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This section is borrowed from the Columbia Business School Private Equity Club Overview FAQ Glossary External Resources |
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Widespread use of the phrase “private equity” dates back to the late 1980s. For most of the decade, leveraged
buyout firms had routinely tried to profit by breaking the companies they had acquired into pieces and then selling
them off. The theory was that by breaking companies apart, a firm could awaken buyers to the true value of a
company’s assets, and then profit from their sale, one by one. The strategy proved a financial success, but a public
relations debacle. By the late-1980s, the business press was regularly lambasting leveraged buyout firms for what
they perceived as their rampant greed and arrogance. By the early 1990s, few leveraged buyout firms were pursuing
“buy-and-bust” strategies anymore, but the damage to their image had been done. Many leveraged buyout shops
decided that the answer was to call themselves something new. They settled on “private equity firms” — an
innocuous sounding moniker that, as with most euphemisms, is less descriptive and more ambiguous than the phrase
it replaced.
For buyout firms, the attempt to rename their business was only a partial success. The press by and large still refers
to leveraged buyout firms as leveraged buyout firms, or LBO firms. However, firms did succeed in getting “private
equity” into the lexicon. Some people, as it was intended, use the term private equity as a synonym for leveraged
buyout. More commonly, however, people use private equity in a broader sense, as we do, to describe any
investment strategy that involves the purchase of equity in a private company. Along with leveraged buyouts, these
strategies include venture capital investments, distressed debt investments and mezzanine debt financings.
The private equity market has experienced unprecedented growth during the past decade, and it is still growing.
Since 1991, venture capital, LBO and other private equity firms have raised record amounts of money to finance
private, entrepreneurial companies. The rise in capital raised and deployed has been astounding. At the beginning
of the decade, in 1991, private equity firms raised just $8 billion for their investments, from individual and
institutional investors. By 2000, private equity firms succeeded in raising more than 20 times that amount, $175
billion, on the strength of double-digit investment returns through much of the decade. However, the recent decline
in the overall economy and lower transaction volume has made capital difficult to deploy. The year 2003 remained
difficult for private equity fundraising. Private equity firms raised $43.9 billion for new investments in 2003, falling
26% from the 2002 level.
The companies that private equity firms finance span the spectrum of technologies, from cutting-edge medical and
Internet start-ups to established, old-line manufacturing companies. They include service companies as well, such
as retail stores, health care management companies, money management firms and similar businesses. The common
denominators for these businesses include sophisticated financial investors, highly motivated owner-managers, and
the opportunity for both to earn exceptional investment returns.
Leveraged Buyouts Leveraged buyout firms specialize in helping entrepreneurs finance the purchase of established companies. The approach of such firms is to provide a management team with enough equity to make a small down payment on the purchase of a business, and then to pay the rest of the purchase price with borrowed money. The assets of the company are used as collateral for the loans, and the cash flow of the company is used to pay off the debt. Because the acquired company itself is paying the freight for its own acquisition, these investments were originally known as “boot-strap” deals. Eventually they became known as leveraged buyouts (LBOs), or management buyouts (MBOs, in which the company’s management, typically alongside some sort of financial sponsor, leads the buyout). The LBO business has changed dramatically since the buy-and-bust days of the 1980s. Largely because companies today are so highly priced, the buy-and-bust approach rarely works anymore. In addition, banks and other lenders today are much more conservative about lending money for leveraged buyouts (typically lenders will provide debt to a company according to a multiple of the company’s cash flow). As a result, buyouts today are financed with more equity. The companies acquired are usually divisions being sold by corporations that are refocusing on their core businesses, or businesses owned by families who wish to cash out. To earn an attractive return on their investment, LBO firms today must build value in the companies they acquire. Typically, they do this by improving the acquired company’s profitability, growing the acquired company’s sales, purchasing related businesses and combining the pieces to make a bigger company, or some combination of those techniques. One of those most popular techniques these days is the consolidation, or “buy-and-build.” The consolidation is the polar opposite of the buy-and-bust. It involves not the breaking up of large companies, but the merging of small ones into an organization that, in theory, at least equals more than the sum of its parts. Buyout firms pursuing consolidations have a number of ways of increasing their returns — through leverage, cost-cutting measures, and internal growth. They also can benefit from the fact that small companies, because they attract fewer potential buyers, generally command lower purchase multiples than large companies. Consolidators can therefore pay low multiples of cash flow on the companies they buy, but sell the large company they create at high multiples -- depending, of course, on market