BY JOSEPH L. JOHNSON III

AND ANDREW J. WEIDHAAS

N IPO is the dream of everyentrepreneur who launches anew company. It is a symbolof success, and can bring with

it intangible benefits like prestige and market visibility. It can also produce tangible benefits such as a public currencythat can be used to acquire other compa-nies and motivate employees, and accessto the public capital markets tofund research and developmentand other capital expenditures.According to IPO.com, sincethe beginning of 1998, morethan 1,400 companies have gone public.

The management and ownersof many of these companies arerealizing that the crash of theU.S. equity markets has turnedthe dream into a nightmare, anightmare that probably is goingto last. Many of these companiesare beginning to revisit the benefits of a strategy that tookhold in the 1980s and had aresurgence in the late 1990s: thegoing private transaction.

Going private deals usuallytake the form of a leveraged buy-out. Aleveraged buy-out is the acquisition of anexisting public (or private) business by aprivate equity firm or other privateinvestor group, and is financed primarilywith debt and equity capital. Typically, theprivate equity firm provides the equityfinancing and arranges the debt financingfrom other sources. The target uses itsoperating cash flows to grow its businessand repay the debt that it has incurred infinancing the acquisition, and the compa-ny’s assets are pledged as collateral for thedebt. The typical strategy of the buy-out

firm in a leveraged buy-out is to buy a pub-lic company in a depressed market sector,rejuvenate the company’s managementand business while paying down the debt,and then exit at a higher valuation by taking the company public once again orselling it to a strategic acquiror.

This is not a new strategy. Leveragedbuy-outs received great notoriety in the1980s when corporate raiders like CarlIcahn and Michael Milken and his junkbond powerhouse Drexel Burnham began

hitting their stride. However, in the mid-to-late 1990s during the bull market,the number of going private transactionsdwindled year after year, reaching a low of25 deals announced in 1998, according toThompson Financial Securities Data.

However, in 1999 and 2000, a surge inprivate buy-outs occurred. According toThompson Financial Securities Data thenumber of going private deals announcedin 1999 was 36, and climbed to 51 in 2000.While this level of going private activitypales in comparison with the number ofdeals in the late 1980s (1988 and 1989

saw 340 and 303 deals announced, respectively), the number of dealsannounced in 1999 and 2000 representeda significant uptick from the 25 dealsannounced in 1998.

Going private deals in that period generally involved friendly bids fororphaned companies with small marketcapitalizations and little hope of attractinginstitutional investors in sufficient numbers to generate a high stock price andinvestor liquidity. At the same time asmoney was pouring into technology company stocks, these companies werewatching their stock prices sink to theirlowest levels in years. They were notenjoying the typical benefits of being a

publicly traded company on theNYSE or Nasdaq market. Sincegoing private transactions typi-cally involve a significantamount of leverage, these tradi-tional businesses with stablecash flows and balance sheetcash were ideal targets for goingprivate deals.

A ShiftingEnvironment

How times have changed.While the market orphans of1999 and 2000 remain viabletargets for going private transac-tions, the dramatic decline inthe equity markets has drivendown the stock price of many

more companies, including those in the once-thriving technology sector. Many ofthese companies in fact now have stockprices that reflect a lower enterprise valuethan that of the last pre-IPO round of private investment. Furthermore, unlikemany of the dot-coms that came to thepublic markets with high cash burn ratesand nothing more than a dream of one day achieving profitability, there is a significant number of technology companies that actually have mature busi-nesses with long-standing customer basesand real, predictable cash flows.

Have buy-out firms now embraced thetechnology sector? Not yet, although notbecause the companies are not good candidates for going private. Rather, thebuy-out firms largely have been unable to

The Going-Private Transaction

Joseph L. Johnson III is a partner in theBoston office of Goodwin Procter LLP, and Andrew J. Weidhaas ias a partner inthe firm’s New York office.

A

close any going private deals because thedebt financing markets have tightened.Buy-out firms use debt financing in going private deals in order to limit the amount of equity they provide andthereby achieve superior returns. In thecurrent market, institutional lenders are generally only providing debt financing at three times EBITDA (earnings before interest, taxes, depreciation and amortization), as compared to providing itat five or six times EBITDA a couple ofyears ago.

