Investopedia/Greg McFarlane: Difference between private and public equity

Investopedia
Difference between private and public equity
By Greg McFarlane
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What is the better way for a company to attract investors; by making its stock available for sale to whoever wants some, or by petitioning rich people (and those who manage and control others’ wealth, which is functionally similar) to buy in?

Both public and private equity have their devotees, and their advantages and disadvantages. Public equity is the type of capital most lay people are familiar with, the stocks that comprise our mutual funds and by extension our 401(k)s and IRAs. The mechanism for garnering public equity is easily understood, if not easy to execute. A growing company begins with an initial public offering, whereby it starts selling its stock on an exchange. Every one of the thousands of publicly traded companies did this at one point, everyone from Aerohive Networks (HIVE), a $200 million Silicon Valley maker of access points and routers for medium-sized businesses, to Hercules Offshore (HERO), a $72 million company that sells jackup rigs and liftboats to the oil and gas industry[1]. Almost all companies’ IPOs are events of limited interest to the public and the media, mostly because said companies are small and unproven at the time. Occasionally, a company has a history of success before “going public”, and such IPOs are newsworthy. Facebook’s (FB) 2012 debut[2] is one example; Visa’s (V) 2008 launch[3] is another. Facebook grew organically from a Harvard dorm in 2004; Visa was previously owned by its member banks.

Private equity differs from public in multiple ways. First, a company looking to go public has to hire an underwriter – usually an investment bank – to handle the sale. In that respect, an underwriter is almost like a wholesaler. The underwriter sets the price of the stock and then takes the responsibility of selling it to its ultimate buyers. The opening price has to be low enough to appeal to investors, yet high enough to be worth the issuer’s while.

A company performing a private placement doesn’t need nor want that broad appeal. Instead, it sells itself to accredited investors who are experienced in the market and able to withstand losses. Accredited investors include institutions such as banks and pension funds, and also include individuals who meet certain salary and net worth criteria.

From the perspective of the nascent company, private equity means having to please a smaller clientele. Long before an initial public offering, analysts estimate the company’s future earnings and stock price[4]. That at least has the potential to create a "perverse incentive" for management.

If the stock price slides too low for whatever reason, company executives might be tempted to take measures (e.g. buying back shares, changing accounting depreciation methods, realizing revenue in earlier periods to boost listed income) that could boost the stock price in the short term but cause damage in the long.

Private investors typically have a longer horizon in mind. That’s why it’s called private investment, and not private speculation. A capital group that’s in the business of buying companies doesn’t care about daily fluctuating stock prices. Instead the focus is on increasing profitability, and/or perhaps market share, rather than what ought to be the secondary short-term goal of appreciation.

Which isn’t to say that private equity firms and investors are philosophically opposed to public equity. Often, a private equity deal is done with the intention of the company someday going public. Conversely, some firms go in the other direction. Former Wall Street favorites Dell Computer and Heinz recently went private, which involves several steps beyond hunting down every last outstanding share of stock and purchasing it. Going private has gotten popular in recent years, as an unforeseen consequence of a contentious piece of early-21st century legislation.

By 2002, formerly titanic corporations Enron and MCI WorldCom, among others, were discovered to have been little more than labyrinths of paper camouflaging enterprises that had minimal true assets and insurmountable liabilities. Enron’s illegal manipulations included wildly over-reporting the money it “earned,” often by taking expected cash flows from decades in the future and reporting it as current income. MCI WorldCom was even more brazen, conjuring up imaginary revenue accounts out of the ether[5].

Stockholders lost money, executives went to prison, and tens of thousands of employees lost their jobs. The United States Congress rushed to pass the Sarbanes-Oxley Act, which tightened regulations on all publicly held companies and their management teams. The law holds senior managers personally responsible for the accuracy of their companies’ financial statements, and mandates the creation of lengthy internal control reports.

The intention of the law was noble: prevent another Enron from happening. The practical result is that smaller firms now spend a disproportionate amount of their finite resources on compliance. This gives them an incentive to go private, and encourages up-and-coming firms not to go public in the first place. Sarbanes-Oxley “worked” in that it caused IPOs to slow in both number and volume[6].

Private equity isn’t subject to the requirements of Sarbanes-Oxley, which means more freedom and less liability for directors and officers[7]. When Dell went private in 2013, after a quarter-century as a public company, founder/CEO/eponym Michael Dell borrowed money and enlisted a leveraged buyout specialist named Silver Lake Partners to facilitate the deal.[8] Never again does Dell have to please an impatient shareholder group by offering a dividend, nor will the newly private company ever need to repurchase its own stock and thus affect its price in the open market. On the other hand, by no longer trading publicly, Dell’s stock can’t go up (and thus immediately enrich all the executives and managers who hold positions in Dell.)

For maturing companies looking for an influx of cash, there’s no definitive answer as to whether private or public equity is the way to go. The greater management’s tolerance for regulation and the demands of impatient analysts, the more likely it is that the company will attempt an IPO. And as any of the early hires at Google (GOOG) will attest, successful IPOs have created more instant millionaires than any mechanism in history. But for companies that want a minimum of interference while concretizing their vision, and who can find investors with deep pockets and plenty of patience, private equity is the financing mechanism of choice.



[1] http://www.herculesoffshore.com/about-us.html

[2] http://money.cnn.com/2012/05/23/technology/facebook-ipo-what-went-wrong/

[3] http://www.sfgate.com/business/article/Visa-shares-soar-after-biggest-U-...

[4] http://www.inc.com/magazine/201109/inc-500-raising-capital-ipo-vs-privat...

[5] http://www.sec.gov/Archives/edgar/data/723527/000093176303001862/dex991.htm

[6] http://www.renaissancecapital.com/ipohome/press/ipovolume.aspx

[7] http://www.mbbp.com/resources/business/private-company.html

[8] http://www.forbes.com/sites/connieguglielmo/2013/10/30/you-wont-have-mic...


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