher counterbid that subsequently emerges.

Adopting this principle would address the conflicts of interest at Alliance Boots. Mr Pessina owns 15 per cent of the company. By structuring a bid as Mr Myners suggests, he would signal that he was a buyer at his proposed price but a seller at a penny more. That would constitute a guarantee that he was not trying to buy Alliance Boots on the cheap. It would also head off any suggestion that Mr Pessina was obstructing an auction by teaming up exclusively with Kohlberg Kravis Roberts, the US buy-out firm. After all, his stake would be available to other buyers.

The snag is that Alliance Boots’ shareholders might not be grateful for this gesture of sincerity. Restrictions on any bidder remove a source of tension in an auction. Shareholders would surely want Mr Pessina to participate in a raised offer if he got the value of the business wrong in the first place, or if the company unexpectedly started to perform better – or if he decided he was happy to overpay.

So Mr Myners’ principle looks only half-right in this situation. A one-off final offer from Mr Pessina ought not to be welcomed by Alliance Boots. All the same, Mr Pessina should still seek to demonstrate that he will not stand in the way of an auction. If he makes a formal offer with KKR, he should say he would be prepared to sell his stake to counterbidders. He should also be open to teaming up with other private equity firms.

Mr Pessina and KKR may still end up tabling the only formal offer. So whatever they come up with next, Sir Nigel Rudd, Alliance Boots’ chairman, must be ready to respond by showing how his board would generate competing value as a public company.

Capital punishment

Tim Breedon, chief executive of Legal & General, talks of capital as the “raw material” of life insurance. If the cost of that raw material comes down – if the insurer is required to hold less capital by the regulator, for instance, or finds sound ways to reduce its cushion of reserves – L&G, like any business, has to consider how to respond. It could reinvest, pass on the saving to customers in lower prices, or pay it to shareholders as higher dividends or buy-backs.

By tailoring itself to new regulatory requirements, which permit insurers to hold lower capital reserves against term assurance and toning up its balance sheet, L&G is readying itself for the latter course.

It’s a complex and slow process, but any annoyance among investors about the pace of progress is misplaced. Speed is not always a virtue in this sector. Tuesday’s annual results were never intended to mark the end of the capital review – if only because the regulator and the taxman must sign off before L&G can make its final decision, scheduled for July.

Could L&G go further and release much more than the £1bn-£1.5bn that the market expects? Technically, yes, but only if it sacrificed its AA credit rating. That would be a step too far for a group that considers financial strength, correctly calibrated for the market and regulatory conditions, is a competitive advantage – particularly when it now finds itself pitching for pension trustees’ custom against comparative newcomers.

The form of the capital return seems most likely to be a combination of buy-backs and a stepped-up dividend and will be based on L&G’s soundings of “where the least number of investors would not want us to be”. Again: don’t rush the company – patient holders of the shares, trading at an attractive 1.2 times end-2006 embedded value, will be rewarded.

Investment drivers

The sale of NCP to Macquarie European Infrastructure Fund shows that protests by the GMB union are not enough to stop the private equity juggernaut. After Thames Water, this is the second acquisition by Macquarie in six months of an asset with a high public profile. The leveraged deal is courting trouble. Some of the car park group’s staff demonstrated against 3i, its existing private equity owners, last month. Strikes are planned. Maybe Macquarie felt comfortable going ahead because NCP’s headcount grew under 3i’s ownership. That makes it a potentially good PR story for private equity. But a better explanation is that the industry is hungry to put capital to work and has a thick skin.

L&G: andrew.hill@ft.com

chris.hughes@ft.com

www.ft.com/lombard

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