At the beginning of this month the Securities and Exchange Commission, in conjunction with the National Association of Securities Dealers, began requiring that 3,300 small-cap companies that currently trade over the counter through brokers begin filing financial statements, such as 10-Q and 10-K forms.
Sources predict many of these companies-because they occupy an unpopular sector among public market investors or because they view the as much as $500,000 in costs that can be incurred in registering for an exchange as prohibitively expensive-will avoid stepping up to board trading and instead will look to be acquired by buyout firms.
The change by the SEC and NASD likely will add fuel to the fire of what already has become an increased level of activity by buyout firms in the small-cap market. Already, groups have become more aggressive in pursuing small exchange-listed companies, with values of less than $400 million, because many of these companies have seen their trading multiples drop by more than 33% in the last year. “We have looked extensively at publicly traded companies that are too small to be on anyone’s radar,” says Bruce Cauley, a vice president at The Dyson-Kissner-Moran Corp. “When I talk to partners at LBO funds, they all say they look at these types of companies.”
However, in spite of the opportunities and the current interest in this arena, sources warn there are risks to buying in the public markets, not the least of which is buyout firms could reclaim the negative stigma of corporate raiders they suffered in the late 1980s.
While buyout groups investing in the public market is nothing new, firms already have shown an increased taste for small, publicly traded companies. The interest is being driven by lower prices in the small-cap market, sources say. According to a recent study by U.S. Bancorp Piper Jaffray, these companies have been suffering from a liquidity crisis-in spite of the strong stock market-because of a lack of analyst coverage. “The lack of analyst coverage exacerbates the liquidity issue, reinforcing movement away from these stocks,” the report states. “Companies in the $50 million to $250 million range have approximately 2.5 analysts covering their stocks versus 10 analysts for companies over $250 million.” The report also notes that analysts covering small-cap stocks often are less well regarded than those covering mid- and large-cap companies, and therefore carry less weight with public market investors.
Small-Caps All the Rage
A look at the scorecard from only the last few months shows G.P.s capitalizing on these low prices. GTCR Golder Rauner, LLC and TA Associates agreed to pay $152 million for CompDent Corp., a surgical instrument manufacturer. Meanwhile, Littlejohn & Co. LLC acquired Durakon Industries, which produces bed liners for pick-up trucks, for $101 million; Bruckmann, Rosser, Sherrill & Co. acquired O’Sullivan Industries Holdings, a manufacturer of ready-to-assemble furniture, for $370 million; and Kirtland Capital Partners invested in Instron Corp., a materials evaluating company, in a $160 million acquisition (BUYOUTS May 17, p. 7). In addition, Mr. Cauley’s Dyson-Kissner-Moran last month acquired Nasdaq-traded Optek Technology, a maker of infrared and magnetic field sensing devices, in a $200 million buyout.
In the case of over-the-counter stocks, sources say firms have been looking at these companies, but few have invested. One recent exception, however, was Apollo Advisors’ May purchase of Clark USA, a marketer of petroleum products, for $230 million.
However, the relatively new nature of the rule change-to date the NASD and the SEC have reviewed over-the-counter stocks with symbols from A to AD, according to a NASD spokesperson, with 54 of the 94 companies opting not to file for listing-has sources speculating that many firms soon will be completing deals in these new waters.
Mr. Cauley, for one, says Dyson-Kissner-Moran will be targeting former over-the-counter companies, while Russell Carson, a general partner of mega-firm Welsh, Carson, Anderson & Stowe, also says his firm will be looking at those companies that choose not to file with an exchange.
Some shareholders have alleged breach of fiduciary duty against Knoll for accepting the bid, allegations that have been exacerbated by Warburg Pincus already having a controlling stake in the company.
The problem with acquiring a company that is sold over the counter is the process can be similar to acquiring a business that is traded on one of the exchanges. The time spent on the deal can be long and several buyers likely will look at every good investment opportunity, sources say.
Also similar to small-cap public companies, there usually are several investment groups that own a bulletin board company. Although the former SEC regulations mandated only that over-the-counter companies have no more than 500 securities holders of record, sources say the number usually is much smaller. The typical makeup for a company that trades over the counter includes a family group, an institutional investor and perhaps one more investor block.
“The goal for a buyout firm may be to pry a block loose and to get the ball rolling,” says Chris Williams, principal at investment bank Harris Williams & Co. The situation, he notes, often becomes more complicated when more groups own a stake. “There’s usually a history to these small public companies and there can be a problem with satisfying several constituencies.”
The risk also exists, for both listed and over-the-counter companies, of buying someone else’s problem, sources say.
The company with a stock price that is falling or the over-the-counter company that is de-listing already has failed to attract much interest in the public market. Sources say throwing money at companies that already have proven unpopular will not make them more attractive when it is time for the financial buyer to exit.
Beware of Bad Merchandise
“I think [a public buyout] should affect your thinking,” says Daniel O’Connell, Vestar Capital Partners’s chief executive officer, adding that many public market investors would view having been taken private once as a demerit. “Exiting a company through an IPO, after taking it private, is unlikely,” he says.
A name change can help and so can using a different underwriter the second time around going public, but sources say that may not be enough.
