U.S. Equity Markets are now into their fourth year of trading at depressed levels. Share prices of thousands of companies have been reduced to mere fractions of where they were just two or three years ago. Recent corporate scandals, and the resulting reforms, have created an atmosphere in which the advantages of remaining a public company are increasingly difficult to appreciate—but in which the disadvantages are more painfully apparent every day.
In this environment it is not surprising that a significant percentage of public companies, particularly those with smaller market capitalizations, have contemplated the pursuit of a "going private" transaction. Whether due to battles over the seemingly never-ending array of rules and regulations emanating from the Sarbanes-Oxley Act and related corporate-governance reform initiatives, or the basic inability to use publicly traded stock as currency for acquisitions or executive-incentive compensation, many public company executives have been frustrated by the growing burdens, risks and costs of remaining public, and have considered removing their companies from the public spotlight by choosing the safer - and perhaps more rational - world of private company operation.
While only a relatively small number of going-private transactions have been consummated in the last several years, recent trends show a marked increase in these deals relative to reduced merger and acquisition activity in general. For example, according to statistics provided by FactSet Mergerstat, a mergers and acquisitions research firm, the number of completed going-private deals as a percentage of total mergers and acquisitions transactions increased by approximately 23.7% from 2000 to 2002. In addition, several factors have converged in recent months that may make going-private transactions even more attractive in the near future.
Various explanations exist for the recent increase in going-private transactions. First, dramatically reduced stock prices across virtually all industry sectors have transformed many public companies into "orphans"—companies with small or dramatically fluctuating market capitalizations that effectively are ignored by the investment banking and institutional investor communities.
Of course, this orphaning also results in part from deep cuts in the ranks of Wall Street analysts in reaction to plummeting investment banking and brokerage revenues. According to statistics provided by FactSet Research Systems, as of May 2003, there were more than 6,800 public companies with an equity capitalization of less than $250 million, representing approximately 75% of all U.S. publicly traded companies. A significant percentage of those companies are not covered by Wall Street analysts, and, as a result, struggle to retain the attention of institutional investors.
The recent settlement between regulators and many of the largest Wall Street firms will only exacerbate this situation. The settlement, which resulted from widespread accusations of market manipulation by analysts offering overly optimistic ratings, requires Wall Street firms to implement internal controls designed to limit the role of analysts and impose more stringent boundaries within investment banking operations. The specific terms of the settlement agreement, as well as the increased attention on analyst activities generally, likely will cause Wall Street firms to be less inclined to provide coverage of many smaller and less stable companies. Without analyst coverage—and the increase in trading volume that typically results—management's ability to increase shareholder value in the public arena could become much more of a challenge.
More reasons to go private
Depressed stock prices and reduced trading volumes also have limited the ability of public companies to use their public currency as an effective strategic or operational tool. Stagnant stock prices have made it increasingly difficult for many public companies to sell additional shares to raise capital, whether through public or private offerings. Similarly, companies have a more limited ability to effect acquisitions through the issuance of stock, as thinly traded shares, and the related lack of liquidity, are less enticing to shareholders of target companies. Stock options with high strike prices granted prior to the market downturn often are too far under water to serve as a meaningful motivational tool for public company management.
More generally, there is broad agreement that a significant percentage of companies that went public in the late 1990s did so prematurely. Many of these companies possess promising business concepts with the potential for long-term financial success, despite the current threats to their survival as publicly traded firms. In order to turn around, these companies need to refocus on some basic aspects of their business model, which could be research and development, expanding into new markets or otherwise rationalizing or restructuring their operations.
Such refocusing is significantly easier to accomplish if management is not required to answer to public shareholders as to any short- or medium-term adverse impact on financial performance that could result from those activities. Supporting this theory, many private equity investors have recently been quoted as stating that a number of public companies may actually be worth more in private hands, given depressed public company valuations and the relative flexibility typically afforded private companies to restructure their operations.
Increased corporate-governance burdens also have increased the risk exposure of public company executives, and thereby created further incentives for taking a company private. New or revised rules emanating from Sarbanes-Oxley and related initiatives have created logistical and financial challenges for public companies across the board. These costs of compliance often have little or no correlation to a company's market capitalization, making them proportionately more burdensome for smaller or midsized companies. According to one recent survey of midsized public companies, the average annual cost of being a public company has almost doubled since the passage of Sarbanes-Oxley, from $1.3 million to almost $2.5 million. See Tamara Loomis, "Costs of Compliance Soars After Sarbanes-Oxley," N.YL.J., May 1, 2003, at 1. This increase relates to items such as directors' and officers' insurance coverage, which has tripled or even quadrupled over the past year for many companies, as well as legal and accounting costs.
