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An IPO is the dream of every entrepreneur who launches a new company. It is a symbol of success, and can bring with it intangible benefits like prestige and market visibility. It can also produce tangible benefits such as a public currency that can be used to acquire other companies and motivate employees, and access to the public capital markets to fund research and development and other capital expenditures. According to IPO.com, since the beginning of 1998, more than 1,400 companies have gone public. The management and owners of many of these companies are realizing that the crash of the U.S. equity markets has turned the dream into a nightmare, a nightmare that probably is going to last. Many of these companies are beginning to revisit the benefits of a strategy that took hold in the 1980s and had a resurgence in the late 1990s: the going private transaction. Going private deals usually take the form of a leveraged buy-out. A leveraged buy-out is the acquisition of an existing public (or private) business by a private equity firm or other private investor group, and is financed primarily with debt and equity capital. Typically, the private equity firm provides the equity financing and arranges the debt financing from other sources. The target uses its operating cash flows to grow its business and repay the debt that it has incurred in financing the acquisition, and the company’s assets are pledged as collateral for the debt. The typical strategy of the buy-out firm in a leveraged buy-out is to buy a public company in a depressed market sector, rejuvenate the company’s management and business while paying down the debt, and then exit at a higher valuation by taking the company public once again or selling it to a strategic acquirer. This is not a new strategy. Leveraged buy-outs received great notoriety in the 1980s when corporate raiders like Carl Icahn and Michael Milken and his junk bond powerhouse Drexel Burnham began hitting their stride. However, in the mid-to-late 1990s during the bull market, the number of going private transactions dwindled year after year, reaching a low of 25 deals announced in 1998, according to Thompson Financial Securities Data. However, in 1999 and 2000, a surge in private buy-outs occurred. According to Thompson Financial Securities Data the number of going private deals announced in 1999 was 36, and climbed to 51 in 2000. While this level of going private activity pales in comparison with the number of deals in the late 1980s (1988 and 1989 saw 340 and 303 deals announced, respectively), the number of deals announced in 1999 and 2000 represented a significant uptick from the 25 deals announced in 1998. Going private deals in that period generally involved friendly bids for orphaned companies with small market capitalizations and little hope of attracting institutional investors in sufficient numbers to generate a high stock price and investor liquidity. At the same time as money was pouring into technology company stocks, these companies were watching their stock prices sink to their lowest levels in years. They were not enjoying the typical benefits of being a publicly traded company on the NYSE or Nasdaq market. Since going private transactions typically involve a significant amount of leverage, these traditional businesses with stable cash flows and balance sheet cash were ideal targets for going private deals. A SHIFTING ENVIRONMENT How times have changed. While the market orphans of 1999 and 2000 remain viable targets for going private transactions, the dramatic decline in the equity markets has driven down the stock price of many more companies, including those in the once-thriving technology sector. Many of these companies in fact now have stock prices that reflect a lower enterprise value than that of the last pre-IPO round of private investment. Furthermore, unlike many of the dot-coms that came to the public markets with high cash burn rates and nothing more than a dream of one day achieving profitability, there is a significant number of technology companies that actually have mature businesses with long-standing customer bases and real, predictable cash flows. Have buy-out firms now embraced the technology sector? Not yet, although not because the companies are not good candidates for going private. Rather, the buy-out firms largely have been unable to close any going private deals because the debt financing markets have tightened. Buy-out firms use debt financing in going private deals in order to limit the amount of equity they provide and thereby achieve superior returns. In the current market, institutional lenders are generally only providing debt financing at three times EBITDA (earnings before interest, taxes, depreciation and amortization), as compared to providing it at five or six times EBITDA a couple of years ago. Furthermore, the types of companies that can secure any debt financing have become more limited. Lenders are looking for stable companies with strong cash flows and established customer bases. As a result, the number of going private deals announced in each of the first three quarters of 2001 has steadily declined, from six in the first quarter, to four in the second and two in the third quarter. So far only one going private deal has been announced in this fourth quarter of 2001 (data provided by Thompson Financial Securities Data). According to Peter Weinbach, managing director of AIG Horizon Partners Fund, L.P., the lack of debt financing means that one of the traditional strategies of the buy-out firm — paying down debt over time with the target’s cash flow and thereby building a company’s equity value — is generally unavailable. That leaves buy-out firms in a position where they have to use more equity to get a deal done. In order for such a deal to make sense, the buy-out firm has to believe that it either will be able to grow the target company’s cash flow or will be able to leverage the company at a later point in time. In the current economic environment, those may be tough conclusions to reach. While some buy-out firms hope that the extra stimulus the Federal Reserve generated a week after the terrorist attacks will help boost the economy and make bank regulators soften their credit posture, this has not yet happened. The tight credit market and turbulent equity markets have also increased the focus on the “conditions” contained in the typical going private merger agreement and financing documentation. The buyer will typically insist on a “financing out,” or at a minimum a broad “material adverse change” clause that will allow the buyer to walk away from the deal if the availability or pricing of the debt financing or the target’s business or prospects have changed as a result of events between the signing and closing of the deal. The target, on the other hand, will resist a financing out and seek a material adverse change clause that is tied solely to its recent performance. At conflict in this debate is the target’s desire for certainty that a deal will be closed once publicly announced and the buy-out group’s need to be protected from subsequent changes that affect the underlying economic rationale for the deal. The importance of this debate has been highlighted by the events of Sept. 11 and the impact those events have had on operating companies and financial markets, as well as by the decision in the Tyson Foods case in which Tyson was ordered to proceed with its $4.7 billion acquisition of IBP Inc. despite a significant drop in IBP’s profitability. The judge in that case ruled that the drop in profitability was not a sufficiently dramatic change in IBP’s business to trigger the material adverse change clause in the agreement. OTHER FACTORS