Going Private

When Texas utility TXU agreed in February to be taken private by Kohlberg Kravis Roberts, Texas Pacific Group and the private equity arm of Goldman Sachs, the $45 billion cash-and-debt deal was the largest private equity transaction in history. Environmentalists like the environmental concessions that come with the deal, and the utilities’ residential customers like the promised 10 percent price decreases. Sometimes, though, the process for going private can be expensive and confusing, perhaps leading to litigation from unhappy shareholders.

With the amount invested in private equity at a record high, there are likely to be even more transactions in the near future. A long list of companies are on private equity groups’ radar screens. But while there may be an opportunity for considerable gain for companies going private, boards and management have a responsibility to maximize value and act in shareholders’ best interests. Therefore, many boards may find themselves examining the costs and benefits of taking their company private. The process is not easy and while the benefits may be considerable, so are the risks.

A ‘going private’ transaction differs from ‘going dark’, where a company deregisters its securities and delists its shares. Generally, a going private transaction involves a change in control of a company. Regulatory filings are significant and there are also considerable transaction costs (the costs of accountants and lawyers) and acquisition costs or prices. Lots of time goes into the preparation and analysis of these transactions before they are ever executed. 

Doing it right

So what’s the process, what are the issues and what are the potential road bumps?

A 13E-3 going private transaction is a transaction involving a company and one or more of its affiliates that is intended to, or will: limit the number of shareholders of record (as opposed to beneficial holders) of any class of equity securities of the target that are registered under the US Securities Exchange Act of 1934 to less than 300; or cause any class of equity securities of the target listed on a securities exchange or on an inter-dealer quote system of a registered national exchange to be neither listed on any national exchange nor on an inter-dealer quote system of any registered national exchange.

Rule 13E-3 going private transactions are usually structured as a merger or tender offer and sometimes involve a reverse stock split. Using a merger or tender offer necessitates that the company have capital sufficient to acquire the outstanding shares. The company must amend its articles of incorporation, create proxy materials and seek shareholder approval. Proxy disclosures must include the fact that management intend to take the company private. 

SEC filing requirements include a Schedule 13E-3 transaction statement before going private. This does not displace other filing requirements. In a transaction involving the filing of a proxy statement, information statement or registration statement, this filing is made concurrently. In a tender offer, the filing should be made as soon as practicable on the date the tender offer is first published or is sent to security holders.

Devil in the details

Getting filings in on time is crucial, but so is good disclosure. A frequent question is who must make the required disclosures, especially those ‘reasonable belief’ disclosures reviewing the fairness or unfairness of going private. In certain cases the SEC believes that target management or other third parties who may play no role in the transaction may have to report on whether the proposed buyout is fair to the company’s public shareholders.

Senior managers of the company going private are viewed as affiliates. In some circumstances, these management affiliates may be perceived as engaged in the transaction, and therefore required to file a separate Schedule 13E-3. The SEC staff look at whether management will be in a position to ‘control’ the surviving company. Do they hold a material amount of outstanding equity? Do they hold board seats, in addition to their management positions?

Questions also arise when an acquirer creates a merger subsidiary or other acquisition vehicle. The SEC staff may well ‘look through’ the acquisition vehicle. This could mean additional filing requirements, although a joint filing is usually allowed. Appraisal rights are a limited statutory remedy, and are available only in some transactions. Some fairly recent Delaware cases find that an ‘entire fairness’ standard won’t apply in a short form merger under Delaware law.

Delaware general corporation law dictates that if directors and officers have a financial interest in the transaction (as is usually the case in going private), they owe a duty of loyalty to the corporation. In an affiliated transaction like going private, the business judgment rule is trumped by the more onerous entire fairness test. This shifts the burden from a plaintiff to the defendant to prove that a challenged transaction was completed at a fair price and through a fair process.

Negotiating change

There are a number of benefits usually associated with going private, including: lower expenses – in legal, compliance, accounting and Sarbanes-Oxley related disclosure as well as PR and investor relations costs; a return to long-term focus – private companies have greater flexibility to focus on research and development and execution of longer-term strategies without the pressure of also ensuring short-term share price gain; and decreased exposure to class action securities litigation compared to a public company subject to SEC disclosure requirements.

But this final point cuts both ways, as shareholder litigation is also one of the greatest risks associated with going private. Shareholders who argue that taking a company private is not in their best interests (either long or short term) may bring suit against management and/or the board. Additional costs and potential risks are: lowered employee morale, lack of access to the public capital markets, decreased brand recognition, and the fact that the company may have ongoing contractual obligations with some shareholders or covenants with lenders and also with the private placement investors.

According to Stephen Older, partner with McDermott Will & Emery and co-head of the firm’s securities practice group, ‘Many companies that go private have public debt, or issue new public debt in the LBO (leveraged buyout) process, so they are still required to make certain periodic filings and will be required to disclose financial information and have to deal with Sox 404. So they are not completely out of SEC or Sarbanes-Oxley requirements. Still, they have more flexibility and fewer restrictions after going private.’

