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Stricter rules and wary investors are prompting more companies to exit the public markets.
Tim Reason, CFO Magazine
May 1, 2003
These days, John Henderson thinks of himself as a brewer. That's not to say the former CFO of Genesee Corp. actually brews beer: "We have talented guys who take care of that," he notes. But ever since Henderson and two other executives orchestrated a management buyout, turning the company's Rochester, New York-based brewing operation into a private entity, he has finally been able to focus entirely on the business of making and selling suds.
Dealing with the requirements of being public "took an awful lot more time than I expected," recalls Henderson, now COO (he shares the CFO duties with the CEO) of High Falls Brewing Co. And while the brewery is still managed as if it were a public company, he says it's "a huge relief" not to have to comply with securities regulations. "I'm thankful that resources can be directed at managing the day-to-day [operations], not complying for compliance's sake," he says. By contrast, the all-but-empty shell of Genesee, which disposed of its three main business units as part of a planned liquidation, was still filing Securities and Exchange Commission documents as late as April, more than two years after High Falls was created to buy out the brewery for $22 million.
Henderson isn't the only one who's relieved. While most companies aren't choosing High Falls's particular method of "going private" — an asset disposition rather than a merger or tender offer — they are leaving the public markets in increasing numbers. In fact, according to Mergerstat, going-private transactions have risen steadily, from 197 in 2000 to 316 in 2002, with 93 announced as of April 1.
Their reasons for exiting differ greatly from those of spurned not-coms -- industrial companies that couldn't compete for equity dollars during the Internet bubble. Today, onerous regulations, depressed stock prices, and investor hostility are sparking a wider withdrawal.
Small-cap companies account for the majority of these transactions, but companies of all sizes have been stepping off Wall Street. The most prominent recent example is $4.4 billion Dole Food Co., in Westlake Village, California, whose chairman and CEO, David H. Murdock, cited "the short-term pressures and constraints of the public equities market" as reasons for taking the company private in late March.
Apparently, those same constraints are leading many more companies to wonder if they can do better without the market looking over their shoulder — or giving them the cold shoulder, as the case may be. Says Richard Kline of Houlihan Lokey Howard & Zukin: "There is a gestation period for these deals, but the inquiry level has increased significantly."
Fueling this newest exodus from the public market, in part, are the onerous regulations embodied in the Sarbanes-Oxley Act of 2002. Recent filings with the SEC clearly illustrate that the new legislation drove many companies out even before the rules were finalized.
In one example, in an SC13e3 filing (the SEC form for reporting going-private transactions) on March 4, Tampa-based Coast Dental Services Inc. complained that the management time and resources devoted to compiling and distributing annual and quarterly reports "are considerable and will likely increase significantly in the future as a result of the [act]."
Similarly, Greenville, Tennessee-based Landair Transport Inc., a $106 million (2001 revenues) firm bought out by its founder and the COO in March, specifically cited the increased costs of complying with both Sarbanes-Oxley and the rules adopted by the National Association of Securities Dealers, adding that "such increased regulation would place additional burdens on management that would further distract them from managing the business operations of Landair."
A backlash against such additional burdens is not surprising. "The intersection of all this stuff — more disclosures, more internal controls, and a stronger audit committee — is frequently in the CFO's office," observes Stephen D. Poss, an attorney with Boston-based Goodwin Procter LLP, who adds that another word for intersection is "crosshairs." For smaller public companies, where the CFO is sometimes a one-man finance department, the new regulations, certifications, and the spectacle of finance chiefs doing perp walks may be a powerful deterrent to staying public.
Or perhaps there is a deliberate effort to scare companies away from the public markets. "I wouldn't be surprised if someone at the SEC is thinking, ÔWe need to make being a public company so expensive and onerous that we get these smaller companies off the screen,'" says Poss. "And that's not necessarily a dumb way of thinking."
What Poss and others suggest, and depressed stock prices seem to confirm, is that the trend toward going private is actually an appropriate market correction. "At the height of the bull market, there were approximately 18,000 publicly traded companies," declares Scott Larson, assistant professor at the business school of Chicago's National-Louis University. "Investors threw money at certain segments of the public equity markets at unsustainable levels, so the implied cost of equity in the more-speculative segments of the market dropped to near zero."
