Everything you need to know about Private Equity

Elements of Alternative Capital – Private Equity and Venture Capital

1. Private equity vs venture capital

Private equity (PE) is capital that is provided outside of public markets:

• 'private' because the source of funds is high net worth individuals and institutional investors (e.g. superannuation funds) as opposed to stock market investors, trade buyers or government; and
• 'equity' because the funds are used as the risk capital that funds acquisitions (together with, and distinct from, bank debt) - ie generally the funds are used to acquire the shares in a target business.

Venture Capital (VC) refers to an equity investment by institutional investors or high net worth individuals in early stage privately owned enterprises.  A VC investment can be crucial for start up companies that do not have access to capital markets. 

The investment opportunities available for VC and PE firms arise at different stages of the growth lifecycle of a company, including early stage investment, expansion stage investment and buyout investment.

While PE firms usually focus on the later stage of the investment cycle (expansion and buyout) and venture capitalists typically invest in higher risk, early stage investments, there are still various similarities between VC and PE firms, including:

• investment period: both have a typical investment horizon of 3 to 5 years;
• realisation of profits: both seek a return for their investors and aim to realise profits within a defined period rather than retaining an interest in the investee company indefinitely; and
• active involvement: both involve active management in the investee company which benefits from the operational, governance and management expertise.

For convenience, the balance of this module focuses on PE firms and their investments.  However, much of the commentary applies equally to VC firms and VC investments.

1. What do PE firms do?

PE firms raise funds from institutions and high net worth individuals and then invest that money to buy and sell businesses (referred to as portfolio companies).  A PE firm is responsible for managing the fund and is generally liable for its legal debts and obligations.  Investors themselves are not involved in the active management of the funds and are protected from losses beyond their original investment as well as any legal actions that may be taken against the fund.

• Life cycle of a PE investment

The mandate or rules governing each PE fund usually contemplate that all investments of the fund be realised and the funds returned to the investors within a particular timeframe, commonly 10 to 12 years.

PE firms normally manage PE funds through an investment life cycle, comprising the stages highlighted below.

• Raising money – 'Funds'

The pool of money raised by a PE firm is known as a 'fund'.  A fund will generally have a strategic focus and will close to investors once a specified amount has been raised.  The majority of money invested in Australian PE funds comes from institutional investors including superannuation and pension funds, funds of fund managers, private family offices and corporate investors, roughly as outlined below.

Source: AVCAL

In general terms, an investor's investment is contracted for a term of 10 years with funds only able to be drawn down by the PE firm during the first 5 years. The second half of the term typically contemplates and facilitates the exit from each of the investments.  Most funds make and hold between 5 and 10 individual investments. The success of a PE firm's previous funds drives its ability to raise future funds.

The fee structure for PE firms varies, however investors are typically charged a yearly management fee of 1.5% to 2% of assets under management and a performance or success fee of 20% of the fund's profits, subject to the PE firm achieving a minimum rate of return for investors known as a 'hurdle rate' (usually around 8%). A fund realises profits mostly via capital gains made on the sale of portfolio companies.

• Fund structures

The structure of a PE fund is determined by a number of underlying factors including the type of investor (i.e. wholesale, institutional, retail, foreign or domestic, etc), the jurisdiction of the investment, the size of the fund, and the investment strategy of the particular PE firm.  In Australia, PE funds can either be structured as limited partnerships or unit trusts.  Generally, a partnership structure will be adopted, with many also investing into 'stapled' unit trusts.

Limited Partnerships

A limited partnership is managed by a general partner (usually the PE firm raising the fund or a special purpose vehicle related to the PE firm) and, in Australia, these limited partnerships can take one of two forms. 

• Venture Capital Limited Partnership (VCLP) – VCLPs are highly regulated limited partnerships restricted by the size and type of investment they can make i.e. single investments may not exceed $250 million. VCLPs are attractive to foreign investors due to tax exemptions from capital gains on their share of profits in the fund made from 'eligible investments'; or
• Early Stage Venture Capital Limited Partnership (ESVCLP) – an ESVCLP's fund may not exceed $100 million and may only invest in early stage investments. Importantly, each investment is capped at 30% of a fund’s total committed capital, unless they are a bank, life office, superfund or the investment is approved by Innovation Australia. An ESVCLP is attractive for both foreign and domestic investors due to tax exemptions from capital gains on their share of profits in the fund made from 'eligible investments'.

