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Thanks and a Further Note on the Regulation of Private Equity

Bobby Bartlett —  26 April 2006

I’d like to thank everyone at Truth on the Market for allowing me the opportunity to guest-blog over the past two weeks. I’ve really enjoyed the chance to share some of my thoughts and contribute in some way to this wonderful forum.

Before departing, I wanted to tie-up a loose end that I left dangling in my earlier post on private equity regulation (I’m sure folks have been up nights awaiting resolution of this issue). As my prior post discussed, I generally find little merit in the recent calls for subjecting the private equity industry to greater regulatory oversight. (You can read my prior post here). I suggested, however, that there are some market imperfections in the private equity industry that may merit some reform. What are these market imperfections? In general, they are the information asymmetries that result from the challenge of valuing privately-held corporations. Continue Reading…

In Financial Regulation, Google, Platforms, Regulation, Truth on the Market ,
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Update on the SEC’s Authority to Exempt Small Issuers from Section 404 Compliance

Bobby Bartlett —  21 April 2006

The momentum seems to be building among legal academics that the SEC may lack the authority to exempt small companies from SOX 404 compliance.  As many may recall, Bill previously analyzed this issue in the inagural post of this blog and concluded that the SEC most likely did not have the requisite statutory authority (he provided a follow-up analysis here).  Larry Ribstein shares this sentiment.  Apparently, they are not alone. Â

Yesterday, the SEC Advisory Committee on Smaller Public Companies concluded its deliberations and approved a draft Final Report to be submitted to the SEC next week.  The Final Report continues to recommend exemptive relief from Section 404 for certain small-cap and micro-cap issuers.  However, I found interesting a revision from the prior draft in the discussion concerning the SEC’s authority to promulgate an exemption.  Specifically, footnote 110 notes that “a different view as to the Commission’s authority under Section 36(a) was expressed in a letter from Professor James D. Cox and 19 other law professors, although the professors acknowledged that ‘[s]pecific disclosure requirements tailored to the unique risks and likely regulatory benefits of smaller public companies are entirely appropriate and consistent with the rulemaking authority the Commission enjoys under Section 3(a) of the Sarbanes-Oxley Act.'”  Sadly, the letter doesn’t cite Bill’s analysis, but it is still worth a read. It can be found on the SEC website (see here).  Â

In Corporate & Securities Law, Truth on the Market
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Is Sox Encouraging Companies to Go Private with Private Equity?

Bobby Bartlett —  19 April 2006

With all of the discussion of late about the compliance costs of Sarbanes-Oxley, I thought I’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 “perfect stormâ€? of sorts for a robust going-private market.  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).  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 “candidatesâ€? should remain the same (all other things being equal).  In fact, all of this private equity money could actually create a private equity “bubbleâ€? in which “too much money is chasing too few dealsâ€?  (also known as the “LP-overhangâ€? problem).Â

But now enter Sarbanes-Oxley into the mix.  As a number of studies suggest (see, e.g., here, here, here, and 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.  The result of these two developments?  You guessed it:  private equity firms should be funding many of these going-private transactions.  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 firms’ going-private decisions is much more complicated that these accounts suggest.  For starters, just because a firm is “taken private� by a buyout shop does not mean the firm is no longer subject to SOX.  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.  The problem, however, is that these major buyouts did not necessarily make the companies immune from SOX.  Only MGM is now truly a “private company� and no longer required by law to comply with the statute.  Hertz, Neiman Marcus and Toys ‘R’ 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 ’34 Act reports but must still comply with all of the costly SOX requirements.   Why?  Because each firm issued hundreds of millions of dollars of public debt to finance the buyout (they aren’t called “leveraged� buyouts for nothing).  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.  This will exclude any LBO utilizing publicly-traded debt instruments, which means it will exclude most medium and large-scale buyouts.  Because these transactions require the lions’ 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.  But this leads to the second problem with the hypothesis: even if a company truly “goes privateâ€? with private equity dollars, it still can’t ignore SOX.   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.  In scenario (a), the company will obviously need to be in compliance with SOX before consummating an IPO.  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.  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 “SOX-readyâ€? well in advance of an anticipated liquidity event.  It is for this reason that the National Venture Capital Association has noted to the SEC that “for many private companies with no immediate plan for offering stock to the public, SOX-compliance is still a necessity.â€?  (The full text of the NVCA’s comment letter to the SEC can be found here).Â

I don’t mean to suggest that there is no connection between SOX, going-private transactions, and private equity.  I simply mean to emphasize that to the extent there is a relationship, it is not necessarily as direct as it might appear.  Â

In Corporate & Securities Law, Financial Regulation, Truth on the Market ,
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So much for disclosure of executive pay…