Furthermore, the types of companiesthat can secure any debt financing havebecome more limited. Lenders are lookingfor stable companies with strong cash flowsand established customer bases. As aresult, the number of going private dealsannounced in each of the first three quarters of 2001 has steadily declined,from six in the first quarter, to four in thesecond and two in the third quarter. So faronly one going private deal has beenannounced in this fourth quarter of 2001(data provided by Thompson FinancialSecurities Data).

According to Peter Weinbach, manag-ing director of AIG Horizon PartnersFund, L.P., the lack of debt financingmeans that one of the traditional strategiesof the buy-out firm — paying down debtover time with the target’s cash flow andthereby building a company’s equityvalue — is generally unavailable. Thatleaves buy-out firms in a position wherethey have to use more equity to get a dealdone. In order for such a deal to makesense, the buy-out firm has to believe thatit either will be able to grow the targetcompany’s cash flow or will be able toleverage the company at a later point intime. In the current economic environ-ment, those may be tough conclusions toreach. While some buy-out firms hope thatthe extra stimulus the Federal Reservegenerated a week after the terrorist attackswill help boost the economy and makebank regulators soften their credit posture,this has not yet happened.

The tight credit market and turbulent

equity markets have also increased thefocus on the “conditions” contained in thetypical going private merger agreementand financing documentation. The buyerwill typically insist on a “financing out,” orat a minimum a broad “material adversechange” clause that will allow the buyer towalk away from the deal if the availabilityor pricing of the debt financing or the target’s business or prospects have changed

as a result of events between the signingand closing of the deal. The target, on theother hand, will resist a financing out andseek a material adverse change clause thatis tied solely to its recent performance. Atconflict in this debate is the target’s desirefor certainty that a deal will be closed oncepublicly announced and the buy-outgroup’s need to be protected from subsequent changes that affect the under-lying economic rationale for the deal.

The importance of this debate has beenhighlighted by the events of Sept. 11 andthe impact those events have had on operating companies and financial mar-kets, as well as by the decision in the TysonFoods case in which Tyson was ordered toproceed with its $4.7 billion acquisition ofIBP Inc. despite a significant drop in IBP’sprofitability. The judge in that case ruledthat the drop in profitability was not a sufficiently dramatic change in IBP’s business to trigger the material adversechange clause in the agreement.

Other Factors in Play

Another factor that has kept going

private transactions on the sidelines hasbeen the unwillingness of companies toaccept the long term reality of their stockprices. Many potential sellers have beenwaiting for the fairy tale prices to return.There is now a growing sense that ownersare acknowledging that we may never see those prices again, so the time for buyers and sellers to meet again may be approaching.

Also, going private transactions take along time to complete. At a time whenevery CEO in the country is complainingabout his or her ability to predict futureearnings, it is difficult for buy-out firms tocommit themselves to a process that maytake six months to complete, if it is completed at all.

A typical deal will require approval byboth the Board of Directors and a specialcommittee of the Board as well as by thestockholders of the company. At the Boardlevel, the need for the Board to exercise itsfiduciary duties adds time, complexity andexpense to a deal. The Board has so-called“Revlon” duties to obtain the best dealreasonably available to stockholders. Inthis situation, the special committee struggles with whether it should enter intoexclusive negotiations with a buy-out firmsupported by management or hold a broader auction for the company. Oftenthe buy-out firm will threaten to pull outof the deal if an auction is held.

The special committee and its advisermust determine if there is the possibilitythat a strategic buyer would be interestedin the company. Buy-out firms are constrained in the price they can pay for acompany by limitations on prudent debtlevels and certain minimum returns oninvestments that their investors desire.This limit has been exacerbated lately bythe tight debt financing market. Because aspecial committee and its financial advisorcan assess the upper limits that a buy-outfirm can pay, a special committee will consider whether there exists a possiblestrategic buyer who will not be bound bythese constraints. Often, special commit-tees may resist providing the buy-out group

—————————Many … companies are beginning to revisit thebenefits of a strategy that

took hold in the 1980s and had a resurgence in

the late 1990s: the goingprivate transaction.

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NEW YORK LAW JOURNAL Tuesday, November 13, 2001

MERGERS & ACQUISITIONS

with this exclusive negotiation right until it has checked with potential strategic buyers.

