Reasons Public Companies Opt for Privatization

A public company may choose to go private for several reasons. There are a number of short- and long-term effects to consider when going private, as well as a variety of advantages and disadvantages.

Here’s a look at the variables that companies must consider before deciding to go private.

Understanding a Public Company

There are advantages to being a public company. For example, the buying and selling of public company shares is a relatively straightforward transaction and a focus of investors seeking a liquid asset. There is also a certain degree of prestige to being a publicly traded company, implying a level of operational and financial size and success, particularly if the stock trades on a major market like the New York Stock Exchange.

However, there are also tremendous regulatory, administrative, financial reporting, and corporate governance bylaws to which public companies must comply. These activities can shift management’s focus away from operating and growing a company and toward adherence to government regulations.

For instance, the Sarbanes-Oxley (SOX) Act of 2002 imposes many compliance and administrative rules on public companies. A by-product of the Enron and WorldCom corporate failures in 2001 and 2002, respectively, 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.

Public companies must also conduct operational, accounting, and financial engineering to meet Wall Street’s quarterly earnings expectations. This short-term focus on the quarterly 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. In an attempt to manipulate the financial statements, a few public companies have shortchanged their employees’ pension funds while projecting overly optimistic anticipated returns on pension investments.

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. Due to the large size of most public companies, which have annual revenues of several hundred million to several billion dollars, it is normally not feasible for an acquiring company to finance the purchase single-handedly. 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.

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 increases the returns on capital deployed. Put another way, leveraging means the acquisition group 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 loan balance 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).

Once an acquisition is agreed to, management typically lays out its business plan to prospective shareholders. This go-forward prospectus covers the company and industry outlook and sets forth a strategy showing how the company will provide returns for its investors.

When market conditions make credit readily available, more private equity firms can borrow the funds needed to acquire a public company. When credit markets tighten, debt becomes more expensive, and there will usually be fewer “take-private” transactions.

Deciding to Go Private

Investment banks, financial intermediaries, and senior management often build relationships with private equity firms to explore partnership and transaction opportunities. As acquirers typically pay at least a 20% to 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—particularly those who have voting rights—often pressure the board of directors and senior management to complete a pending deal to 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.

When 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. In particular, they must decide:

• Does taking on a financial partner make sense for the long term?
• How much leverage will be tacked onto the company?
• Will cash flow from operations support the new interest payments?
• What is the future outlook for the company and industry?
• Are these outlooks overly optimistic, or are they realistic?

Management needs to scrutinize the track record of the proposed acquirer. Among the criteria to consider:

• Is the acquirer aggressive in leveraging a newly acquired company?
• How familiar is the acquirer with the industry?
• Does the acquirer have sound projections?
• Does the acquirer have hands-on investors, or will it give management leeway in the company’s stewardship?
• What is the acquirer’s exit strategy?

Advantages of Privatization

Going private, or privatization, frees up management’s time and effort to concentrate on running and growing a business, as there is no requirement to comply with SOX. 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 for private investors.

Private equity firms have varying exit timelines for their investments, but holding periods are typically four to eight years. This horizon frees up management’s prioritization to meet quarterly earnings expectations and allows management to focus on activities that can create and build long-term shareholder wealth. For instance, managers might choose to retrain the sales staff and get rid of underperformers. The extra time and money that private companies enjoy once they’re free of reporting obligations can also be used for other purposes, such as implementing a process improvement initiative throughout the organization.

Disadvantages of Privatization

A private equity firm that adds too much leverage to a public company to fund the deal can seriously impair an organization if adverse conditions occur. 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 privatized company has difficulty servicing its debt, its bonds can be reclassified from investment-grade bonds to junk bonds. This will make it 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.

Obviously, private company shares don’t trade on public exchanges. In fact, the liquidity of investors’ holdings in a privatized company varies depending on how much of a market the private equity firm wants to take—that is, how willing it is to buy out investors who want to sell. In some cases, private investors may easily find a buyer for their portion of the equity stake in the company. However, if the privacy covenants specify exit dates, it can make it challenging to sell the investment.

The Bottom Line

Going private is an attractive and viable alternative for many public companies. Being acquired can create significant financial gain for shareholders and CEOs, while fewer regulatory and reporting requirements for private companies can free up time and money to focus on long-term goals.

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.