Private equity has long been a fast way to earn quick, massive returns on investment. Private equity firms invest in undervalued or underperforming companies and seek to make significant changes to their operations, often leading to dramatic results.
With the right company and strategic decisions, private equity firms can realize their return within two to six years. Once the pace of growth begins to slow down, private equity firms sell their acquired companies to other investors — typically other private equity investors.
Returns to private equity firms from their investments are often enviable and unmatched through other traditional methods, like regular trading on stocks. If the private equity firm has the necessary capital, it can hold multiple portfolio companies at once, implement specific changes, and turn around and sell them for a return on the open market.
While the private equity model has much to offer, most U.S. public companies have failed to jump on the trend. Certain factors prevent many of them from doing so. Some elements are financial, like the potential for capital gains taxes, while others are mindset-related.
Public companies tend to tread lightly on short-term gains in favor of a buy-and-hold mindset. However, a public company can use specific strategies to benefit from its acquisitions, just like a private equity firm.
Traditional private equity firms follow a buy-to-sell strategy. They don’t plan to hold on to the companies they invest in for the long term. Instead, they make their investment with a process in mind and immediately deploy it as soon as the ink is dry on the paperwork.
For public companies to adopt the buy-to-sell method for their acquisitions, they’ll need to shed some long-held beliefs. Most public companies make their acquisitions happen with the view that the company they purchase will add long-term value or synergy to the organization.
To shed their buy-to-hold mindset, corporations will likely have to find new resources and potentially change their business structure. The focus of running the acquired company will need to change.
Instead of looking at the new companies as new partners in their portfolios, corporations will have to see them as objective investments — something to grow and then sell when the timing is right.
In the U.S., corporations face tax consequences when selling an investment for gain. Capital gains taxes on corporations are pretty high and significantly reduce the return the company would earn by selling its acquisition.
Europe once had a similar issue but changed the rules for capital gains taxes in most countries in the mid-2000s. Thus, European public companies are in a much better position to sell their acquisitions without fear of heavy taxation.
A few public companies have found a loophole that allows them to reap the benefits that private equity firms have. One, American Capital Strategies, used the “business development company” organizational structure to circumvent capital gains tax.
However, the business development company structure does involve certain legal and regulatory restrictions, like a limit on the amount of debt it can use in its purchase.
Bringing public companies into the private equity field does have some benefits to investors seeking safety. Typically, private equity funds are illiquid. If they make a wrong investment choice, they can quickly lose their investors’ confidence (and money).
In contrast, a public company is traded on the stock exchange and must answer to stockholders. Investors can feel more comfortable that they’re not putting money into an acquisition that may prove unworthy. If they do, there are legal consequences to face.
While many public companies are unlikely to join in the buy-to-sell trade due to stockholder concerns, financial investment firms may be more likely to. They’re already engaged in managing consumer investments; such a strategy may align quite well with their dedication to earning a return for their investors.
Flexible ownership may appeal to public companies that already own several businesses that don’t provide similar products or services. For instance, General Electric has long been a player in the conglomerate field. It has a management program that encourages the development of cross-functional skills among employees.
As employees develop their skills, they move across business sectors, adding value as they go. The model is attractive to both General Electric and its workers; General Electric benefits from a cross-functional skill set while employees garner more knowledge than they would have if they had followed a traditional employment path.
Applying the flexible ownership model to newly acquired companies could give General Electric an edge over its competitors. It could move people with various skill sets across organizations by utilizing its current management program. At the end of the year, it could sell the businesses it has grown to maximum potential and purchase new ones.
While flexible ownership does not dissolve a public company’s capital gains tax responsibilities, there are ways that it could reduce them. For instance, creating a spinoff, where the owners of the public company receive equity in a new, independent entity, could eliminate the capital gains tax constraints.
The holding company would simply build up the acquisition until it was time to sell, then divest it to new investors with no additional taxes paid.
While there are a few options for public companies seeking to get in on the private equity action, they’re a tough sell. A change in mindset is necessary, and this can prove very difficult to implement in a stable public company that’s reluctant to change its business model.
Tax and legal constraints present their own problems. The simple buy-to-sell strategy doesn’t work very well with public companies seeking to minimize their capital gains tax exposure. Certain organizational limitations can make adopting a private equity acquisition mindset too prohibitive.
However, some public companies may benefit from the private equity model. Financial investment firms would be the most likely to see results from private equity acquisitions, as they’re already in the business of investments and have resources that could identify strategic acquisitions and appropriately manage them.
With time, more public corporations may be able to earn returns through acquisitions similar to the private equity model.
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