For Firms, Private Control Can Be Costly

Private ownership offers businesses opportunities to invest in long-term growth free from market speculation, but that latitude comes at a price.

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In February 2013, personal computer giant Dell completed an unusual deal, taking itself private in a $24 billion buyout organized by Michael Dell, the company’s founder and CEO, and private equity firm Silver Lake Partners. The largest privatization in American corporate history followed a hammering of the company in the markets, as shares slipped from $40 to less than $12, and an aggressive — and highly public  — campaign led by Carl Icahn, to depose Dell and replace the company’s board.

The move allowed Dell to focus on charting a course in the changing economy without being beholden to short-term market demands. And in November 2014, Michael Dell wrote in the Wall Street Journal that the privatization had “unleashed the passion of [his] team members.”

While privatization can allow companies to make bold, innovative moves that public investors would balk at, it’s not without costs. Privately held companies, like Dell, are consistently considered riskier investments than similar public companies, says Sharon Katz, who researches firm valuation, cost of capital and private equity ownership. Consequently, Katz explains, “corporate bond ratings are lower and the yield higher, just because a company is private.”

Private companies are further constrained by their limited access to public equity markets. Public companies, on the other hand, “can always raise additional equity via a secondary offering,” Katz says. One example was Citi Bank, which issued a secondary offering during the recent recession, after its value plunged from around $50 per share to near $1. However, it was still able to issue equity to continue financing operations as well as pay off its debt from the federal bailout. “If you’re a private company you cannot go to the market and issue equity. So unless a private owner puts money into the company, it’s going to run out of cash.” That risk is particularly acute during recessions, as private owners are less likely to make cash injections while they’re already tightening their belts.

But in a recent paper, Katz found that not all privately owned companies are the same: companies owned by employees or families are frequently considered less risky than companies owned by private equity (PE) firms. “We find that public debt of companies owned by PE firms will be more expensive, more risky, than companies owned by families,” Katz says. That difference can be partially attributed to the greater separation between ownership and management in PE-owned firms. “When considering family-owned and managed companies,” Katz explains, “if the company defaults or goes out of business, it’s the family name and reputation that are on the line  They’re much more risk averse.”

PE firms, on the other hand, are more likely to take on risks that could drive companies to default. “If you’re a large PE firm, you own a diverse portfolio of companies,” Katz says. “You don’t need all of them to be successful.” It’s sufficient if only a few of the companies in their portfolios are highly profitable. The rest can be merely adequate, or even fail, and the PE firm will still turn a profit. Through diversification, firms build an effective response to failure into their strategy — and they plan on failure. “Because they have diversified, they’re willing to take more risk. A family will do as much as possible to save the company, but for a PE firm, it doesn’t matter as much.” A consequence of this behavior? “We find that private companies, especially those owned by PE firms, tend to default more than similar public companies.”

While there are undeniable benefits to private ownership, the more than 100 basis point yield spread that private companies face relative to their public peers — even after controlling for a host of variables (firm fundamentals, information environment, bond characteristics etc.) — indicates that any decision to change ownership structure must be taken carefully.

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