Step up to the private equity cash window
New types of funds offer family businesses less costly and more flexible terms for financing growth and liquidity programs.

By François M. de Visscher

  
With the turbulence of the stock market during the summer and early fall, many of us have seen our liquid investment portfolios tumble in value. While optimists view this volatility as temporary and not affecting long-term investment strategies, the gyrations in stock prices have deterred companies from even thinking about raising capital through an initial public offering (IPO).

Many foresighted family companies have instead begun to look for alternative financing. In today’s low-interest-rate environment some are seeking bank loans as their best option to secure long-term growth or liquidity funds. However, more and more family companies are turning to a relatively new and growing financing option: the private equity market.

More money is flowing into these funds as financial institutions and individuals look for new and creative ways to invest their stock market gains. Over the last three years alone, the size of the U.S. private equity market has more than tripled, reaching several hundred billion dollars. Despite its enormous growth, family companies have so far paid very little attention to this market, primarily because they lack information about it. The transactions are exempt from SEC registration since they don’t involve public offerings. Indeed, it is the very privacy of the market that makes these vehicles an attractive option for family companies seeking to preserve confidentiality and keep a low profile.

The private equity market consists primarily of pools of funds from institutional investors, such as public or corporate pension funds, foundations, bank holding companies or insurance companies, as well as from wealthy individuals and families. Those pools of funds are created by a group of professionals called “intermediaries,” who manage the funds on behalf of investors and then structure the terms of the financing transactions. If you are involved in a private equity transaction, you most likely will deal only with the intermediary, and never meet the underlying investors. Eighty percent of today’s intermediaries are limited partnerships, with the intermediary firm serving as the general partner and the investors as limited partners.

Venture capital funds were until recently the only source of private equity capital. Family companies, however, shied away from them because many venture capital sources required giving up a major share of equity and perhaps control of the business. Few owners want to do that! Currently, however, there are myriad alternatives in the private equity market. To get an idea of the range of offerings in the private equity capital market—and the pros and cons of each—let’s review four basic types.

Venture capital funds

In general, venture capital investors are mostly interested in funding start-up companies, development companies (“early-stage venture capital”), or companies with a proven technology that still lack a going-concern infrastructure (“later-stage venture capital”). Given the significant risk involved in many venture capital investments, it is not surprising that the investors expect a very high rate of return on their money, often as high as 50 percent a year. This return accrues to the investor not in cash, but in the form of ownership. By the same token, venture capital investors will usually expect to exert significant control over strategic and policy decisions in the company.

How much of the company the venture capital investor expects to own is usually figured according to how long they commit the funds (typically three to five years) and what the expected future valuation of their investment will be. The longer they need to stay with the company to realize the expected valuation, the more ownership they will want in return. The faster the growth in value, the sooner they will reap their return and the less ownership they will require.

Hence, for small but very fast-growing family companies, venture capital may be an attractive source of funds, possibly even the only one available. However, the high cost and the investors’ preference for an early exit—via a sale of the company or an IPO—makes this kind of private equity financing less attractive for established family companies.

Institutional private equity funds

For family businesses that are established and have reached a certain level of revenues and profitability, institutional private equity capital offers a more attractive and less costly source. First of all, institutional private equity funds are much more flexible on the issue of control and hence more willing to consider holding a minority, or non-controlling, interest in the company. Second, unlike venture capital financing, which is primarily interested in funding growth, the institutional private equity funds can be used to satisfy the immediate liquidity needs of shareholders, not just growth needs.

Finally, by providing an alternative or even a supplement to bank borrowing, this form of financing does not weaken the balance sheet. On the contrary, it strengthens the balance sheet by leaving open the possibility of future borrowing from banks (which impose a limit on credit determined by company assets).

There are several hundred institutional private equity funds in the United States, each with different characteristics or specialties (ranging from health care to automotive) and size preferences for investments (say, over and under $5 million for each deal). The majority of the capital inside institutional equity funds comes from financial institutions, whose investment cycle is typically five to seven years. Hence, most institutional private equity funds will want to exit their investment after five to seven years. Their exit will usually happen in the form of a refinancing or a buy-back of the shares owned by the fund.

