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 placements exceed 50 percent of all long-term corporate debt outstanding.
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 on bonds 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 save 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.
In the 1980s, 1990s, and mid-2000s, 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. In the most frequent method, a publicly owned company is purchased by a private company or a private equity fund. Private equity funds typically are partnerships formed specifically to buy companies. An alternative avenue for going private is for a company to repurchase all publicly traded shares from stockholders. Both methods have been in vogue and are usually 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 has 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.
Finance in ACTION Managerial Tulip Auctions and the Google IPO
While traditional investment banking relies on institutional relationships, there is a move afoot to do some initial public offerings on the Internet using auctions. Most individual investors (especially those with less than million-dollar accounts) find it very difficult to acquire shares in a traditional IPO. Shares are typically allocated to mutual funds, pension funds, and other institutional investors who have connections with the investment bankers. Often, these institutions are repeat customers who participate in most of an underwriter’s offerings. While this is obviously bad for small investors, firms that are going public also have concerns with the traditional distribution system. They wonder whose interest the underwriter is looking out for. Are they looking out for the issuer? Or is the banker looking out for the interests of the institutional investors who are the banker’s repeat customers?
In 1998, William Hambrecht founded WR Hambrecht & Co., which helped pioneer U.S. stock auctions. Hambrecht’s Open IPO® auctions are based on the method developed to auction Dutch tulip bulbs in the 17th century. In a “Dutch” auction, prices are determined after all prospective buyers have placed bids. Then one price is set for all buyers. That price is the highest price at which all the securities can be sold to the bidders. No investor pays more than his bid price, but many will receive securities at a price that is less than their bid. Dutch auctions are commonly used to sell U.S. Treasury securities, and about 150 auctions of Treasuries are held each year. One of the attractive features of Dutch auctions is that connections don’t matter. Mom-and-Pop investors can compete for shares alongside big institutional investors.
In August 2004, Google Inc. went public using a variation on the Dutch auction. Google’s IPO was, by far, the largest auction-based offering ever. The auction rules ensured that small investors could participate because orders as small as 5 shares were accepted. In traditional IPOs, allocations of less than 100 shares are rare, although most deals have no official minimum. Google’s IPO did not go off without a hitch. The company originally estimated a selling range between $108 and $135 per share, but the eventual issue price was only $85 per share. Noting this fact, many Wall Street bankers and professional investors declared the IPO auction a failure. Of course, there is no evidence that a traditional IPO would have yielded a higher initial selling price, and Google paid underwriting fees of only 2.8 percent, which is less than the norm. On the first day of trading, Google’s price rose in the aftermarket to $100.34, an 18 percent gain that is about average for IPOs. By January 2009, Google’s price had risen above $600 per share.
In 2005, Chicago investment research firm Morningstar Inc. chose to go public using Hambrecht’s OpenIPO system. However, traditional Wall Street underwriters strongly discouraged Morningstar from using the auction format. After all, the traditional underwriting method is extremely profitable for underwriters and institutional investors. Institutional investors clearly did not receive preferential treatment in the Morningstar IPO. Investment behemoth Fidelity Investments received no shares in the IPO. Its $17.50 bid for 2.2 million Morningstar shares was too low. The auction clearing price was set at $18.50. Morningstar paid underwriting fees of less than 2 percent of the offering proceeds, much less than would be expected in a traditional offering.
Internet-based auctions may eventually capture a significant share of the underwriting market, but that time is probably still far off.
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.
It should be further pointed out that the impetus to going private was once again stimulated in 2002 by the Sarbanes–Oxley Act, which greatly increased the reporting requirements and potential liability for publicly traded companies. This was especially true for smaller companies where the financial burden of reporting was a significant expense. Many of these decided to go private.
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