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Private equity and the death of the public company

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“I TOLD YOU I WAS ILL!”

It was once the apogee of commercial success. But now, many Australian business owners are challenging the notion that a public stock exchange listing is the most suitable course for their companies. Andrew Pegler explores the emerging trend towards securing private equity investment over the once mighty IPO.

Around the end of October last year a significant but also humourous thing happened in Australian business. The significant thing was that for the first time an Australian private equity firm completed a public-to-private transaction for a NASDAQ-listed company. The humourous thing was that it was for a company that made and sold barbeques. Perhaps Backyard World Series Cricket is next?

Ironbridge Capital, an Australian independent private equity manager, acquired all the outstanding shares and options in Barbeques Galore in a deal worth $110 million and then summarily de-listed the company. It’s a familiar story, and unless you’ve been living in a cave for the past year or so, you would know private equity is the new black. And it has the cumbersome, short-term focused, publicly-listed company squarely in its sights.

BEDSIDE MANNER

Private equity financers, banksters or ‘Barbarians at the gate’ (as they were tagged in the late 1980s) most notably attracted world attention in 1989 when huge US food conglomerate RJR Nabisco was bought for US$30 billion; a deal eclipsed in August 2006 by the US$33 billion dollar takeover of HCA, a US-based medical services provider. Private equity (PE) is defined as an equity investment in an asset in which the equity used is not freely tradable on a public stock market. Typically, a private equity firm will control the management of a company they’ve invested in, and will often bring in new management whose job is to make the company more valuable for an exit event, usually a tradesale (a flip) or a re-listing. According to Macquarie Bank, in the second quarter of 2006, 739 funds across the globe were seeking US$300 billion. Fund sizes have crept up dramatically and now average US$413 million, with the largest tipping US$10 billion. All are attracting the sort of oversubscriptions historically enjoyed by venture capital. And no wonder, with average returns of 21 percent per annum.

At the moment, PE is in the midst of its perfect storm; a heady combination of credit being plentiful for those who need to borrow, a record stretch of corporate profits and the increasing short-termism of the publicly-listed company (PLC), with its inherent inefficiencies and clumsiness and the onerous disclosure regulations that followed the collapses of HIH, One Tel, World com and Enron, et al. Add to that the Federal Government’s recent tax changes exempting foreign investors from paying capital gains on investments not involving the acquisition of property and the smouldering pyre of the PLC is firing up.

CLOSING THE DRAPES

Peter Yates, MD of Allco Equity Partners Limited (AEP), one time CEO and MD of PBL, and part of the Airline Partners Australia consortium gunning for Qantas, agrees that the PLC is in trouble.

“There are several reason for this. Firstly, the high agency cost of a PLC, such as reporting and regulatory obligations and the liability born by those in charge,” says Yates. “Secondly, the person who sold their share at 3:58pm on Friday evening establishes the company share price for the weekend, which can send timetables and decision making processes into a tail spin. It’s the same with quarterly reporting. In other words, a PLC is vulnerable to data that ultimately has no real impact on its core strength. For example, when I was at PBL, if we had bad ratings on a Monday night, the share price would drop five cents, even though financially the rating had no impact. Thirdly, if a board feels it is forced to behave conservatively, because of over-governance or debt, then the equilibrium point that it needs to react for decisions is sub-optimal. PE doesn’t have this sort of pressure, so it has more optimal decision making.”

Stephen Mayne, founder of crikey.com.au and widely acknowledged as Australia’s leading corporate agitator, believes the PLC is walking wounded in the face of this plucky new rival.

“There is no doubt that private equity is striking a serious blow to the role of the PLC, by bringing in greater accountability and introducing a new, leaner, faster way of doing business,” says Mayne. “However, I don’t see it going altogether because with PE you don’t have an exit, so if you are a pension fund you can not sell it, so the best way to turn it over is to sell it back to the public. Good examples of this are Repco and Pacific Brands. Pacific Dunlop did a terrible job, ran them badly and flogged them off to PE, which fixed them up over two to three years and then re-listed to make investors five times their money.

“Where it gets worrying is when a healthy company gets taken over by a PE firm and it becomes all about financial engineering and greed, which is what is happening at the moment,” continues Mayne. “Qantas is a well-performing company and so is Coles, and for a PE firm to come in and offer $11 billion and $17 billion respectively is excessive. Also, having these companies that are important to society go private is a loss to the public.”

Twenty-five years ago there was a lot of cache in being the CEO of a PLC. But since the dot-com cowboys came, saw and sold out, this has been down-graded. Today, more and more talent is pouring into the investment banking and PE sector.

Mind you, a CEO of a big PLC can still make a fortune. Roger Corbert at Woolworths is now worth close to $100 million, as is Westpac’s David Morgan. Yet it is a fish bowl type of existence where even a minor utterance can move the share price.

