Private equity ideas

Which form is best for your growing company? Consider all of the angles before making a decision.

By Elliott Knox, CMA

Private equity investing comes in many forms, and companies have to pick and choose which are best for their particular situation. This isn’t always easy, so it’s wise to review what each type of investing entails, how control over the company is affected, and what the trade-offs are.

Private equity broadly includes various types of equity and equity-like capital. Buy-out funds, mezzanine financing, and venture capital are the most commonly known forms of private equity. This capital is traditionally used to re-finance, acquire or further develop private companies.

The most mature private investing communities are the U.S. and Great Britain. There is more than $900 billion of private equity capital under management in the U.S. alone. According to the U.S.-based National Venture Capital Association, the venture capital segment of private equity invested a total of US$21.2 billion across 3,028 deals in 2002, and is on track to exceed that number in 2003.

Historically, the largest private equity participants have been institutional and private pension funds. Approximately 50% of all private equity capital in the U.S. comes from pension funds, with the balance provided by insurance companies, foundations, banks and individuals. While every investment group approaches asset allocation differently, putting a portion of the capital pool in private equity can increase the overall return of a portfolio while reducing volatility and risk. This is due to both the enhanced returns of private equity and the low correlation between the returns on private equity and those of the public bond and equity markets.

In Canada, merchant banking is developing in a similar fashion to the U.S. model. Larger institutions, most notably Canada Pension Plan, Ontario Teachers Pension Plan, the Province of B.C. Pension Plan and OMERS, have backed a number of fund managers to make private placement investments in Canada and internationally. At the same time, many of these same institutions are participating directly in private equity transactions.

The success of institutional investors in the U.S. has encouraged more individual investors to enter the private equity market over the last several years as well. High net worth individuals and successful entrepreneurs have teamed with professional private equity investors to develop new pools of capital. Labour-sponsored funds, which offer a tax-advantaged investment structure, were created to further encourage this trend and specifically promote venture capital investment in Canada.

Despite these developments, the relative size of capital deployed and available in the Canadian market is dwarfed by that of the U.S. A recent Macdonald & Company report on private equity states that private equity funds in Canada have a relatively small market share and noted that the “difference between institutional participation in Canada and the U.S. is considerable.” According to Macdonald & Associates, $7.5 billion was raised in Canada for private equity between January 2000 and December 2002, providing a total of $49 billion under management in 2002 or just 5% of the funds under management in the U.S.

The importance of private equity as a source of capital for re-financings, growth, succession, management buyouts, leveraged buyouts, and acquisition is growing dramatically as the capital made available by the more traditional sources of financing (the public markets and banks) remains restricted. But which form of private equity do you choose? Consider carefully.

The mezzanine market

Mezzanine financing represents the middle layer of financing on the balance sheet of an investee company after senior debt, which is traditionally provided by the major banks. A typical mezzanine investment includes a term loan and some form of equity or equity-like participation — normally stock, warrants to purchase stock, or a participation right. This structure gives mezzanine financing characteristics of both debt and equity financing. The interest rate charged on the loan component can vary but is normally around 8-12% with varying payment options. The loan is almost always subordinated to loans made by one or more senior secured lenders, such as the major banks.

Mezzanine capital is an integral component of the financial structure for larger investments. To optimize returns, buy out funds often encourage the leverage provided by mezzanine capital to achieve the required higher returns on their investments. The typical structure is outlined in the chart above.

There are, of course, advantages and disadvantages to each type of financing. On the positive side, mezzanine financing allows a company to add term debt beyond what is acceptable to most major banks; as debt, it is less dilutive to the existing shareholders, allowing them to retain greater control over and ownership of their companies; including mezzanine debt can greatly reduce the overall cost of capital and permits existing shareholders to retain more of the up side as compared to pure equity; and lastly, mezzanine debt is considered “self liquidating,” as it is structured to allow the investee company to retire the debt over a term, and sometimes earlier if performance exceeds expectations.

On the negative side, there is always some form of required payment plan, and the amount of debt that can be raised is limited. Companies that deviate substantially from their plans may find the payments difficult or impossible to make, resulting in loan defaults. Mezzanine debt, while normally behind senior lenders such as banks, is ahead of common and preferred shareholders in terms of ranking if the company is dissolved or otherwise sold to pay off the debt, leaving the original shareholders with a much smaller share of the proceeds, if any.

Buy out funds

Buy out funds provide the lowest layer of financing on the balance sheet of an investee company, through the purchase of common or preferred shares. This is the riskiest form of financing for investors, as they are treated in the same manner as existing shareholders. Actual terms of the investment vary considerably depending on the situation but some form of board representation and/or comprehensive shareholders agreement governing the relationship is standard.

On the positive side, the amount of equity financing that can be raised is greater and, unlike term debt, there are no required payments, which use up critical company funds and can lead to a default if there is a significant negative deviation or delay in achieving the business plan. All investors at this level rank equally and share in the profits and losses according to their ownership stake. For this reason, buy out funds are often more active and involved with an investee company, to assist them in achieving the business plan.

There are disadvantages to this type of financing as well, however. Because they do not rank ahead of existing shareholders, buy out funds require higher returns and more control over the investee company to protect their investment, normally in the form of a controlling interest, board representation or a shareholer’s agreement, which defines the relationship up front for everyone. This can mean greater dilution and reduced control and ownership for the company’s existing shareholders.

Equity-only structures are mirror images of debt only structures, increasing the cost of capital if the performance of the investee company meets its business plan, but reducing the risk and downside impact if the company stumbles.

Equity investments, because there is no repayment plan, have the inherent problem that they need to find a way to exit the investment, normally within five to seven years. Valuation mechanisms, agreements to seek third party purchasers by a fixed date or puts (where the company is contractually required to purchase the stock held by the investors) are common ways to manage this problem.

Venture capital

Venture capital is essentially a buy out fund for earlier-stage companies in which the concept, product line, management team, track record or overall risk profile make the investment unattractive to most debt providers and to more conservative buy out fund managers. Groups focused on this segment generally make smaller investments and exert more influence over operations. Returns vary considerably because of the high incidence of failure but expectations are for well over 30% on average.

The pros and cons are similar to buy out funds but more magnified. Alternative financing options for early stage companies are limited because of the risk profile.

The lines between these various forms of financing are not fixed, with buy out funds using preferred shares rather than common shares to reduce their risk relative to existing shareholders, and traditional mezzanine funds participating in equity-oriented deals. The advice, support and contacts provided by a private equity manager are sometimes as important as the form and structure of the proposed investment. In the end, all forms of financing have their place on the balance sheet and work together to optimize the return for the company and its existing investors.

Elliott W. Knox, BMath, CMA (elliott@bedfordcapital.net) is president of Bedford Capital Corporation, a private equity manager focused on established lower mid-market companies.

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