This article first appeared in The Edge Malaysia Weekly on January 22, 2018 - January 28, 2018

BUY low, sell high. This is the golden tenet of investing. Thus, investors are always looking to identify undervalued companies with the intention of cashing in when the market starts to revalue the firms properly.

But the scales are not tipped in the favour of small investors. Well-heeled investors with access to large sums of capital are often in a better position to take advantage of undervalued companies by launching a bid to privatise them.

Unlike retail investors who have to rely on the market’s pricing of the company’s shares, big corporate raiders can often strike deals with controlling shareholders with or without the management. And once they seize control of the company, they can always strip the assets for a quick buck or ride the upside as the company’s prospects turn around.

“When you look to take a company private, you must have a plan. You can’t just buy it because it is cheap. Maybe you are going to strip the assets, maybe you are going to relist it down the road at a better valuation. Retail investors however, can only wait for the market to better value the company ... they are disadvantaged,” explains one veteran banker who declined to be identified.

Not surprisingly, it is rare for minorities to bag a good deal from a privatisation these days, and they should consider themselves lucky if they are offered a premium of 20% from the one-month volume weighted average price.

In fact, most general offers these days are certifiably “unfair”, as determined by independent advisers. Nonetheless, minorities often have little choice but to accept the lowball price, or risk being stuck with an illiquid stock, or even worse, in a suspended counter.

To be fair, no offeror can be expected to hand out high premiums to take a company private; they, too, wish to pay as little as possible to maximise their investments.

However, the balance of power heavily favours the offerors, who can twist and bend the terms of the offer to their advantage.

In brief, corporate raiders that intend to take a company private have several key advantages over ordinary investors:

Information — Offerors are often the company’s management or act in concert with management to take a company private. This gives them the edge as they understand the inner workings of the company and are able to anticipate turnarounds or upside potential of the company.

Power — Offerors also tend to be the controlling shareholders or act in concert with them. While it is difficult to prove, proxies can be used to help tighten their grip on a company.

Capital — Unlike minorities, offerors often have access to more funds and may even tap bank facilities for a leveraged buyout of a company.

Sophistication — With more money comes a suite of professional advisers, from bankers to lawyers and corporate consultants, which can help offerors maximise their chances of a successful privatisation. This includes a better grasp of regulations and the best ways to skirt them.

Time — Arguably the most underrated advantage that offerors have. Oftentimes, the best way to privatise a company is to exercise patience while slowly tightening one’s grip on a company. After a year or two, most retail investors would rather exit at a small premium rather than have their capital tied up in a company.

Put it all together, and 2017 saw a number of lopsided privatisation exercises, for example, the privatisation of Wing Tai (M) Bhd and Hwang Capital (M) Bhd.

Even the general offers that did not take the company’s private also resulted in disadvantaged minorities.

Strategies

The privatisation of Century Bond Bhd was easily the fairest on the market last year. It was a textbook exercise, with Kumpulan Perangsang Selangor Bhd (KPSB) buying out the controlling shareholders and triggering a mandatory general offer.

Century Bond was generating highly stable cash flows, so KPSB just borrowed money from the bank at a lower rate to take the company private — a classic example of a leveraged buyout.

The nature of the deal also ensured that minorities got a good price, as KPSB had to convince the controlling shareholders to part with their block.

An upcoming privatisation that is shaping up to be a fair deal for minorities is that of OldTown Bhd by Dutch company Jacobs Douwe Egberts Holdings Asia NL BV (JDE Asia) at RM3.18 per share — a 23% premium to the company’s one-month volume weighted average price.

While certainly not a stellar premium, it is likely to be fair. Just like the Century Bond deal, JDE Asia is also buying out OldTown’s controlling shareholders, who hold 51% of the company.

Such privatisation exercises, however, are the exception rather than the norm.

In general, offerors want to create a situation that forces minorities to accept the lowest price possible. Oftentimes, this does not mean taking the company private immediately. By gradually increasing control of a company, offerors reduce the trading liquidity of the stock, making it less attractive for other investors to buy into the company.

Furthermore, once a shareholder controls 51% of a company, it effectively blocks competing bids.

“Squeezing out minority shareholders is the underlying basis for any privatisation. It may seem unfair, but these corporate raiders aren’t breaking the rules. It may not be nice, but why should they give away their profits?” says the banker.

Here are some recent examples of how these strategies were employed:

How Hovid squeezed out minorities

The one-sided nature of privatisation exercises is evident in the ongoing attempt at Hovid Bhd — undertaken by a private equity fund, TAEL Partners, together with the company’s controlling shareholder and managing director, David Ho.

