Early or late, buying in or out?
So you’ve decided to allocate 5% to private equity but face the question of which category to invest in. Private equity is the generic term for funds invested in any business, be it an idea on the drawing board or the purchase of a seasoned (if somewhat underperforming) company. In general, early investment entails a far greater risk, but with great potential returns, while both risk and expected return generally diminish as time passes. Listed below in progressive stages (for ease of presentation) are the various types of private equity investment.
Those willing to shoulder great risk in the pursuit of huge returns should be investing from the word go. The earliest stage of private equity is so-called seed capital – finance provided for the development of a business concept, perhaps involving the production of a business plan, prototypes and initial research. At this stage, the company is no more than an idea and the venture is high risk. One stage on from this is start-up capital. This is finance provided to companies for product development and initial marketing. Companies may be in the process of being set up or may have been in business for a short time, but have not yet sold their product commercially.
One step on is other early stage investment – financing for companies that have completed product development and initial marketing and require funds to initiate commercial manufacturing and sales. At this stage, companies may not be generating funds. It is in this co-called venture capital area that it is where the enormous returns on capital are to be had – initial backers of America’s eBay, for example, made 2,000 times initial capital. Venture is normally taken to include every stage up to expansion financing. As the financing rounds progress, so the risk begins to fall, albeit relatively. According to John Barber, a partner at Helix Associates, on a seed portfolio you’d be very happy if 10 out of 30 initial ideas survive and, of those 10, you can realistically expect three (or 10% of the initial total) to be real winners. In other words, great potential returns, as ever, reflect a significant risk premium
The next stage is expansion – investing money in a company that is fairly well established. As the name might suggest, expansion is capital provided for the growth and development of an established company. Funds may be used to finance increased production capacity, for product development, to provide additional working capital, and for marketing purposes. A typical example according to Barber, would be a UK, family-owned small manufacturing business wanting to expand, for argument’s sake, on to the continent. At this stage the company has normally turned a profit. Expansion, in short, is normally the result of one corporate event that requires a flood of capital and one way of doing this is to sell a slab of the company’s equity. Since the company is well established, this practice is less risky and expected returns are therefore lower.
Early stage investment is far riskier and for some investors, particularly the inexperienced, unsuitable. By far the most popular (and more cash-intensive) sector is that of the management buyout, commonly referred to as MBOs. These are funds provided to enable current operating management to acquire or to buy a significant shareholding in the business they manage. In most cases the management team seeks the support of private equity investors to buy the shares of the company
In addition to this is a variant, the management buyin – funds provided to enable a manager or group of managers from outside a company to buy into it. Management buyins occur when there are insufficient internal management skills to conduct a buyout. A team from outside the company normally acquires a controlling interest- again with the support of private equity investors.
There are other types of buyout, each referring to the buyer – for example, an investor-led and management-employee buyouts. Institutional buyouts are the purchase of a company by a venture capital firm following which the incumbent and/or incoming management will be given or will acquire a stake in the business.
Buyouts have long been a major part of private equity and the most important. According to the EVCA, in 1997, of the E9.7bn invested in private equity, 50.1% was invested in buyouts and by 1999, 53% of the E25.1bn invested in private equity went into buyouts. Barber says this is for one simple reason: “With a buyout, you’re buying an established enterprise and one that has proven cash flows, profits and assets.” In contrast, when you’re starting a venture, it’s totally novel, has no track record and hence takes much less money because it’s unproven. As an illustration, there are multi-billion buyout funds, the largest in the US being around $6bn, whereas the largest venture fund is about $2bn.
In terms of reward, Barber says an excellent return on a buyout is getting about five or six times your initial capital. A buyin can be a little riskier than a buyout because the new management isn’t familiar with the company. “There are times, though, when the private equity manager judges that the only way to do something is as a buyin, as they’d rather take the risk under the new management rather than back the existing management,” says Barber.
Mezzanine financing is yet another private equity category, although one that remains relatively obscure. In the US, for example, in 1999 5% of funds raised were for mezzanine financing. Although reliable, up-to-date figures are hard to come by, this figure is probably less for Europe. Mezzanine financing takes its name as loan finance sitting between equity and secured debt, often provided as part of a venture capital package. It is basically a loan secured by the existing company’s assets and is very often a constituent in a buyout strategy.
Take, for example, a company with a certain equity/debt ratio but one with scope for greater leverage due to surplus cash. A potential investor can buy it with less equity and replace it with mezzanine financing while keeping debt at existing levels. Mezzanine investors still have to see cash as it’s pretty high risk and therefore normally only applied to established companies. “It’s a rare mezzanine investment where there isn’t cash to support the debt incurred so, again, it’s a proven company that can use mezzanine,” says Barber.
One final private equity sector presently in vogue is public to private, essentially finance provided to take a quoted company into private ownership. This is popular at the moment as the public markets are not valuing traditional companies in the way they used to. According to Barber, public to private transactions are likely to be a future source of business in the US. Historically, those public to private deals have involved a large company selling a division it no longer wants. Instead, private to public deals have progressed and typically it is now whole companies being purchased. Again, the European market lags a little but nevertheless, there’s plenty of talk about conglomerates being undone.
The problem is that these are extremely difficult transactions to manage. You’re dealing with thousands of shareholders and a board that is often very nervous about selling at the right price. The main risk associated with a public to private deal is the transaction – once you announce a public bid, competitors can scour the company financials and take a shot themselves. Boards are often anxious that they don’t get sued. Typically, private equity investors are only interested in buying when the price is depressed. There are also exchange rules to be adhered to, there’s a chance the financing packet can be nullified by a counterbid in a public to private (opposed to a private deal). Also coming off a bull market there’s a reluctance to accept offers as shareholders remember heady share prices. There are likely to be numerous deals in Europe, although Barber predicts there will probably be less than expected.
And, as a footnote, there are a number of small, specific categories. Refinancing bank debt, for example, and secondary purchase- the practice of buying existing shares in a company from another venture capital firm. Rescue and turnaround is financing provided to a company in difficulties or to rescue it from receivership and leveraged build- up is when a venture capital firm buys a company as principal with the aim of making further relevant acquisitions to develop an enlarged business group.