Tuesday, May 27, 2014

The risk with owning closely held companies

One of the hallmarks of my investing style is that I usually invest in closely held companies.  A closely held company is one where a shareholder, often a founder, or founding family owns a controlling stake.  The idea is that with a closely held companies minority shareholder interests are aligned with the controlling holder's interests.  There is a lot of research to back up this assertion and shows that family owned and closely controlled companies have outperformed the market over the long term.  But long term outperformance doesn't mean there won't be a few duds along the way.  While it's always nice to talk about and tout investment successes I think it's also important to look at our failures as well.

I wrote about First Aviation (FAVS) in last March.  When I found them they were selling an unprofitable division for more than their current market cap.  I've found that investments like that often end successfully.  This is mostly because the profitable division's hidden value is exposed to investors.  The company also has proceeds from the sale that can be used to fortify their balance sheet.  When an investor can purchase a company for less than the proceeds from the sale and get a profitable business for "free" it makes sense to invest.

What took place at First Aviation didn't quite follow usual the divest your way to profits playbook.  The company is an aviation parts supplier and outsourced maintenance vendor.  They specialize in commercial propellor planes, the ones that are used on short haul commercial flights.  The company's majority shareholder is an aviation focused private equity group located in Connecticut.  I mention the location on purpose, the aviation company's facilities are in North Carolina, Wichita, and Texas.  Yet the company leases their office space from the private equity group's headquarters.  This was an item that gave me a bit of caution, but wasn't enough of a red flag to pass on the investment.  It's hard for executives to manage a company remotely.

In the last year the company has done exactly what it said it would do, they used the proceeds from their division sale to pay down debt and their profitable division's profits have grown nicely.  The company reported earnings last week where they reported they earned $.32 in the first quarter.  Extrapolated out for the year the company could earn $1.20 a share or more, significant considering their shares trade at $8.40.  They aren't only cheap on an earnings basis, they also trade for 68% of a growing book value.

The problem is shareholders aren't going to be the beneficiaries of this growth story.  Management decided they'd prefer to take the company private by engaging in a 10,000 for 1 reverse stock split.  Any shareholder who owns less than $84,000 worth of stock will be forced out of their shares and paid $8.40 per share in cash.  The 10,000 share limit is significant in that it's a much higher amount than normal for a reverse merger.  Most likely the company is squeezing out all but a few large shareholders by setting such a high threshold.  The company is already a non-SEC reporting entity meaning they have less than 300 shareholders of record.  This corporate action isn't an effort to stop filing and reduce costs, it's a way to eliminate all but larger shareholders.

When I purchased the stock shares were priced at $9, so this take-under won't be a huge loss, but it's still a loss.  What hurts most about this transaction is that my initial thesis was, and still is correct.  I would classify First Aviation as an investment failure, but not an investment mistake.

Unfortunately in the case of First Aviation having a significant controlling shareholder didn't help minority shareholders, it hurt them.  I suspect this is because the majority holder is a private equity group who is only watching out for themselves and their (the PE investors) shareholders, not everyone.  Private equity doesn't have a great reputation for being shareholder friendly.  At times investors can profit investing alongside private equity firms, but it's not a relationship of equals.  It's more like the minority shareholder is the bird riding on the rhinoceros' back.  You can get a free ride, but if you're in the wrong spot you're likely to be crushed without regard.

I think it makes sense in response to this investment failure to consider whether I'd do anything differently?  I'm not sure I would.  If this company weren't going private I'd be happy to be a buyer at this price today, especially with how their results have improved.  The lesson I've taken away from this investment is that even when everything works out according to a plan it's still possible to experience an investment loss.  The problem is as a minority shareholder I am tagging along on all of my investments.  I can't control what a company's management does to outside shareholders.  If management decides to take action which is detrimental to shareholders I can experience a loss even if my investment thesis is correct.

My experience with First Aviation has made me wary of the recent news out on Schuff Steel, a company I wrote about in 2012.  The Schuff family sold their controlling stake to a private equity group.  Schuff has the potential to play out in a manner that's similar to First Aviation.  The company's results have been recovering dramatically but it's possible outside minority shareholders won't get to enjoy the reward associated with the results.

Disclosure: Long FAVS, SHFK

12 comments:

  1. In regards to SHFK, you can always buy shares in the acquirer (HCHC). I think it's a reasonable buy here. Phil Falcone (Harbinger Group) bought around 40% of the company @ $4.00/share a few months ago. It's still trading at that level. However, Falcone just gave himself options for >10% of the company @ $4.56/share.

