08.15.05
The Reorganization of Fresenius: Is there a Case for Reasoned Inaction? – August 15, 2005
There is an investor-led campaign to reject the reorganization scheme proposed by the German health-care company, Fresenius, which is the world’s largest provider of kidney-dialysis machines and services. Management is proposing that the company abandon its current status as a public corporation (an AG in the German abbreviation) in order to become a publicly-quoted limited partnership (KGaA) with its controlling shareholder—a holding corporation— as the general partner. As justification for the move, the company has cited its declining trading volumes on the Frankfurt bourse, and the fear that the company could fall out of the DAX 30, the narrow index which attracts most investor attention in Germany. How would the proposed transformation help? In becoming a limited partnership, the company will be able to exchange all its preferred shares (about 1/3 of the free float) for ordinary shares, increasing its index weight, and issue more shares without having to participate in the capital increase or risk loss of control. Thus the company is trying to have the best of both worlds, increasing the capitalization without losing control.
As so often is the case in these beautiful schemes dreamed up in some investment banker’s fur-lined office, what the corporate client gains, minority shareholders lose. Ordinary shareholders are being asked to give up their theoretical rights as shareholders in a corporation in order to see themselves heavily diluted in a quoted partnership. Preferred shareholders will have to pay a premium equivalent to half of the average price differential between the preferred and the ordinary in order to receive ordinary shares. The share price of the ordinary will likely decline due to the historically greater discount demanded by the market in a partnership, as there is not even the remote possibility of a contest for control. It is not even clear that liquidity in the shares will improve under the new mode of organization, given that the link between shares outstanding and trading volumes is imprecise, to say the least. In short, this is a scheme which seems to benefit minority shareholders not at all.
To add insult to injury, the company is attempting to ram the measure through at an Extraordinary General Meeting in Frankfurt on August 30th, when most of Europe is and has been on vacation, and even workaholic Americans are more likely to be found at beach houses than at their desks reading tedious proxy advisories, let alone at foreign shareholder meetings. It is difficult to believe that this measure was so urgent that management could not have waited a month to bring it before shareholders.
So why, then, is this sad but all-too-common sort of event the occasion for a column on “reasoned inaction?” In a brief conversation with a colleague and friend of mine, he disclosed that his fund was planning to vote with management. Why? Because the controlling shareholder would be the same no matter what, and because it had done a ‘pretty good job’ running the company. Also, he was afraid that otherwise management would have to launch an even greater share offering than that contemplated under the present scheme. My first reaction was to try to refute his arguments. For starters, if I had an extra dollar for every time I have been told during my investment career that a company was already controlled and that whether I had a voting share or not didn’t matter, when it subsequently turned out that it did matter, I would be able to take my wife out to dinner at one of New York’s best restaurants, and not have to be too careful about the wine we ordered, either. I have also learned that in business at least, it is better to trust those we are not obligated to trust, than those whom we have no choice but to trust—especially when they frequently remind us that we must trust them.
But my friend is not only intelligent, he is also dedicated to the cause of better governance, so I tried to understand the arguments he might bring to bear on this issue. One is that there is not much point antagonizing those who will probably prevail in any case, and who will also continue to run the company even if they lose the vote. The controlling holding company will walk into the EGM with 51% of the outstanding votes. True, they need 75% of those cast in order to prevail, but this means that of the outstanding minorities, more than 50% have to vote against management for them to lose. Given that the turnout at German meetings is seldom more than 25 – 30%, and that some shareholders will inevitably vote with management, this makes the 75% hurdle less high that it might seem at first glance. On the other hand, if one could rally, say, 40% of the minority shareholders to actually vote against the proposal, given the general apathy of the other minority shareholders, this could be sufficient to make the 75% threshold unreachable, and management would have to either abandon the proposal or make significant concessions in order to win over the dissenting shareholders. The question is: what could management concede that would really be of help to the minority ordinary shareholders? Lowering the exchange premium for the preferred shareholders hardly helps the holders of ordinaries— they would suffer the same dilution and their company would receive less cash, requiring further capital raising in a short time. The company could make all sorts of governance concessions, but most would be unenforceable, given the legal responsibilities defined by the KGaA ownership structure. Of course, if you don’t at least threaten to oppose management, then they will be under no pressure to concede anything, but how much can really be gained here?
Another argument in favor of inaction could be that the limited partnership is actually superior to the joint-stock corporation when there is a controlling shareholder. It is true that controlled corporations have been subjected to many abuses due to the fact that an unchecked management was able to play with minority investors’ money, while hiding behind the limited liability of the corporation, and the fiction that the governance of the company is subject to review and approval by all the shareholders. By contrast, the typical KGaA has been a family-run company with no Burle-Means agency problem, just getting its feet wet with the idea of independent shareholders. The advantage to this intermediate structure is that the general partners are still personally liable for the debts of the company. If they mess up, they will be ruined just as they would have been in the private partnership or family business, and this prospect should focus their minds on the prudent management of the company as few compensation schemes can. The problem in the case of Fresenius is that the general partner will be another corporation, privately held and itself subject to no outside supervision or market scrutiny. Neither the individual managers nor the controlling family foundation will be directly liable for anything, yet meanwhile the company’s board will be entirely removed from shareholder control. It may be that the limited partnership structure gives the company a bit more flexibility in decision-making than the two-tiered board structure of the German AG, but most AGs have little difficulty working around it. The real difficulty comes when a company’s management has lost control of increasingly fragmented shareholders, and then does something stupid— but this is exactly when shareholder rights should come to the fore. Perhaps I am missing something, but from a minority investor’s viewpoint, I cannot see how the KGaA structure would be preferable, so far as governance is concerned.
The real question is whether it is realistic to expect management, and especially the family foundation, to relinquish any measure of control no matter how pressing the capital requirements of the company might be. If the controlling group would rather see the company curtail its investment plans or become overly dependent upon debt than open up the capital further and suffer partial loss of control, then minority investors may indeed have to decide whether to see control imprinted by this or some other such structural gimmick, or face the prospect of an investment gone ex-growth. In the case of Fresenius, this would mean either the issue of more non-voting capital in multiple subsidiaries (there is a limit to the proportion of voting to non-voting shares an AG can issue in Germany), more reliance upon debt, or the creation of even more exotic structures to protect the existing control. Faced with these alternatives, the KGaA might actually be the lesser evil. This may ultimately be the logic behind my friend’s decision not to oppose this proposal. If so, it is a sad commentary upon the lack of trust German managements have in market forces, that they might actually prefer to throttle their own companies’ growth, rather than share control with minority shareholders.