Regulators and impatient investors are driving U.S. public companies to go private. Major investors, along with some executives, will gain; other investors can only watch.
While public company officers and directors spend more time these days on administration and less time growing their businesses, the private equity world asks only one thing from its executives: Grow earnings and cash flow meaningfully over the next three to five years. Which type of company would you rather own?
Wall Street’s heavy hitters are voting with their dollars, and the private companies are winning in a landslide. While fewer companies are going public than in the last strong market of the late 1990s, far more are going private, in deals that are far bigger.
But not every investor gets to cast a ballot. U.S. securities rules typically limit investments in unregistered securities such as hedge funds and private equity funds to individuals with at least $5 million in investments and institutions with $25 million. “Funds of funds” can have smaller minimums, but even those generally require at least $1 million in net worth or $200,000 in annual income.
Public company executives face daunting pressure to at least meet, if not top, the stock market’s earnings expectations for each and every quarter, while avoiding any risky bets that could trigger litigation — justified or not — if the stock price abruptly tanks. Such litigation could even jeopardize the personal assets of the public corporation’s top officers and directors.
Enron and WorldCom were colossal failures that arose from fraud and deceit. Nonetheless, even though management committed fraud, the outside directors’ personal assets were at stake. They wrote checks totaling $31 million from their personal accounts to settle shareholder lawsuits.
The U.S. Justice Department and Eliot Spitzer, former New York attorney general and current governor, also have attacked the personal assets of executives and directors. These law enforcers went so far as to threaten companies with indictment if the companies paid the legal fees of officers, directors and employees under investigation for alleged criminal actions during their employment. Other demands from these justice crusaders have included requirements that corporations and their employees waive attorney-client privilege. These coercive tactics will drive more companies to take less risk. As three law school professors pointed out in the Winter 2005 edition of the journal Stanford Lawyer, “With jittery directors at the helm, prudent caution can readily transform into counterproductively defensive decision making and even paralysis in the boardroom.”
In this unfriendly environment, directors may quit for fear of losing personal assets, may insist on more conservative business plans or may let attorneys run the board. As one private equity executive noted, “Boards of publicly traded companies are now focused on process, not substance.”
Private Returns Top Public
Private equity returns have outpaced public market returns over the last couple of decades. If current trends continue, private equity returns will likely increase their lead. According to Thomson Financial/National Venture Capital Association, through June 30, 2006, the annualized 10- and 20-year returns, net of fees, for all private equity funds were 11.4 percent and 14.2 percent, respectively, compared with 8.3 percent and 11.0 percent, annually, for the S&P 500.
Cash flow growth drives investment returns, and private companies — at least the ones run by the industry’s top players -- seem to be doing better at building their cash flow. In its marketing material, one major private equity firm states that its portfolio companies increased their cash flow by 14 percent annually, on average, from 2000-2005. The broad-based Russell 3000 index, on the other hand, saw its cash flow growth increase by 7 percent annually over the same period.
In a private company, risk is managed, not avoided. Many private companies take on significantly more debt than public companies, frequently securing twice as much debt as equity. Compare that with non-financial companies in the S&P 500, which, according to Barron’s, had approximately twice as much equity as debt in 2006. As long as interest rates remain near 25-year lows, greater leverage should not pose a problem for private companies. But higher interest rates would put pressure on companies that overborrowed. Some could fail.
Nonetheless, private equity firms encourage their management teams to take risks. There is no fear of shareholder lawsuits, other than for outright fraud, and the Securities and Exchange Commission has no jurisdiction over private companies. Diversification plays a large part in private equity shops’ risk management strategies. Most private equity funds invest in 10 to 20 portfolio companies. While nobody likes to see any business fail, private equity firms accept that a few of their portfolio companies will not succeed. In a private equity fund, if 12 companies are successful and three fail, the fund will still likely generate an excellent investment return for its clients. Therefore, all of the fund’s companies may take appropriate risk as a result of a fund’s diversified portfolio.
In a typical arrangement, a company’s existing management joins forces with a financial sponsor to buy the outstanding stock of all public shareholders and take a company private. Due to the conflict of interest between the buyer (management) seeking to buy low and the seller (the Board, which may include members of management) seeking to sell high, the Board often establishes a special committee of independent directors to analyze the proposed deal. An investment bank is hired to express its opinion on the deal’s fairness.
Of the more than 500 management-led buyouts in 2006, one in particular attracted attention. Shareholders of Four Seasons, the luxury hotel chain, were offered a 28% premium to their stock’s previous closing price by management and its financial partners. Management is required to act in the best interest of all shareholders. Still, that did not prevent Isadore Sharp, Chairman and Chief Executive Officer of Four Seasons from boldly stating in the press release about his buyout offer, “Having given this proposal very careful consideration, this transaction, with these investors, is the only one I am prepared to pursue.”
It’s not hard to see why several commentators have suggested that management-led buyouts are great...for management. Ben Stein, a free-marketer and frequent contributor to The New York Times Sunday Business section, went so far as to suggest that “...these deals should be illegal on their face.” Stein continues, “...as a matter of basic fiduciary duty law, managers are bound to put the interests of stockholders ahead of their own, in each and every situation. By buying the assets on the cheap and then reaping the benefits, management is breaching that fiduciary duty...”
