Fleeing From Public Ownership: Going private helps many companies escape Sarbanes-Oxley and stock price pressures.

In the Sarbanes-Oxley era, the management version of moving to a commune in Mendocino may be to ride the increasing tide of going-private transactions, as staying public becomes more and more of a bummer for a lot companies. According to Thomson Financial, in the first nine months of this year 60 public companies have retreated from the spotlight – up from 49 in the same period in 2002 and 32 in 2001. Some bankers think the consistent increase represents a huge opportunity. “If you’re an investment banker serving the mid market, going-private transactions will become a major source of business,” says Stephen Blum, a managing director at Burnham Securities. Blum says that numerous factors are motivating companies to think about ditching their connection to the public markets. They include the cost and the hassle of meeting Sarbanes-Oxley compliance and the battering suffered by shares of many less-followed companies in more mundane industries. Besides the companies going private, others have given in to the pressures by putting themselves up for sale in more or less orthodox fashion. How many have joined the sell side in the m&a market primarily because of Sarbanes-Oxley is not yet clear. But more details may emerge when the dealmaking environment improves and the deal flow accelerates. Although many of the potential opters-out are small- and mid-cap companies, larger-cap cousins are also shedding their public-ownership status. The $2.5 billion sale of Dole Food Co. and the $1.1 billion sale of National Golf Properties this year are large-cap examples of the trend toward going inside. David H. Murdock, CEO of Dole Food, cited “the short-term pressures and constraints of the public equities market” as one reason for taking the company off the market. But small companies generally are the most likely candidates for going private. “Today, it really isn’t very attractive to be a public company of under $500 million market cap,” says Michael Murphy, a managing director at Piper Jaffray. Scott Larson, an assistant professor of business at Chicago’s National-Louis University, says that at the height of the bull market, there were about 18,000 public companies. At the time, it was easy for many of the companies to raise capital. Now that the bubble has burst, he says, executives should consider going private as an option potentially as compelling as buying back stock or other strategic alternatives. Going-Private Basics In a going-private transaction, the sellers are the public shareholders and the buyer is management, often with the support of a private equity group. The most common method of going private is for the company to merge, with shareholder approval, with an acquisition company created by management and its financial backers, which usually pays cash to the tendering holders at a premium to the market price. There are other structures, but any going-private transaction presents some conflicts of interest that must be managed appropriately. Sometimes, they discourage more companies from making the move. John LeClaire, co-head of the private equity practice at Goodwin & Procter, a Boston law firm, cautions that management should recognize the inherent conflict for boards as they consider a going-private pitch. Boards may well ask if there’s money to be made out there, why not do it for the shareholders? Management must be able to show projections that demonstrate how the board will be leaving money on the table if it stays public. “You want to be able to show why going private will make money and staying public won’t,” LeClaire says. Because of their fiduciary responsibility to protect shareholders, boards must evaluate whether the going-private transaction is in the best interests of the shareholders. One part of this responsibility is the so-called fiduciary out, a provision allowing a target company to terminate a merger agreement if its board believes, on the advice of counsel, that its fiduciary duty requires it to accept a competing – usually superior – bid. In a going-private transaction, the board must juggle its responsibility to protect shareholders with management’s assertion that the company will have a better future as a private entity. LeClaire says that decisions to go private can be challenged if it appears that the board didn’t make an independent decision. Sarbanes-Oxley and Other Drivers While some of the reasons increasing numbers of companies are going private aren’t new, for many enterprises the reporting requirements of the Sarbanes-Oxley Act of 2001 have tipped the balance in favor of withdrawing from the public markets. “Sarbanes-Oxley is the single most important development that has encouraged companies to go private,” Blum says. He points to a number of effects of the legislation that make management’s life more difficult. From the basic requirement of CEOs and CFOs having to certify results to indirect effects, such as more expensive audits, more expensive directors and officers’ insurance, the mounting difficulty of recruiting qualified directors, increasing pressure from shareholders to separate the roles of chairman and CEO, and increased penalties if results must be restates, all add up to more headaches for management. Throw in an estimated cost of more than $1 million per year for Sarbanes-Oxley compliance and it is easy to see why small caps, mid caps, and some large caps cite Sarbanes-Oxley requirements as being the last straw in their disenchantment with the public markets. These regulatory woes are often combined with more general market conditions such as many companies’ inability to attract analyst coverage. While this was always a problem for small and mid-cap companies, it has become even harder in the wake of the Enron debacle and other corporate scandals. Now that most of the largest investment banks have settled with New York State Attorney General Eliot Spitzer in his probe of analyst conflicts, the role and the number of analysts have changed in ways that only make it harder for small caps to get coverage. “Due to regulatory changes, there are fewer analysts out there, and their employers point them toward the most exciting stories or the fastest-growth companies, which leaves a lot of small and mid-cap companies with no coverage,” Blum says. Another problem for some companies is that their stock prices have been depressed or volatile, both of which mean that public shareholders must be constantly reassured. “When you’ve had an extended period of lousy stock prices, as we have, executives are under heavy pressure from unhappy shareholders,” Blum adds. Jim Grein, a managing director at TM Capital, agrees, adding, “People should realize that a lot of wealth has evaporated in the last few years. A publicly quoted stock price is great when the stock is going up, but it’s a burden when it’s stagnant or falling.” Growing out of the pressure to keep public shareholders happy is the concern that in doing so, management must concentrate on meeting quarterly goals instead of planning for the company’s long-range future. Another pressure on some public companies has been the increasing withdrawal of institutional investors from small- and mid-cap companies. “With