Larson 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.
Schmidt says he has full support from his investors to spend the next 12 to 18 months integrating Monarch's businesses and installing Bright Now's platform. "The one big benefit of the private sector is that you end up with a business partner instead of a shareholder," he says.
That's a common sentiment. "People say it must be nice being private — you don't have to report to a lot of people," says Klock. "That's a misconception. I have a dozen institutional people I report to every month and three different VC firms." The difference, say private-company executives, isn't the level of reporting, it's the nature of the relationship. "It always amazes me to sit in on analyst calls for public companies and realize the questions are just scratching the surface," says Schmidt. In Bright Now's case, he says, he not only meets regularly with investors, he also relies on them "in many respects as mentors."
Typically, of course, those investors are still looking for some sort of exit strategy — including going public again. But executives at once-public firms don't seem keen on that idea. While opportunities may arise sooner, says Schmidt, he's comfortable keeping Bright Now private for the next three or four years while it digests Monarch. If High Falls Brewing needs more money, adds Henderson, "I think there are more than enough places to go besides the public equity markets." And while going public again is a possibility for Comp Benefits, it probably won't happen before 2005. "That's assuming there is a capital market," says Klock.
In the next few years, there will likely be far more companies dropping out of the public markets than joining them. To steal a phrase from Wall Street, going private is the next big thing.
Sidebar: Going Private...
There are several ways to take a company out of the market, although going private typically involves some combination of the first two of these techniques.
Leveraged Recapitalization Merger. The classic going-private method, involving a proposal to merge with an acquisition company created by management and financial sponsors for the purpose. A special committee of the board typically is established to negotiate, and may feel compelled to solicit competing bids.
Tender Offer and Merger. Tender offers are common when there is a need for speed, since they can close in 20 business days (rather than the three months or more for the merger proxy-vote process). Tenders can be used to gain majority control to ensure a smooth merger process, but this can require a pricey bridge loan until the post-tender merger closes. Tenders are more common when management's goal (and often a condition of the offer) is to gain the 90 percent of shares needed to execute a short-form merger.
Reverse Stock Split. Also known as 'the squeeze out.' A rare technique used in small companies where the majority of shares are closely held by a few controlling shareholders. The split is engineered to leave minority shareholders holding fractional shares, which are paid out in cash. The goal, typically, is simply to eliminate public reporting requirements (and those shareholders), rather than to recapitalize the company.
Asset Disposition. Acquisition companies purchase all of the company's assets through a planned liquidation that returns funds to shareholders. Although not typically thought of as a going-private transaction, the effect can be similar if management purchases some of those assets with outside funding.
Sidebar: Wanna Buy Your Company?
In this era of intense investor scrutiny, everyone from private equity advisers to CFOs is circumspect about the personal payout that comes with a buyout. 'The CFO is a fiduciary of the company, and ought not to be directing the company to where his best personal interests lie,' warns attorney John LeClaire of Goodwin Procter. But make no mistake: taking a company private can be the most lucrative move of a CFO's career.
In fact, CFOs who take their companies private often wind up with a 1 to 3 percent equity stake and a key role as liaison with the bank and equity investors. 'It can be a great outcome for the CFO,' concedes LeClaire. Along with the payout that comes when the firm exits, the CFO of a successful effort can expect to be tapped by private equity firms to repeat that performance elsewhere.
Of course, personal interests aren't always financial. CFO John Henderson and the executives of Genesee Corp. orchestrated a buyout of the company's brewery after a sale to outsiders fell through. Rochester, New York, natives all, their move saved the 125-year-old hometown institution, and 400 jobs that went with it. As if that weren't satisfying enough, they're also now owners of Genesee Cream Ale — something of a fabled label in the Northeast. Recalls Henderson, 'We had a couple to celebrate the event.'
Chart: Going Private - Deals are steadily increasing
Year Number of Deals
*As of 4/1/03
Chart: Market Movers
Not all market defectors are small companies.
Year Company Size of transaction
2003 Ameripath* $839.4 million
2003 Dole Foods $2.5 billion
2003 National Golf Properties $1.1 billion
2002 Herbalife International $685.0 million
Source: Scott Larson, National-Louis University