WHY PUBLIC COMPANIES GO PRIVATE

Why Public Companies Go Private

by Marv Dumon (Contact Author | Biography)

A public company may choose to go private for a number of reasons. An acquisition can create significant financial gain for shareholders and CEOs, while the reduced regulatory and reporting requirements private companies face can free up time and money to focus on long-term goals. Because there are advantages and disadvantages to going private as well as short- and long-term issues to consider, companies must carefully weigh their options before making a decision. Let's take a look at the factors that companies must factor in to the equation.



Advantages of Being Public

Being a public company has its advantages and disadvantages. On the one hand, investors who hold stock in such companies typically have a liquid asset; buying and selling shares of public companies is relatively easy to do. However, there are also tremendous regulatory, administrative, financial reporting and corporate governance bylaws to comply with. These activities can shift management's focus away from operating and growing a company and toward compliance with and adherence to government regulations.

For instance, the Sarbanes-Oxley Act of 2002 (SOX) imposes many compliance and administrative rules on public companies. A byproduct of the Enron and Worldcom corporate failures in 2001-2002, SOX requires all levels of publicly traded companies to implement and execute internal controls. The most contentious part of SOX is Section 404, which requires the implementation, documentation and testing of internal controls over financial reporting at all levels of the organization. (For more on the regulations that govern public companies, seeCooking The Books 101 and Policing The Securities Market: An Overview Of The SEC.)

Public companies must also conduct operational, accounting and financial engineering in order to meet Wall Street's quarterly earnings expectations. This short-term focus on thequarterly earnings report, which is dictated by external analysts, can reduce prioritization of longer-term functions and goals such as research and development, capital expenditures and the funding of pensions, to name but a few examples. In an attempt to manipulate the financial statements, a few public companies have shortchanged their employees' pension funding while projecting overly optimistic anticipated returns on the pension's investments. (For further reading, see Five Tricks Companies Use During Earnings Season.) 

Advantages of Privatization

Investors in private companies may or may not hold a liquid investment. Covenants can specify exit dates, making it challenging to sell the investment, or private investors may easily find a buyer for their portion of the equity stake in the company. Being private frees up management's time and effort to concentrate on running and growing a business, as there are no SOX regulations to comply with. Thus, the senior leadership team can focus more on improving the business's competitive positioning in the marketplace. Internal and external assurance, legal professionals and consulting professionals can work on reporting requirements by private investors.

Private-equity firms have varying exit time lines for their investments depending on what they have conveyed to their investors, but holding periods are typically between four and eight years. This horizon frees up management's prioritization on meeting quarterly earnings expectations and allows them to focus on activities that can create and build long-term shareholder wealth. Management typically lays out its business plan to the prospective shareholders and agrees on a go-forward plan. This covers the company's and industry's outlook and sets forth a plan showing how the company will provide returns for its investors. For instance, managers might choose to follow through on initiatives to train and retrain the sales organization (and get rid of underperforming staff). The extra time and money private companies enjoy from decreased regulation can also be used for other purposes, such as implementing a process-improvement initiative throughout the organization.

What It Means to Go Private

A "take-private" transaction means that a large private-equity group, or a consortium of private-equity firms, purchases or acquires the stock of a publicly traded corporation. Because many public companies have revenues of several hundred million to several billion dollars per year, the acquiring private-equity group typically needs to secure financing from an investment bank or related lender that can provide enough loans to help finance (and complete) the deal. The newly acquired target's operating cash flow can then be used to pay off the debt that was used to make the acquisition possible. (For background reading on private equity, see Private Equity A Trendsetter For Stocks.)

Equity groups also need to provide sufficient returns for their shareholders. Leveraging a company reduces the amount of equity needed to fund an acquisition and is a method for increasing the returns on capital deployed. Put another way, a company borrows someone else's money to buy the company, pays the interest on that loan with the cash generated from the newly purchased company, and eventually pays off the balance of the loan with a portion of the company's appreciation in value. The rest of the cash flow and appreciation in value can be returned to investors as income and capital gains on their investment (after the private-equity firm takes its cut of the management fees).

When market conditions make credit readily available, more private-equity firms are able to borrow the funds needed to acquire a public company. When the credit markets are tightened, debt becomes more expensive and there will usually be fewer take-private transactions. Due to the large size of most public companies, it is normally not feasible for an acquiring company to finance the purchase single-handedly.

Motivations for Going Private

Investment banks, financial intermediaries and senior management build relationships with private equity in an effort to explore partnership and transaction opportunities. As acquirers typically pay at least a 20-40% premium over the current stock price, they can entice CEOs and other managers of public companies - who are often heavily compensated when their company's stock appreciates in value - to go private. In addition, shareholders, especially those who have voting rights, often pressure the board of directors and senior management to complete a pending deal in order increase the value of their equity holdings. Many stockholders of public companies are also short-term institutional and retail investors, and realizing premiums from a take-private transaction is a low-risk way of securing returns. (To read about privatization on a massive scale, check out State-Run Economies: From Public To Private.)

Balancing Short-Term and Long-Term Considerations

In considering whether to consummate a deal with a private-equity investor, the public company's senior leadership team must also balance short-term considerations with the company's long-term outlook.

• Does taking on a financial partner make sense for the long term?

• How much leverage will be tacked on to the company?

• Will cash flow from operations be able to support the new interest payments?

• What is the future outlook for the company and industry?

• Are these outlooks overly optimistic, or are they realistic?

A private-equity firm that adds too much leverage to a public company in order to fund the deal can seriously impair an organization in adverse scenarios. For example, the economy could take a dive, the industry could face stiff competition from overseas or the company's operators could miss important revenue milestones.

If a company has difficulty servicing its debt, its bonds can be reclassified from investment-grade bonds to junk bonds. It will then be harder for the company to raise debt or equity capital to fund capital expenditures, expansion or research and development. Healthy levels of capital expenditures and research and development are often critical to the long-term success of a company as it seeks to differentiate its product and service offerings and make its position in the marketplace more competitive. High levels of debt can thus prevent a company from obtaining competitive advantages in this regard. (To learn more, readCorporate Bonds: An Introduction To Credit Risk and Junk Bonds: Everything You Need To Know.)

Management needs to scrutinize the track record of the proposed acquirer based on the following criteria: 

• Is the acquirer aggressive in leveraging a newly acquired company?

• How familiar is it with the industry?

• Does the acquirer have sound projections?

• Is it a hands-on investors, or does the acquirer give management leeway in the stewardship of the company?

• What is the acquirer's exit strategy?

  Conclusion

  A take-private transaction is an attractive and viable alternative for many public companies. As long as debt levels are reasonable and the company continues to maintain or grow its free cash flow, operating and running a private company frees up management's time and energy from compliance requirements and short-term earnings management and may provide long-term benefits to the company and its shareholders.

  by Marv Dumon (Contact Author | Biography)

  Marv Dumon serves as Business and Finance Examiner and International Sports Examiner for Examiner.com. He previously served as a mergers and acquisitions advisor for a middle-market financial services firm. Dumon's background includes experience in consulting, finance and operations. He received BA, BBA, and MPA degrees from The University of Texas at Austin.

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