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    1. Yes, that's a good point. When I saw the news I thought about putting together a post detailing how an investor can buy Schuff at a discount through HCHC. Maybe I will still do that.

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    2. Are there any dissenting shareholders with First Aviation? I'm not a lawyer but I believe state law gives minority shareholders "appraisal rights" which is the right to be bought out at "fair value" in such situations.

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    3. First Aviation is a Delaware corporation. Under DE law, shareholders who are cashed out through a reverse stock typically do not have appraisal rights. But on these facts (essentially a buy-out by the majority shareholder), 8 Del. C. 155 should provide shareholders with a remedy that is similar to appraisal. See the Delaware Chancery Court's opinion in Reis v. Hazelett Strip-Casting Corp., 28 A.3d 442 (2011) (available on Google scholar).

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    4. Appraisal Rights....I have looked in depth at this. Sort of ambiguous, but a person demanding appraisal rights could potentially end up paying an undetermined legal bill.

      I am not familiar with First Aviation's situation, but I am guessing they paid a CFA/Evaluation firm for a fairness opinion...so you would have to build a case to refute that (probably hiring your own evaluation firm). Since you don't have a major position (apparently less than 84,000), I think it would be foolish to initiate this on your own.

      With that said, I have been contacted by dissenters with much more skin in the game (ADRS as an example) organizing a legal battle. I passed as I thought the buyout was at a fair price and it was a small position.

      I think the lesson here is margin of safety and the anecdotal evidence that management is treating the minority shareholder well. Perhaps a PE of 8 and trading at 100% Plus of Book Value is fair valued for a minority position in a small company.

      I think pink sheet stocks have more than their fair share of shady majority owners. Sort of a self selection process (they chose to delist...while many can rightly say it is to save accounting fees, I am sure many view this a first step to go unabated into the cookie jar).

      There are exceptions; Tower Properties (TPRP) comes to mind for me. And when you find this combination (ethical competent management and a cheap valuation). I back the truck up (TPRP is 15% position for me).

      Anyway...Nate, thanks for sharing your experiences with us. I have learned much from your blog.

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    5. Yes, appraisal rights probably exist, but they're not worth it. Each shareholder has to contest the valuation themselves which means hiring a valuation firm and a lawyer to go through with it.

      This really isn't cost effective for anyone who would be cashed out, even someone with a half a million position probably wouldn't find it worth their time. Sometimes the appraisal cases can drag on for years, and sometimes the court finds that the company was too generous in their payout. It's possible to pay all of the fees, go to court and have a judge rule that $7.50 a share is the 'fair value', you're now stuck with it.

      I agree that there are plenty of shady managements on the pink sheets. I've run across more than a few. Usually the only tool an investor has is valuation. But even at 10-20% of book value some of these things are a pass, it's all a case by case situation.

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    6. I do not believe this is correct. The appraisal rights statute (8 Del. C. 262) does not apply to reverse stock splits, which are governed by 8 Del. C. 155. Section 155 does not have all the procedural requirements of Section 262 (which I assume you are referring to when you say "each shareholder has to contest the valuation themselves"). Thus, it may be easier to bring this case as a class action.

      On the facts of this case, the the Chancery Court would undertake a very searching analysis of whether the price paid to cash out minority shareholders is "fair," though any case would likely come down to a battle of valuation experts.

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  2. Wow Thanks for this write up- I love the experience and learning from these cases.
    One question - what if you took your share count above $84,000? Would you not be able to participate in the companies future if you were able to ramp up your shares?

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    1. If you own more than 10,000 shares you'll continue to be a shareholder. The problem is information might become scarce to nonexistent, and management doesn't look like they're willing to return capital. You'd essentially own shares in a private company. I have nothing against private company ownership, the issue is when there is no market at all for your shares you need a dividend to be paid.

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  3. really good post, thanks. what would you recommend to avoid/control this risk? simply to track such transactions with PE companies or anything else?

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  4. I have observed that you mentioned this kind of risk with some other investments in closely held companies. My question is why the controlling family of these companies still keep the share of the company in the market. why do not they take the company private always?

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  5. I can answer this for you. Perhaps incomplete but some reasons for keeping these closely-held companies public are as follows:
    For the owner:
    - personal satisfaction from running a publicly-traded company vs. a private co.
    - puts a price tag on the company and allow for easier cash-out in future
    - rip off minority shareholders by using OPM (i.e. egregious salaries, related-party transactions,etc...); not often the case need to be watched out nevertheless
    For the business:
    - enhances reputation
    - better able to attract talented employees
    - easier to raise capital and conduct secondary offerings

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