IN PLAY Another factor that has kept going private transactions on the sidelines has been the unwillingness of companies to accept the long term reality of their stock prices. Many potential sellers have been waiting for the fairy tale prices to return. There is now a growing sense that owners are acknowledging that we may never see those prices again, so the time for buyers and sellers to meet again may be approaching. Also, going private transactions take a long time to complete. At a time when every CEO in the country is complaining about his or her ability to predict future earnings, it is difficult for buy-out firms to commit themselves to a process that may take six months to complete, if it is completed at all. A typical deal will require approval by both the Board of Directors and a special committee of the Board as well as by the stockholders of the company. At the Board level, the need for the Board to exercise its fiduciary duties adds time, complexity and expense to a deal. The Board has so-called “Revlon” duties to obtain the best deal reasonably available to stockholders. In this situation, the special committee struggles with whether it should enter into exclusive negotiations with a buy-out firm supported by management or hold a broader auction for the company. Often the buy-out firm will threaten to pull out of the deal if an auction is held. The special committee and its adviser must determine if there is the possibility that a strategic buyer would be interested in the company. Buy-out firms are constrained in the price they can pay for a company by limitations on prudent debt levels and certain minimum returns on investments that their investors desire. This limit has been exacerbated lately by the tight debt financing market. Because a special committee and its financial advisor can assess the upper limits that a buy-out firm can pay, a special committee will consider whether there exists a possible strategic buyer who will not be bound by these constraints. Often, special committees may resist providing the buy-out group with this exclusive negotiation right until it has checked with potential strategic buyers. Also adding to the time it takes to complete a going private deal is the Securities and Exchange Commission filing and review process. Prior to soliciting the consent of the company’s stockholders, depending on the nature of the going private deal, the company must file with SEC the Schedule 13E-3 (Rule 13-E3 Transaction Statement pursuant to � 13(E) of the Securities Exchange Act of 1934) and the Preliminary Proxy Statement (filed on Schedule 14A). The detailed disclosure required in the Preliminary Proxy Statement and in Schedule 13E-3 is then subject to SEC comments, which can lead to multiple amendments to the filings and is a process that in itself can take two to three months to complete. Even if a company and its going private sponsors carefully document each step in the decision-making process, carefully delineate and implement the role of the special committee, and provide full and detailed disclosure, it is still likely that the transaction will result in litigation. This litigation risk is another factor in the long litany of issues that cause many buy-out firms to shy from going private deals, particularly in the current market environment. While the buy-out firms are largely staying away from going private deals these days, there are scenarios in which the going private transaction may make sense for a company. For example, the Board of Directors of a company with a large amount of cash on its balance sheet may conclude that returning the cash to its shareholders is a better use than investing it in projects that will have little or no impact on the company’s stock price. As opposed to a cash dividend, a going private transaction can be a tax-efficient method of getting the cash into the shareholders’ hands. PRIVATE COMPANY BENEFITS As the credit and equity markets begin to stabilize and recover, for many of the companies that are appropriate targets for going private deals, the advantages of being a private company should begin to tip the scales in favor of going private. These advantages include the following: Lower Legal, Accounting and PR Costs. The typical small capitalization public company can easily spend up to $1 million per year in legal, accounting and public relations costs. These costs are largely driven by SEC disclosure requirements, securities filings, annual reports and by increased plaintiffs’ lawsuits, as well the additional staff required to interface with a public company’s shareholders. By going private, such a company can expect to save between $200,000 and $300,000 per year by reducing these costs. Out of the Public Spotlight. Due to the SEC disclosure requirements, a public company is forced to disclose to the public sensitive information that its competitors, customers and suppliers can use against it. Aside from the competitive issues, the preparation of such disclosure and its presentation to analysts, portfolio managers and the press requires valuable management time. Once out of the public spotlight, management can return its full attention to the company’s business, its vendors and its customers. Ability to Focus on the Long Term. Public companies are often forced to focus on quarterly results, as opposed to long-term goals and strategies. For smaller companies trying to attract and retain analyst coverage, missing a single quarter’s numbers may mean the difference between solid or no coverage. These companies are therefore often faced with the dilemma of postponing promising long-term projects that may have a negative impact on the short-term numbers. Over time, many companies find that this type of decision-making can lead to stagnation of their growth. By going private, a company is able to return to the appropriate mix of short- and long-term goals that positioned the company to reach the public markets in the first place. Taking the Company Off the Block. A public company with a low price to earnings ratio is always a candidate for a sale, which may be unattractive to its management given the depressed sale price the company may be forced to accept from a public suitor. If management believes it can structure a better long-term deal by first going private and retaining more equity, they may want to take the preemptive step of taking the company off the public company block, although there is the risk of the third-party bid in the middle of the process. CONCLUSION While the going private market has clearly cooled due to the confluence of the lack of debt financing and the structural issues that make going private unduly risky in this turbulent market, it would appear that going private deals are poised for a resurgence as the financial markets rebound and buy-out firms are able to better judge the business prospects of target companies. The number of companies that would consider, or be considered for, a going private transaction has likely increased as many companies that once benefited from the bull market of the 1990s have joined the list of those with languishing stock prices, low market capitalizations and low trading multiples. The companies in the industry sectors that remain unfavorable as the market rebounds, and that have capable management, strong cash flows and cash on the balance sheet, will be presented with the decision whether to regain the advantages of being a private company. Many of these may choose to return to private status, where they can then once again dream of an IPO one day. Joseph L. Johnson III is a partner in the Boston office of Goodwin Procter LLP, and Andrew J. Weidhaas is a partner in the firm’s New York office.

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