Why Are More Companies Going Private?

The Financial Times reported yesterday, as its lead story, that a record number of companies had gone private in 2006, lowering the value of listed companies in the US:

The value of companies taken private reached record levels in 2006, with New York and London’s stock markets taking the brunt of the $150bn of de-equitisation, according to figures from Thomson Financial…..The value of companies taken private has almost trebled since 2004. The New York Stock Exchange saw a net withdrawal of listed capital of $38.8bn after public-to-private transactions are taken into account. Nasdaq suffered a net withdrawal of $11bn – almost twice its loss through de-equitisation in 2005.

Note that this data excludes repurchases, so the total “de-equitisation” is even greater.

While the London Stock Exchange beat every other world exchange in IPO activity due to its popularity with foreign companies, UK companies themselves also showed more buybacks than IPOs; $27 billion versus $19 billion. After including the effect of buybacks, the UK equity market shrank by 3%.

The article speculated why this is happening: cheap financing, perhaps the superior ability of private equity funds to recognize value. And we also have:

Consultants at McKinsey & Co, in a forthcoming bulletin to be published in January, conclude that public companies “will need to raise their governance game if they are to compete with private equity”.

While the average private equity investor produces returns that are only equal to those of stock markets over time, the top 25 per cent of them produce returns far in excess of that.

McKinsey forecasts that private equity could eventually rival public stock ownership in size if the disparity in governance remains. “That scenario presents a clear challenge to public companies and their boards; they simply must raise their governance game,” McKinsey concludes.

Ahem. It will be interesting to see what McKinsey means by “raising their governance game.”

But these explanations miss the chief culprit: public markets have become a hostile environment for corporations.

Stocks fall out of bed when companies miss earnings or revenue guidance. Concerns that don’t show enough growth are told either to improve margins (which usually leads to cost cutting, a short-term expedient that simply starves the enterprise) or to rid themselves of mature businesses, no matter how much cash they throw off, so that the remainder will garner a higher earnings multiple. And analysts are even lobbying for changes in areas once considered to be management’s purview, such as pricing, wage levels, and employee benefits, at successful, premium multiple companies.

Companies’ efforts to please the markets have gone to such extremes that they are damaging, not just to individual companies, but also to the economy as a whole.

Many organizations are deferring high-payoff projects simply to bolster current earnings. One example: a telecom cancelled an ad program to promote second phone lines to retail customers. These second lines are one of their most profitable services, and the past campaigns had an 11 month payback. But that isn’t attractive enough in the current environment.

Or consider how companies restructure themselves, either buying or selling businesses in the hope of showign better growth. Any reader of the business press knows that just about every academic study has found that most acquisitions fail (the typical finding is 60% to 75%). And some Wall-Street-pandering divestitures are misguided.

Consider the case of Big Pharma, starting with Bristol-Myers Squibb. The company, like many other pharmaceutical concerns, had a consumer products business to steady earnings and fund drug development.

Far and away, Bristol-Myers’s biggest cash generator was Clairol. Hair color is a license to print money. Former insiders tell me that even with aggressive attribution of Bristol overhead to Clairol, the fully-loaded product cost was less than a tenth of the wholesale price.

Bristol nevertheless sold Clairol in 2001 to Proctor & Gamble. This was at a time when, like most other large drug companies, Bristol had blockbuster drugs coming off patent and thus was under pressure in its core activities. Drug development, with its uncertainty, large bets on single products, and long time for payoff, is a poor candidate for external financing. Yet Bristol chose to divest Clairol when the prospects for cash generation within the pharmaceutical arena were declining, and the markets had become short-term oriented, and therefore a less attractive venue for funding.

Despite the dubious wisdom of Bristol’s move, other pharmas have gone down the same path. Pfizer sold Howmedica, its medical device business, in 1998 (admittedly the prospects for drug companies looked rosier then than now) and in December 2006 sold its consumer healthcare business to Johnson & Johnson. (Purists will argue that the capital asset pricing model says that rational investors will diversify their portfolios to eliminate specific risk, and it is inefficient for corporations to diversify in their stead. But the model assumes that all investors have access to the same information. Clearly, corporate insiders know more than investors about, in this case, the prospects for a particular drug under development. For competitive reasons, the company can’t tell all publicly. Investors may well discount a company’s belief in its various projects in the absence of full disclosure. Hence the desirability of funding internally.)

On a macro level, the corporate sector, which normally borrows to finance investment, has instead been a net saver since 2002, despite prevailing economic growth and low interest rates (preliminary data says this trend has continued in 2006).

To a considerable degree, this corporate savings has been achieved by clamping down on compensation and hiring. In all previous postwar recoveries, the lion’s share of economic growth went to labor compensation (increases in hiring, wages, and benefits) rather than corporate profits. This time, according to the National Bureau of Economic Statistics, not only is the proportion going to workers lower than ever before, it is the first time that the share of GDP growth going to corporate coffers has exceeded the labor share.

Corporations have fallen prey to a syndrome decried by Edwards Deming, the world-renown quality expert, namely, rigid adherence to “visible figures.” Ironically, for someone who had first established his reputation in statistical control, Deming was opposed to Peter Drucker’s notion of management by objectives, which argued that managers should be held to performance targets. One of Deming’s objections was that managers could miss their targets for reasons beyond their control – bad weather, a strike, an unforeseeable problem with a supplier. The only way for them to meet their goal would be to disinvest.

But the real question is why have corporations done this to themselves? Unlike the managers in an MBO system, they haven’t had performance targets imposed upon them by an unyielding boss.

Even though analysts and CNBC might make disappointing performance more visible than it was before, corporate executives are less likely than in the 1980s to be thrown out by hostile bidders. Despite the drum-thumping of the media, it rare when an outside group displaces a CEO, which is why the resignation of Home Depot CEO Bob Nardelli was so surprising (as footnoted.org points out, he hadn’t even met with Relational Investors). Mirable dictu, Hank McKinnell, like Nardelli, was also thrown out due to anger over his pay package, so these were both self-inflicted wounds. Phil Purcell of Morgan Stanley doesn’t count, for the “grumpy old men” were former insiders and managed to foment an exodus of key producers. Carl Icahn’s run at Time Warner was a joke, and Kirk Kerkorian’s attempts to shake up General Motors came to naught.

So why are companies running scared? There hasn’t been a major change in the legal framework of corporate governance, save Sarbox, which took place after short-termism was well established. Widespread criticism of CEO pay hasn’t led companies to behave better (the reversal of a couple of egregious cases does not yet constitute a real change). Why does negative press on performance produce a different reaction? Or is it a perverse consequence of option-linked compensation?

Perilously few companies have challenged the empty yet damaging authority of “what the markets want.” Although it seems the only thing these companies have to fear is fear itself, it appears easier for them to go private than take a stand.

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