Happiness is an inefficient market

For the shrewd and successful investor, happiness is an inefficient market, a market in which either the buy or the sell side has an inherent edge.

Historically, for example, venture funds were able to achieve superior returns because there were more first-class investment opportunities than professional private equity investors. In the '80s, the LBO funds were able to buy assets cheap and shift much of the risk of loss to highly motivated lenders, the providers of capital styled as 'debt', (sometimes as senior debt and often as junk) which my friend, Steve Gilbert, liked to describe as 'puttable equity.' The LBO fund investors had locked in a good portion of their profit when the initial deal closed. If the company was able to subsequently do well, on an on-going basis, so much the better.

An efficient market is troublesome for asset managers of both public and private equity. It is very hard to beat the averages (e.g. S&P 500) and to stand out in the crowd of a truly efficient market with willing sellers, willing buyers, each with equal access to relevant information. The managers are victims of the Efficient Capital Markets theory, which states that if a fund buys fully priced securities, then the fund manager has to be confident the company itself has some kind of edge which the market has not yet fully appreciated. This is a tough call.

Accordingly, and particularly in this environment when predicting market movements is seen as unusually difficult, the hunt for market inefficiencies is urgent. And some of the more sophisticated funds are seeing potential opportunities in the 'orphanage,' which is the collection of public companies (approximately 7500 out of the entire 12,500 company universe), which are gaining little or no advantage from the fact that their stock is public. Thus, the companies in the 'orphanage' enjoy no analytical following to speak of and, therefore, the securities are chronically underappreciated. The shares typically sell for under $5, making them so-called 'penny stock' in legal and technical parlance, and that means that all kinds of eccentricities can creep into quotidian prices. On one side of the spectrum, some bad guys may be running a 'pump and dump' scheme to inflate the price, making a bogus company appear attractive for those who follow the dictum, 'the trend is my friend.' On the other hand, lack of interest in penny stocks generally may make for an artificial down side bias… not enough trading activity means the stock lacks support at any level. Some companies are selling at market capitalizations that are less than the cash they have in the bank.

And, if the company is reaping no benefits from public ownership (its shares are not adequately priced to provide currency for acquisitions and employee incentives), there are ample reasons why the company should surrender its public registration. First, and most obvious, of course, is the expense of maintaining that status… 10Qs, 10Ks, 8Ks, annual meetings, proxy statements, occasional shareholder litigation brought by 'strike suit' plaintiffs' lawyers. Secondly, the stock price may be artificially low and the company, therefore, difficult to finance. How do you persuade investors to pay $3 a share, even though you swear up and down, and convincingly, that such is a valid and conservative price, when the stock keeps bobbing along in the $1.25 range because no one is interested in buying it? To be sure, you can argue with an institutional funding source that it would cost the institution $4 a share to fulfill its investment appetite if it started to accumulate stock in the open market; but, that $1.25 price is a fearsome psychological block.

Next, one has to factor in the time senior management has to take away from running the company and spend on trying to build up investor interest, a job that would ordinarily be handled by the analysts. Most companies in the orphanage generate little trading activity and, since analysts are paid largely on the basis of brokerage commissions to their employer, a dearth of trading activity generally means that the analysts cannot afford to cover a small cap stock. Finally, with many of the companies in the 'orphanage', those parties to whom the company is least anxious to make disclosures to (competitors, customers and vendors) entertain genuine interest in the company's public statements to investors. One of the problems in going public is that, once your customers start figuring out how much money you make on their transactions, they start asking for rebates. The SEC's policy of full disclosure, while admirable for investors, often gives aid and comfort to one's competitors. And, the record of companies seeking approval of confidential treatment from the SEC staff is pretty dismal these days.

Accordingly, there are bargains in the orphanage and a growing host of private equity funds are willing to finance 'going private' transactions. There are, to be sure, non-trivial transaction costs involved in going private, the most obvious of which is the tender price for public securities necessarily pegged at something in excess of the current trading price in order to attract a crowd. But the net rewards to the promoters are eye-catching if the right situation can be found. The returns can be in the 'venture capital' spectrum regardless of current market conditions; indeed, the definition of 'venture capital' in its early years included just such nimble activities as LBOs, MBOs, and privatization.
The trick is to find the most promising deals. And some tips, excerpted from a research paper prepared by my colleague, Chip Korn, should help. The best candidates for 'privatization' are those companies that display some or all of the following characteristics:

• Enterprise value reflects a single-digit EBITDA multiple





• Strong cash flow projections





• Substantial cash on balance sheet





• Adequate debt capacity





• Low trading volume





• Low stock price – i.e., in the orphanage





• Good, but frustrated management





• Underwater employee stock options





• No access to public markets for cash or credit





• Earnings volatility, frequently causing them to miss analyst's projections





• Inability or unwillingness to make strategic acquisitions due to dilution concerns



The most common form for a going 'private transaction' entails the buyer group forming Newco; the target is offered a chance to merge with Newco (or a subsidiary of Newco) and the promoters, together with target management, solicit tenders from the required majority of the target's shareholders; the shareholders of the target receive cash (or non-equity securities) in exchange for their target stock, plus appraisal rights for the dissenters.

Newco is typically financed by:

1. senior debt, secured by the assets of the target, the debt comprising 40-70 per cent of the purchase price, plus

2. several layers of subordinated debt, which is often convertible or accompanied by warrants, interest payable in cash or P.I.K.;

3. preferred stock to a private equity firm, which typically contributes 35-40 per cent of the capitalization;

4. at least 25 per cent of the common stock reserved for management; and

5. the remainder is held by promoters of transaction

If challenged in court, the process of the negotiations can be just as important as the substance of the transaction. Thus, it is essential that certain procedural safeguards be employed and documented in detail, namely:



• The initial purchase price offered should be fair, but Newco should be prepared to increase the offer, possibly more than once, as independent directors and/or large shareholders negotiate an increase in price;





• A fairness opinion from an independent investment bank (ordered by the target's committee of independent directors) is derigeur;



An independent committee of the target directors is also routine, with separate counsel; and that committee should try hard to negotiate a higher price;





• If the management and the promoters dominate the target, a vote of minority stockholders (approval by majority of the minority) can eliminate the appearance of unfairness.