Sarbanes-Oxley

When accounting scandals such as Enron's were brought to light, the U.S. government had to deal with public anger the best way they know how - more regulations! Thus was born The Sarbanes Oxley Act of 2002 (SOX). SOX meant public companies were now required to identify areas in their operations where internal financial accounting and reporting controls need to be strengthened. The idea sounds great, but the implementation costs for businesses escalated very quickly.

Many security software companies profited greatly because every public company had to look for solutions to ensure compliance. It was the best thing since the Y2K fiasco. Investors who were able to see this trend also benefited from the process. The moral of the story here is to always be aware of new laws and regulatory changes as these changes often reshape the investing landscape.

But SOX did more than just add expenses and cut into company profits. SOX became the greatest catalyst, the biggest motivator for small public companies to go private. Only public companies trading on exchanges were subject to this regulatory action. Small-cap and micro-cap companies were most motivated to reconsider remaining public because the costs and efforts in complying with increasing securities regulation simply wasn't worth it!

Along comes Private Equity ... The perfect mate?

Private investor groups have always been around and have always been looking for acquisitions. But they suddenly found a much larger audience that was willing to listen! More and more company boards are hiring investment bankers to search for buyers with the ability to take their companies private. Of course, these investment bankers earn their commission from brokering the deals. So we now have another industry (investment bankers) that have profited from the introduction of SOX.

Other companies didn't believe going private is the right route and decided to merge with their former competitors to enjoy economies of scale. Two or more merged companies can benefit from reduced compliance costs as processes are consolidated together. That's why we've been seeing record numbers of mergers and acquisitions (M&As) in the last 2 years. Again, the investment banking industry reaped the rewards.

How does Leveraged Buyouts fit in?

Whether it is a privatization or a public merger, there's always the issue of how to pay for the transaction. You may say I'm stretching the effects of SOX too much here, but SOX definitely helped clean up the balance sheets, income statements and cash flow statements of many public companies. The curious result of focusing on good accounting is that companies are increasingly able to build up cash reserves! It's easier to maintain a squeaky-clean image for the regulators when you can show them the money.

If you were company A looking to buy out company B, and company B has a decent amount of cash reserve, it's much more attractive to pursue a leveraged buyout. A leveraged buyout is essentially a strategy to acquire another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. It's easier to borrow this money if you can put up the cash reserves of company B as a collateral for the loans. Cash remains the most preferred form of asset collateral.

I slept through the lesson, what should I have learned?

Honestly, it'd be best if you declared you learned nothing and simply internalize this information for the next time you look at stocks and regulatory changes. There in lies the zen of investing. Currently, if you want to exploit the industries that have benefited from this regulatory directive, you've already missed the train. Recent rumblings from Washington seem to suggest that many in power are considering perhaps SOX may have gone too far and could eventually be scaled back. Which makes sense! After all, their public humiliation was 5 years ago! People forgive and most importantly, forget.

Nevertheless, there are still many companies pursuing privatization and M&A opportunities. Such actions often mean they are paying a premium on share prices to facilitate the buy out. Battered and beaten down companies who have good growth prospects become good buy out candidates. They are even more attractive if they have a healthy cash reserve and little or manageable debt.

Vince Chan is an InvestorGeek, and editorializes about investment / financial media at Investorial.com.