The Real Cure for SARBOX or the Iatrogenic Illness

Implications: Ms. Orit Gadiesh, Chairman, and Mr. MacArthur, Director of The Global Private Equity Practice at Bain & Company, believe that private equity is becoming a benchmark of performance for CEOs and boards of directors. The authors offer the following reasons for the popularity of private equity funds: -Funds focus on a reasonable time frame, three to five years typically, rather than on quarterly performance, the common timeframe for public companies. -Funds have detailed plans and time tables, enforcing discipline for clearly understood goals. -Funds quickly dispose of poorly performing assets, unlike some traditional managements. -Funds have a record of success, and exceptional earnings. Though not the only model, private equity funds provide an example of clear planning and solid execution with high returns from 1969-2006.

Analysis:  

Private equity funds have been around for a long time and have a solid track record for doing very well with certain companies and situations. Traditionally, their targets were troubled corporations that needed the hard financial discipline a highly leveraged capital structure requires.

Now there is much more interest, with traditionally organized new funds but also, new sources of funding for them, such as GS TRuE -- short for Goldman Sachs Tradable Unregistered Equity. This market will only be open to large institutional investors with assets of more than $100 million and will be neither registered with or subject to SEC regulation. NASDAQ and others are planning similar markets.

There are a broad list of evils which going private will correct to some degree.

-There will be less concern with making or meeting quarterly earnings estimates, which is time consuming, risky in a sense, and is pandering to fund managers who are just gaming the system, rather seeking true opportunities.

-As mentioned above, private management can plan and execute those plans over a reasonable period of time. Public Utilities have been willing to make significant regulatory concession to have, say, five years with no rate cases.

-Private funds get to choose there ground and have considerable experience with a range of companies. If you need surgery would you rather go to a hospital with a big practice in the area or a smaller one?

-Private funds are owner/managers so you do not have the agency costs associated with traditional management. There are no stock options, which are a sucker bet for stakeholders: heads I win, tails, we flip again, says management.

-Private funds can streamline internal systems and practices, needing only enough information to manage, rather than to satisfy the SEC. Current SEC disclosures, based on my experience as a Naval Intelligence Officer, resemble nothing so much as Soviet dezinformatsia, in both volume and clarity.

-Private equity funds must value all assets of the acquired company, to determine new GAAP and tax bases, which forces all concerned to look very closely at the ascribed values, and decide on which areas to emphasis and which to curtail or drop.

All the above have been present for decades in these deals, but now they are generally more attractive.

-SEC mandated disclosures, are seen as being less useful to investors. Navistar actually went up in value and has continued to do so despite being delisted by the NYSE, for failure to file financial statements in February 2007. It is now on the pink sheets and the market seems satisfied with periodic report of shipments and the status of the required multi-year restatements. Share price has gone from under $50, when it was delisted to $63 on May 30, 2007.

-Sarbanes Oxley compliance is quite expensive, and many have complained that these reports help neither the company function nor protect investors. In many instances, the control weakness relate to reporting issues that do not provide useful information to investors, or management.

-Sarbanes Oxley compliance can result in companies with a decentralized or holding company structure being priced out of their niche by these requirements. AES Corp. might be an example of such a company. It has over 700 subsidiaries, and has control weakness in the SFAS No. 109 area (taxes) and hedging, none of which has the slightest thing to do with whether it is a solid investment or not.

Again, Sarbanes-Oxley is one of the salient forces in the move from the SEC regulated markets. It should be noted that if it were radically changed, as Mr. Oxley suggests, the trend would still exist to leave regulated environments. Not only are the requirement expensive, even without all the onerous parts of this act, but many are coming to feel that the obsession with quarterly earnings, and the agency costs of current management are simply not the most effective method of wealth creation.

In the article, the authors mention that British supermarket chain J Sainsbury turned down repeated offers from a group including, Blackstone, TPG and Kohlberg Kravis Roberts & Co. because it felt management could solve its own problems without taking on the massive debt involved in going private. The critical question is if they can do it and know what has to be done, why haven’t they done it already? I would suggest that management is much too comfortable, with their current situation. I am reminded of the ancient Persian folk character Nasruddin. He promised the Shah that he could teach a donkey to talk in three years. A friend asked him what might happen, and Nasruddin said: “I could die, the Shah could die, or the donkey could learn to talk on his own.”

Sarbanes-Oxley is the villain of the piece. The law was written before all the facts related to Enron, WorldCom and the other scandals were known through the public record. Mr. Oxley has admitted that the law went much too far, especially Section 404 which establish the PCAOB. What has happened in an exercise in the Precautionary Principle, which in the name of preventing problems ignores the costs of doing so.

As a result, companies not only have unnecessary expense, but decentralized organizations are simply not feasible with the rules in question. These rules further serve as barrier to entry, requiring expenditures which might better be spent on the core business. The world will never know the cost because what might have been, will never exist: a silent witness as Cicero was first to note..

In summary, this article shows how flexible the world capital market is, and how bad law is defeated by it. Investors will simply not pay for what they don’t need, seeing information as just another good, and in the case, it will not be supplied, no matter the law. No matter, Sarbanes-Oxley has wounded the US capital market, and the corrections, it will not be the same again.