Shareholders of Restoration Hardware (RSTO) are the beneficiaries of a class action lawsuit against the buyout that saw the firm go to the low private equity backed bid rather than the higher bid from Eddie Lampert’s Sears Holdings (SHLD). Shareholders will receive an extra $0.19 per share from the litigation in addition to the $4.50 merger consideration. After legal fees, total payout should be roughly $4.63, a 2.9% increase over the price negotiated by the board. Nothing to make you rich, but a lot more than the annual dividend yield of the S&P index. The extra payout explains why Restoration Hardware trades currently a few cents above the $4.50 merger consideration.
The Restoration Hardware settlement is atypical in that the payment has been agreed well before the merger has closed. Shareholders approved the $179 million acquisition by private equity firm Catterton Partners only last week, and the settlement of the litigation was announced a day before the shareholder meeting. For the most part settlements are struck years after the deals have closed.
The amount of the settlement is somewhat disappointing in light of the serious failures of the board to obtain value for shareholders, while trying to maximize the personal payout for CEO Gary G. Friedman. We believe that higher damages might be appropriate in light of the gross shareholder abuse by the board and its frustration of Sears’ attempts to buy the firm for more. From the outset, the sales process was biased in favor of the management-led group, and Lampert’s Sears stood little chance of winning control of RSTO. As a strategic bidder, Lampert would have been able to outbid the management team and their financial backers because Sears can achieve synergies with its other retail operations, as it did after its acquisition of Land’s End. Indeed, Sears always bid slightly more than the management group, but was always rebuffed.
Sears entered the bidding war that was none with a $6.75 bid, compared to the initial $6.70 bid by the management-led group (the management group had bid $7.50 earlier but in the absence of a real auction to sell RSTO reduced its bid to $6.70). Sears repeatedly asked for due diligence information that would allow it to increase its conservative bid. Restoration Hardware’s responses were terse and made clear that Sears was not welcome. Adding to Sears’ woes was the law firm of Morrison & Foerster (MoFo), which represented both Friedman’s acquisition group and the independent committee of RSTO’s board. This is a clear conflict of interest, and we are surprised it passed the otherwise stringent engagement criteria of large law firms. MoFo procrastinated Sears’ attempts to sign a non-disclosure agreement with RSTO. Access to non-public information would have enables Sears to evaluate RSTO better and make a higher bid. Eventually, Sears did get to conduct its due diligence, just in time for the revision of the price down to $4.50 after the disappointing holiday shopping season. Despite attempts by RSTO’s board to dissuade Sears from bidding again, it made a $4.55 bid. The board decided arbitrarily that the lower bid was superior and that Sears bid was “highly conditional,” which it was not.
Restoration Hardware’s board went to great lengths to favor management over Sears. A committee of independent directors was set up only well after management was in advanced discussions with its private equity backers. Normally, a committee of independent directors is the driver of the sales process, not management, especially when management wants to buy the firm. As a result, self-dealing was deeply ingrained in RSTO’s sales process. The board even went to far to disenfranchise Sears’ voting rights in the shareholder meeting. A majority of the minority shareholders is required to adopt the merger agreement. This is standard practice in similar situations. However, the board excluded Sears from voting its 13.7% against the merger.
After Restoration Hardware becomes a private firm, Friedman will receive up to 20% of its equity through a management incentive plan. This stake will be cashed out if RSTO goes public again or is sold – something that is sure to happen because Catterton Partners will want to exit eventually. Friedman’s continued employment by Restoration Hardware after a deal with Catterton was agreed upon very early on in the discussions. Nevertheless, it was never disclosed to shareholder and only became public through discovery in the class action lawsuit.
Shareholders can get at least some consolation from the additional payout. Unfortunately, they will receive nowhere near as much as a fair sale of the company could have achieved if Sears had been able to make a bid.
Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of Restoration Hardware.