With all of the discussion of late about the compliance costs of Sarbanes-Oxley, I thought Iâ€™d address a hypothesis that has been bandied around with increasing frequency about the relationship between SOX, going-private transactions, and private equity.
One might think that in the private equity world, there is a â€œperfect stormâ€? of sorts for a robust going-private market.Â As I have noted before, buyout funds have raised record amounts of cash in the last few years which they will need to deploy in a relatively short period of time (a fund generally seeks to invest most of its capital in its first 4-5 years).Â The downside is that a significant increase in the amount of private equity capital does not necessarily translate into a concomitant rise in going-private transactions, as the supply of buy-out â€œcandidatesâ€? should remain the same (all other things being equal).Â In fact, all of this private equity money could actually create a private equity â€œbubbleâ€? in which â€œtoo much money is chasing too few dealsâ€?Â (also known as the â€œLP-overhangâ€? problem).Â
But now enter Sarbanes-Oxley into the mix.Â As a number of studies suggest (see, e.g.,Â here, here, here, andÂ here), the significant compliance costs of SOX (especially Section 404) may very well be creating a greater supply of companies interested in going private than in the past.Â The result of these two developments?Â You guessed it:Â private equity firms should be funding many of these going-private transactions. Â Indeed, there is no shortage of press accounts (see, e.g., here, here, here) suggesting that this is exactly what is happening.Â
In actuality, I think the relationship between private equity, SOX and firmsâ€™ going-private decisions is much more complicated that these accounts suggest.Â For starters, just because a firm is â€œtaken privateâ€? by a buyout shop does not mean the firm is no longer subject to SOX.Â Consider, for instance, the following quote in a recent Business Week article that advances the hypothesis at issue:
At the same time that some companies may be looking to go private to avoid regulation, private equity firms are on an acquisition tear. In recent years, private equity firms have taken many previously-public companies private, including well-known names such as Hertz, Neiman Marcus, Metro-Goldwyn-Mayer, and Toys ‘R’ Us. These deals totaled more than $22 billion. Overall, private equity firms have spent more than $130 billion this year to date for the acquisition of public companies. With an additional $100 billion believed to be available to these firms, a lot more buying is likely.
This sounds like a pretty impressive connection between private equity, SOX and buyouts.Â The problem, however, is that these major buyouts did not necessarily make the companies immune from SOX.Â Only MGM is now truly a â€œprivate companyâ€? and no longer required by law to comply with the statute.Â Hertz, Neiman Marcus and Toys â€˜Râ€™ Us are all still subject to Section 12 of the Securities and Exchange Act of 1934, meaning that they must not only file their regular â€™34 Act reports but must still comply with all of the costly SOX requirements.Â Â Why?Â Because each firm issued hundreds of millions of dollars of public debt to finance the buyout (they arenâ€™t called â€œleveragedâ€? buyouts for nothing).Â Thus, it is only going to be buyouts that retire all publicly-traded securities that might have been driven by a desire to avoid SOX.Â This will exclude anyÂ LBO utilizing publicly-traded debt instruments, which means it will exclude most medium and large-scale buyouts.Â Because these transactions require the lionsâ€™ share of private equity capital, most private equity dollars will not be devoted towards helping firms escape SOX.
This still leaves buyouts of smaller companies, which are arguably the most adversely affected by the compliance costs of SOX and so should be the most willing to seek out private equity money.Â But this leads to the second problem with the hypothesis: even if a company truly â€œgoes privateâ€? with private equity dollars, it still canâ€™t ignore SOX.Â Â At some point, the buyout firm will need to liquidate its investment, which will require the firm to either (a) push the company towards an IPO, (b) push the company towards a cash acquisition, or (c) push the company towards an acquisition for publicly-traded securities.Â In scenario (a), the company will obviously need to be in compliance with SOX before consummating an IPO.Â Likewise with an acquisition by a public company in scenarios (b) or (c), certifiable SOX compliance by the target will almost certainly be a key aspect of the transaction. Â Of course, a company might let SOX compliance slide a little during its life as a private company, but the smart money will recognize the benefits of being â€œSOX-readyâ€? well in advance of an anticipated liquidity event.Â It is for this reason that the National Venture Capital Association has noted to the SEC that â€œfor many private companies with no immediate plan for offering stock to the public, SOX-compliance is still a necessity.â€?Â (The full text of the NVCAâ€™s comment letter to the SEC can be found here).Â
I donâ€™t mean to suggest that there is no connection between SOX, going-private transactions, and private equity.Â I simply mean to emphasize that to the extent there is a relationship, it is not necessarily as direct as it might appear.Â Â Â