But there are major hurdles
With so many compelling reasons to seek private company status, why haven't more public companies taken the plunge? To be sure, any public company and its management must overcome significant hurdles to effect a going-private transaction, and going private is not a universal cure for an ailing public company. First, and most simply, a public company's low stock price may suggest more than just an attractive purchase price. Many times it accurately reflects the company's poor financial performance or other operating deficiency, such as a faulty business model, ineffective management, over leverage or an unreliable cash flow stream.
Realistic going-private candidates must be fundamentally healthy businesses that can project consistent cash flow, as the commercial banks, private equity funds and other institutional investors that typically finance such transactions must be convinced that they have a reasonable chance for a fair return.
Nevertheless, many equity funds are relatively less active and flush with cash because of the dearth of recent merger and acquisition activity. Accordingly, they are highly motivated to close deals, and many have been targeting smaller public companies to gauge their interest in pursuing going-private transactions.
Removal from the spotlight
Second, public company executives often enjoy the prestige and visibility attained from taking a company public, and sometimes view the withdrawal of their company from the public company spotlight as an inherent failure.
However, considering the extensive commitments of time and resources required by recent corporate governance reforms, executives are more likely to appreciate that removing the yoke of quarterly earnings pressures and disclosure requirements offers greater control over corporate decisions and additional flexibility to manage operations.
The ability of a company and its equity sponsor to absorb the attendant financing costs and transaction expenses is another obstacle to going private. Acquirers must ensure that the private entity will have sufficient ongoing cash flow to operate effectively, particularly because the company may be fully leveraged after financing the transaction. It helps that the burden of financing a going-private transaction often is reduced by significant insider participation.
Because members of senior management of a going-private entity typically agree to "roll over" their existing equity into the acquisition entity, the amount to be financed is substantially lower than the overall market capitalization of the public entity. Further, historically low interest rates, and the resulting low cost of capital, will make debt service more manageable for companies that go private in the near future.
Transaction costs
Many companies also are surprised by the significant transaction costs of a going-private deal, which typically will reach above seven figures and include investment banking, legal and accounting fees. A company considering a going-private transaction usually appoints a special committee of its board of directors, which must consist solely of independent members, because the acquiring entity includes members of management or the board. The committee is charged with conducting an arm's-length negotiation with the acquirer, protecting minority-shareholder interests and ensuring that the consideration received is fair, from a financial point of view, to the public shareholders.
Accordingly, at least three sets of legal and financial advisors--for the acquired company, the bidding group and the special committee of the acquired company's board--typically are actively involved in the transaction.
The preparation of a proxy statement or other document that explains the transaction, and the review of that document by the Securities and Exchange Commission, requires intensive attention by the working group, and, as a result, generates significant additional cost.
Increased litigation risks
Another deterrent to going private is potentially increased litigation risks, particularly because bidding groups often include members of company management who might benefit financially from the transaction. With the recent dramatic drop in equity markets, public shareholders might lose money in a going-private transaction even if their shares are acquired at a significant premium to current market prices.
The risk of litigation can be exacerbated by the fact that minority shareholders may not control the decision-making process, to the extent that approval of a majority of disinterested shareholders is not required to effect the transaction.
With smaller companies, the litigation risk is sometimes reduced by the fact that the potential damages to the cashed-out shareholders are not sufficiently sizeable to support a substantial litigation campaign by plaintiffs or class-action plaintiffs' attorneys.
In addition, many executives might conclude that the litigation risk of going private is not so troubling in comparison to recent shareholder scrutiny of public company management, increased director and officer exposure arising from the corporate-governance reform movement and the heightened threat of shareholder lawsuits that under performing public companies already face.
It is clear that today's depressed markets, the growing number of "orphaned" public companies and intense regulatory scrutiny make escaping the public eye a more attractive alternative. While these trends may drive an increase in the number of going-private transactions, the consummation of these transactions will remain a difficult task for most small public companies to accomplish. Nonetheless, the process of evaluating the benefits and risks of taking a company private can provide public companies with an honest assessment of whether they are likely to thrive as a publicly traded firm going forward, or whether the company instead would benefit from escaping the public glare.
Reprinted with permission of The National Law Journal
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