The recent news that Dell, the world’s number three PC-maker, is returning to private hands may have triggered similar thoughts among the leaders of many other tech firms, especially those whose stock prices have been languishing.
A consortium led by the firm’s founder, Michael Dell, is expected to buy back the company for around US$24.4bn, taking the firm off the Nasdaq after a quarter of a century as one of the biggest names on the index.
Over the last five years, Intel’s stock price has performed unspectacularly while Cisco Systems’ stock price has gone down. So should these giants also consider a similar path as Dell? Under what conditions does a privatisation move such as Dell’s make strategic sense?
Let us first understand the ‘costs’ and benefits of privatisation. Since privatisation involves replacing a lot of equity with debt, it carries risk, especially if there is an economic downturn when the privatised company may find it difficult to service its debt.
The costs of capital for a private company may also be higher because it is not held to the same standards in respect of transparency and governance as a public company.
On the benefits side, privatisation gives more freedom to the management to pursue a chosen strategic path without having to worry about delivering strong quarterly results. Privatisation could also take advantage of a genuine mismatch between the true worth of a company and the value attached to it by the market.
History offers us examples of both failed as well as successful privatisations. In 2007, the well-performing Singapore luxury watch retailer, Sincere Watch, was privatised by Hong-Kong based Peace Mark Holdings, which collapsed under the weight of its debts within six months.
On the other hand, in my recent book (High Performance Companies: Successful Strategies from the World’s Top Achievers, Wiley, 2011), I discuss Nestle’s privatisation of Alcon, the ophthalmic products company. After acquiring the company, Nestle trusted Alcon’s management (which had a strong record) and provided only broad guidance and strategic support -possibly also including capital to fund some of its acquisitions.
Without accounting for the time value of money and possible additional investments by Nestle, the value of Alcon rose from a ‘mere’ US$280 million in 1978 to US$2.5 billion in 2002 when it was re-listed on the New York stock exchange, and further to almost US$40 billion by January 2010 when Novartis agreed to take it over in another privatisation.
Broadly, privatisation would make sense under a few conditions.
1. First, there must be some uncertainty either in the environment or in the strategic path and future prospects of the company being privatised. In Dell’s case, the uncertainty arises because of two factors. There are diverse perspectives on the future growth of the PC market with some predicting that PCs would become obsolete over time, and yet others predict that PCs might be less significant to the computing world than today but would, nevertheless, not become entirely obsolete. Secondly, in terms of issues specific to Dell, there is uncertainty about Dell’s ability to increasingly move towards high margin services business. Clearly, Michael Dell and his co-investors believe that the market is over-estimating the decline in demand for PCs and under-estimating Dell’s ability to move into new businesses. This gap in perception (between the market and Mr Dell and his co-investors) is causing the undervaluation of Dell, a key trigger for privatisation. In the absence of the aforementioned uncertainty, the possibility of mispricing by the market is rather low and hence the likelihood of successful privatisation will be slim.
2. Privatisation may be risky in cyclical industries. Because the capital structure of a privatised company is debt-heavy, a cyclical downturn can wreak havoc on a privatised company. Peace Mark Holdings found this out the hard way shortly after it bought up Sincere Watch when the global financial crisis caused it to go under.
3. When a company undergoing privatisation has privileged access to capital, it can moderate its risk as well as capital costs. In Dell’s case, Michael Dell has risked a significant sum from his personal fortune (his 16 per cent stake in the company) to support the privatisation. Dell was also supported by the deep-pocketed Microsoft, which had its own vested interest – namely use of its Windows operating system in Dell’s PCs and laptops – in the firm’s better performance.
4. The company being privatised must have some strengths which can be supplemented by its partners, through acquisitions or otherwise. The combination of strengths could lead to a dramatically better performance. In a rather famous instance of supplementing strengths, Philip Morris was able to transform the 7th ranked Miller Brewing Company into a 2nd ranked player within a short period of time by infusing it with marketing and branding skills.
However, privatisation is not for every company. Firms with very high market valuations (e.g., Intel or Cisco which have valuations in excess of US$100 billion each) may simply be unable to find sufficient capital to go private.
The investors taking a company private must also have strong beliefs about the mispricing by the capital markets and also a favourable outcome from the resolution of uncertainty. In other words, there should be a strong expectation that the privatised company will emerge a winner when the uncertainty is resolved.
A high interest rate regime might also discourage privatisation because the interest burden inflicted by a debt-heavy capital structure may prove to be too onerous in such an environment.
It may be important to emphasise that this article discussed the ‘voluntary’ privatisation of companies that are not in distress – many of the above issues may be moot in a distress situation such as Blockbuster, which would have gone bankrupt without acquisition (or rescue) by the Dish Network in 2011.
In conclusion, privatisation is an important and interesting strategy that is suitable in specific situations and for specific companies. We might see many more privatisations in the current economic environment which is awash with liquidity.