How to raise capital, privately.
A QUIET REVOLUtion has changed forever the way American companies gain access to the capital necessary to grow and create jobs.
Private equity investment capital is now available to small and large companies in nearly every industry. The growth of the private equity industry in the past 10 years has been astounding, as the total funds committed have grown from $5.6 billion in 1982 to $95.3 billion in 1992, according to the Private Equity Analyst, a leading industry publication. Financial executives in public and private companies should consider using private equity as they attempt to optimize the capital structures of their companies.
Private equity comes in many shapes and sizes, roughly corresponding with a company's position in the corporate life cycle. The three most common types of private equity are venture capital, strategic block investments and leveraged buyouts.
Venture capital, provided at the formation of a company or during a period of rapid growth, is the riskiest form of private equity, due to the high failure rates of new companies. But it provides the highest return to investors. Among the most successful venture capital-backed firms in the U.S. are Apple Computer, Federal Express and Office Depot.
A strategic block investment usually takes the form of a large minority position, typically in a public company. Its popularity has grown considerably in the past five years, as U.S. companies have wanted to concentrate large blocks of stock in friendly hands. Examples of strategic block investments include Warren Buffett's purchase of a stake in Salomon Brothers and a $300-million investment by Corporate Partners in Polaroid to help the company avoid a hostile takeover.
Leveraged buyouts, by far the largest category of private equity, involve the purchase of a company or division, utilizing the assets and cash flow of the acquired entity to borrow heavily to finance the purchase. Leveraged buyouts range in value from a few million dollars to multibillion-dollar transactions. Many leveraged buyouts have involved household names, such as the acquisition of RJR Nabisco by Kohlberg Kravis Roberts, the purchase of Gibson Greeting Cards by William E. Simon and Forstmann Little's acquisition of Dr. Pepper.
American companies, now more than ever, must raise capital to grow their businesses and remain competitive in a global economy. This requires huge capital investments to improve manufacturing productivity, provide for sophisticated information technology and fund overseas expansions. Today's sophisticated financial executive may believe there are many alternatives to raising this capital but may not recognize the volatility inherent in the most common forms of corporate financing.
ARE YOU LIMITING YOURSELF?
The traditional methods of funding capital requirements are through internally generated cash flow, supplier credit, bank borrowing and issuance of public debt and equity. Private equity investments have some advantages over these traditional methods and can be used in combination with other sources of funds. Private equity is available on a consistent basis, regardless of the condition of public equity and debt markets, and doesn't come with burdensome and costly disclosure requirements. And private equity investors typically are patient, long-term holders.
What are some of the limitations of the traditional forms of financing?
* Internally Generated Cash Flow -- As the pace of business change intensifies, internal cash flows have become increasingly volatile. Once considered fortresslike and unassailable, the cash flows of companies like GM and IBM have deteriorated rapidly. And claims on corporate cash flows are growing, as shareholder dividends, federal and state government taxes and employee health care costs consume more cash flow.
* Supplier Financing -- During difficult economic conditions, suppliers become increasingly concerned about the potential for large credit losses. Many vendors are tightening credit standards, limiting the credit available and demanding shorter payment terms, all of which decrease the amount of financing available from suppliers.
* Bank Borrowings -- The credit crunch many companies experienced in the early 1990s shows no signs of abating. Commercial banks now earn more in their trading activities and can earn comfortable spreads in today's low interest rate environment by investing in Treasury securities rather than providing loans.
* Issuance of Public Debt and Equity -- The low interest rate environment of the past 18 months, coupled with a huge supply of funds searching for higher returns, has led to a booming market for initial public offerings and other issuances of debt and equity. Corporations have taken advantage of low interest rates and high P\E ratios to raise capital and replenish depleted balance sheets. However, the public markets are notoriously fickle. The financial landscape is littered with CFOs who relied too heavily on the public markets, only to find the proverbial "window" shut before they could complete an offering.
Given the uncertain and often volatile nature of the traditional sources of capital, the consistent availability of private equity is a safe harbor for many capital-constrained companies. The providers of private equity aren't concerned about the direction of market psychology or the latest rumors in the European currency markets. Their most important concern is investing in solid companies with strong management, so they can generate high rates of return over a five- to seven-year time horizon. That's why private equity investors are always willing to invest, in economic expansions as well as downturns, in high and low interest rate environments and in both high-growth and low-growth industries.
Another advantage of private equity is the lack of volatility in the pricing of a company's equity securities. Because private equity investors aren't beholden to daily mark-to-market policies, they're flexible in structuring terms and conditions that allow a company to choose capital projects with longer-term paybacks, rather than short-term initiatives to bolster the next quarter's earnings. And providing private equity doesn't require burdensome disclosures, which can drain time and resources from management and give competitors, customers and suppliers a detailed look into a company's operations and finances. This is a particular advantage to closely held, nonpublic companies.
Private equity investors tend to be value-added investors, sometimes in sharp contrast to the peripatetic traders and "gunslinger" money managers who own vast amounts of public equities. The trader, who may own a security for an hour, and the money manager, who can turn over his portfolio five times a year, are typically not concerned with the long-term outlook for a company's business. The private equity investor, with a multiyear horizon, has a strong vested interest in working closely with management to add value to his holdings. This added value can come in many forms:
* Board Representation -- The private equity investor will often sit on the board of directors and provide business insight gleaned from experience in many industries. This role can be very valuable in situations like Salomon, where Warren Buffett took over the chairman's role and provided stability after Salomon became embroiled in the Treasury bidding scandal.
