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To Placate U.K. Critics, LBO Firms Offer “Stub Equity”

As shareholders and regulators in Europe take a harder look at leveraged buyouts, LBO shops have responded with an offer that some critics can’t refuse: a piece of the action.

Before taking public companies private, buyout firms have begun offering hedge funds and other big shareholders so-called “stub equity,” which gives them an ownership stake after the take-private. That way, they can share in the substantial returns normally allotted only to limited partners.

“If the private equity guys make the returns they aim for, the hedge fund guys will be happy to have a piece of the action,” said Michael Francies, managing partner of the London office of law firm Weil, Gotshal & Manges, explaining the rationale behind stub equity.

For now, at least, stub equity is primarily a British phenomenon, mainly because securities laws in the United States would require buyout shops to disclose intimate secrets in a prospectus if they wished to offer stub equity to shareholders, Francies said.

But the concept has begun to creep across the Atlantic. Bain Capital and Thomas H. Lee Partners, facing stiff opposition in their bid to take private radio operator Clear Channel Communications, reportedly offered a dissatisfied hedge-fund investor the opportunity to roll its 5 percent holding in Clear Channel into the new private entity. The hedge fund, Highfields Capital Management, declined, but the buyout shops have offered the same proposal to other major shareholders, according to published reports.

Meanwhile, American firms are taking advantage of the opportunity abroad. Apollo Management recently offered stub equity—in the form of unlisted shares—to investors as part of its pending £1 billion takeover of Witham, England-based real-estate firm Countrywide Plc. Despite support from Countrywide’s board, U.K.-based buyout firm 3i failed in its bid last year to delist the company after shareholders called the deal too cheap. Apollo’s offer of stub equity is seen as essential to gaining the required 75 percent approval from Countrywide’s investors, according to the Financial Times.

Francies said the equity stub on offer in the Countrywide deal, valued at about £100 million, isn’t enough to really hurt Apollo’s returns. Instead, Francies called stub equity a “sweetener” that can win over recalcitrant shareholders. It also can counter a growing sentiment that buyout shops are making money at the expense of the public—and, for that matter, hedge funds.

“This is one option private equity funds can consider to give existing shareholders an ongoing share of the cake and a greater potential return,” Francies said.—J.H.