Douglas Karp, a managing director at E.M. Warburg, Pincus & Co., says his firm judges public market companies with similar criteria it uses when making private transactions. “You need to judge whether you can transform it or whether the value will be recognized in a different market, or if it will be a logical choice as a consolidator,” he says.
Oddly enough, some sources also say that it can be more difficult to obtain information when performing due diligence from a public company than from a private company. “The risk always is that you may not get perfect information,” Welsh Carson’s Mr. Carson says. “They can supply you with a lot of information, but the company can have confidentiality issues that may make it difficult for you to receive all the relevant information. The risk is that you can overlook an important fact.”
Even outside of the obvious risk of buying a public market dog, some recent public market deals have cast buyout firms as opportunists that short change shareholders by employing questionable tactics. This image could eventually have an impact on limited partners-especially public pensions-that are required to make investments with firms that invest in a fiscally responsible manner, G.P. and L.P. sources say.
“I think it is difficult for a main-line firm to be in many situations where they gain a reputation of stealing a company,” Mr. Karp says, referring to companies acquired by LBO firms suffering shareholder lawsuits for breach of fiduciary duty.
He believes L.P.s will and should be concerned about the increasing trend. “I think a prudent investor with public responsibilities should be sensitive to these issues.”
Even outside of the obvious risk of buying a public market dog, some recent public market deals have cast buyout firms as opportunists that short change shareholders by employing questionable tactics.
Or in the words of one endowment manager, in reference to recent shareholder lawsuits in buyout firm deals, “There is a fine line between bribing and cutting a shrewd deal.”
In one recent case, management last month allegedly helped Trivest win a $276 million agreement to buy WinsLoew Furniture because they had received a guarantee of remaining with the company.
Trivest already owned a minority stake in the company and had thereby been able to build a cozy relationship with the board, management and members of the special committee, says a source close to the deal. The firm eventually won a lengthy bidding war to acquire a majority of the company-after having imposed a short time limit on a shareholder vote-in spite of a group backed by Desai Capital Management being prepared to make an offer that was $.50 more per share than the winning Trivest offer of $34.75 per share (BUYOUTS June 21, p. 10).
Earl Powell, CEO of Trivest, maintains that Desai never actually made their bid, and that the sale process was, therefore, conducted in a fair manner. “The special committee was guided by two very competent law firms and was only concerned about getting a high price and doing it in a timely fashion,” he says, noting that the company shopped itself to other bidders for six months before Trivest entered its bid.
Other companies recently have been accused by shareholders of not even accepting outside bids when fielding a favorable offer from a financial buyer. Shareholders of Juno Lighting accused management of not seeking a better bid than Fremont Partners’ $326 million buyout proposal.
In this example, some of the shareholders claimed the company’s board of directors was not independent and received a sweetheart deal that was good for them and not fair to the shareholders. This resulted in more than 35 percent of voting Juno shareholders not to back the buyout and the April filing of a shareholder suit in the Court of Chancery in Delaware against the company for breach of fiduciary duty.
Juno reportedly contends that it did not receive any higher offers than the Fremont Partners bid. Partners at Fremont did not return calls.
In other cases, a company sometimes has absorbed a poison pill weeks before receiving an offer, making it difficult for alternate buyers to enter a bid and leading to the appearance of an unfair process.
Vestar early this month completed a $514 million buyout of St. John Knits, a women’s clothing manufacturer, that it had inked in the fourth quarter. The founder of the company, Robert Gray, prior to the sale had absorbed a poison pill to ward off another bidder-effectively granting him control of the choice of the company’s suitor-seemingly weeks before receiving Vestar’s offer; through the buyout, his family has increased its stake by nearly 50 percent. Seven shareholder lawsuits were filed in a California State Supreme Court in December for breach of fiduciary duty in connection with the deal. The cases have been consolidated into a single suit and are slated to go to trial in November.
Mr. O’Connell contends that Vestar had not spoken to Mr. Gray until after St. John Knits absorbed the poison pill. “The board at St. John Knits made decisions before we entered the process,” he says. “The case against St. John Knits is completely baseless.”
A St. John Knits spokesperson contends the company was shopped around by Wasserstein Perella & Co., Merrill Lynch & Co. and others for six months after Vestar’s initial bid.
The company with a stock price that is falling or the over-the-counter company that is de-listing already has failed to attract much interest in the public market. Sources say throwing money at companies that already have proven unpopular will not make them more attractive when it is time for the buyer to exit.
Then there is the case of Warburg Pincus and Knoll Inc. The private equity firm had owned 60 percent of the maker of business furniture and office systems through a prior fund and last month managed to acquire the remaining stake in a $496 million investment, raising some shareholder eyebrows in the process.
Some shareholders have alleged breach of fiduciary duty against Knoll for accepting the bid, allegations that have been exacerbated by Warburg Pincus already having a controlling stake in the company. Six lawsuits were filed against Knoll in March in a Delaware Court of Chancery and this month were consolidated into one case.
Mr. Karp contends the firm paid 80% more than the trading price at the time the bid was announced. He also noted the company had hired Lazard Freres & Co. LLC as an independent adviser to issue a fairness opinion on the bid.
He says the Knoll deal is evidence that some shareholders always will be unhappy with the price that is offered.