VideoLarson doesn't blame those companies for pursuing the practically free capital offered by the public equity markets during the 1990s. But now that that bubble has burst, he believes that "the same sort of analysis that CFOs apply to determine whether to buy back debt or shares ought to be applied to determine whether they should still be public."
While some CFOs are clearly doing just that, he says, others are reluctant, or dismiss the out-of-pocket expense of being public as minimal when compared even with their depressed market cap. That's the wrong calculation. In addition to increased compliance costs, Larson explains, the cost of being public includes the cost of equity — that is, the return shareholders expect from their stock.
But with hostile or frightened investors fleeing to large, blue-chip stocks — or exiting the market themselves — the trading liquidity that gave stocks additional value and kept the cost of equity low has disappeared. Three years ago, thin trading drove certain industrial companies out of the stock market. In 2003, that problem afflicts the market's entire bottom tier. "Today, it really isn't very attractive to be a public company of under $500 million market cap," notes Chicago-based managing director Michael Murphy of Minneapolis-based U.S. Bancorp Piper Jaffray Inc., whose research focuses on small-caps that are likely takeover targets or going-private candidates. Analysts ignore thinly traded stocks, denying them the very coverage they need to attract investors, and many once-hot initial public offerings are finding themselves as "forgotten as last year's prom queen," says Goodwin Procter attorney John LeClaire.
Not Exactly a Private Matter
Still, going private is no easy task. The classic method is for the company to merge — if shareholders approve — with a private acquisition company created by management and their financial backers (for other methods, see "Tender Squeezes," right). Yet the same fear and loathing that is driving some companies off Wall Street has made their boards extremely wary of such management buyouts.
Moreover, the duty of boards to maximize shareholder value ensures a tug of war over price. Private equity firms like to buy at multiples of 6 to 10 times cash flow, says LeClaire, but public boards think in terms of premium to stock price. That, says Roger Kafker, managing director of Boston-based private equity firm TA Associates, is difficult for directors who fondly recall the 52-week high of their stock. "Many boards are still reluctant to believe the good old days aren't coming back," he says.
The difficulty of holding bank financing together during the six to nine months this process can take is one reason many deals fall through. That's ironic, because once the decision to go private is made, companies enjoy ample access to capital to make it happen. The overhang in the private equity market is so large that it can help make up for the relative dearth of debt financing, says LeClaire. "No longer is being a public company the best venue from which to obtain capital," says Kafker.
Indeed, Larson believes the relative cost and availability of private equity is yet another variable CFOs should include in calculating the cost of remaining public.
The Tyranny of the Quarter
By far the best thing about getting such a deal done, according to those who have done one, is that private equity frees companies from the market's relentless focus on quarterly earnings. The universal corporate irritation caused by such a short-term focus was underscored recently when a handful of large public companies — McDonald's and Coca-Cola among them — announced they would no longer provide quarterly guidance.
"The Coca-Colas of the world can decide not to give guidance anymore, but if Comp Benefits was a public company, we wouldn't have that luxury," notes CEO David Klock, who took that company private in the summer of 1999. Not only does the market demand guidance from companies without Coke's clout, he says, but it has zero tolerance for any expenditure that isn't instantly accretive. "I am glad we are private," says Klock, "not because of governance issues, but because of the ability to make investments that may take two or three quarters to give a good return. That's difficult to do as a public company."
The benefits of a longer-term focus can also be seen in the February acquisition of Dallas-based Monarch Dental Corp. — a public company — by privately held Bright Now Dental Inc., of Santa Ana, California. Both companies started as rollups of private dental-practice management firms, a red-hot stock sector in the late 1990s. Bulging with pricey new acquisitions and highly leveraged, Monarch went public just before that sector tanked. Bright Now, about the same size, chose to stay private, says CFO Brad Schmidt.
The result? Bright Now spent the next four years combining businesses and installing an integrated information system. Meanwhile, the market's focus on top-line growth forced Monarch to defer such investments and spend capital on additional acquisitions.
By February 2002, that strategy — or lack thereof — had taken its toll. Monarch's stock was trading at about $1.50, the company was in violation of its debt covenants, and the CEO and CFO had been replaced with a team looking to sell the company. With $80 million in annual revenues, Bright Now bought Monarch ($180 million in revenues) for roughly five times EBITDA. "Their operations proved to be extremely competent, but because they hadn't integrated, they weren't able to do what they did best," says Schmidt.
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