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Protecting the secondary shareholder
July, 19th 2007

In the absence of strong signals backed by credible action from primary shareholders, it is the secondary shareholder who influences prices in the market.

P. B. Ramanujam

Acquisition is a useful strategy to scale up and get access to new products and markets. But it is also a high-risk strategy, as it can destroy shareholder value and place large demands on investors both in both the short and long term.

The board and the principal shareholders often presume, in the name of majority, shareholders approval for such a strategy.

Look at some of the recent large acquisitions/divestures Corus, Novellis, Beta Pharm, Terapia, or Sahara Airlines. The capital market reacted to these deals almost on predictable lines. Despite explanations/statements by promoters and managers, the market knocked down value massively. In the process, the small/retail investors who havelimited holding power or limited access to information lost out.

If both equity and debt holders do not like the acquisition, there must be either true value destruction or a problem of divergence in perceptions between those who took the decision to go ahead with the specific acquisition and those who have given the thumbs down..

The agency problem

In its simplest form, an agent does not take decisions the way the principal would. An agent ends up maximising his wealth even at the cost of secondary shareholders, who could include small shareholders, debt-holders, customers, employees and even the government.

Even taking a limited view of defining secondary shareholders to include only the non-managing equity- and debt-holders, the agent ends up, though not deliberately, working against their interests due to what can be labelled secondary shareholder haziness a situation where it is often difficult to identify, clearly articulate, negotiate and balance their position.

This singular, multi-variable optimisation is important due to time horizon, and risk/return perception differences between the primary and the secondary shareholders.

The primary shareholders are rarely active participants in the secondary capital market, and it is the secondary shareholders who influence the price in the absence of strong signals backed by credible action from the primary shareholders.

On top of this, primary shareholders have access to much more credible information and can influence the direction of the company by virtue of the position they occupy.

Unfortunately, agent managers are often ill-equipped to deal with secondary shareholder haziness, and they quickly take umbrella under simplistic, formula-driven analysis such as cost-benefit, rule of majority and discounted cash flow. Such a purely economic approach misrepresents the problem, and creates a sense of disconnect.

Invincible yet un-winning

Companies often gloss over this disconnect by arguing that eventually it is the analysts who move the market. One will be surprised to see that most often their time horizon of investment will be much shorter than that of their analysis.

The second argument, that with the exit of one set of investors another always comes in, is only partially true. One has seen how concerted action of selling even by small investors can keep the share under water for a fairly long time.

The cycle of exit and entry by another set of investors, while theoretically elegant is, practically bumpy, and could spread over a fairly long period, to be of concern to the corporate. Recently, one saw in an otherwise successful public offering retail shareholders largely stayed out despite a price concession.

The efficient market argument does not really sell. The short term is very important.

The secondary shareholder really matters, and successful promoters such as Dhirubhai Ambani have always cared for this segment, thus enabling them create an army of loyal investors.

Managing by analytics

One is surprised at the extent of customer data used by marketing teams. Be it a small change in the product or shop layout, the question hotly debated is: How will the customer perceive and react to it? And no change is done till all possible reactions are figured out

This is welcome, but what is surprising is that the same company adopts a different philosophy towards its investors. In this electronic age, investors are often willing to share a lot of information, about their finances and trading pattern, if approached the right way.

One seldom comes across a company that tries to dynamically profile its secondary investors, by getting their views on possible strategic options. It is quite possible to undertake a profiling without actually divulging or diluting the confidentiality of competitive moves. This is an alternative to real-time ear on the ground approach.

Unlike the primary shareholder, the secondary shareholder has no mechanism to protect his interest when major business decisions are taken, particularly aggressive and risky ones. Formalising and structuring the managerial decision process and post facto scrutiny is not easy and may even not be desirable. But there has to be a framework within which the corporate has to work.

Rather than an external agency setting the norms, proactive managements would do well to set their own norms and articulate them for the benefit of the secondary shareholder.

Role of independent directors

While corporate governance, autonomy of the board and the presence of independent directors are all welcome, these fall short of balancing the interests of the primary and secondary shareholders.

The roles of independent directors need to be a lot more specific in acquisitions and price/terms of bidding, keeping in view the urgent need for self-imposed discipline and framework.

At the macro level, inclusive growth seems to be the mantra. India Inc. should make a start by looking at inclusive management.

(The author is partner in Managing Consortium, a Chennai-based M&A advisory company)
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