The Market for Buyouts of Public Companies, Part I –

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Most buyouts today involve private companies or components of public companies, not acquisitions of entire public companies. Of the more than 180 transactions listed in Buyouts’ year-end deal list for 2001, less than 10% involved the acquisition of a public company as a whole. That may change over the next twelve months, as interest in a particular type of buyout – the “going private” transaction – is likely to increase significantly.

The factors affecting the market for buyouts of public companies include the large number of companies that went public in the late 1990s, the decline in market valuations, the Sarbanes-Oxley Act of 2002 and corporate governance initiatives at the exchanges and Nasdaq, and the availability and cost of capital for privatizations. As a result, investment banks and buyout funds are likely to see public companies – particularly smaller public companies – increasingly willing to explore the feasibility of going private. This article describes some of the factors driving the market for buyouts of public companies and explores some of the implications for investment banks and buyout firms.

The IPO Process and its Aftermath

The number of public companies increased substantially at the end of the last century. Over 2,400 U.S. companies conducted their initial public offerings in the period from 1996 through 2000, and going public came to be seen as a validation of the business acumen of a company’s entrepreneurial founders and venture capital backers. The collapse of market valuations and the reaction to the corporate scandals of the last year have dramatically altered the landscape. Boards, stockholders, and management may be receptive to a buyout in part because their post-IPO experiences have not lived up to their pre-IPO expectations.

Some factors relevant to a decision to go public may be less relevant to a decision to stay public. The considerations that led companies to go public have also been affected by the substantial decrease in market valuations – public companies as a whole lost $7.7 trillion in market capitalization between March 2000 and July 2002 – and by the response to developments at Enron and other companies. In particular:

* While a public company should still generally be able to access the capital markets more easily than a private company, the advantage is diminished if the public company cannot easily tap the capital markets at an acceptable price. In considering the “price” of raising additional equity, boards and management must consider the current market price for their stock and the dilution of existing investors. Boards and management of public companies must make similar calculations when considering whether to pay for an acquisition with stock. An acquisition may be unattractive if too many additional shares must be issued at the current market price, even if the acquisition will be accretive to earnings.
* Options have come under pressure. As market valuations have declined, the values of many option-packages have evaporated, leaving management with difficult choices, including re-pricing existing options, issuing new options with an exercise price equal to the current (lower) market price, or doing nothing (and losing the benefits that options provide). In addition, there is growing pressure on public companies to recognize a compensation expense, equal to the fair value of stock options granted to employees, when the options are granted. Senators John McCain and Carl Levin have introduced legislation that would require this accounting treatment for options. Several public companies have voluntarily begun to account for options in this way. On July 31, 2002, the Financial Accounting Standards Board stated that recognizing a compensation expense for the fair value of employee stock options is the “preferable approach” under existing accounting rules. If the “preferable approach” becomes mandatory whether by congressional fiat or FASB directive or if investor pressure leads more companies to recognize compensation expense for options voluntarily, the effective cost of option programs to companies could increase. The net result of these developments is that options would supply a less compelling rationale for a company to stay public.
Whether a public company today is more stable than a private company, and whether the prestige associated with being a public company is commensurate with the costs, risks, and aggravation associated with remaining public today, will obviously depend on each company’s circumstances.

Enhanced Costs and Risks of Staying Public

The response to the corporate and accounting scandals of the last year has also affected the decision to stay public, by increasing the costs and risks of being a public company. Among the increased costs and risks that public companies, their management, and their boards must now bear are the following:

Independent audit costs have increased and are likely to continue to rise. Among the factors driving this trend are:

* Provisions in the Sarbanes-Oxley Act of 2002 and the SEC’s new requirement that public companies describe their “critical accounting policies” are causing companies’ independent accountants to devote more time to companies’ Annual Reports on Form 10-K and Quarterly Reports on Form 10-Q. (The Form 10-K must include audited financial statements, and a company’s independent accountants typically review the Form 10-Q.) These new requirements are also causing public companies’ independent accountants to spend more time with companies’ audit committees.
* Sarbanes-Oxley also prohibits accounting firms from providing their audit clients with eight specific types of non-audit services, including financial information systems design and implementation services. Under the Act, other services, including tax services, can be provided by a company’s independent auditors only with the prior approval of the company’s audit committee.
* The SEC has mandated more expeditious filing of companies’ annual and quarterly reports. By the end of the three-year phase-in period, the filing deadlines for Forms 10-K and 10-Q will have been accelerated to 60 and 30 days, respectively, from 90 and 45 days.
* The demise of Arthur Andersen LLP has removed a significant competitor from the market, while accountants’ costs – notably, insurance costs – have increased.
* The Sarbanes-Oxley Act imposes new risks on officers of public companies, including two new personal certification requirements.
* Under Section 906 of the Act, the chief executive officer and chief financial officer of each public company must certify, in each of their reports on Form 10-K and 10-Q, that the information in the report “fairly presents, in all material respects, the financial condition and results of operations of the issuer.” An officer who signs this certification, knowing that the report does not meet the requirements recited in the certification, may be fined up to $1 million and imprisoned up to 10 years; “willful” violators may be fined up to $5 million and imprisoned up to 20 years. A conscientious officer might justifiably wonder whether he or she could go to jail because a Form 10-K did not disclose a known fact or trend that was not considered material at the time the Form 10-K was filed but that, with the benefit of hindsight, turned out to be material.
* Section 302 of the Act contains a second and more extensive certification provision. The principal executive and accounting officers of each public company must certify that (1) the signing officer reviewed the report; (2) based on the officer’s knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements, in light of the circumstances made, not misleading; and (3) based on the officer’s knowledge, the financial statements and other financial information in the report fairly present, in all material respects, the financial condition and results of operations of the company as of, and for, the periods presented in the report. The officers must also certify as to the company’s internal controls and “disclosure controls and procedures” (a newly-defined term covering non-financial as well as financial controls). An officer who makes a knowingly false certification will presumably face criminal liability, but the SEC will also be able to seek civil penalties for false certifications.
* The Act specifically empowers the SEC to prohibit a person who has violated the antifraud provisions of the securities laws from acting as an officer or director of a public company if the person’s conduct demonstrates “unfitness to serve” as an officer or director of a public company.
* If a public company is required to restate its financial statements because of material noncompliance with any financial reporting requirement under the securities laws, the company’s chief executive and financial officers must (1) reimburse the company for any bonus, incentive-based, and equity-based compensation received in the twelve months following the filing required to be restated and (2) disgorge any profits realized from the sale of the company’s securities during that twelve-month period.

Michael J. Levitin and Steven S. Snider are senior partners in the Washington, D.C. office of Hale and Dorr LLP.

Look in the next issue of Buyouts for the conclusion to this two-part article, which explains more risks to staying public and outlines the benefits to going private.