One may wonder how management is “buying the assets on the cheap.” Stock traders in the public markets determine a stock’s value based on everything that is publicly known about a company. Therein lies the rub. A public corporation’s managers, who are supposed to work in the interest of the public shareholders, have access to material, non-public information. It is illegal to trade stocks on the public market based on such information, but this rule has not been applied to management-led buyout offers.
When those trusted to manage an enterprise on behalf of absentee owners suddenly want to buy the entire company, be suspicious. It’s rare that a fiduciary buying from its client acts in the client’s best interest.
Jonathan M. Bergman
In contrast, every public company must manage its risk as a stand-alone entity for which failure is catastrophic. Nearly every failure of a significant public company generates shareholder lawsuits, among other unpleasantness. Public companies therefore are inherently more risk averse than firms held within private equity funds. Because risk and return go hand in hand, private company investors can expect to do better.
One sign of how public companies have become more risk-averse in the post-Enron era is in their cash holdings. Non-financial S&P 500 companies now hold nearly 10 percent of their assets in cash, compared with 5 percent 10 years ago. The cash provides an extra cushion against business setbacks. But retaining high cash levels lowers a company’s return on equity, reducing an investor’s expected rate of return.
Public Executives Face More Demands
A Palisades Hudson client who is CFO of a publicly traded company estimates that he spends 30 percent to 40 percent of his time communicating with investors. Executives at private companies focus on improving their businesses. Therefore, it is no surprise that senior executives are beginning to prefer running private companies.
In a striking example of this trend, David L. Calhoun, vice chairman of General Electric and head of its most profitable unit, Infrastructure, left in August to become chairman and CEO of VNU Group, a media company that was recently taken private by a consortium of investors. Calhoun was a candidate for several top public company posts and was named by Fortune in 2006 as the most sought-after executive for a CEO position.
Calhoun may have joined VNU for more money (reports have suggested up to $100 million if VNU executes its long-term plan); he may have joined seeking a new management challenge; or he may have joined so that he could be free to do his job the way he thinks is best. Addressing a group of private investors in November, Calhoun said it is nearly impossible to restructure a public company because investors are too concerned with companies meeting quarterly earnings estimates rather than making strategic decisions that affect long-term results.
Amid the recent criticism of executive pay packages, could Calhoun have reached an agreement that might lead to a $100 million payout at a public company? My guess is no.
The private equity firms that own VNU are willing to pay Calhoun a bundle, but only if he succeeds. According to media reports, and consistent with industry practice, Calhoun will make an adequate salary, but he won’t be paid handsomely until VNU’s investors are paid handsomely. This is a major improvement from some public companies, which bestow sizeable salaries on their executives regardless of whether the company meets its financial targets. Again, consistent with industry standards, Calhoun also will be required to invest a substantial portion of his net worth in VNU. Calhoun will have his big payday when the private investors have their big payday — and not before.
SOX Needs Mending
The Sarbanes-Oxley Act of 2002, or SOX, enacted after the accounting scandals at Enron and WorldCom, has created additional concerns for public companies and their managers. The law requires each public company’s chief executive and chief financial officer to attest to the accuracy of the company’s financial reports. A false certification can bring up to 10 years in prison and a $1 million fine if it is “knowing” and up to 20 years and $5 million if it is “willful.” While CFOs arguably should have been deeply involved in corporate accounting issues all along, there is no doubt that SOX requires CEOs to devote much more attention to financial reporting, leaving less time for other matters that might have more to do with a company’s long-term success.
SOX also demands a greater role for independent directors on corporate boards, and it imposes more rules governing internal reporting systems. Though those rules are not unduly expensive for large enterprises, several smaller public companies have gone private rather than incur substantial costs to implement SOX controls. According to accounting firm Grant Thornton, the number of public companies of all sizes going private jumped 30 percent in the 16 months following the passage of SOX compared with the 16 preceding months. As more public companies go private, public equity investors who do not qualify to own unregistered securities, or for whom relatively large and illiquid private investments are inappropriate, will be left with fewer options.
Some help may be on the way. The Committee on Capital Markets Regulation, a group of business leaders and academics chaired by Glenn Hubbard, former White House economic advisor, and John Thornton, former president of Goldman Sachs, concluded in a November report that “The United States is losing its leading competitive position...[O]ne important factor contributing to this trend is the growth of U.S. regulatory compliance costs and liability risks compared to other developed and respected market centers.”
Among the committee’s recommendations were changing portions of SOX to limit auditor liability and to provide some regulatory relief for smaller public companies, and limiting certain litigation against auditors, directors and management.
These recommendations are a step in the right direction. Public company executives are fed up with SOX compliance, compensation questions and investors’ constant demand for short-term results. They, and their companies, will transition ever more into private ownership. The private equity firms, who face little threat of being sued by investors or regulators, will take on more risk and will make more money. These gains will flow to those private equity firms and their clients, namely wealthy families and institutions. Individual investors who cannot or do not invest in private companies will have fewer investment opportunities and lower returns.
