Why Public Companies Go Private: Exploring the Decision-Making Process
Public companies sometimes choose to go private due to various reasons, weighing the advantages and disadvantages associated with this decision. Going private entails freedom from costly and time-consuming regulatory requirements, such as the Sarbanes-Oxley Act of 2002 (SOX). This article delves into the factors that companies consider before going private and provides insights into the implications of such a transition.
The Benefits and Challenges of Being a Public Company
Advantages of Public Companies:
- Liquidity: The buying and selling of public company shares offer investors a liquid asset.
- Prestige: Being publicly traded implies operational and financial size and success, especially on major stock exchanges like the New York Stock Exchange.
Challenges of Public Companies:
- Regulatory Compliance: Public companies are subject to numerous regulatory, administrative, financial reporting, and corporate governance bylaws, shifting management’s focus away from core operations.
- Sarbanes-Oxley Act of 2002: SOX, enacted in response to corporate failures like Enron and Worldcom, imposes compliance and administrative rules on publicly traded companies. Section 404, in particular, requires the implementation and testing of internal controls over financial reporting at all levels of the organization.
- Quarterly Earnings Expectations: Public companies must meet Wall Street’s quarterly earnings expectations, potentially diverting attention from long-term functions such as research and development, capital expenditures, and pension funding.
- Pension Fund Issues: Some public companies have manipulated financial statements, compromising employees’ pension funds by projecting overly optimistic anticipated returns.
Understanding the Transition: Going Private
Definition of “Take-Private” Transaction:
- In a “take-private” transaction, a private-equity group or consortium acquires the stock of a publicly traded corporation.
- Due to the substantial size of most public companies, acquiring companies often require financing from investment banks or lenders to facilitate the purchase.
- The acquiring private-equity group uses the target company’s operating cash flow to repay the debt incurred during the acquisition.
Benefits of Going Private:
- Reduced Regulatory Burden: Private companies are relieved from the costly and time-consuming requirements of regulatory frameworks such as SOX.
- Resource Allocation: Private companies can allocate more resources to research and development, capital expenditures, and pension funding, as they face fewer external reporting obligations.
The Role of Private Equity Groups:
- Financing and Returns: Private equity groups secure financing from banks or lenders and aim to provide sufficient returns for their shareholders.
- Leveraging: Leveraging the acquired company reduces the amount of equity needed for the acquisition, enhancing capital gains for investors.
- Business Plan: After the acquisition, management outlines a business plan that demonstrates how the company will generate returns for its investors.
Factors Influencing the Decision to Go Private:
- Relationships with Private Equity Firms: Investment banks, financial intermediaries, and senior management build relationships with private equity firms to explore partnership opportunities.
- Premium Over Stock Price: Acquirers typically offer a premium of 20% to 40% over the current stock price, attracting CEOs and managers of public companies who are incentivized by stock appreciation.
- Shareholder Pressure: Shareholders, particularly those with voting rights, often urge the board of directors and senior management to complete a deal that increases the value of their equity holdings.
- Long-Term Outlook: Management must balance short-term considerations with the company’s future prospects, assessing factors such as the financial partner’s compatibility, leverage, and cash flow sustainability.
- Acquirer Evaluation: Scrutinizing the acquirer’s track record is crucial, considering factors like leverage practices, industry familiarity, sound projections, level of involvement in company stewardship, and exit strategies.
Market Conditions and Going Private:
- Credit Availability: The ease of borrowing funds for acquisitions depends on market conditions. In favorable credit markets, more private-equity firms can acquire public companies, while tightening credit markets make debt more expensive and lead to fewer take-private transactions.
The decision for a public company to go private involves weighing the advantages and challenges associated with regulatory compliance, earnings expectations, and other factors. Going private relieves companies from burdensome regulatory requirements like the Sarbanes-Oxley Act of 2002, allowing them to allocate resources more efficiently. Acquiring private-equity groups play a vital role in financing and implementing business plans, while management must carefully evaluate the potential acquirer’s track record. Ultimately, the decision to go private requires a thorough assessment of the company’s long-term outlook and market conditions.
Advantages and Drawbacks of Privatization: Understanding the Implications
Advantages of Privatization:
- Focus on Business Operations: Going private allows management to concentrate on running and growing the business without the burden of complying with regulatory requirements like the Sarbanes-Oxley Act of 2002 (SOX). This enables the senior leadership team to enhance the company’s competitive positioning in the market.
- Flexible Reporting Requirements: Private companies can tailor reporting obligations to meet the needs of private investors, allowing internal and external assurance, legal professionals, and consulting professionals to focus on relevant reporting requirements.
- Long-Term Focus: Privatization frees management from the pressure of meeting quarterly earnings expectations. This longer-term horizon allows management to prioritize activities that create sustainable shareholder wealth, such as implementing process improvement initiatives and investing in sales staff training.
- Utilization of Resources: Private companies have more time and financial resources at their disposal, which can be allocated to initiatives like process improvements, research and development, and capital expenditures.
Drawbacks of Privatization:
- Excessive Leverage Risks: Private equity firms that employ excessive leverage to fund acquisitions can expose the company to financial risks. Economic downturns, increased competition, or missed revenue milestones can severely impact the organization’s ability to service its debt.
- Capital Constraints: If a privatized company struggles to service its debt, its bonds may be downgraded to junk status. This makes it challenging to raise debt or equity capital for vital investments in capital expenditures, expansion, or research and development, hindering long-term success and competitive differentiation.
- Limited Liquidity: Shares of private companies do not trade on public exchanges, resulting in reduced liquidity for investors. The availability of buyers for equity stakes can vary, making it more difficult to sell investments, especially if exit dates are specified in the privacy covenants.
Going private offers several advantages for public companies, including reduced regulatory obligations, increased flexibility in reporting, and the ability to focus on long-term goals. However, the drawbacks of excessive leverage, capital constraints, and limited liquidity need to be carefully managed. By maintaining reasonable debt levels, preserving free cash flow, and utilizing resources effectively, privatized companies can benefit from the freedom to prioritize strategic initiatives and create sustainable value for shareholders in the long run.
Websites and Online Resources:
- U.S. Congress. “H.R.3763 – Sarbanes-Oxley Act of 2002” – Link
- U.S. Securities and Exchange Commission. “Study of the Sarbanes-Oxley Act of 2002, Section 404, Internal Control Over Financial Reporting Requirements” – Link
- “The Sarbanes-Oxley Act: A Brief Introduction” by Guy L. Fardone
- “Sarbanes-Oxley For Dummies” by Jill Gilbert Welytok and Mark R. Williams
Academic Journals and Research Papers:
- Hope, Ole-Kristian, and Wayne B. Thomas. “Managerial Empire Building and Firm Disclosure.” Journal of Accounting Research 49, no. 5 (2011): 1091-1123.
- Carcello, Joseph V., and Terry L. Neal. “Audit Committee Composition and Auditor Reporting.” The Accounting Review 81, no. 3 (2006): 823-849.
Reports and Studies:
- Ernst & Young. “Sarbanes-Oxley Section 404: A Guide for Management by Internal Controls Practitioners.” (2018) – Link
- PricewaterhouseCoopers. “Going private: Unlocking value in a changing business environment.” (2017) – Link
Professional Organizations and Associations:
- Financial Executives International (FEI) – Link
- National Association of Corporate Directors (NACD) – Link
These resources offer authoritative information and valuable insights for readers seeking further information on the topic of going private, the Sarbanes-Oxley Act, and related considerations.