Always yummy, Abnormal Returns (with whom we seem to be having a torrid affair involving the exchange of multiple links) notes Bobby Bartlett over at "Truth on the Market" suggesting that the pull towards private transactions that Sarbanes-Oxley exerts is perhaps less dramatic than we might think. I think there are some flaws in his analysis. Specifically, he comments that:
One might think that in the private equity world, there is a “perfect storm” 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 “candidates” should remain the same (all other things being equal).
This ignores the pricing effect of the wash of cash out there today. The surplus of free capital for buyout deals pushes up valuations as more cash chases more marginal deals and cash in good deals is so cheap and easy to come by that it's much easier to bid another 10%, 15% and even 20% for a firm. Bartlett assumes here that supply stays the same but forgets to account for the marginal case firms that are "near misses" for a buyout at 7.5x EBITDA, but are "slam-dunks" when the owners can get 8.5x EBITDA. Multiples are way up and to believe that this isn't pulling people into deals they would not otherwise have done is to put your head in the sand. It is like any other supply-demand relationship. When the price goes up, the incentive to enter the market with your inventory goes up as well.
(Mr. Bartlett rightly points out to me that he noted this "deal supply" assumption as just an assumption in his entry and that his comments are more geared towards debunking the silly Business Week assumption that all LBO's are about SarOx avoidance).
For starters, just because a firm is “taken private” by a buyout shop does not mean the firm is no longer subject to SOX.
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.
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-ready” 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."
The problem here is that none of these firms with public debt ever intended to reduce (or cared much about) SarOx costs. To argue somehow that SarOx is not a major driving factor in buyout expansion, you have to look at firms that would not have gone private but-for SarOx, not firms that would have gone private regardless.
This argument also ignores the potential value of not committing to SarOx. Assuming, for a moment, that "first time" SarOx costs are 150% of ongoing SarOx costs, let's do some math.
Take a $250 million LBO. By no means does this sort of transaction require a resort to public debt (and therefore SarOx costs). Let's assume that, unlike some of the nearly "Magic" 18-months-to-IPO deals that have floated around lately, the exit via IPO is in year 7 (a much more reasonable timeframe). The Corporate Roundtable predicts annual 404 compliance to cost about $2 million per year for such a firm. Assuming that this additional $2 million is applied to debt service, and that SarOx compliance is begun with the 150% adjustment the year before an IPO liquidity event (first year compliance difficulities), how much is lost/saved by not SarOxing until the last minute?
Well, I threw together a VERY quick and VERY dirty model probably filled with errors but based on the following assumptions:
1. $250 million LBO with $50 million in equity.
2. 7 year mandatory amoritization on the senior debt.
3. No restriction on favoring junior tranches with optional repayments (some lenders prefer that all the senior be retired before the junior can be addressed).
4. Exit is at exactly the same multiple as paid at acquisition.
5. No revenue growth.
So how much do you save by not spending $12 million extra on SarOx for 6 years?
$26.8 million. $19.98 million. (Thanks to JR for catching a double count).