conditions. Venture Capital Risk capital for starting, expanding and acquiring companies is critical to the growth of any economy. During most of the history of the United States, the market for arranging such financing was fairly informal, relying primarily on the resources of wealthy families. After the Second World War, the system started to change. Specialized investment management firms began to be formed with the specific purpose of financing start-up companies that entrepreneurs were launching. Two of the earliest such firms were Boston-based American Research & Development Corp. (ARD) and Connecticut-based J.H. Whitney & Co. ARD’s best known investment was the start-up financing it provided in 1958 for computer maker Digital Equipment Corp. One of J.H. Whitney’s seminal investments was financing that helped to transform a military technology intended to provide a nutritious beverage for troops in the field into a product that today is a household name: Minute Maid Orange Juice. The number of such specialized investment firms, eventually to be called venture capital firms, began to boom in the late 1950s. The growth was aided in large part by the creation in 1958 of the federal Small Business Investment Company program. SBICs are federally licensed venture capital firms that can borrow money with a government guarantee of repayment. That guarantee allows SBICs to raise money inexpensively. They must then invest the money in entrepreneurial companies. Hundreds of SBICs were formed in the 1960s, and many remain in operation today. They have been surpassed in number, however, by more than a thousand independent private venture capital companies that don’t rely on government support. During the 1960s and 1970s, venture capital firms focused their investment activity primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data-processing technology. Early successes include, for example, Intel Corp., Apple Computer Corp., Lotus Development Corp., Genentech Corp. and Federal Express Corp. As a result, venture capital came to be almost synonymous with technology finance. Today, an estimated 900 venture capital firms in the United States raise outside capital from individual and institutional investors to finance their activities. Most are quite specialized, often investing in a single field, such as telecommunications or health care, and often only in one part of the country, such as the San Francisco Bay area, or Texas. Venture capital firms also tend to specialize by stage of investing. There are no hard and fast definitions for these stages. Roughly speaking, however, seed-stage firms tend to provide a few hundred thousand dollars, and perhaps some office space, to an entrepreneur who needs to flesh out a business plan. Early-stage investors back companies at a point where they have a completed business plan, at least part of a management team in place, and perhaps a working prototype. Late stage-round investors typically provide a second or third-round of financing, often of $10 million or more, that funds production, sales and marketing, and carries the company into the revenue- producing stage. Mezzanine, or pre-IPO-stage, investors provide a final round of financing that helps carry the company to an initial public offering. The advent of the Internet as a new medium for both personal and business communications and commerce created an avalanche of opportunities for venture capitalists in the mid- and late-1990s. As a result, the industry experienced extraordinary growth, both in the number of firms, and in the amount of capital they raised. In 2000, for example, 494 venture firms raised $92.3 billion for new investments, a 57% increase from the $59.8 billion raised the year before. Yet, the activity peaked in 2000, with 6587 companies obtaining venture funding through 8 303 deals, with a total investment of $108 billion. After the bubble burst, investment activity returned to less exuberant levels. In 2004, 1364 companies received venture capital investment through 1447 deals, with a total investment of $10.6 billion. Mezzanine Debt Just as mezzanine seating is in the middle balcony of a theater, mezzanine debt firms provide a middle level of financing in leveraged buyouts — below the senior debt layer and above the equity layer. A typical mezzanine investment includes a loan to the borrower, in addition to the borrower’s issuance of equity in the form of warrants, common stock, preferred stock, or some other equity investment. Often, the loan is contractually subordinated to a loan made by one or more senior secured lending institutions. Typically, the note evidencing the loan has a maturity of between six and 10 years, with interest paid only during the first five years. Because the loan is subordinated, the interest rate generally is higher than the rate on the senior debt, and a limited amount of equity is issued to the mezzanine investor for nominal consideration. Mezzanine investments have been used extensively to help fund the purchase and recapitalization of private, middle- market companies. Mezzanine investors also invest in smaller public companies and in foreign entities. Often, the borrower is highly leveraged after the investment is made. Because mezzanine investments include both debt and equity portions, mezzanine investors have defied the traditional classifications of lenders, on the one hand, and equity investors, on the other. The flexible nature permits a mezzanine investor to emphasize the capital preservation and current-pay features of a loan and, at the same time, seek significant upside on its investment through the equity participation. It is the combination of the two features which form the economic rationale for the investment and which justifies investor involvement in the mezzanine market. The subordination of the loan creates risk that cannot be compensated solely by the coupon on the debt. The equity portion