While the average public market investor day dreams about each month’s hot new initial public offering, savvy private equity investors are turning to a different type of opportunity – taking public companies private.
For some companies, conditions in the public equity markets have never been better. But at the lower end of the Russell 2000 index, all is not well. Many companies with market capitalizations in the range of $50 million to $250 million trade at multiples of cash flow significantly below sale multiples for comparable private companies and at prices well below their IPO offering levels. These companies often are characterized by limited analyst coverage, low trading volume, relatively erratic earnings histories (including one or more instances of failing to meet expectations of Wall Street analysts), employee options that are out-of-the-money, a substantial amount of cash, an inability or unwillingness to complete strategic acquisitions due to a depressed stock price or concerns about dilution and capable but frustrated senior management. When these difficulties occur in sectors that are out of favor with investors, the problems are amplified. For the directors and management of these enterprises – referred to as “market orphans” in some quarters – being a public company might be much less glamorous than during the IPO process. At this point, a private transaction becomes a viable alternative.
While the inflows into new and existing private equity funds have grown significant in recent years, the phenomenon of “market orphans” is of growing importance to private equity investors. In response, private equity firms have sought to deploy larger amounts of capital while trying to sustain superior returns. In this environment, private equity firms that historically have focused on minority investments, recapitalizations and negotiated acquisitions of private companies have turned their attention to smaller public companies, both for full and partial buyouts and for minority investments (private investments in public entities, so-called “PIPEs”). The pace of these transactions in recent months reflects this convergence of supply and demand. During the first nine months of 1999, nearly 40 smaller cap going private deals were announced, compared to 22 in all of 1998, according to a recent survey by Piper Jaffray. Anecdotal experience suggests that the number of announced deals is but a fraction of the number of transactions that have been and are being considered, particularly in sectors such as health care, business services and so called “low-tech” industries.
Who’s Doing It?
Acquisitions of smaller cap public companies can present attractive investment opportunities for private equity investors, and firms such as TA Associates, Berkshire Partners, Thomas H. Lee & Co., Golder Thoma, Bain Capital, Welsh Carson, and E.M. Warburg, Pincus & Co. L.L.C. have been active as sponsors of going private transactions. A combination of cash on the balance sheet, a trading price that reflects a single digit multiple of EBITDA (earnings before interest, taxes, depreciation and amortization), strong projected cash flows and adequate debt capacity can create the prospect of superior investment returns. Also, private equity investors typically have access to better financial information when investing in a public company rather than a private company, as well as the benefit of teaming with a management team that is seasoned and used to working with a strong board of directors. But to seize these opportunities, the investor must have a clear understanding of the issues and the process associated with public M&A. Many of these issues are different from those associated with private transactions, and most of the problems are unfamiliar, at least initially, to some private equity investors.
Time, cost and uncertainty of execution are important dynamics that affect going private transactions. Because of the conflict of interest that arises when management seeks to buy out public stockholders, investors must negotiate with a committee of independent directors, and they cannot assure execution by forming an alliance with management. Negotiations with the independent committee usually occurs concurrently with negotiations with management and senior lenders, each of whom will have separate advisers. Reflecting corporate law concepts developed in part during the bond-financed takeover battles of the 1980s, including so-called “Revlon” duties, the independent directors must seek to obtain the most favorable transaction for the public stockholders once a decision has been taken to sell the company. This requirement can (but need not) result in an auction process, and at a minimum, will result in an inability to fully lock up a deal during the lengthy Securities and Exchange Commission review process. The acquisition of a public company can take six months or more, and costs mount as the transaction proceeds. Thus, a private equity firm seeking to acquire a public company should seek to protect itself against execution risk through break-up fees, expense reimbursement provisions and the like.
Several legal issues are particularly noteworthy in a public company transaction. For example, federal securities laws restrict trading in public company securities on the basis of material inside information. These regulations and Williams Act disclosure requirements preclude or affect accumulation of a position in the target’s stock in advance of a bid. In addition, the SEC’s going private regulations mandate extensive disclosures regarding potential conflicts and transaction history, all of which must be set forth in a detailed proxy statement that is subject to careful SEC review. Finally, private equity investors must be aware that seller representations and warranties usually do not survive closing in a public company acquisition, which leaves the investor without recourse if problems later surface.
Private equity firms must be institutionally equipped to prevail in the public company marketplace. Assets that can promote success include strong relationships with the target’s management, ready sources of funding (in this regard an “in-house” subordinated debt fund can be a significant advantage), and a deep and experienced staff of investment professionals and external advisers who can anticipate problems and satisfy the demanding pace and timetable of the public company sale process. Knowledge of the business, legal, tax and accounting issues that distinguish a public company purchase from a private company investment is essential. In some respects, of course, the public company sale process can be simpler than a private company transaction, as there are typically fewer opportunities for innovative structuring. In general, however, the most important investment analyses – an assessment of the management team, knowledge of the business and sector and understanding of the technology – are no different.
Complex accounting considerations also affect public company acquisitions by private equity investors. Among these are requirements that must be satisfied to gain so called “leveraged recap” accounting treatment, which enables the target to avoid booking goodwill for generally accepted accounting principles (GAAP) purposes. To date, this has been an important aspect of investors’ planning of exit strategies, which can include a strategic sale, a recapitalization or an IPO. With the Financial Accounting Standards Board’s proposed elimination of pooling of interests accounting for acquisitions, the leveraged recap structure may become useful mainly to facilitate a later IPO. Ironically, such an exit would return the company to the very arena – the marketplace for small- to medium-cap companies – that it sought to escape by going private in the first place.
The number of going private transactions by private equity investors is likely to increase, at least absent a broad and sustained rebound of small-cap stocks. Armed with an understanding of the process and issues gained through experience, as well as adequate infrastructure and capital, private equity firms are well positioned to take advantage of current market dynamics and to help find homes for “market orphans.”
By John LeClaire and Kevin Dennis, co-chairs, Goodwin, Procter & Hoar Private Equity/ Emerging Companies Group.