From 2005 through the middle of 2007, one public company after another was bought out and went private. The size of the deals escalated — Hertz for $15 billion, HCA for $33 billion, Equity Office Properties for $39 billion, TXU Energy for $44 billion. Then the megadeals stopped. Andrew Metrick explains what happened.
Q: Has there been something new going on in private equity in the last several years?
The size of it is new. They were setting all types of records until the middle of 2007. Things have quieted down considerably. Certainly, in that last 12 months it’s much tighter. This was credit-cycle driven — both the boom and the slowdown. But, it’s still a very important industry; it has close to a trillion dollars under management, and then you multiply that by the leverage that they can bring to a transaction and it’s really a lot.
Q: Were there any lessons learned in the boom period about what companies should and shouldn’t go private?
I think the question is, are you worth more to a private shareholder than you are to a public shareholder? So let’s ask under what circumstances you’d be better off as a private company than as a public company. As a public company you have access to a very broad capital market, diversified shareholders, and the people who are buying you don’t have to be paid an enormous amount of money to oversee what you’re doing. That’s what it means to be a public company, right? You have the market doing a lot of the work of monitoring you and making sure that you’re doing your job. When you’re a private company, you have to pay for that privilege, because the managers of private equity funds receive enormous fees and a share of the profits. So basically you have to be worth a lot more to a private owner than to a public owner in order to make it worthwhile for a private company to buy you.
Consider a typical dollar that goes into a public company versus a private company. When the dollar goes through a public company, I give it to my mutual fund manager, he buys the share of the company, I pay the mutual fund manager 1% a year, and that’s pretty much it. If I’m a pensioner in California, and that California pension plan gives money to these big buyout shops like Blackstone and KKR, those guys take a huge chunk of fees, several percent per year, and on top of that they’re going to take a certain fraction of any profits that are made from the deal. My one dollar isn’t really buying a dollar worth of capital, or even 99 cents like it did from the mutual fund; it’s something significantly less than that. Therefore, to make it worth the while of the private equity firm to buy from public it really has to be the case that the company is worth more in private hands than it would be in public hands.
Now why might that be? First of all there are straight costs to being a public company. Since Sarbanes-Oxley, the costs of being a public company have gone up. But this case is often overstated as being the reason companies went private. It doesn’t explain why Chrysler went private. Chrysler’s compliance costs are not a significant chunk of Chrysler’s overall enterprise value. For some smaller companies, it matters, but those companies went private pretty quickly. The big monster companies tend to be a different story. What most players in the industry will say about what happened in ’05, ’06, ’07, and I think that it’s true, is that what happened was some arbitrage on the fact that debt was extremely cheap. It wasn’t really an equilibrium phenomenon. They were giving away debt really cheap. The private equity investors are just taking advantage of this very cheap debt. That raises the question of why these companies couldn’t have just gotten all this debt on their own. And I think the answer there is that it’s very hard organizationally to change the leverage of a company without changing its ownership structure.
The central thing that the evidence points to is the fact that you see much bigger multiples paid by private equity shops when debt is relatively cheap. When debt is cheap, they’re able to load more of it on and pay more for companies.
Q: What qualities in a company make it attractive?
This is tricky because I think we can talk about the theory and then the practice. All hell broke loose over the last few years and none of that theory mattered. But in theory, there are costs and benefits of being public. The benefit is it’s relatively cheap capital compared to private capital. The costs are the straight compliance costs, and then, the management costs that it takes to assuage the public shareholders. So say you are a CEO of a company that is about to undergo a very significant transition, something that might be really hard to explain to public shareholders and to explain to analysts. You might be worried that you’re a good manager, but you’ll lose your job because of all these very complicated things that you need to do now. There’s an argument then for the company to be in private hands while it’s undergoing that transition.
Q: Are these companies that are essentially badly managed?
That was really the 1980s-style buyout, which was you buy the company, you replace the management, and you lever it up and sell off the pieces. That’s not really what’s happened over the last 10 to 15 years. For the most part, when these firms buy these companies they don’t replace the management.