Bobby Bartlett —  13 April 2006

For those interested in following the latest in executive compensation, you might find interesting today’s New York Times story on Lee Raymond’s retirement package at Exxon.  The Times values the package at $398 million—one of the largest payouts ever (the top payout being the $550 million paid to Michael Eisner in 1997).  Among the retirement perks include Exxon’s continued payment of Raymond’s country club fees, use of the company aircraft, and a one-year consulting gig (paying $1 million).  Not surprisingly, the Times is quite critical of the arranagement.Â

Given that Exxon reported the largest annual corporate profit in history last year ($36 billion), the package seems at first blush plausibly more defensible than a number of packages the Times has criticized of late.  In any event, I’m hardly in a position to pass judgment on its merits.  (Of course, as an investor in Vanguard’s 500 Index Fund, I probably should at least try:  Vanguard holds 1% of Exxon, meaning I paid almost a dollar towards Raymond’s payout.  Hey, Lee, the next 1/3 gallon of premium is on me!)

What I find interesting is that Exxon was all too willing to pay—and defend—the package given the virtual certainty it would get slammed in the press.  This is not the time for Fortune 50 companies to slip over-sized executive pay packages into the back of a proxy statement.   They will get noticed—and publicized.  All of this seems to confirm the comments of Charles Elson of the University of Delaware that additional disclosure of executive pay “is like aspirin; it can make you feel a little better, but it can’t even cure the common cold.â€?  In an interview in last Sunday’s Times, Elson elaborated on this statement in the following exchange:

Q [Times]. Public humiliation has been an effective tool ever since the Pilgrims and the public stocks. Why don’t you think that disclosure of excessive pay will make executives think twice before demanding it and directors think three times before granting it?

A [Elson]. Anyone who isn’t embarrassed to ask for $100 million isn’t embarrassed if it is disclosed. And directors assume that shareholders think of the board as a group of generic directors, and will get mad at the board as a whole for signing off on the package, rather than try to assign blame to a specific name.

It’s almost as if he were anticipating Exxon’s announcement.

In Corporate & Securities Law, Truth on the Market ,
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Regulating Private Equity

Bobby Bartlett —  11 April 2006

Thanks to everyone here at Truth on the Market for inviting me to guest-blog for the next couple of weeks. As I mentioned during my stint on the Conglomerate, one of my primary areas of research is private equity, so as before, I’ll be focusing a fair amount on developments in the exciting world of buyouts and venture capital.

To begin, I’d like to comment on yesterday’s story in the Financial Times regarding the formation of a “trade body� to represent the interests of the world’s largest buyout firms. The initiative appears to be in the early phases of development and is being spearheaded by four of the major players in the industry— Blackstone, Carlyle, KKR, and Texas Pacific Group. As the story notes, the move appears to be in response to growing concern among public policymakers and journalists about the growth of private equity and a sense that increased regulation of the industry may be a distinct possibility.

The notion that private equity should be subjected to greater regulatory oversight is hardly new. In fact, calls for increased regulation of the industry have been circulating for some time now. Recently, however, it seems the voices have gotten a lot louder. Hardly a week goes by without some reference to it (for last week’s reference, see here), and no less a bastion of capitalism than Forbes has contributed to the discussion in a rather scathing article on the subject last month (article here). Why all the fuss? Part of the clamor seems to echo the concerns voiced during the buyout frenzy of the 1980s that LBOs ultimately harm employees and communities through layoffs that often follow an LBO (this seems especially true of the criticisms voiced overseas in Germany and France). Other critics focus on the secretive nature of LBO firms and their proclivity for keeping their operations under the radar. For many, this is especially troubling considering how much money is being poured into private equity. As Forbes noted, “globally, 2,700 funds are raising half a trillion dollars in cash to invest; this will bankroll them for $2.5 trillion in deals, given their penchant for putting $4 (or more) of debt leverage atop every dollar they put up.� Add to this the occasional bad buyout deal (e.g., TH Lee’s Refco debacle) and the conclusion seems obvious: the industry needs more regulation to avert a catastrophic meltdown.

To be sure, there are definitely some market imperfections in the private equity industry that should be addressed (more on these later). What concerns me with the current discourse is that the primary criticisms almost always boil down to the same thing: buyout firms are raising too much money (much of it from pension funds) to exist without meaningful regulation. The mere fact that buyout firms are raising record levels of funds, however, says little about why this might be a regulatory problem. Likewise, it says nothing about what regulatory response might be needed (if any). Is there a market failure that results in “too much� money going into private equity? If so, it seems we would be better off trying to isolate this problem at its source (e.g., perhaps we need to reexamine our prudent investor standard). Likewise, if there are problems with favored LBO techniques (e.g., dividend recapitalizations, etc.), why not address these transaction structures directly (just as Congress did in the 1980s with two-tiered tender offers)?

In short, before we talk about regulating private equity, we need a lot more precision in understanding exactly what (if any) problems are posed by the current private equity market and the best means to address them. Otherwise, I fear ending up with another set of hedge fund investment advisor regulations: regulations that give the appearance of providing oversight of a growing industry, but which are of questionable effectiveness.

In Financial Regulation, Truth on the Market
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