Does an employee buyout of the distressed airline make sense?
Once India’s largest airline, Jet Airways has now ceased all its operations. Saddled with a huge debt, unprofitable operations and promoter mismanagement Jet has crash landed. Apart from the shareholders, the biggest losers have been the employees of Jet. They have not been paid salaries since January, and face a bleak prospect. Since then they have been running from protest grounds to the PM’s Office, without any relief coming their way. In a last-ditch attempt to save the airline, and their future, the employees have proposed an Employee or Management Buyout. Along with a group of frequent fliers, they have proposed a plan called ROJA (Revival of Jet Airways). As part of the plan, the employees will take over the airlines, with a combination of personal loans, pre-selling of tickets to frequent fliers, Employee Stock Ownership Programme (ESOP), and possibly, Private Equity funding. Commentators have argued that this is not a bad plan to go ahead with.
This article seeks to evaluate the viability of this option. In pursuance of this, I will undertake an investigation into the nature of Management Buyouts, their feasibility, and their success in the airline industry. This theoretical analysis will be carried out within the context of the current state of the Indian airline industry to argue that, “employees will subject themselves to greater risks by investing their future in a failed enterprise.”
Management Buyout is a transaction where a company’s managers or employees buy a controlling share in the company. This is generally done with the financial backing of private investors as the employees often lack the kind of financial muscle required to take over their company. Such buyouts became extremely popular in the western world in the 1980s. This surge was primarily a result of the success of the mantra of “back to basics”, causing diversified conglomerates to divest out of their subsidiaries. It was further made popular because of the extended recession during this period. One study mentions, “the companies were bought out because the parent companies could not make the business work to their satisfaction”. This begs the question, “what is it about Management Buyouts that makes it useful during times of crisis?”
The Minimization of Agency Costs
Adam Smith wrote that the managers of other people’s money cannot ‘well be expected to watch over it with the same anxious vigilance with which its owners will’. This, later on, came to be elaborated by Berle and Means as the Agency Cost Theory in their book “The Modern Corporation and Private Property”. They depicted the phenomenon of large corporations having two different sets of interested parties, the shareholders (owners) and the managers. However, they found that the shareholders exercised near to no control over how the company functioned, even though they were the owners, and it were the managers who exercised complete control over the working of the company. This gives the managers a significant control over how the resource allocation of the company takes place. Naturally, the managers will give precedence to maximizing their own benefits as against that of the shareholders. The loss of shareholder value as a result of this is called the agency cost. However, if the manager themselves were to become owners, as they will after a management buyout, such agency costs shall be reduced to a minimum, creating huge efficiency benefits. Additionally, owner-managers will be incentivized to seek innovative and high risk-high returns projects. These reasons coupled with other benefits like teamwork, enhanced motivation and greater transparency can result in an improvement in the performance of the company.
As a result, in the face of acute mismanagement of corporate assets and company failure, a managerial buyout is a quick and efficient way to deliver economic value. This, along with a survival instinct or entrepreneurial vision, sets the occasion for a management buyout.
Survival Instincts or Entrepreneurial Visions
Theoretically, management buyout occurs because the two primary parties (owners and managers) place differing values on the firm in question. The owners acknowledge that they have failed to run the company, and the employees believe that by taking over the company, they can successfully run it. This implies that the employees are either moved by an entrepreneurial vision of earning riches, or by a survival instinct, as they have no other means to pay their monthly bills.
When a vision guides the employees going for a buyout, the employees are generally under the impression that they can run the business better without the control of external forces (e.g. promoters, shareholders, etc). This happens when the failure of the business can be blamed on corporate overhang/promoter interference rather than any fundamental economic weakness in the business.
In contrast, employees may be driven by instinct when they are likely to lose their jobs or be subjected to unacceptable conditions by a new owner group. Such situations are generally a result of fundamental flaws in the business model or extremely fateful market conditions. As a result, such buyouts tend to end up as a failed attempt by “a group of washed-up executives doing a buyout to preserve their jobs”.
These arguments can be illustrated by instances of successful and failed buyouts.
Instances of Successful Buyouts
The Stone-Platt Industries
The Stone-Platt group of industries went up for bidding in 1982. Its former managers teamed up with external investors to take control of the electrical division of the bankrupt group. In three years’ time this new company was posting profits exceeding targets, and upon listing in the market saw its shares being oversubscribed eighteen times. The value of the company had increased over thirty times. Thus, the buyout could be said to have been a major success. However, one must look into the state of the company when it was bought out. The company’s primary business was to design, manufacture and supply passenger comfort systems, air conditioning, lighting, etc. The market for these services was characterized by high demand, and Stone was a market leader. Additionally, the company already had quite a few high-value contracts. However, it was facing troubles primarily because it was part of a larger group, which was mired by a financial crisis. Thus, the individual electrical business as such was not problematic. The main risk at this point was to lose customer trust. To avoid this, the management swiftly announced its intention to take over the electrical division. This slowed down the procedure of loss of existing contracts and avoided competitors from gaining ground. Upon taking over the company, the managers acted quickly to crystallize its customer base and turned the company profitable. The prime actor of this buyout, Robin Tavener, later remarked, “If a buyout is mounted merely as a survival exercise, the managers trying to save their jobs may not have the necessary dedication and enterprise to achieve a level of success comparable to Stone”.
Metsec was a metal component manufacturing subsidiary of Tube Investments. It was bought out by its managers during divestment. The company had been posting poor financial statistics for past many years. However, within a few years of getting control, the manager-owners turned the company profitable, had a successful listing and saw their investment rise by 3000 per cent. However, it must be noted that during takeover, the managers got the benefit of over fifty per cent discount on the total value of assets owned by Metsec. This provided the managers with the necessary silver lining to take calculated risks. This coupled with the availability of a profitable consumer base meant that orchestrating the turnaround was a matter of vision and planning.
