PriPub model offers boards an alternative

Comment: Corporate boards are increasingly preoccupied with the issue of whether to take their companies private. The resulting debate has acquired political and social overtones, writes Roberto Mendoza.

Simply put, the question for the shareholders is: would you prefer to sell your shares for cash now at a premium to the market price, or hold on to your shares in the hope that you will do better in the long run?

This question can disguise the underlying complexity of the issues, to the cost of the current shareholders. Boards must ask whether there is a third way that provides shareholders with the benefits both of the private equity model and public ownership.

Private equity firms, without exception, aim to generate returns higher than those demanded by the public markets.

Many achieve their objective by employing well-tested techniques. For example, a more efficient capital structure (more debt); highly disciplined management (cost-cutting); strategic focus on core competencies (selling underperforming or undervalued assets); and aligning management and owner incentives (pay based on performance, often in the form of options).

These techniques are well known and could arguably be used in the interests of current shareholders rather than private equity firms. Boards and managements that are wrestling with the public versus private question should therefore consider a third alternative: a hybrid business model that integrates private equity techniques with public ownership - let us call it the PriPub model. Implementation of such a model would generally imply a so-called leveraged recapitalisation of the company, ie supporting a new corporate strategy with a more highly leveraged capital structure.

Boards need to challenge the conventional wisdom that increased leverage reduces flexibility to the detriment of the long-term success of the company.

This represents another deceptively simple argument that can destroy significant value for shareholders.

Given the relative flexibility of modern capital markets, publicly owned corporations today can leverage and deleverage themselves at lower cost and risk than ever before. Boards have a responsibility to make use of this flexibility for the benefit of the current shareholders.

For example, it is arguable that a publicly owned company with a high credit rating that borrows money to buy back its stock - and sees its credit rating significantly reduced as a result - has increased rather than reduced its corporate flexibility.

Why? Because a properly executed leveraged recapitalisation can increase the value of a holding in the company's equity.

At a minimum the deductibility for tax purposes of interest expense represents a potentially significant source of value.

The company retains the flexibility to reissue its more valuable stock for cash (to fund investment projects) or for the shares of another company.

Of course, more leverage does increase the risks and potential rewards of equity ownership.

But many companies have more capital than they think - they in effect waste capital by using it to support risk-taking activities in which they have no comparative advantage.

For example, the decision to invest the assets of a corporate defined benefit pension plan in equities is economically equivalent - from a shareholder perspective - to a decision to borrow money on the corporate balance sheet and invest the proceeds in the stock market.

The company implicitly allocates shareholder capital to this gamble. Immunisation of the pension plan assets (matching them with liabilities) would permit the company to reallocate the equity to organic growth investments, value-creating acquisitions or stock buybacks in that order.

The buyback can be viewed from a managerial perspective as a temporary store of liquidity for the shareholders - one that earns a riskless return because the interest on the debt is deductible for tax purposes and the gain (if any) on the stock is tax free.

Implementation of such a model requires that boards adopt a different perspective to governance than is commonly the case. They should exercise their responsibilities from the viewpoint that their economic interest is tied to the fortunes of the current shareholders of the company. This is arguably what shareholders elect them to do.

This view should be reinforced by compensating directors largely, or wholly, in company stock with a substantial holding period requirement.

Of course, this model is based on the similarly simple assumption that boards can capture the profits generated by private equity firms and transfer them to the current shareholders.

This is a tall order. The traditional private equity model does far more than simply implement a standard set of well-worn techniques. Private equity firms often provide the concentrated attention as owners that makes the whole value-creation process - including the leverage - possible.

Public company boards should learn from the successes of the private equity model.

When they address the simplified public versus private ownership question, they should aggressively explore the third way - the PriPub business model.

This will serve to lower the profitability of the traditional private equity model and increase returns to public shareholders. Imitation remains the simplest form of flattery.

The writer chairs Trinsum Group

- (Financial Times service)