Both VCLPs and ESCVLPs can invest in eligible investments, and in order for the PE fund to invest in ineligible investments, unit trusts (often MITs) are 'stapled' to the VCLP or ESCVLP.

VCLP and ESVCLP structures were introduced by the Australian government to encourage investment in Australia's venture capital sector and are subject to the Venture Capital Act 2002 (Cth).

Unit trusts

PE firms can also adopt a unit trust structure. This structure benefits from flow-through tax treatment and, under Australian common law, investor liability can be expressly excluded in the trust deed. Common unit trust structures include:

• 'single' unit trust – this is the simplest structure adopted where a PE firm is not seeking to take a controlling position in the target investments.
• 'twin' unit trust – this is the most common PE structure and is used in transactions where the PE firm wants a controlling position. The purpose of having multiple trusts is to split the ownership between the trusts so that no single trust controls the investee companies in which the PE fund invests. If there was only one trust, the PE fund may be treated as a 'public trading trust' under the Income Tax Assessment Act 1936 (Cth), and be taxed as if it were a company.
• managed investment trust – this is a unit trust that satisfies certain tests under the Income Tax Assessment Act 1997 (Cth), including that the trust be a 'managed investment scheme' under the Corporations Act 2001 (Cth) (both registered and unregistered managed investment schemes can meet this requirement), the trustee must be an Australian resident for tax purposes, the trust must be widely held, a substantial proportion of the trust's investment activities must be carried out in Australia and that the trust not be carrying on a trading business or control another entity that is carrying on a trading business.

Importantly, the assets of a unit trust are generally managed by the PE firm or a special purpose vehicle/subsidiary of the PE firm.

• Invest money and add value – 'Develop and build portfolio'

PE firms 'call' or draw down funds as required to make new investments.  They typically acquire controlling stakes in private or public companies using a combination of debt and their investor's equity.  A PE firm will usually leverage its principals' expertise to implement and engineer strategic improvements to increase profitability and add value to the acquired business, which may include a combination of financial, governance and operational changes.

• Financial – a PE firm will typically require the CEO and other top operating managers of a portfolio company to personally invest in the company and have some 'skin in the game'. This aligns equity incentives and the fund's objectives, and ensures the commitment and motivation of management;
• Governance – a PE firm will typically control the boards of their portfolio companies and be more actively involved in the governance than public company directors and public shareholders; and
• Operational – a PE firm's strategy is influenced by the expertise of its principals, who tend to have legal, investment banking or strategy/management consultancy backgrounds. Industry and operational expertise and best practices add value to a portfolio business by reducing costs, increasing efficiencies, and adopting best practices.
  • Exits (Divestments) – 'Realise returns'

It is important to note that PE investments are illiquid, meaning that investors usually only receive a return on investment when the fund sells its portfolio companies and a profit is realised.  In contrast, a quoted fund or hedge fund's investments can return ongoing dividends and capital gains to investors throughout the investment period.

A PE firm can terminate its investment in or exit a portfolio business in a number of ways, including through:

• an initial public offering (IPO) – where a company's shares are offered for sale to the public. This is a common form of exit for PE and VC investors.
• a trade sale - the sale of a business (either shares or assets) to a third party buyer, usually a player within the same industry.
• a secondary buy-out – where a PE firm/fund sells its interest in a portfolio company to another PE firm/fund. This typically occurs when one PE fund has executed its strategy for the portfolio company (likely an early stage investment), making it attractive to another PE firm that specialises in later stage strategies, for its next stage of development.
• a share buy-back/ repurchase – in some circumstances the portfolio company may be financially strong enough to buy back the shares that are held by the PE fund. This mechanism lacks the independence of an arm's length sale, so an independent valuation may be required to remove any potential conflict between management shareholders and the PE fund.
• a back door listing – sometimes referred to as a reverse takeover and occurs where a private or unlisted company lists on the stock exchange by purchasing the shares of a publicly-traded company.
• a recapitalisation – reorganising a company’s capital structure (i.e. debt and equity) by, for example, issuing additional shares, buying back shares, reducing capital or paying dividends using surplus cash and/or new debt finance.
• a dual track process – this involves running a trade sale in parallel with an IPO process, and makes sense in circumstances where it is unclear if a trade buyer or an IPO may provide the best pricing outcome for shareholders.
• a liquidation – a liquidation is not a planned exit route, however it does represent the ultimate fate of a number of leveraged buyout transactions. Where a business fails it will typically mean a loss of all, or a material proportion, of shareholder's funds.

