Buzz Article:
Sources of Capital - Private Equity

by Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser and D. L. Sonny Williams, 5/19/2010

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Introduction

PRIVATE EQUITY

Private equity is a term used to broadly group funds and investment companies that provide capital on a negotiated basis generally to private businesses. This category of firms is a superset that includes venture capital, buyout-also called leveraged buyout (LBO)-mezzanine, and growth equity or expansion funds. The industry expertise, amount invested, transaction structure preference, and return expectations vary according to the mission of each. Additional information about the fund types mentioned is provided hereafter in this handbook.

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Over the past two decades, private equity has developed into a major asset class, providing significant riskheward benefits to institutional investors' portfolios. During the 1980s, the industry was still considered a niche sector, with less than $10 billion in capital invested annually. Today, private equity has over $1 trillion of capital to invest from more than a thousand funds.^[1]

Private equity is an alternative asset in which many institutional investors in the United States allocate on average 7.5 percent of their total portfolios.^[2] About 50 percent of the private equity in the United States is provided by public and private pension funds, with the balance from endowments, foundations, insurance companies, banks, individuals, and other entities who seek to diversify their portfolios with this investment class.^[3]

Private equity firms act as the intermediary between institutional investors and the entrepreneurial and portfolio companies (issuers). In addition, there are publicly traded investment companies that play the same role between public investors and the same issuer market. Their investments are sometimes augmented by angel and corporate investors. Issuers include the following types of companies:

• New ventures (early and later stage).

• Middle-market private companies:

• Expansion.

• Change in capital structure (recapitalization).

• Change in ownership.

• Public companies:

• Going private.

• Leveraged buyouts.

• Financial distress.

• Special situations.

• Private investment in public equities (PIPE).

Figure 5.9 provides a perspective of the private equity landscape and the players.

You will find that the types of firms and the types of investments they make are not clearly delineated. Some venture funds invest in the same rounds of financing alongside buyout funds that provide expansion and growth capital. It seems a bit confusing because the terms in the private equity business are not used consistently among firms. Some firms will only take a controlling interest while others will make minority investments. The actual deal structure varies greatly based on the experience and preferences of the general partners of each of these types of firms.

In some instances, private equity firms take a controlling interest in the target investment, with minority stakes left to management and prior company stockholders, some of whom may have been involved in creating

the company or developing the company to the stage where the acquisition or investment became attractive.

In other situations the private equity firms leverage their buyouts by pooling bank and other financial institution debt in a financial package that could include convertible subordinate debt and tranches of unsecured financing.

Some private equity firms deal only in a specific business field where they have a strong expertise, while others seek opportunities in diverse industries.

Many private equity firms have staffs with strong management skills, although they seldom take a day-to-day operating role in the firms they acquire or in which they invest. Their staffs are accustomed to consulting and guiding company executives in how to achieve growth and profitability that will increase firm value during the holding period. The support staff could be organized as a management consulting arm of the firm, and it may charge fees to portfolio companies.

In the past, private equity firms typically purchased a private company, spruced it up, and then took it public or sold it to another operating company, hopefully at a profit. In recent years, more private equity firms are passing portfolio companies among themselves. Such deals, where investment firms are on both sides of a transaction, used to be relatively rare. In 2001, for instance, there were only $2.5 billion worth of such deals, according to Dealogic, which tracks merger-and-acquisition activity. In contrast, there were almost $41 billion worth in the first seven months of 2004.^[4]

As in the turmoil of 2001, the credit crisis of 2008 has caused a pause and reevaluation in private equity strategy. The lack of cost-effective debt capital used to underwrite transactions is causing most buyout funds to allocate more capital to the equity component of their deals, particularly for the larger ones.^[5] In some instances, buyout funds are contemplating growth equity investments. Whether buyout, growth, or venture capital, most private equity funds are setting aside additional capital to fund existing portfolio companies. This trend coupled with tightened credit and compressed valuations has caused a near-term shortage of private equity for all but the highest-quality companies.

Read more about the Sources of Capital in the Encyclopedia of Private Equity and Venture Capital

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^[1] www.cfo.com/printable/article.cfm/l2958163.

^[2] www.altassets.com/knowledgebank/learningcurve/2002/nz3100.php.

^[3] "The Venture Capital Industry: An Overview," www.nvca.org/.

^[4] Henry Sender and Dennis K. Berman, "For Sale: Again and Again and. . .," Wall Street Journal, September 4,2004, C1.

^[5] Bryan Jaffe, "The New Dynamics of Capital Availability", Cascadia Capital, LLC, 2008.

