MBOs have serious consequences for the firms involved but they can also have a big effect on stock exchanges, write Liam Gallagher and Ciarán Ó hÓgartaigh

The recently declining stock markets and low interest rates contribute to the current emergence of a number of management buyouts (MBOs) in Ireland and elsewhere.

A number of companies have departed the Irish Stock Exchange (ISE) through takeover or MBO. In recent weeks, Alphyra, Riverdeep, Dunloe Ewart and Conduit have become targets for MBOs.

These trends have implications at two levels: the micro (company) level and the macro level (such as for the ISE).

In the case of a typical MBO, an investor group, including members of management, buys out the owners of the company, which, if listed, ceases to be listed on the stock exchange. The typical MBO has three main characteristics: debt finances a substantial portion of the purchase price; managers own a significant equity stake in the post-buyout company; and the buyout partnership controls the company through its majority shareholding and the appointment of the board of directors.

Investor groups usually pay a premium of more than 40 per cent above the prevailing market price to take the firm private (although the premium in the case of the recent Conduit offer is 33 per cent).

While the process may be perceived by shareholders as a derogation of their rights in the share, the offer price at least offers a premium over current market value.

Buyout investors are willing to pay such a premium as they expect that operating profits (or income) will increase after the buyout. Managers generally possess company information not available to other bidders. Such asymmetric information creates asymmetric expectations, where managers believe that the value of the company is higher than the price they are offering. These expectations may also be fuelled by cost-reduction strategies - such as redundancies and reduced wages - with a view to enhancing profitability.

A consequence of these expectations is that MBOs tend to happen in companies where the share price has experienced a fall, offering management the opportunity to buy out at a lower price. This is the case in recently emerging MBOs, particularly in the technology sector. Riverdeep was trading at a price of 75 cent last Friday compared to €4.85 this time last year. (Interestingly, at the time of writing the Riverdeep share price is above the MBO offer price.)

MBOs may also be an effort by management to enhance the share price, at least in the short term, by signalling what they perceive the intrinsic value of the share to be.

Low share prices have another consequence as the issue of shares at such prices may not raise sufficient funds for acquisitions and the pace of share-based acquisition (which would potentially supplant MBOs) slows. Also, as MBOs are generally financed through borrowings, periods and/or prospects of low interest rates significantly reduce the potential cost attached to such borrowings.

Other factors also come into play in the market for corporate control: some of these in recent times have hinged around shareholders having different objectives or strategies for the company. Relationships between shareholders and/or between shareholders and management may become strained. In that sense, buyouts, whether MBOs or otherwise, have sub-cutaneous consequences for minority shareholders (as some Eircom shareholders found when the Valentia offer became unconditional and they had to sell their shares).

Other qualifications to untrammelled democracy in the governance of companies include requirements such as a three-fourths majority to make changes to the articles of association and limitations on the oppression of minorities. Such restrictions may also create the circumstances where a rearrangement of ownership of shares is desirable for a majority of the shareholders and an MBO may be adopted. In these instances, a shareholder with a substantial shareholding who does not wish to participate in the MBO may sell at a price below the MBO offer price.

These considerations in a sense reflect a qualified democracy in corporate governance at the micro level. At the macro level, recent developments perhaps reflect a retreat of the democratisation of the stock markets that was loudly trumpeted in the 1980s and 1990s.

While this democratisation never developed to the same extent in Ireland as elsewhere, the longest bear run in nearly 20 years and continuing concerns regarding corporate credibility have meant that many are staying away from the stock market. This is particularly the case in the small-cap sector where firms are prone to exit the market. Recently the Deutsche Börse announced plans to close the Neuer Markt and bring its "new market" listings into the main exchange.

These international developments also have implications for the ISE. Over recent years, a number of high-profile firms have left the market, including Smurfit (whose weighting this time last year was 3.4 per cent of the ISE) and Eircom (approximately 4 per cent at the time of takeover).

These recent developments represent a challenge for the ISE. A significant element of its activities is in bonds and specialist investment products. Furthermore, the recent development of covered warrants represents a potentially significant diversification.

Nevertheless, the activities of a stock exchange rest primarily on the exchange of shares. In the area of small-cap companies, in particular, stock exchanges internationally are searching for new paradigms and products to maintain their function as an exchange (if not primarily a stock exchange).

Liam Gallagher is professor of finance and director of the MSc in Investment & Treasury at Dublin City University Business School. Dr Ciarán Ó hÓgartaigh is the Irish Life senior lecturer in accounting and director of the MBS in Accounting at DCUBS.