1. Pros and cons of PE for your business

As an alternative source of capital, PE offers a portfolio company a number of benefits but also has some characteristics that may be considered less attractive to the portfolio company.  The key benefits include:

• Alignment of objectives – if a PE firm achieves a minimum rate of return from the fund for its investors, it generally receives a success fee. The PE firm is, therefore, incentivised to contribute to and assist management with the growth and success of the business.  A PE firm will often take control of the portfolio company's board in order to drive desired financial, operational and governance improvements.
• Long-term investment – a PE firm will work with management of the portfolio company to develop a long-term growth plan and will often co-invest its own money (generally 2%-5% of the fund) in the portfolio company.
• Profit growth – increasing profitability is the most obvious opportunity to increase the value of a business. Accordingly, a PE firm will undertake detailed due diligence to analyse the market, details of the business and the growth opportunities before making an investment decision.  Once invested, the PE firm will often seek growth through strategic acquisitions (bolt-ons) to increase economies of scale and/or scope, oversee staff development and achieve cost-savings.
• Enabling innovation and growth – the provision of capital and business expertise incentivises the portfolio company to be more innovative and creative, resulting in greater growth, employment and profitability prospects.
• Deleverage using cash flow – the PE firm will often use operating cash flows to repay business debt which results in an increased proportion of the company's value resting with the shareholders.
• Access to industry expertise and best practices – the PE firm's principals will use their industry expertise and knowledge of best practices to unlock value in a portfolio company.
• Autonomy and financial rewards for managers – portfolio company managers may receive bonuses linked to profits on the sale of the business and often have greater autonomy than managers in a public company.
• Multiple arbitrage – this refers to selling a business for a higher multiple of earning than what it was bought for, which ultimately results in increased equity value for investors.

Some aspects of PE that may be considered less attractive include:

• Debt – PE firms generally use a significant amount of debt when acquiring a portfolio company. The assets of the company are used to secure the debt, which is usually serviced using business cashflow.
• Dilution of control – PE firms generally acquire a majority stake or the entire share capital of the portfolio company. Although the company's founders or existing management are financially rewarded for a PE firm's investment in the company, some may prefer alternative sources of capital where they retain ownership and control of the direction of the company, including strategy, financing and management/employee decisions.  
• Eligibility – PE firms are attracted to companies in which they can enhance performance in the short to medium term. These companies tend to be mature with at least modest market growth, market dominance, and predictable cash flows.  Cash flows are fundamental to buyout focused PE firms as these help to finance the high levels of debt required for the acquisition.

PE firms tend not to invest in start-ups and early stage companies as they are not debt financed, have few assets, and take a long time for research and development investments to be realised – VC and angel investment/seed financiers are more appropriate sources of alternative capital for early stage companies.

• Turnover – financial and operational changes implemented by a PE firm may result in significant changes to the structure, governance and staffing of a portfolio company.

1. Other key concepts
   • Angel investment

An angel investment is an early or expansion stage investment into an entrepreneurial company. These investments are typically made by high net worth individuals using their own capital, rather than that of an institution or fund. The investment can be a one time injection of funds or ongoing payments through the early stages of development.  In return for the investment, an angel investor is usually given an ownership stake, often in the form of preferred stock or convertible debt, in the portfolio company.

• Leveraged Buyout

A leveraged buyout (LBO) is an acquisition of a company/business funded by a combination of significant levels of debt to a small proportion of equity.  The debt used for the acquisition is usually secured by the acquired company's assets and serviced by its cash flows.  The advantage of an LBO is that it allows PE firms/portfolio companies to make large acquisitions without having to commit large amounts of capital.

• Management Buyout

A management buyout (MBO) is where a PE firm acquires a controlling stake in a company, together with the existing management team of the company (Management).  To facilitate an MBO, a PE firm provides the equity capital to fund the acquisition price (i.e. as opposed to balance sheet funding) alongside participating Management, who are employed by the company to be acquired.  Similar to an LBO, an MBO is typically characterised by a high level of gearing to assist in maximising the return on the equity investment of the fund.

Posted by Neu.Capital and authored by lawyers from MinterEllison: Daniel Scotti (Partner), Aidan Douglas (Senior Associate), David Conway (Lawyer) and Daniel Ezekiel (Lawyer)