TO LIST OR NOT TO LIST

Over 40 companies have de-listed from the ASX’s over the past six months, mostly seeking to break free of the additional costs and to avoid what James Packer recently described as “public market considerations”. After all, imagine if you didn’t have to produce annual reports and financial statements and keep up that continuous disclosure hoop lah. This, along with the ongoing pressure to deliver short-term results, makes de-listing an attractive option for many companies. And with huge swathes of private equity cash looking for a home there is ample opportunity for companies to de-list without the fear of the funding drying up.

One of the largest and most widely reported Australian public to- private transactions was AUSDOC, through ABN AMRO Capital. ABN shut down the failed mail business, sold the Australian courier business and split AUSDOC and Freightways, all the while investing heavily in equipment and facilities and remuneration incentives. Freightways was listed on the NZSX a year later for NZ$365 million, returning more than the original equity investment in the combined transaction. Not long after, AUSDOC was sold to a major competitor, Recall Australia, for $260 million, amongst a flurry of bids from local and offshore industry operations.

“The returns we generated would have been difficult to achieve had AUSDOC continued to trade as a public company,” says ABN AMRO Capital Managing Director Mr JP Kaumeyer. “We presented an appealing offer and were able to acquire and restructure the group’s prized subsidiaries, which were either subsequently re-listed or divested via trade sales.”

BLOOD MONEY

Generally, a private equity firm will use a mix of its own money and debt to reinvigorate the ailing company it has bought out, while focusing on creating a leaner, meaner entity, employing a lot of discipline and always being conscious of the debt hanging over its head like the sword of Damocles. When it feels that the business has achieved the most it can under its stewardship, it either sells it to someone else or re-lists it. As far as the profit metrics are concerned, the bottom line for managers in determining the appeal of a private equity investment is the internal rate of return (IRR), which sat at an industry average of about 25 percent a year or two ago, falling to 20 percent last year. This year, according to Deutsche Bank, investors should be happy with a 15 percent IRR due to the large size of deals last year and higher fees. Finally, to attract shareholders to sell, a private equity firm must offer a premium on the existing price, which varies but at present averages about 20 percent.

Australian private equity firms have been able to raise a lot of funds domestically, but for the big deals debt has played a large role, as seen in the Qantas, PBL and Seven deals involving the two leading US private equity firms, CVC and Kohlberg Kravis Roberts. Just like the lead banks in these deals, Australian banks hold little, if anything, of the loans on their own balance sheets, which ensures the risk of failure lies with the other institutions. Bankers have long and painful memories of the leveraged buy-out craze of the late 1980s that left them dangerously exposed.

Ralph Norris, Managing Director and Chief Executive Officer of the Commonwealth Bank, is resisting making an across-the board generalisation about PE and takes each case on its merits. “You have to look at what market the investment is in, the asset, the potential returns and look at the risks and their offsetting mitigants. I worry about the ones in very competitive and tight markets,” he told Lateline Business.

“At the moment, banks are lending with their ears pinned back, enabling private equity to pay premiums for PLCs,” says Stephen Mayne. “They are farming out the debt to the very same institutions that are buying up the equity and taking huge fees for their trouble. So with the benefit of gearing, particularly with the tax changes of last year, it is worth taking the risk of loading up your private equity bid because at the end of the day you can only loose your equity, you can’t loose your debt, so with the bank taking much of the risk it’s easier to double your money.”

There is no doubt that as a means of ownership PE is proving an attractive alternative to the PLC for many companies. If fact, it is now its own long-term, growing, global asset class. As a form of agency, it offers a litheness, adaptability and sexiness that the PLC can’t. Also, the circumstantial evidence seems to suggest that managers do better when they are held to account. PE offers a clear demonstration of the benefits of accountability.

However, rumours of the PLC’s death may have been mildly exaggerated, as there will be an inevitable rash of re-listing over the medium term, breathing life into the old girl yet. PE managers will need to be cautious, as the pillars holding up the PE playhouse – such as low interest rates, creative financial engineering, affordable capital and a leveraged bet on rising stock markets – can splutter and fail just as fast as they ignite.


CARROT AND STICK…

As revealed in a recent article in the Economist magazine, each PE firm has its own formula for distributing profits to managers who can make millions off a single deal. For example, at Sentinel Capital Partners in New York, as at most firms, managers are required to put in some of their own money as a sign of commitment. Up to 15 percent of a company’s equity is then made available to them. They get paid a third of that if they last at the company until the fund sells out. Another third comes their way if the fund earns three times its investment and the remaining third when it earns five times. In addition, Sentinel’s managers earn a basic salary and a bonus structured to reward profit growth and balance-sheet management.

VOICES FROM THE PAST…

“The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own…. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.”

– Adam Smith in the Wealth of Nations, criticising the corporate form because of the separation of ownership and management.

