The public versus private debate goes on.
With the costs of complying with the Sarbanes-Oxley Act and the tedium of Regulation FD putting bigger burdens on public companies — not to mention the deep-seated pressure to please shareholders and Wall Street via financial and operational growth — why would a retailer, or any private firm, put itself through the hassle of becoming a publicly traded company?
The easy answer is: money.
An infusion of capital is needed for a maturing or reemerging company to grow the way it sees fit. And for some firms, trading shares on the public market is a way of showing that the company has arrived, so to speak — or, in some cases, returned.
But the workings of the financial market, Wall Street and the private equity market are mired in complexities and nothing is ever black or white. The reasons for going public or staying private vary.
Several new retail initial public offerings have been backed by venture funds that are looking to eventually reclaim at least part of their investments. Seeing exit strategies and growth plans come to fruition has become important for both the venture funds and retailers.
Besides, raising money via an IPO is often less costly than attempting to raise more money via venture or private-equity transactions.
“The capital markets are still a great way for venture capital firms to get a good return on their investment,” said Jay McIntosh, director of retail and consumer products research for the Americas at Ernst & Young LLP.
Or are they? What with compliance now a looming issue in more ways than one, public retailers have grappled in the last year — and are still grappling — with the expenses and confusion of 100 percent compliance with Securities and Exchange Commission rules. Is it acceptable to trade cheap capital for high compliance costs?
Experts say yes, despite the spate of retailers who have recently gone, or are in the process of being taken, private.
“There certainly is a higher cost to be a public company in the U.S., but I think that’s being returned in higher multiples than what a company would get in another market in the world,” said Joseph Muscat, partner with Ernst & Young’s strategic growth markets practice.
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A positive by-product is that the hoops companies must jump through to fulfill SEC regulations are making them fundamentally more sound organizations, which the government certainly likes. Companies looking to go public are often likened to someone getting ready to sell a house. They have to clean things up a bit, maybe add a coat of paint and make sure the closets are neat.
Still, there are barriers of entry into the public realm.
“The bar is higher than it was for IPOs before the accounting compliance issues because a company needs to be larger, usually in terms of income, to withstand the extra expenses of being public,” said Francis Gaskins, president of IPO-tracking Web site Ipodesktop.com.
DSW Inc., Maidenform Brands Inc., Volcom Inc., Citi Trends Inc., Golf Galaxy Inc. and Zumiez Inc. are the latest in a string of 2005 retail-related IPOs. Of those, Citi Trends, Volcom, Golf Galaxy and Maidenform have had some capital infusions in the past by venture funds.
Within the last couple of years, retailers such as Conn’s Inc., New York & Co. Inc., Build-A-Bear Workshop Inc. and Shopping.com Ltd. have successfully completed IPOs. And expected offerings next year are a spin-off of Sara Lee Corp.’s branded apparel division and an IPO sometime in 2006 from J. Crew Group Inc., a company that has public debt and already releases quarterly earnings.
“There is always a market for specialty retailers of one sort or another, if they have a track record of successful store openings, increasing sales per store and a growth plan that includes expansion,” said Gaskins. “Often, the specialty retailers go public as they transition from a regional to a national business, and they need money to pay off debt incurred in past expansion and/or they want to have money for future expansion.”
Take Seattle-based retailer Zumiez, which sells skate and snowboard apparel and accessories to young men and women ages 12 to 24. The 150-store specialty chain went public in early May, raising $56 million.
David Dandel, managing director at investment bank D.A. Davidson & Co., which participated in the Zumiez offering and was a co-lead for Volcom’s IPO, noted that a public offering was the best route for both companies.
“The public capital that Zumiez and Volcom were raising, from Davidson’s perspective, is at a lot better valuation than they would ever be able to get in a private market transaction,” he said.
Even though Zumiez shares are 23 percent owned by Los Angeles-based venture firm Brentwood Associates, which, in the IPO, sold 1.3 million of the 4.3 million Zumiez shares it held, or 36 percent of the total transaction, Tim Shimotakahara, an associate at D.A. Davidson, said returning capital to the firm was not the only motive for the new issue. Shimotakahara called the 1.3 million shares sold by Brentwood a “meaningless number” that demonstrated, he said, that Brentwood was not looking for an immediate exit strategy from Zumiez.
“What we see with growth-company IPOs, the IPO is typically to raise growth capital to help them execute their business plan,” Dandel explained. “Then, if they’re secure in executing their plan, there might be an opportunity to do a secondary offering [later], which is more geared toward private liquidity to the previous shareholders.”
Yet, in another example, Hampshire Equity Partners, which owns 55 percent of the 221-store specialty chain Citi Trends, sold only 10 percent of its shares during the company’s May 18 IPO, which raised $53.9 million.