should provide enough upside potential to make the mezzanine investment attractive to the investor. The mezzanine investor has determined not to take equity risk, otherwise it would buy only equity securities and price the investment for an equity return. Distressed Debt Distressed debt firms, as their name implies, buy corporate bonds of companies that have either filed for bankruptcy or appear likely to do so in the near future. Their penchant for seeking out highly troubled companies has led some in the financial press to refer to them as “vulture capitalists.” The unflattering metaphor only goes so far, however. Distressed debt firms do, of course, sniff out the sick and weak. But they generally have no taste for carrion. They make their highest returns not by liquidating a company, but by nursing it back to health. The strategy of distressed debt firms involves first becoming a major creditor of the target company by snapping up the company’s bonds at pennies on the dollar. This gives them the leverage they need to call most of the shots during either the reorganization, or the liquidation, of the company. In the event of a liquidation, distressed debt firms, by standing ahead of the equity holders in the line to be repaid, often recover all of their money, if not a healthy return on their investment. Usually, however, the more desirable outcome is a reorganization that allows the company to emerge from bankruptcy protection. As part of these reorganizations, distressed debt firms often forgive the debt obligations of the company, in return for enough equity in the company to compensate them. (This strategy explains why distressed debt firms are considered to be private equity firms.) Unburdened of the interest payments on the forgiven debt, the company becomes better positioned to rejuvenate itself. In addition, distressed debt firms typically employ people expert in effecting “workouts,” or company turnarounds. When the newly healthy company is later sold or taken public, distressed debt firms stand to profit handsomely from cashing out their equity positions. Funds-of-Funds For any number of reasons, investing directly in private equity funds can be difficult — particularly for individual investors and small institutional investors. Information about the performance of private equity managers is generally difficult to find. Gaining investment access to what are perceived to be the top-performing venture capital and buyout funds is problematic, since the fund managers often have more demand for their funds than they can accommodate. Finally, the relatively high investment minimums that fund managers generally require -- $20 million isn’t uncommon for a large buyout fund — make it challenging for a small institutional or high-net-worth investor to gain sufficient diversification. For these and other reasons, private equity funds of funds have grown rapidly in popularity during the past few years. The fund of fund manager co-mingles the investments of many small investors into a single pool, and then uses it to assemble a portfolio of private equity funds. The minimum commitment to a fund of funds for individual investors is often in the $250,000 to $500,000 range — a single, manageable investment that gives investors an instantly diversified set of private equity investments. As the fund of funds industry has matured, managers have begun creating more specialized investment pools that provide investors with more targeted exposure — say, for example, to a portfolio of venture capital funds. For this reason, even many large institutional investors have found the fund of funds to be a useful vehicle for giving them additional exposure to areas of private equity in which they have been under-weighted. The main drawback of investing in a fund of funds is the added layer of fees. Fund of fund managers generally charge a 1 percent annual fee for their services. Many also take a small carried interest, or share of profits, in the 5 percent to 10 percent range. This layer of fees exists in addition to the management fees (typically 1.5 percent to 2.5 percent) and carried interest (typically 20 percent to 30 percent) charged by the underlying fund managers. Private equity funds of funds have been in existence for more than 20 years, but the past three years have seen a sudden surge in their numbers and capital under management. Secondary Purchases Private equity investments are generally considered illiquid. There are no public stock exchanges, as there are for publicly-traded securities, on which to buy and sell interests in private equity funds. However, a small secondary market for these interests has developed over the years, giving investors the chance to sell if they desire to. This, in turn, has led to the creation of additional investment opportunities for individual and institutional investors. A small group of private equity firms specialize in purchasing secondary interests in private equity partnership interests. Managers of secondary funds are not altogether different from those of funds of funds. They don’t generally invest directly in companies, but rather in the private equity funds managed by buyout firms or venture capital firms. The big difference is that they are buying their interests in a fund after the fund has been at least partially deployed in underlying portfolio companies. So unlike fund of fund managers, which generally invest in blind pools, secondary buyers can evaluate the underlying companies in which they are indirectly investing. The secondary market remains a relatively small part of the private equity world with $1.8 billion raised exclusively for secondary purchases in 2000, compared with $1.6 billion the year before. However, as mentioned, investors in funds of funds often gain exposure to the secondary market, as fund of fund managers who have secondary allocations generally set those allocations at up to 20 percent. |