more and more retirement money in the market, funds are forced to invest in larger companies. As a result, institutional money becomes trapped in larger and larger companies,” Blum says. One big advantage of being public is supposed to be that it enhances a company’s access to capital. But as their visibility shrinks, smaller public companies may find capital raising easier as a private company, especially if they enjoy the good office of private equity investors. Yet another problem for small and mid-cap public companies has been the shrinkage of banks and advisers serving this sector of the market. “We’ve seen the demise of a large part of the infrastructure that we thought of as the core mid-market sponsorship and service group due to consolidation among investment banks,” Grein says. Downsides of Going Private Before readers rush out to try and privatize their children’s public schools, deal experts caution that there are negatives to the structure that must be considered. “It costs as much to take a micro-cap private as it does a much larger company,” LeClaire says. “It’s the same process whether it’s a big company or a small one.” One of the reasons it’s so costly, Blum says, is that you have to have two of everything. “The board has its set of advisers, the sub-committee (of independent directors) might have its own, and the buyers might have as many as three separate legal and financial advisers.” Another problem with going private is that it isn’t a quick fix. It can take at least six months to complete a simple going-private deal and up to 18 months for a complex one. Management also should be aware that there could be a downside to switching from running a public company, answerable to shareholders, and working for the LBO firm that supplied the capital to go private. “There are situations where, unfortunately, management would rather have stupid public oversight than a smart private owner reviewing their actions,” Murphy says. One deal adviser says that a subtle reason companies stay public, often in the face of reasons to bolt from the marketplace, is that board members like going to the annual meetings, having dinners, and being asked to oversee a company’s operations, albeit in a very general sense. LeClaire notes that there aren’t that many scenarios where you can come in and join a company, or retain your previous title from the company’s public days, and make eight figures. “A going-private transaction, if done right, can be one of the greatest things in business life. If the managers maintain a good relationship with their private equity partners, they can go on to do another company,” he says. The going-private process also can allow management to trade stock options for equity in the concern. LeClaire says this can have significant tax advantages that are attractive in themselves, and that can have positive implications for the executive’s estate planning. LeClaire says that one advantage a financial buyer has if it is competing with a strategic buyer is that the LBO deal can give the executive’s kids and grandchildren a chance to share in the proceeds. Fouling Up Your Going-Private Deal In light of the many motivations management may have for going private, M&A canvassed dealmakers for their advice on what to avoid when doing these types of deals. Right off the bat, strategists note that dealmakers must make sure the company is profitable. “These have to be attractive companies. Maybe they’ve been abandoned because of their size. But whether it’s a leveraged buyout or other going-private structure, you need to see strong operations and decent cash flow,” says Roger Kafker, a managing director at TA Associates. He states that sophisticated counsel, both legal and financial, is essential for companies going private. “A lot of small and mid-size companies don’t understand the intricacies of the process.” You have to be able to show that the transaction is in the best interest of the shareholders and that the board has fulfilled its responsibilities to them, he adds. One common misconception, says Murphy, is that a company can be bought for its listed share price in the paper. “The company may appear to be cheap, but that doesn’t mean the board will allow the company to be taken private at that price.” Murphy adds that management teams have yet to realize that their higher, bubble-era valuation isn’t coming back, and cautions that even if a buyer offers a 40% premium to the listed share price, there is no guarantee that someone on the board won’t assume that a 45% premium offer isn’t a possibility from a strategic buyer. Something to remember, according to Larson, is that a strategic buyer always can pay more because it has more post-deal options. It can integrate product lines, wring out efficiencies, and increase barriers to entry if it chooses to. “You want to do a going-private deal when you think you have an advantage over a strategic investor,” Larson says. Both buyers and sellers should realize that at the start of a going-private transaction there is no guarantee that the outcome will follow the course plotted by management. “Once you make the bid, it’s public, and the company is in play,” he adds. Even though management must bear this in mind, it is not always a strong disincentive to proceed with the going private because for many mid- and small-cap companies “stranded” in the public market, there isn’t any interest from strategic buyers. “Most happily, you start the going-private process after a strategic auction has been tried and there are no interested strategic buyers,” LeClaire says. But even if this is the case, he cautions that there are significant limits on the ability of management to lock up a deal. LeClaire also stresses that it’s best to have a clean process – that is, that the board must be making an independent decision or there will be challenges to the process. Steps toward thwarting such challenges are creating an independent board committee to vet the transaction and getting a fairness opinion from a third-party expert that would cover valuation and other issues. Ideally, management should be able to show projections that spell out how the company is going to make more money as a private concern than it could by remaining public. Larson says that there is always the danger of loading up the newly privatized company with too much debt. Another pitfall is the lack of a strategic plan for the company as a private entity. “Management must have some better future in mind. You don’t go private just because you don’t like being public,” LeClaire says. Larger Effects of the Upswing Blum says he thinks an unintended consequence of the Sarbanes-Oxley Act and some of the other conditions that are encouraging companies to go private will be a reduction of the mobility of capital. As more U.S. companies exit the capital markets, Blum believes it will reduce investors’ choices and shrink what has been the world’s deepest and most transparent marketplace. “There have always been a lot of reasons for companies to go private. There have never been more reasons to do it than now. But it matters, because it’s going to change the way people do business today and to some degree will affect the fluidity of our economy tomorrow.” Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com