According to Laurens Goff, principal at Hampshire Equity Partners, the IPO was a way for the private equity firm to give value back to its own shareholders.
“We tell our investors that we are going to return their capital on a certain time horizon and therefore, like all private equity funds, we have to think about an exit strategy for our investors and we felt that we could get them some value by going public [with Citi Trends],” Goff said.
Complying with the rules imposed on public companies is costly and complicated, and certainly has had an impact on how quickly private companies can feasibly go public. The U.S. capital markets have the now-famous scandals at Enron, WorldCom and Tyco to thank for the Sarbanes-Oxley Act of 2002, which went into effect in 2004 and required for the first time that all public companies prove the effectiveness of their internal auditing controls to the SEC.
“Compliance is the new corporate bogeyman. It’s lurking around every corner. It’s in every shadow. It’s everywhere you look in all of the public companies. And it goes form S-OX to accounting to directors’ and officers’ liability insurance,” said Dandel. Sarbanes-Oxley “has made the [IPO] process much more expensive, so it just, again, reflects on the level of commitment and the quality of a company that’s required in order to do a successful IPO.”
Retailers especially are still adjusting to the act’s Section 404, with which they had to be in compliance by Dec. 15 last year. Section 404 requires managers to establish and maintain internal controls in financial reporting.
In fact, Carleen Kohurt, chief financial officer of the National Retail Federation, a Washington industry trade group, said recently that she wouldn’t be surprised to see some public companies delist from U.S. markets due to difficulties complying with Section 404.
“Our cfo’s are telling us year-one costs are going to be most significant, but year-two costs are not dropping down to zero,” said Kohurt. “It’s dropping, but for many companies, it will not be as big a drop as they might have hoped.”
A Korn/Ferry International study found that complying with Section 404 can cost companies an average of $5.1 million and that ongoing compliance can cost $3.7 million a year.
“The staffing and the financial reporting requirements are just voluminous,” Kohurt said. “The person who is responsible for the SEC filings [is] probably a director of financial reporting; it’s a very, very hard job to fill.”
Section 404 also is creating other problems. According to a recent report from Standard & Poor’s Ratings Service, during the past nine months, “approximately 9 percent of the U.S. companies rated by Standard & Poor’s Ratings Services reported material weaknesses under Section 404, or delayed filing of their annual reports as a result of internal control deficiencies or related findings,” the ratings firm said.
Another fairly recent snafu has been Regulation FD, which has somewhat limited how public companies can communicate. The SEC adopted Regulation FD in 2000 to eliminate the practice of selective disclosure. It “requires that, when a public company chooses to release any information, it must be done in such a way that the general public has access to it at the same time as institutional investors and analysts,” according to a definition from Investorwords.com.
So, while becoming a public company is a cheaper way of raising money, there are more costs associated with being public than ever before. That said, there is a flip side to the public-versus-private discussion. The billion-dollar private equity market has shown a lot of interest in the retail sector, and public retailers are not against being taken private.
In recent examples, department store chain Mervyns was sold to Cerberus Capital Management, Sun Capital Partners and Lubert-Adler/Klaff and Partners by publicly held Target Corp. in July 2004, and drugstore chain Duane Reade was taken private in mid-2004 via a leveraged buyout from subsidiaries of private equity fund Oak Hill Capital Partners.
In May, Neiman Marcus Group was bought for $5.1 billion by Texas Pacific Group and Warburg Pincus LLC, two private equity firms, and likely will become a public entity; Saks Inc.’s Proffitt’s and McRae’s stores were bought by the nation’s largest privately held department store company, Belk Inc., in July; regional discount retailer ShopKo, which was purchased in April by an affiliate of private equity firm Goldner Hawn Johnson & Morrison Inc., is expected to be taken private, and last year, Toys ‘R’ Us was bought by a group of investors, including Vornado Realty Trust, and is now privately held and in the process of being delisted from the New York Stock Exchange.
The main benefit of being bought out and taken private is that a company can revise its business model or change the capital structure in relative peace, away from the glare of Wall Street, said Ernst & Young’s Muscat, chair of his firm’s annual IPO retreat for pre-IPO companies.
“It’s just simply more efficient to be a private company in doing that,” he said, noting that companies who can focus on fixing their business in this way tend to have a high success rate, and some even go public again.
Muscat cited the case of FTD, a network of florists that first went public in 1999 as FTD.com and was taken private after an LBO by private equity firm Leonard Green & Partners LP in October 2003. FTD Group Inc. went public again last February.
“Typically, the private equity guys, they believe the public markets are undervaluing the inherent assets of [a] company,” Muscat explained. “They use various equity and debt mechanisms to finance that purchase and the changes the company tends to undergo.”
But, eventually, private equity funds want their money back, too. And so the hunt begins again….