* Financial Acumen -- The leveraged buyout investor brings a keen understanding of the financial techniques that can improve a company's access to capital. Many leveraged buyout firms have recently taken advantage of attractive debt financing at low rates and strong public TABULAR DATA OMITTED equity markets to bolster the value of their portfolio companies.
* Capital Available for Add-On Investments -- Private equity investors often provide additional investments to their portfolio companies. These investments are made to take advantage of growth opportunities or to provide support for expansion. Conversely, incremental investments are sometimes provided so a poorly performing company can stabilize its capital structure. In either case, the private equity holder is a logical investor for the company, due to its knowledge of the company, familiarity with management and substantial stake in the long-term success of the corporation.
GETTING THERE FROM HERE
To access the huge pools of private equity available, you must understand the providers of private equity and what motivates them. The ultimate financiers of private equity are large institutions, such as pension funds, insurance companies, endowments, commercial banks and investment banks. Pension funds and endowments typically invest their money with intermediaries, such as venture capitalists, leveraged buyout firms and strategic block investors. The intermediaries select investments and monitor the performance of companies in return for annual fees and a percentage of the capital gains earned. Commercial banks, investment banks and insurance companies usually invest directly in companies.
The motivation of the private equity investor is to earn a return superior to public equities' return. Many institutions earmark a certain percentage of their capital to private equity to improve their overall returns. For example, according to the Private Equity Analyst, the California Public Employees Retirement System (CalPERS), the largest pension fund in America, has allocated $3.5 billion to private equity investments, and Princeton University recently announced it would earmark 10 percent of its investments to private equity. Also, insurance companies like Equitable Life and Prudential and commercial banks such as Chemical and Citicorp each have private equity portfolios in excess of $1 billion. According to the Private Equity Analyst, there are 19 private equity intermediaries with more than $1 billion in committed private equity.
With such a variety of alternatives, how do you find and choose the right private equity investor? And what type of equity investment structure is right for your company? The answers to these questions depend largely on the long-term capital needs of your company and its stage in the corporate life cycle. The chart on page 32 illustrates the appropriate matching of the private equity investor with the company.
Private equity investors are constantly searching for the types of investment opportunities listed in the chart. If you're interested in identifying a private equity investor for your firm, it's imperative that you get on the "radar screens" of private equity investors, much in the same way that you interact with commercial bankers and investment bankers. Because the private equity investor represents an integral part of the capital structure, you have to carefully cultivate these relationships over time. Choosing the right investor, who shares your company's vision, can be as important as choosing the management team of the company.
You can contact private equity sources by using existing relationships. For example, talk to your commercial bankers and investment bankers to see if they have private equity investment arms. Similarly, for public companies, your investor relations department should have a listing of the major institutional holders of your company's stock. Many of these pension funds, endowments and insurance companies invest private equity and will already be familiar with your company.
Competitors, customers and suppliers also can give you information on private equity sources; chances are that many of them have used private equity to grow their business. Finally, consider attending conferences where private equity investors gather to talk about trends in their industry, much as you would attend conferences that address other issues central to your work, such as accounting standards and cash flow management.
BEWARE THE SNAGS
While private equity financing can be a good fit for your firm's capital needs, you should enter into any agreement with a full understanding of its implications.
For instance, consider the impact of the liquidity needs and control provisions that often accompany private equity investments. The private equity investor will require a way to liquefy its investment, typically within a five-year period. The most common forms of liquidity are registration rights, tag-along rights on future sales of equity by the company, and put and call arrangements. Each of these liquidity options could prove troublesome if your company doesn't have a well-thought out plan to achieve an exit strategy for the private equity investor. For example, a put of stock to a privately held company could come at a time when the company isn't able to finance the purchase of the stock, or the exercise of registration rights could depress the value of a public stock by increasing the supply of stock available.
To mitigate these issues, companies and investors must work together at the outset to insure that the investor's liquidity goals closely match the company's ability to access the necessary capital. Typically, companies do this by staging the liquidity rights over time and limiting the investor's liquidity in circumstances where the company can't achieve liquidity for the investor.
Control provisions will vary with the percentage of ownership held by the private equity investor. For example, the leveraged buyout investor owning 85 percent of a newly private company will control the company, while the strategic block investor with 20 percent of a public company may have one board seat and little or no influence over day-to-day operations.
Another control provision that may prove sticky is the question of whether the private equity investor must approve your company's business plans, financings and significant corporate events, such as acquisitions or the sale of the company.
To avoid problems in these areas, evaluate the control provisions in your private equity investment agreement with these points in mind: How compatible is the investor with your management? What is the investor's understanding of the strategic goals of your company? And to what extent could the investor's liquidity needs hamper your firm's growth strategy?
If you can untangle these snags, the private equity investment field could become another powerful tool for you to use to raise capital. Remember, at some point in your company's development, you may need private equity; it's up to you to investigate the options and cultivate the relationships well in advance.
Mr. Hofmann is a general partner of Chemical Venture Partners in New York, New York.
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|Title Annotation:||State-of-the-Art Treasury Management|
|Author:||Hofmann, Donald J., Jr.|
|Date:||May 1, 1993|
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