Q: So what kind of changes are they making?
Maybe completely changing the strategy of the company. Say I am CEO and I say, “You know what, we need to get out of this space and into this space; we need to close down those seven factories; we need to do some M&A to take our company a different direction.” I don’t want to deal with public markets when I do this, right? It’s going to be very complicated, it’s going to be a pain in the neck, and I might get fired. Whereas, if I can get Blackstone to buy into my vision and they buy me and manage me during this process, things will go more smoothly. They’ll get the company very cheap because the market doesn’t understand what we’re going to do. That’s the theory.
Q: From the perspective of this CEO, who seizes an opportunity to take a company private and complete a big transition in his or her company, there seems to be a potential for a lot of conflict of interest. They often end up...
Making a lot of money themselves...
...whereas they could have been doing that for the shareholders that they had before. Yes, I think that is a real issue. A lot of times it’s the CEO of a public company that has the idea of doing A, B, and C, and rather than doing A, B, and C while the company is public and making the paltry sum of $5 million a year, they take their company private and make $50 million a year. So, that is a complication, and certainly the fact that it is quite lucrative for current management may explain a bit of the appeal of private equity.
Q: Do you see a difference between public and private markets in their short-term and long-term perspectives?
Everybody is short-term. Private is short-term, too. These firms are not in it for 20 years. They’ll say we’re in this for the long haul, but they want to be in and out in three to five years. Is that long-term? Maybe. It’s not about the next quarter, as it is for public companies, and so, there can be some advantage there. But private equity investors worry a lot about their quarterly numbers. They look to see how they’re doing every quarter. In theory, the private markets can resist the true short-termism of the public markets. But I think that the advantage they have is really that it’s a more sophisticated ownership base. So when the company is undergoing a transition, they can be more patient. They can be more sophisticated about when the results need to come in and they can drill down deeper into the numbers than a public company would be able to.
Q: Who shouldn’t go private?
Companies that are on a relatively stable growth path. I don’t see why they would be worth more if they were private than public. If you have a well managed company that’s just going along, like Apple — I don’t see what the point would be of Apple being private. They certainly could use a change in their capital structure; they have about $40 billion in cash, which is too much. The only argument would be the 1980s argument, which is that we are going to use the cash better in this company. But I wouldn’t want to tinker with what seems to be a magic formula at a company like that. I can see why the private equity firm, when debt is cheap, might be able to pay more in the short run, but I think ultimately they’ll lose money for their investors if they buy those kinds of companies.
Q: Given this discussion, what do you make of the private equity companies going public?
I understand why they did it. I wouldn’t want to be one of the buyers. It is a very human-capital-intensive business. I understand what it means to be public if you’re IBM. IBM owns the name IBM, it owns patents on a lot of different IBM things, it has the brand equity in all of the different things that they sell. So, if I buy a share of IBM, not only do I own a piece of all these capital stock that IBM has, but I also own a piece of that brand equity and the patents and all of that stuff. If I buy a share of Blackstone, I don’t even have a claim on the portfolio that Blackstone is managing; I have a claim on the fee income that the managers will generate. Well, that’s not a capital claim. They have some desks and some computers, but most of the worth is embedded in the human capital of the people that work there. And if I paid those people everything that they deserve, that should probably soak up all of the money that the whole firm makes. If it doesn’t soak up all the money, then a lot of those people will go elsewhere. The only argument for going public is that there’s a brand, Blackstone, which can be monetized. When you buy a share, you’re buying a share in that brand equity. But I don’t see why that brand should be worth tens of billions of dollars. It’s valuable; I’d rather be called Blackstone than Whitestone. But tens of billions seems like an awful lot in a very competitive business.
People said the same things about investment banks when they first went public. Of course, there are not that many public investment banks anymore, so those people might have been right.
Interview conducted and edited by Jonathan T. F. Weisberg