Both these examples indicate that the success of a Management Buyout requires more than just a change of hands and enhanced motivation. It requires a healthy mix of market demand, profitability of the business, a practical business model and consumer trust.
Airline Sector: Saddled with failed Management Buyouts
Just like other sectors in the west, airline sector also saw multiple management buyouts in the 90s. However, most of them ended up as futile attempts at saving failing businesses.
In the 1990s, United Airlines, which ran on a model similar to Jet, faced very similar problems. It was about to shut down, when its employees in a last-ditch attempt to save it, took over 55 per cent shareholding in the company. The stated aim of the buyout was, “to put in place a lower cost structure which is designed to allow United to compete effectively against low-cost carriers currently influencing the domestic marketplace and improve United’s long-term financial viability”. The employees used an Employee Stock Option Plan (ESOP) to take control of the airline. An ESOP is an employee benefit plan, where a trust is created to hold securities of the employer company. The beneficiaries of the trust happen to be the employees. Thus, the employees get a pie of the company ownership through ESOP. Generally, the subscribing employees pay for the shares at suitably discounted rates. In the case of American Airlines, the employees paid for the ESOP by agreeing to deep salary cuts for the next five years. This proved favourable for the airline, which gained immensely due to the buyout. However, by the time the five-year period came to an end, the airline had once again started to accumulate debts and losses as a result of rapid expansion, slumping economy and rocketing oil prices. By 2002, the airline had filed for bankruptcy.
In 1983, the employees of Eastern Airlines took control over 25% shareholding of the company, in exchange for pay reductions. While not a full-fledged buyout, it is representative of the failure of management buyouts in the airline industry. Once again, the airline greatly benefitted due to the pay cuts in the short term and was back on its wings. However, by the end of 1984, the airline was facing the brunt of loss of customer loyalty. The airline started incurring losses yet again, and the employee union representing different groups like pilots, cabin crew, ground staff, etc. could not agree on further changes in salary packages. This caused customer service to deteriorate, leading to loss of reputation and failure of the company. The company ceased its operations in 1991.
In 1993, the employees of the now-defunct Eastern Airlines came together to start a hundred per cent employee-owned airline, called Kiwi International. It quickly became the talk of the town because of its impeccable service and benefitted from its favourable cost-structure. It was rated the best domestic airline in the US by Conde Nast, and Richard Branson mentioned it as his favourite airline. However, this was not enough to create a successful business. Kiwi was unable to turn profitable due to a recessionary economy and increases in oil prices. The airline was also saddled with investigations by the Federal Aviation Administration. By 1996 the company had failed and was liquidated.
Even if Jet Takes-Off Again, the Weather will be Harsh
The above three instances of employees taking control of an airline are representative of the unsuitability of management buyouts in the airline sector. The airline business is extremely volatile, and is subject to security, economic and oil price fluctuation risks. This implies that more than mere good management and employee motivation is needed to run an airline business. It requires, inter alia, a solid corpus of funds, scale of business, customer loyalty, favourable business environment and a practical business model. Currently, Jet enjoys none of these.
Even when India’s economy is growing and rate of airline passenger growth is the highest in the world, almost all of its airlines are struggling. However, the business environment is only worsening. Oil prices have risen 45 per cent in the last five months. A worsening trade war and a complete sanction on Iran’s oil exports will cause a further rise in oil prices. India, which imports 11% of its oil from Iran, is set to be the worst affected. The balance sheets of airline firms are significantly affected due to oil price rises.
Furthermore, competition has become more heated than ever due to complete capture of the premium-economy segment by Vistara, which used to be Jet’s space. Further, Indigo, Spice Jet, and Air Asia have captured significant market share at Jet’s cost. Customers, who care more about convenience and pricing, are unlikely to shift their loyalties back to Jet. Uneasy experience faced previously due to cancellations and delays will prevent them from boarding Jet again.
The implication of all of this is that Jet is unlikely to take off again. However, the government has attached significant attention to Jet. It has asked the lenders to go soft on it and is channelling extraordinary energies towards saving a failed business. Such move by the government is ill-thought and focused on short-term redressal. The state which the Indian airlines industry is in today, the impact of which Jet and others have faced, is largely because of the continued government intervention. The sector is prone to corruption on which Jet had continuously relied. Further, the continued channelling of funds into Air India has been manipulating competition since a long-time. Additionally, socialist policies like $35 cap on flights connecting small cities have placed limits on profitable expansion. If the government tries to save Jet artificially, it would add to the manipulation of an already inefficient market.
Instead of orchestrating a survival attempt, which will impose a huge opportunity cost on their skills, time, energy and money, Jet employees should allow the business to either be acquired or be liquidated. Buying it out may be effective in the short run, but as our analysis above displays, will not aid in the creation of a sustainable business. Furthermore, the government should exercise caution, limit the role it plays in saving the airline, and allow market forces to take their course.
Binit Agrawal is one of the founding-editors of Law School Policy Review.
 Sebastian Green and Dean F. Berry, Cultural, Structural, and Strategic Change in Management Buyouts, Pg. ix (1991).
 Sebastian Green and Dean F. Berry, Cultural, Structural, and Strategic Change in Management Buyouts, Pg. 49 (1991).
 Sebastian Green and Dean F. Berry, Cultural, Structural, and Strategic Change in Management Buyouts, Pg. 68 (1991).
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Categories: Corporate Law