A public company may choose to go private for a number of reasons. There are advantages and disadvantages to going private as well as short- and long-term issues to consider, so it's not a move management can take lightly. Here's a look at the factors that companies must factor into the privatizing equation.

Advantages of Being Public

Being a publicly traded company has its pros and cons. On the plus side: The buying and selling shares of public companies is relatively easy to do, and an attraction for investors seeking a liquid asset. And there is a certain degree of prestige to being a public company, implying a level of operational and financial size and success, especially if the stock trades in a major market like the New York Stock Exchange.

However, there are also tremendous regulatory, administrative, financial reporting and corporate governance bylaws that public companies must comply with. These activities can shift management's focus away from operating and growing a company and toward compliance with and adherence to government regulations.

For instance, the Sarbanes-Oxley Act of 2002 (SOX) imposes many compliance and administrative rules on public companies. A byproduct of the Enron and Worldcom corporate failures in 2001-2002, SOX requires all levels of publicly traded companies to implement and execute internal controls. The most contentious part of SOX is Section 404, which requires the implementation, documentation, and testing of internal controls over financial reporting at all levels of the organization.

Public companies must also conduct operational, accounting, and financial engineering in order to meet Wall Street's quarterly earnings expectations. This short-term focus on the quarterly earnings report, which is dictated by external analysts, can reduce prioritization of longer-term functions and goals such as research and development, capital expenditures and the funding of pensions, to name but a few examples. In an attempt to manipulate the financial statements, a few public companies have shortchanged their employees' pension funds while projecting overly optimistic anticipated returns on the pension's investments.

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Why Public Companies Go Private

What It Means to Go Private

A "take-private" transaction means that a large private-equity group, or a consortium of private-equity firms, purchases or acquires the stock of a publicly traded corporation. Due to the large size of most public companies, which have annual revenues of several hundred million to several billion dollars, it is normally not feasible for an acquiring company to finance the purchase single-handedly. The acquiring private-equity group typically needs to secure financing from an investment bank or related lender that can provide enough loans to help finance (and complete) the deal. The newly acquired target's operating cash flow can then be used to pay off the debt that was used to make the acquisition possible.

Equity groups also need to provide sufficient returns for their shareholders. Leveraging a company reduces the amount of equity needed to fund an acquisition and is a method for increasing the returns on capital deployed. Put another way, the company or the group acquiring it borrows someone else's money to buy the company, pays the interest on that loan with the cash generated from the newly purchased company, and eventually pays off the balance of the loan with a portion of the company's appreciation in value. The rest of the cash flow and appreciation in value can be returned to investors as income and capital gains on their investment (after the private-equity firm takes its cut of the management fees).

Once an acquisition is agreed to, management typically lays out its business plan to the prospective shareholders. This go-forward prospectus covers the company's and industry's outlook and sets forth a strategy showing how the company will provide returns for its investors.

When market conditions make credit readily available, more private-equity firms are able to borrow the funds needed to acquire a public company. When the credit markets are tightened, debt becomes more expensive and there will usually be fewer take-private transactions.

Deciding to Go Private

Investment banks, financial intermediaries, and senior management often build relationships with private equity firms in an effort to explore partnership and transaction opportunities. As acquirers typically pay at least a 20% to 40% premium over the current stock price, they can entice CEOs and other managers of public companies – who are often heavily compensated when their company's stock appreciates in value – to go private. In addition, shareholders, especially those who have voting rights, often pressure the board of directors and senior management to complete a pending deal in order to increase the value of their equity holdings. Many stockholders of public companies are also short-term institutional and retail investors, and realizing premiums from a take-private transaction is a low-risk way of securing returns.

In considering whether to consummate a deal with a private-equity investor, the public company's senior leadership team must also balance short-term considerations with the company's long-term outlook. In particular, they must decide:

  • Does taking on a financial partner make sense for the long term?
  • How much leverage will be tacked onto the company?
  • Will cash flow from operations be able to support the new interest payments?
  • What is the future outlook for the company and industry?
  • Are these outlooks overly optimistic, or are they realistic?

Management needs to scrutinize the track record of the proposed acquirer. Among the criteria to consider:

  • Is the acquirer aggressive in leveraging a newly acquired company?
  • How familiar is it with the industry?
  • Does the acquirer have sound projections?
  • Does it consist of hands-on investors, or will it give management leeway in the stewardship of the company?
  • What is the acquirer's exit strategy?

Advantages of Privatization

Going private, or privatization, frees up management's time and effort to concentrate on running and growing a business, as there are no SOX regulations to comply with. Thus, the senior leadership team can focus more on improving the business's competitive positioning in the marketplace. Internal and external assurance, legal professionals and consulting professionals can work on reporting requirements by private investors.

Private-equity firms have varying exit timelines for their investments depending on what they have conveyed to their investors, but holding periods are typically between four and eight years. This horizon frees up management's prioritization on meeting quarterly earnings expectations and allows them to focus on activities that can create and build long-term shareholder wealth. For instance, managers might choose to follow through on initiatives to train and retrain the sales organization (and get rid of underperforming staff). The extra time and money private companies enjoy from decreased regulation can also be used for other purposes, such as implementing a process-improvement initiative throughout the organization.

Drawbacks to Privatization

A private equity firm that adds too much leverage to a public company in order to fund the deal can seriously impair an organization in adverse scenarios. For example, the economy could take a dive, the industry could face stiff competition from overseas or the company's operators could miss important revenue milestones.

If a privatized company has difficulty servicing its debt, its bonds can be reclassified from investment-grade bonds to junk bonds. It will then be harder for the company to raise debt or equity capital to fund capital expenditures, expansion or research and development. Healthy levels of capital expenditures and research and development are often critical to the long-term success of a company as it seeks to differentiate its product and service offerings and make its position in the marketplace more competitive. High levels of debt can thus prevent a company from obtaining competitive advantages in this regard.

Obviously, private companies shares don't trade on public exchanges. And in fact, the liquidity of investors' holdings in a privatized company varies, depending on much of a market the private equity firm wants to make – that is, how willing it is to buy out investors who want to sell. In some cases, private investors may easily find a buyer for their portion of the equity stake in the company. If the privacy covenants specify exit dates, it can make it challenging to sell the investment, however.

The Bottom Line

A take-private transaction is an attractive and viable alternative for many public companies. Being acquired can create significant financial gain for shareholders and CEOs, while the reduced regulatory and reporting requirements private companies face can free up time and money to focus on long-term goals. As long as debt levels are reasonable and the company continues to maintain or grow its free cash flow, operating and running a private company frees up management's time and energy from compliance requirements and short-term earnings management and may provide long-term benefits to the company and its shareholders.