This form of equity financing is thus a very attractive one-time capital solution for family businesses. As an example, consider a first-generation chemical company that was making the transition to a new generation of leaders. The family’s goals were to provide liquidity for the older generation, ensure growth capital for the development of the company under the second generation, and maintain long-term family control. An institutional private equity fund was invited to buy stock from the first generation and to invest additional funds in the company. With supplemental funds in bank debt, the company was launched on a new growth path under the second generation, while satisfying the liquidity needs of the older generation.

After five years, the younger generation was able to buy back the institutional private equity shares, bringing the company back to 100 percent family ownership. A great investment for the institutional private equity fund, and a successful transition for the family business!

Institutional private equity funds have one major drawback. Since investors want to exit their investment after five to seven years, they would not allow funds to be used for ongoing liquidity programs for family shareholders who wish to cash in stock in the future.

Family equity funds

Over the last decade, the number of family offices, in which wealthy families pool their resources and invest as a group, has multiplied. With the price-earnings ratios of many publicly traded companies peaking, moreover, many of these families are seeking to invest in other places besides the stock market. Relatively new funds are springing up to regroup the dollars family offices are looking to invest in private equity.

Most of the investors in family equity funds are families or individuals with taxable income of various kinds. This makes them much more sensitive to differences in tax rates between, say, ordinary income and capital gains. Because they often prefer to defer capital gains tax, for example, they tend to maintain a long-term horizon on investing. That makes them more attractive to family businesses than institutional equity funds as a source of both growth capital for the business and long-term liquidity programs for the shareholders.

This flexibility is particularly important for multiple-generation companies approaching a succession. Whenever such generational transitions occur, stock is often redistributed, the number of shareholders increases, and liquidity demands start to occur. The family equity fund becomes the long-term financial partner to the family and to the business.

Mezzanine funds

The least expensive source of private equity capital for family businesses is the so-called mezzanine fund. A mezzanine fund lends subordinated debt to family companies. The investment is subordinate in the sense of being second to bank debt in terms of risk and priority. Bank debt has to be repaid currently and is secured by assets or has some restrictive covenants; subordinated debt has very few covenants, does not have to be paid back currently, and is totally unsecured. This makes it a “quasi-equity” instrument.

Compared with other sources of private equity, mezzanine debt is more like bank debt. It carries a specific interest rate, typically much higher than bank debt. And the company does not give up equity ownership except in the form of warrants or other add-ons to the debt instrument. The high annual interest payment due on subordinated debt (between 10 and 17 percent) makes it less attractive for a company seeking to preserve its annual cash flow for growth. In addition, since this form of financing usually has a fixed time limit of five to seven years, at which point the principal has to be repaid, it is most appropriate for funding one-time, immediate liquidity needs of shareholders.

The main advantage of mezzanine financing is that it costs less than family equity funds, institutional equity funds, and certainly venture capital. Lastly, it does not require immediate control over management decisions, though the mezzanine investors may want certain assurances about the company’s strategy and its implementation.

No surprises

Your fnancial adviser or an investment banker can guide you to sources of private equity financing. But you have to evaluate the type of equity that’s best for your company. Along with the cost, you have to assess the objectives and compatibility of your partners and the degree of control you may have to give up. Make sure that in choosing one type of private equity financing or another, your short- and long-term expectations match those of the investors. No surprises make for solid financial partners.

The uses of private equity funds

  Venture Capital Funds Institutional Equity Funds Family Equity Funds Mezzanine Funds
Growth Capital Yes Yes Yes No
Immediate Liquidity No Yes Yes Yes
Ongoing Liquidity No No Yes Yes
Expected IRR 25% 20% 17%  
Above, the advantages and disadvantages of different funds. The generally expected investor rate of return (IRR) of each is shown along the bottom. The percentage returns are pictured as a continuum, since the upper end for one type of fund is often close to the lower end of the next.


By permission of the publisher from Family Business (Autumn, 1998). Family Business Publishing Company, http://www.familybusinessmagazine.com.