Into the light

Rules for going private are stringent, since this is, in essence, an insider transaction. Regulators must scrutinize the processes carefully, focusing on the true independence and fair dealing of the duly appointed special committee of the board, the retention of independent legal counsel and financial advisers by the special committee, and the preparation of a fairness opinion by the financial advisor.

Potential bumps in the road can happen when shareholders revolt and refuse to tender shares, or when the company’s own independent directors refuse to bless a proposed transaction as fair to shareholders. In addition, proposed transactions can be seen as putting a company in play.

High beam scrutiny

‘Talk of the demise of the US public market is overstated. But companies no longer need the public capital markets to have a shareholder base,’ says Bracewell Giuliani partner Mark Palmer. ‘When a company is out of the public limelight, although it may avoid the public light previously trained on it, the new private scrutiny is at extremely high beam. The new owners will demand performance, but one benefit is they will also pay for performance. Private equity investors are willing to pay well to align the interests of investors and management. Therefore, compensation costs that create value are enhanced, while useless and inefficient costs are taken out.’

Judging the value of a company can cause confusion. ‘Most going private transactions are done at a premium to a prior period’s trading value,’ says Palmer. ‘Whether the target company is worth more than what is offered is always in debate.’ Potential savings are usually taken into consideration and may augment the transaction’s face value. ‘By taking the company private and reducing the so-called agency costs the company saves money and value can be created simply through the implementation of a more efficient capital structure.’ But Palmer offers a cautionary warning: ‘Those post-transaction savings and that potential new value should not alone justify any demands for a higher price.’

Good options

Older expects that as the private equity space becomes more competitive, more creative financing techniques will develop. One such technique is used by his colleague William Merten, a partner in the firm’s Chicago office and a specialist in employee stock option plans (ESOPs).

‘The use of an ESOP in a going private transaction allows the company to share ownership with its employees on a tax-advantaged basis,’ says Merten. ‘As a qualified plan, the ESOP provides benefits for all employees. Used alone or in conjunction with other incentive plans, it can also help a company retain key employees and maintain a continuity of management. Tax incentives made available by Congress actually encourage companies to move shares to their employees as a part of the privatization process. A company can make tax-deductible contributions to the ESOP to enable it to repay acquisition indebtedness undertaken to allow the ESOP to purchase company shares. The fact that an ESOP is able to borrow money to purchase shares and that related indebtedness can be repaid through deductible contributions makes both acquisition loan interest and principal effectively deductible.’

In addition to the aforementioned pluses of ESOPs, ‘if a company that has gone private makes an S election, yet another tax benefit becomes available,’ says Merten. ‘In an S corporation, there is no tax at the corporate level. Instead each S corporation shareholder is taxed at the shareholder’s tax rate on the shareholder’s portion of the company’s profits. As a qualified plan, an ESOP is exempt from federal income tax. Accordingly, in an S corporation, federal income taxes are deferred as to the ESOP’s proportionate share of income until employee participants pay taxes on distributed ESOP benefits following termination of employment. As an example, if an ESOP owns 40 percent of an S corporation’s outstanding shares, annual federal income taxes will not be payable as to 40 percent of the company’s profits. This deferral of taxes can allow the company to utilize more of its cash flow to repay outstanding acquisition indebtedness.’

Why aren’t more companies using ESOPs? Merten believes that most executives do not fully understand the benefits of an ESOP and the way that ESOPs can be used in acquisitions, management buyouts and going private transactions.

Both the IRS and the Department of Labor have rules that prohibit an ESOP from paying greater than the closing date fair market value for the shares it purchases. For this reason, Merten stresses the importance of hiring an independent trustee to represent the ESOP in purchasing the shares and making sure that the trustee is represented by a well-qualified independent financial adviser (a valuation firm). The chosen valuation firm should have a practice focused on leveraged ESOP transactions. According to Merten, the valuation firm needs to know ESOP transactions inside and out as well as both IRS and DoL valuation methodologies and expectations.

Question period

Older suggests that ‘investor relations officers and corporate secretaries should expect to get many questions along the lines of: why is the company going private? Why now? Is this private equity firm taking advantage of hidden value that we as shareholders should get? Why is this company more valuable as a private company?’

If the board and management are not able to answer these questions then it is likely they will have trouble gaining shareholder, and possibly regulator, support. Preparing answers early and presenting a clear value proposition will go a long way to ensuring a smooth process once the deal is publicly announced.

Kees Koetsier, a partner with Dutch law firm NautaDutilh, believes that going private transactions are a global phenomenon. ‘These [private equity deals] started in the US and UK. Now that the low hanging fruit in the US is gone, firms are expanding to Asia and Europe. In essence, the type of transaction is similar. And as global regulators continue to talk with each other, that convergence will continue,’ he says. ‘But for now there is still some devil in the details.’