The pharmaceutical company became a prime target for privatisation after the National Pharmaceutical Regulatory Agency of the Ministry of Health revoked the manufacturing licences of two of its plants in January last year.

Hovid’s share price plunged almost 22% on the news, to a low of 28.5 sen. Subsequently, the company’s earnings fell due to the closure of the plants and by October, TAEL Partners teamed up with Ho to attempt a privatisation at 38 sen per share.

However, Ho and TAEL Partners quickly realised that the market was not prepared to sell out at a mere 21.79% premium to Hovid’s one-month volume weighted average price. The offer of 38 sen a share struggled to get close to the 90% acceptance that would make it unconditional.

The offerors dropped the acceptance level to 75%, but it still failed to pass. Subsequently, it was brought down further to 67%.

This put minorities in a difficult position. By dropping the conditional acceptance level several times, the offerors ensured that the exercise would ultimately be completed, even if it did not allow them to take the company private right away.

This strategy allowed them to accumulate as many shares as possible at the 38 sen offer price.

Note that the offerors had made it clear that they had no intention of maintaining the listing status of Hovid and would make no effort to maintain the required public shareholding spread of 25%.

Thus, minorities had to choose between a poor offer (one that many were reluctant to accept initially) and being stuck with a company whose controlling shareholder wants to delist it.

The latter is a credible threat. As the offerors seize control of more shares, the trading liquidity of the company will fall. Eventually, it will be difficult for the remaining minorities to exit or for the market to accurately value the company.

While the intention was not explicitly stated, this strategy had achieved the desired outcome — 44.89% acceptance as at Jan 12, handing the offerors a 79.55% stake in Hovid.

The remaining shareholders may have been able to exercise their rights not to accept the offer but the road ahead for them will be a tough one.

To be fair to Hovid’s offerors, however, the independent advisers to the deal had assessed the offer as fair and reasonable. Minorities in other privatisation deals were not so lucky.

Wing Tai Malaysia

Once a company is taken private, the offerors that executed the deal often enjoy the fruits of their success beyond the purview of the public eye.

In the case of Wing Tai Malaysia’s privatisation, however, the offeror is Singapore-listed Wing Tai Holdings Ltd.

The deal was arguably one of the best last year, at least, from the perspective of the offerors. Conversely, it was arguably a raw deal for minorities.

Since the announcement of the privatisation in May last year, Wing Tai Holdings’ share price has surged by 25%. Analysts covering the stock last year upgraded their ratings ahead of the expected conclusion of the deal.

In stark contrast, Wing Tai Malaysia’s share price performed very poorly in the 2½ years leading up to the privatisation offer, losing more than half its value, to as low as RM1.

While it was certainly true that the company’s earnings were not stellar, the poor share price performance could also be because of low trading liquidity due to the tightly held nature of the shareholding — the controlling shareholders held over 66% of the shares.

It also did not help that management kept a low profile and was not active in engaging stakeholders beyond the bare-minimum requirements like holding annual general meetings.

Of course, one sore point for investors was that the company’s property development arm accumulated nearly RM900 million in inventories, mainly from unsold residential properties. Note that this figure values the inventories at cost.

It is understood that the company’s inventories were inflated to that level because it chose not to launch sales of its prime residential development in the Kuala Lumpur — Le Nouvel, opposite KLCC. Hence, a huge amount of Wing Tai Malaysia’s earnings potential was trapped in its balance sheet.

With an offer price of RM1.80 a share, some minorities who were late into the stock certainly enjoyed a decent premium. But the offerors got the best deal, taking Wing Tai Malaysia private at roughly half independent advisers’ estimated value of RM3.55 a share.

So what?

On the topic of privatisation, one cannot forget how Datuk Yu Kuan Chon managed to block Tan Sri Quek Leng Chan from privatising Hong Leong Capital Bhd (HL Cap) via Hong Leong Financial Group Bhd.

Back in 2013, Yu suddenly emerged as a substantial shareholder in HL Cap and increased his stake to 7.82% just weeks before Quek’s bid to privatise the company. While trading in HL Cap was ultimately suspended, Yu was able to single-handedly throw a spanner in the works of the HL Cap’s privatisation — the company has yet to be delisted till today.

For most investors, however, duplicating such an act of defiance is unthinkable.

Thus, when hunting for undervalued stocks, investors should also be cautious of value traps — companies with deep unrealised value that minorities will not be able to fully enjoy.

While some investors who take positions right before an offer will enjoy some upside, those who hold on to such stocks hoping for a big payday may be ultimately disappointed.

For corporate raiders, however, there are plenty of opportunities in the market.

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