What does it mean when a sizable publicly traded company is taken private? The answer, of course, depends on how one responds to a follow-on question: What does it mean to whom?
For shareholders, the answer seems fairly straightforward. Typically, when a company has become a bona fide target for takeover, the value of its shares increases smartly. Surges of between 20 and 50 per cent are not uncommon, and final takeover premiums can exceed even that. Takeover firms typically target companies that they believe have pent-up value that the new ownership structure can release.
For other stakeholders, however, a pending change in ownership often opens up the possibility of a fundamental shift in the risk profile of their positions without any explicit promise of a compensating upside. Perhaps the most telling evidence of this is that it's not uncommon for the target company's bond price to fall, sometimes precipitously, even as the stock price climbs.
When bond markets effectively downgrade companies that are in the sights of private equity (PE) firms, they are saying that the company has become riskier. A lower bond rate effectively raises the coupon rate, and higher interest rates are one price a company pays for the risk it incurs.
Conversely, the increase in share price can be seen as a reflection of anticipated lower risk for equity investors expecting a given rate of return. (Alternatively, it can be seen as an increase in anticipated returns for a given level of risk, but these are computationally equivalent in expected value terms.)
One interpretation of this risk inversion is that bond markets typically expect new ownership to extract sufficient cash from their new properties to deliver a suitable return on their investment, but in so doing these same firms might be less likely to be able to retire their debt obligations.
It would be a mistake to see all PE investments in these terms. Some PE funds acquire relatively small startup companies and are in it for the long haul. They invest in research and development, product development, new market entry and all the other activities required to create great new companies. These investments realize a return when the company subsequently is taken public as a growing, successful organization with a bright future.
Other PE investments have a very different justification. Some acquirers focus on companies with stable cash flows that are being squandered by spendthrift management on empire building and the perquisites of power. In these cases, the new ownership tends to put a new management team on a short leash, making sure that the cash thrown off by the business ends up in shareholders' hands.
Of late, however, we've seen what might be a new kind of PE investment. Some of the companies being acquired – in such sectors as telecommunications, publishing and transportation – have a core franchise with stable cash flows, and are led by prudent management teams. They are neither startups nor deep into flabby senescence. Their problem is strategic risk. Whether it is a newspaper's efforts to create a platform for user-generated content or a telecom company's struggles with voice over Internet protocol, or an auto maker's struggles with alternative fuels, existing management teams have not shown profligacy, but rather a desire to re-invent their old-school companies in the face of ubiquitous, undeniable, yet strangely nebulous strategic uncertainty.
What the bond markets seem to be telling us is that the kind of focus necessary to deliver the return on equity that PE funds tend to insist upon will make it that much more difficult for acquired companies to address successfully the strategic risks they face.
In well-managed companies, the core franchises will no doubt be able to continue throwing off cash for years to come, but only if they stop investing in the fundamentally new strategies required for long-term viability. And the smart money would appear to believe that for many companies, looking the same in 20 years as they do today is a recipe for not being able to pay the bills.
Bondholders, of course, are relatively liquid – they can sell, if at a loss, to investors with a bigger appetite for risk. They also tend to be fairly diversified; it would be rare to find an investor whose entire portfolio consists of a single company's 20-year bonds.
Other stakeholders, however, aren't nearly so lucky. Employees and customers typically have neither the liquidity nor the diversification to mitigate the increased risk they might face as a result of any change in a company's risk profile. Where is their increased upside to compensate for the increased risk they had no say in taking on?
PE firms rarely seek to strip-mine their investments for free cash flow and leave a rusting hulk on the beach when the gig is over (to rather aggressively mix my metaphors). But the impact of takeovers by PE firms need not have such an extreme complexion to merit closer analysis.
What would make sense is for there to be an explicit conversation among the board members of a targeted company about precisely what are the new owners' intentions for the strategic future of the company. What are the strategic risks the company faces, and what will the new owners do to address them? Several current PE targets have been led by management teams that have taken considered and reasonable steps to position their companies for the future. If new ownership intends to manage similarly with an eye to long-term survival and prosperity, it would help if they could fill in the board on what they see that current management has missed.
There is nothing legally or morally questionable about extracting value from an acquired company (rather than building it). But it does seem that there is an obligation to ensure that those affected by a material shift in future prospects are informed, and so able to respond accordingly. Just as bondholders bid down the principal to increase their interest rates, I wouldn't be surprised if employees at targeted companies demand higher wages and stronger pension guarantees to increase their returns in compensation for the new risks they now face. After all, the promise of greater wealth in exchange for accepting greater risk is the bedrock of capitalism, which in turn rests on efficient markets for both risk and return.
Michael E. Raynor is a Distinguished Research Fellow with Deloitte Consulting LL. He is also author of the recently released The Strategy Paradox: Why committing to success leads to failure [and what to do about it], an examination of how to identify and manage strategic uncertainty. See thestrategyparadox.com. He lives in Mississauga, Ont.
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