Foundations of Financial Management: An Analysis (part 57)

“Wealth is not about having a lot of money; it’s about having a lot of options.” 

– Chris Rock

Investment Banking (part C)

by

Charles Lamson

Public versus Private Financing

Our discussion to this point has assumed the firm was distributing stocks or bonds in the public markets (through the organized exchanges or over-the-counter). However, many companies, by choice or circumstance, prefer to remain private---restricting their financial activities to direct negotiations with bankers, insurance companies, and so forth. Let us evaluate the advantages and disadvantages of public placement versus private financing and then explore the avenues open to a privately financed firm.

Advantages of Being Public

First of all, the corporation may tap the security markets for a greater amount of funds by selling securities directly to the public. The greatest pool of funds is channeled toward publicly traded securities. Furthermore, the prestige of a public security may be helpful in bank negotiations, executive recruitment, and the marketing of products. Some corporations listed on the New York Stock Exchange actually allow stockholders a discount on the purchase of their products.

Stockholders of a heretofore private corporation may also sell part of their holdings if the corporation decides to go public. A million share offering may contain 500,000 authorized but unissued corporate shares and 500,000 existing stockholder shares. The stockholder is able to achieve a higher degree of liquidity and to diversify his or her portfolio. A publicly traded stock with an established price may also be helpful for estate-planning.

Finally, going public allows the firm to play the merger game, using marketable securities for the purchase of other firms. The high visibility of a public offering may even make the firm a potential recipient of attractive offers for its own securities. (This may not be viewed as an advantage by firms that do not wish to be acquired.)

Disadvantages of Being Public

The company must make all information available to the public through SEC and state filings. Not only is this tedious, time-consuming, and expensive, but also important corporate information on profit margins and product lines must be divulged. The president must adapt to being a public relations representative to all interested members of the securities industry.

Another disadvantage of being public is the tremendous pressure for short-term performance placed on the firm by security analysts and large institutional investors. Quarter to quarter earnings reports can become more important to top management than providing a long-run stewardship for the company. A capital budgeting decision calling for the selection of Alternative A---carrying a million dollars higher net present value then Alternative B---may be discarded in favor of the latter because Alternative B adds two cents more to next quarter's earnings per share.

In a number of cases, the blessings of having a publicly quoted security may become quite the opposite. Although a security may have had an enthusiastic reception in a strong "new-issues" market, a dramatic erosion in value may later occur, causing embarrassment and anxiety for stockholders and employees.

A final disadvantage is the high cost of going public. For issues under a million dollars the underwriting spread plus the out-of-pocket cost may run in the 15 to 18 percent range.

Private Placement

Private placement refers to the selling of securities directly to insurance companies, pension funds, and wealthy individuals, rather than through the security markets. This financing device may be employed by a growing firm that wishes to avoid or defer an initial public stock offering or by a publicly traded company that wishes to incorporate private funds into its financing package. Private placement usually takes the form of a debt instrument.

The advantages of private placement are worthy of note. First, there is no lengthy, expensive registration process with the SEC. Second, The firm has greater flexibility in negotiating with one or a handful of insurance companies, pension funds, or bankers than is possible in a public offering. Because there is no SEC registration or underwriting, the initial costs of a private placement may be considerably lower than those of a public issue. However, the interest rate is usually higher to compensate the investor for holding a less liquid obligation.

Going Private and Leveraged Buyouts

Throughout the years, there have always been some public firms going private. In the 1970s, a number of firms gave up their public listings to be private, but these were usually small firms. Management figured it could have several hundred thousand dollars a year in annual report expenses, legal and auditing fees, and security analysts meetings---a significant amount for a small company.

And the 1980's and 1990's, however, very large corporations began going private and not just to save several hundred thousand dollars. More likely they had a long-term strategy in mind.

There are basically two ways to accomplish going private. A publicly owned company can be purchased by a private company, or the company can repurchase all publicly traded shares from the stockholders. Both methods have been in vogue and are accomplished through the use of a leveraged buyout. In a leveraged buyout, either the management or some other investor group borrows the needed cash to repurchase all the shares of the company. After the repurchase, the company exists with substantial debt and heavy interest expense.

Usually management of the private company must sell assets to reduce the debt load, and a corporate restructuring occurs, wherein divisions and products are sold and assets redeployed into new, higher-return areas. As specialists in the valuation of assets, investment bankers try to determine the "breakup value" of a large company. This is its value if all its divisions were divided up and sold separately. Over the long run, these strategies can be rewarding, and these companies may again become publicly owned. For example, Beatrice Foods went private in 1986 for $6.2 billion. One year later it sold various pieces of the company---Avis, Coke Bottling, International Playtex, and other assets worth $6 billion and still had assets left valued at $4 billion for a public offering. Leslie Fay, an apparel firm, bought its shares for $58 million in 1982 and a number of years later resold them to the public for $360 million.

However, not all leveraged buyouts have worked as planned. Because they are based on the heavy use of debt, any shortfall in a company's performance after the buyout can prove disastrous.

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 449-454*

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