Dispatches from the front
Going-Private Equity
(3/19/2003)
Lots of financial advisors and pundits have been speculating recently that the day of private equity investors in going-private transactions is upon us. Their arguments are persuasive and we generally agree with them, but meanwhile the market hasn’t been busy converting theory into practice. Why not?
Going private in today’s market would seem to offer the following clear advantages: - Market caps, especially among IT companies, are miserable (some even less than cash value), and many analysts believe they will remain depressed or even decline further over the next year or so. In other words, to the CFO, the cost of capital associated with the sale of public equity looks expensive, or even unavailable. Better to seek less dilutive private equity or sell debt instead.
- For the smaller and weak public company, the threat of Nasdaq delisting by the SEC means living with the sword of Damocles poised over your neck. If it swings down, you’re looking at an instant, substantial loss of market cap. Better to escape the sword and work without heartburn by going private.
- In its haste to look busy in the aftermath of the late spate of corporate scandals, Congress passed the sprawling Sarbannes Oxley Act. Among the law’s myriad obligations are a host of new reporting requirements and regulations that directly effect public company operations. These burdens are a fixed cost that falls disproportionately on the smaller company and, in many cases, the law’s language is opaque enough to represent continuing vague liability. Better to finesse these new obligations by exiting public status.
- Private equity sources have burned out on early-stage venture investments: now they’re interested in real businesses, like those already listed on the exchanges.
But working against the wholesale embrace of going private are several reasons that may explain why these transactions are not yet commonplace:- Especially among IT companies, pipeline visibility is poor. In other words, they don’t yet see a stable demand floor (in fact, except for mortgage refinancing, that’s true across most US industry sectors). General trends still point down with a slowing in the rate of decline, though researchers have lately been promising incremental increases in software sales. Regardless, the problem of weak demand is being accentuated by the simultaneous migration of American IT services to cheaper venues offshore, like India. For IT services, it’s a perfect storm. So until they see firm evidence of increases in demand, or at least a stable floor, private investors are chary of pouring more money down what may be ratholes.
- A lot of private equity money is tied up in VC firms that are fully occupied trying to figure out which limping portfolio companies should be given a financial crutch and which ones should be put down. Meantime, their decision is to wait and see, passing up on all but the most compelling new investments until they get a better handle on their current portfolio’s cash needs.
- VC’s aren’t well-fitted for going-private transactions anyway. They’re used to working in reverse -- with IPO’s -- and their investment criteria call for earlier-stage investments. Going-private is a better fit with LBO firms.
- But LBO firms aren’t a perfect fit either. Their meat is the already-private, family-owned stable, asset-rich niche manufacturer. Most currently public companies don’t conform well to this mold. And LBO firms are still having difficulty getting banks to the table, especially for deals that feature operating companies with anything less than highly predictable revenues.
So for the going-private opportunity to flower fully may require two currently missing crucial ingredients -- industries or an economy that demonstrate stable (even rising!) demand, and the emergence of going-private specialty investor groups. For their part, small public companies are already primed to deal.
We expect that large numbers of going-private specialists won’t materialize until after demand has stabilized. But acting now may reward the thoughtful and discriminating going-private investor with the sorts of returns consistent with entrepreneurial risk.
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