Also adding to the time it takes to complete a going private deal is theSecurities and Exchange Commission filing and review process. Prior to soliciting the consent of the company’sstockholders, depending on the nature ofthe going private deal, the company mustfile with SEC the Schedule 13E-3 (Rule13-E3 Transaction Statement pursuant to§13(E) of the Securities Exchange Act of1934) and the Preliminary ProxyStatement (filed on Schedule 14A). Thedetailed disclosure required in thePreliminary Proxy Statement and inSchedule 13E-3 is then subject to SECcomments, which can lead to multipleamendments to the filings and is a processthat in itself can take two to three monthsto complete.

Even if a company and its going privatesponsors carefully document each step inthe decision-making process, carefullydelineate and implement the role of thespecial committee, and provide full anddetailed disclosure, it is still likely that the transaction will result in litigation.This litigation risk is another factor in thelong litany of issues that cause many buy-out firms to shy from going privatedeals, particularly in the current market environment.

While the buy-out firms are largely staying away from going private deals thesedays, there are scenarios in which thegoing private transaction may make sensefor a company. For example, the Board ofDirectors of a company with a largeamount of cash on its balance sheet mayconclude that returning the cash to itsshareholders is a better use than investingit in projects that will have little or noimpact on the company’s stock price. As opposed to a cash dividend, a going private transaction can be a tax-efficient method of getting the cash into the shareholders’ hands.

Private Company Benefits

As the credit and equity markets beginto stabilize and recover, for many of thecompanies that are appropriate targets forgoing private deals, the advantages ofbeing a private company should begin totip the scales in favor of going private.These advantages include the following:

Lower Legal, Accounting and PRCosts. The typical small capitalizationpublic company can easily spend up to $1 million per year in legal, accountingand public relations costs. These costs are largely driven by SEC disclosurerequirements, securities filings, annualreports and by increased plaintiffs’ law-suits, as well the additional staff requiredto interface with a public company’s share-holders. By going private, such a companycan expect to save between $200,000 and$300,000 per year by reducing these costs.

Out of the Public Spotlight. Due to theSEC disclosure requirements, a publiccompany is forced to disclose to the public sensitive information that its competitors, customers and suppliers canuse against it. Aside from the competitiveissues, the preparation of such disclosureand its presentation to analysts, portfoliomanagers and the press requires valuablemanagement time. Once out of the publicspotlight, management can return its fullattention to the company’s business, itsvendors and its customers.

Ability to Focus on the Long Term.Public companies are often forced to focuson quarterly results, as opposed to long-term goals and strategies. For smallercompanies trying to attract and retain analyst coverage, missing a single quarter’snumbers may mean the difference betweensolid or no coverage. These companies aretherefore often faced with the dilemma ofpostponing promising long-term projectsthat may have a negative impact on theshort-term numbers. Over time, manycompanies find that this type of decision-making can lead to stagnation of their

growth. By going private, a company isable to return to the appropriate mix ofshort- and long-term goals that positionedthe company to reach the public marketsin the first place.

Taking the Company Off the Block. Apublic company with a low price to earnings ratio is always a candidate for asale, which may be unattractive to its management given the depressed sale pricethe company may be forced to accept froma public suitor. If management believes itcan structure a better long-term deal byfirst going private and retaining more equity, they may want to take the preemptive step of taking the company offthe public company block, although thereis the risk of the third-party bid in the middle of the process.

Conclusion

While the going private market hasclearly cooled due to the confluence of thelack of debt financing and the structuralissues that make going private unduly riskyin this turbulent market, it would appearthat going private deals are poised for aresurgence as the financial marketsrebound and buy-out firms are able to better judge the business prospects of target companies.

The number of companies that wouldconsider, or be considered for, a going private transaction has likely increased asmany companies that once benefited fromthe bull market of the 1990s have joinedthe list of those with languishing stockprices, low market capitalizations and lowtrading multiples. The companies in theindustry sectors that remain unfavorable asthe market rebounds, and that have capable management, strong cash flowsand cash on the balance sheet, will be presented with the decision whether toregain the advantages of being a privatecompany. Many of these may choose toreturn to private status, where they canthen once again dream of an IPO one day.

NEW YORK LAW JOURNAL Tuesday, November 13, 2001

MERGERS & ACQUISITIONS

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