“Corporations, which previously had been considered artificial entities with no rights, were accorded all the rights of persons, and far more, since they are “immortal persons,” and “persons” of extraordinary wealth and power. Furthermore, they were no longer bound to the specific purposes designated by State charter, but could act as they choose, with few constraints.”

– Noam Chomsky, criticising the legal decisions that led to the creation of the modern corporation.


THE CASE FOR PRIVATE EQUITY…

Harvard Business School Professor Michael C. Jensen has argued the case for private equity since 1979, when he published Can the Corporation Survive, alongside academic colleague William Meckling. The release of his award winning paper Eclipse of the Public Corporation in 1989 cemented his reputation as a leading mind on the role of private equity.

Jensen’s main argument for the appropriateness of private equity, as a better way to run a business than a public listing, is that the private equity model ensures that the interests of shareholders and managers are aligned.

According to Jensen, the main problem with standard public companies is that chief executives have no bosses, and prefer for their performance to be measured against things over which they have the most control, such as the ability to implement cost reductions. While boards could, in theory, play ‘boss’ and execute control over the CEO, this is often regarded as unrealistic goal because most board members owe their position to the CEO.

Jensen’s views on why shareholders’ and managers’ interests may clash are among the most cited in economic literature. It has often been said that the proof of his theories, and the proof of the success of private equity as a model, can be derived from the fact that the top private equity firms have consistently generated profits substantially above the market average since the advent of a formalised private equity industry.

In a recent interview with The Australian newspaper, Jensen said:

There is no reason why the publicly held company can’t adopt virtually every single element of the new management model of the private equity firms, without going private. They could bring active investors on board and work out arrangements so the CEO would have a boss. They don’t have to leverage the company, but could get the CEO involved through equity or through loans. And yet they don’t do it. In short, the management and the shareholders would share the same interests. Both would stand to win or lose, entirely dependent on the value of the company.

Also talking to The Australian, Jensen makes the point that a major strength of private equity comes into play at the point of takeover. “ The management and the private equity buyers end up doing an enormous amount of due diligence. If it is well done, the management team and the private equity buyer will know more about the details of that company than has ever occurred in its history, other than when it was young under an entrepreneur.”

Jensen advocates getting active investors involved and in charge, using debt to enable management to take a substantial equity stake in the business and use the debt repayments to impose a discipline on the investing CEO.

THE CASE FOR THE PUBLIC COMPANY…

The advent of the public corporation changed the world, creating a structure where the ownership of business could be transferred from the few to the many, while also limiting personal liability, fuelling commerce and initiating new types of governance and protection for businesses and shareholders.

There is no doubt that the public corporation has made a positive difference to social welfare and the distribution of wealth (including the facilitation of superannuation) and much has been written about its egalitarian qualities and its fundamental importance to a free-market economy.

But what most company shareholders really want to know is, ‘What’s in it for me?’

By listing on a stock exchange a business gains access to a pool of institutional and retail investors and to the capital market. In short, a listing on a stock exchange allows a company to raise capital and use it to fund investment and growth. Even after a company is listed, it can continue to raise capital from the market, through the issue of new securities or through the issue of new types of securities.

The chief advantage of raising capital from the market is that it avoids some of the intermediation costs evident in the alternative forms of capital raising. Hence, it can be said that the market provides companies with capital at a lower cost.

A listing on a stock exchange can also add value to a company. A listing can enhance a company’s corporate stature and can advance brand awareness of company products. Furthermore, the enhanced profile, coupled with the greater transparency, can also enhance a company’s ability to borrow from traditional sources of capital. A listing can also be expected to add value to a company’s Employee Share Ownership Scheme.

Even Professor Jensen, leading advocate for the private equity model (see above), agrees that a listed company may be the most effective structure in growth industries, where profitable investment opportunities exceed the internal cash generated. In short, public companies are unlikely to choose growth projects that will be unprofitable.

Ultimately, a public listing offers one of the most common mechanisms for realising the value of a private company, including those owned by private equity funds. Improved liquidity is one of the biggest motivations for listing. If you can’t cash out, you can’t access a capital gain on your investment.

THE ‘ANTI-SOCIAL’ CORPORATION…

The 2003 Canadian documentary The Corporation gained international attention and acclaim by highlighting the ‘anti-social’ nature of public companies.

One central theme of the documentary was an attempt to assess the personality of a corporation, as if it were a ‘person’, by using diagnostic criteria from Robert Hare, a University of British Columbia Psychology Professor and FBI consultant.

The human characteristics of a corporation, according to Hare, are as follows:

  • Callous unconcern for the feelings of others
  • Incapacity to maintain enduring relationships
  • Reckless disregard for the safety of others
  • Deceitfulness: Repeated lying and conning of others for profit
  • Incapacity to experience guilt
  • Failure to conform to the social norms with respect to lawful behaviours

In other words, The Corporation compares the modern, profit-driven corporation to that of a clinically diagnosed psychopath.

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