When Sarbanes-Oxley first took effect, private equity groups thought they had it made. Public company executives horrified at the cost of SOX compliance and its intrusive governance provisions, they figured, would try to escape the law’s purview by rushing into the arms of private equity buyers.

Wender

It hasn’t worked out that way. For starters, managements know they can’t control the process: once a public company is in play, another strategic buyer independent of management could outbid a preferred private-equity buyer. “That fear has probably been the check on the system,” says Justin Wender, senior managing director and chief investment officer of Castle Harlan, a private equity firm in New York, “It isn’t the panacea it was billed as.”

Then there’s the other annoying truth: many businesses cannot avoid SOX even if they do go private.

For many deals, the financing includes debt securities that are publicly traded or have registration rights attached—and as soon as that debt is registered, SOX and its nettlesome Section 404 review of internal controls apply. Especially for large, multi-billion dollar buyouts, “the private equity firms are assuming those companies will be subject to the SOX rules,” says Jay Mattie, national assurance leader of PwC’s private company services practice.

Friedman

At the Blackstone Group in New York, most of its portfolio companies do have some sort of public debt, Chief Administrative and Legal Officer Robert Friedman says. From his perspective, SOX has no effect: it applies both before and after the firm acquires its typical target, which already has the compliance staff and systems in place.

That’s not to say Friedman likes SOX; he deplores how its “up and over” rules that govern auditor independence intrude on private equity firms since they act as an umbrella business owning many operating companies. He gave the example that when Blackstone bought Celanese Corp., Ernst & Young was performing a minor prohibited non-audit service for Celanese in Germany. Ernst & Young is also the auditor for TRW Automotive, another company Blackstone controls. Blackstone had to terminate Ernst & Young’s Celanese project because the work tainted the auditor’s independence at TRW and three other portfolio companies, Friedman says.

With more than 40 companies under its umbrella, Blackstone devotes “a monumental amount of effort” to policing the auditor independence rules, he adds. “It’s ridiculous. How can Ernst & Young’s independence at TRW be affected by a minor engagement at Celanese which Ernst & Young’s TRW people didn’t know about?”

SOX has crept into the mid-market private equity world, too, where companies do not always have public debt outstanding. Wender notes that if the exit strategy for a portfolio company contemplates an initial public offering, the firm must first build a SOX infrastructure. Although SOX compliance can be less important in trade sales to public companies because they already have systems in place, private equity firms prefer to keep the IPO option open.

“In many cases the public market will pay you more for the growth characteristics of a business than a private firm would,” Wender says. “So as long as that arbitrage exists, people will continue to do IPOs.” Castle Harlan’s companies typically incur an incremental recurring annual cost Wender estimates at $500,000 for SOX compliance.

SOX, All The Way Down

When SOX extends to cover smaller public companies—currently scheduled for 2007, although the date may slip again—its influence on private equity firms “incubating” those small companies will tighten. At the low end of the market, Mattie believes those higher costs of SOX compliance could undermine the viability of an IPO exit strategy, forcing firms to sell to a strategic buyer or another private equity shop instead.

For medium-sized portfolio companies, private equity firms will face a dilemma, Mattie says. If the exit is a sale to a buyer that has its own infrastructure, a seller’s investment in SOX compliance will be money down the drain. “That investment decision gets a little tricky as you start to move up the spectrum from smaller-sized companies to larger ones,” he says.

His suggestion: Private equity groups should incorporate SOX into their plans from the beginning. If the target company has never been part of a public company, implementing internal controls and having outside auditors test them can take a year or more, so Mattie always tells clients to allow enough time if they are considering an IPO. “I hate to see a deal a month and a half away and they ask what they have to do to get through this market window to take it public,” he says, “You can’t do it unless you have been working toward it and you’re 75 percent of the way there.”

Kramer

Some firms believe they will recoup compliance costs through a higher selling price. Marc Kramer, a managing director of Fenway Partners in New York, says his firm embraces SOX as part of a broader move toward managing portfolio companies to what he calls a “public company standard.” At Greatwide Logistics Services, a Dallas-based transportation company that Fenway acquired in 2000, Fenway has adopted a stock option plan, set up an internal audit function to comply with Section 404, and introduced independent directors to the board.

Kramer isn’t sure the company will ever go public, however. He believes that Greatwide, which has grown rapidly through acquisition from $175 million in revenue to more than $1 billion, has greater flexibility in deal negotiations as a private company. Yet being SOX-compliant reassures target companies that Greatwide has proper internal controls to handle repeated acquisitions. When exit time does come, Kramer thinks potential trade buyers will have more confidence in what they are getting—and if an IPO makes sense after all, the company already has appropriate internal controls and meets the standards for independent directors.

Although private equity groups can build SOX compliance costs into their business plans, the corporate governance requirements irk Wender, who says they interfere with Castle Harlan’s customary oversight. If the firm takes a portfolio company public but retains a significant minority stake, its representatives on the board cannot qualify as independent directors. They cannot sit on the audit committee; if the company is listed on the New York Stock Exchange, the compensation and nominating committees are off limits, too.

“You are telling people who own a lot of stock that they shouldn’t help ensure that the company succeeds,” he gripes. “We can’t be as directly involved in the decision making process in a number of areas as we would normally like to be.”

The governance rules affect how Fenway approaches exits through the public market. Kramer says his firm has always been reluctant to cede control of the compensation committee, although it recognizes that qualified professionals can add value on the audit committee. As long as Fenway retains more than half of the equity, the rules do permit its representatives to sit on the key committees. If they can’t, Fenway seeks to attend meetings as an observer, or at least to have access to the information presented. Kramer looks for directors who will focus on developing the business so that their independent decisions will still serve Fenway’s best interests.

“Our comfort level is higher if we have a significantly reduced ownership in the company,” Kramer says. “We spent a lot of time looking at those ownership cutoffs.”