While public company buyout, or “take-private”, transactions have been a staple activity for most large private equity firms, many traditional mid-market and smaller buyout firms have shied away from targeting public companies in their core buyout activities. According to a recent Schulte Roth report, there were only 20 take-private transactions between $100 million and $500 million from 2015 to 2017.
At the same time, the public markets have become increasingly inhospitable for small- and mid-cap companies given the high cost of being public and the Street’s lack of interest in small-cap companies. This has led to increasing interest on the part of small- and mid-cap public companies in evaluating the alternative of becoming a private company.
Why is it that many private equity firms have not entered the take-private realm, despite having such a favourable backdrop? Part of the answer lies in the fact that executing take-private transactions comes with a set of challenges that are unfamiliar to firms that operate predominantly in the private company arena. Acknowledging that certain challenges exist, we can examine approaches for successfully capitalising on opportunities that are increasingly presenting themselves among public company targets.
Take-private benefits for public companies
Being publicly traded has historically conferred numerous benefits, but the costs of being public outweigh the benefits for many companies. When we look at the reasons for companies to go private, some are obvious and well understood, while others are subtle but nevertheless impactful:
- Going private immediately removes public company costs. As a private company, these costs can be redeployed to more productive uses or eliminated altogether.
- Private companies do not have to deal with quarterly reporting, and management can shift to a value creation mindset optimised for the longer-term.
- Private equity incentive arrangements can unleash the productive and creative energies of management teams.
- Public markets disproportionately reward growth with high valuations, and vice versa. Being private can better align a company’s stage of life with capital structures and capital allocation priorities that are more appropriate for companies no longer operating in the sweet spot of their growth curves.
Challenges for private equity firms
Private equity firms accustomed to operating solely in the private company sphere may find that pursuing take-private opportunities presents some unfamiliar challenges.
Foremost among these challenges is a public company governance model that requires sale processes to maximise shareholder value while minimising potential shareholder liability. Firms accustomed to negotiating with a single owner or concentrated group of owners who can move without external scrutiny must adjust their expectations.
While value maximisation is generally no less important for private company sellers, the perception among potential buyers is that public company processes are less hospitable to the creation of “advantage” for any buyer, and many private equity firms view participation in public company processes as a suboptimal use of time and resources.
Another challenge is a sale process that may hinder relationship-building with company management. For private equity firms, creating alignment with company leadership in advance of signing a deal is critical to success. That opportunity is far narrower in a public company process where the need, from a governance hygiene standpoint, to wall management off from potential conflicts of interest is pronounced.
Fewer deal structuring options and limited ability to negotiate purchase agreement terms, which are important tools to manage risk for buyers, are also endemic to take-private deals. Moreover, navigating various technical requirements of public company processes may present additional obstacles.
Finally, in times of elevated public market valuations, the typical requirement to pay a premium over the current market price can make the required purchase valuation unattractive for typical private equity buyers. That said, it is just as often the case that private market valuations exceed public market valuations, given intense competition for deals in the private market.
Creating advantages in the take-private realm
It is very difficult to succeed in the take-private market if a firm is reactive and begins work only when the call comes in from a banker. Simply put, success requires private equity firms to be proactive.
- Proactive pre-work: Even though the process of selling a public company is generally designed to limit the advantages of any one bidder, that does not mean that a prospective bidder cannot create competitive advantages before a process begins. That advantage is typically created by proactively researching a target so that when a process begins, one is way ahead of other bidders in understanding the business, the critical value drivers and the key risks.
- Toeholds: One tool some private equity firms have successfully employed is toehold investments in a prospective target. A toehold investment allows a potential buyer, as a public shareholder, to get to know and build a trusted relationship with management by interacting through normal public investor relations channels. In addition, a toehold can be a catalyst for a private equity firm to do the type of pre-work needed to create an advantage.
- Special circumstances: In certain situations, being proactive can also open up the possibility of a bilaterally negotiated transaction with no formal process, but with a go-shop period – which allows a public company to seek out competing offers even after it has received a firm purchase offer. These are rare situations where a firm has insights, relationships and/or angles that enable it to persuade a public company board that it can credibly deliver a price that no one else is likely to match.
The desire of public companies to go private is a recurring phenomenon that is a natural off-ramp in the life cycle of companies. Private equity firms with the right proactive mindset and approach stand to capitalise on this stream of opportunities.
David Chung is an executive director at HGGC, a leading middle-market private equity firm based in Palo Alto with over $4.3 billion in cumulative capital commitments.