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The above material is excerpted from:

The Handbook of Financing Growth: Strategies and Capital Structure by Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser and D. L. "Sonny" Williams.

To order the Entire Second Edition of, The Handbook of Financing Growth: Strategies, Capital Structure, and M&A Transactions, 2nd Edition

This material is used by permission of John Wiley & Sons, Inc.

Kenneth H. Marks, CM&AA,* is the founder and a managing partner of High Rock Partners, Inc., providing strategic consulting, investment banking, and interim leadership services to emerging growth and middle-market companies. As CEO he founded a high-growth electronics company and, led and sold a technology business to a Forrune 500 buyer. As adviser, he has worked with managers and board members ro develop and implement growth, financing, turnaround, and exit srrategies in over two dozen companies. Marks' past positions include president of JPS Communications, Inc., a fast-growth technology subsidiary of the Raytheon Compnny, and president/CEO of an electronics manufacturer that he founded and grew to $22 million.

Mr. Marks created and teaches an MBA elective titled "Financing Early Stage and Middle-Markct Companies" at North Carolina State University; and created and teaches "Managing Emerging Growth Companies," an MBA elective, at the Hult International Business School in Boston (formerly the Arthur D. Littlc School of Management) in connection with Boston College's Carroll School of Management. He is the author of the publication Strategic Planning for Emerging Growth Companies: A Guide for Management (Wyndham Publishing, 1999).

Mr. Marks was a member of the Young Presidents Organization (YPO); the founding YPO Sponsor of the Young Entrepreneurs Organization (then YE0 and now EO) in the Research Triangle Park. North Carolina Chapter; a member of the Association for Corporate Growth: and a member of the board of directors of the North Carolina Technology Association. Marks obtained his MBA from the Kenan-Flagler Business School at the University of North Carolina in Chapel Hill.

Larry E. Robbins is a founding partner of Wyrick Robbins Yares & Ponton LLP, a premier law firm locared in the Research Triangle Park arca of North Carolina. He is a frequent lecturer on the topics of venture crlpital and corporate finance and serves on the boards of directors of entrepreneurial support organizations, technology trade associations, and charitable and arts organizations. Mr. Robbins receivcd his BA, MRA, and JD from the University of North Carolina at Chapel Hill. He was also a Morehead Scholar at UNC.

Gonzalo Fernández is a retired vice president and controller of ITTs telecom business in Raleigh, North Carolina. Subsequently he spent 15 years working as a finance executive for emerging growth companies and as an accounting and business consultant to other companies. He is a past president of the Raleigh Chapter of the Institute of Management Accountants. He received his BA in accounting from Havana University, Cuba. He wrote the book Estados Financieros (Financial Statements) (Mexico: UTEHA, third edition, 1977).

John P. Funkhouser has been a partner with two venture capital funds, and operated as chief executive officer of four companies in a variety of industries from retail to high technology. In his venture capital capacity, he was a corporate director of more than a dozen companies and headed two venture-backed companies. The most recent company he led from a start-up concept to a public company is a medical diagnostics and devices business. Mr. Funkhouser worked in commercial banking with Chemical Bank of New York, in investment banking with Wheat First Securities, and in venture capital with Hillcrest Group. He has an undergraduate degree from Princeton University and an MBA from the University of Virginia, Darden Graduate School of Business Administration.

D. L. "Sonny" Williams is a managing partner at High Rock Partners. As CEO, for over 25 years he led three global manufacturing/technology companies through major transitions; and as an adviser, he has worked with companies in numerous industries to create value and implement change. Mr. Williams has over 30 years successful operating experience in engineering, manufacturing, sales/marketing, and senior executive roles. His career is highlighted by having led the turnaround of three global manufacturing/technology enterprises ($50 million to $330 million in revenues in nine countries) over a 20-year span in CEO/president/director roles, serving the automotive, consumer, industrial, aircraft, and medical component markets. Mr. Williams' leadership accomplishments include successfully achieving dramatic lean enterprise-based cost restructures, low-cost country expansions/sourcing, and accelerated organic growth through strategic value proposition repositioning; complemented by leading eight acquisition/ merger/joint venture-related negotiation/lintegrations. Mr. Williams' value-creating experiences were magnified by successfully repositioning two of the corporate companies for investment-attractive management buyouts.

Mr. Williams received his BSEE from Kettering University and his Executive MBA from the Kenan Flagler Business School at the University of North Carolina, Chapel Hill. He is president of the Association for Corporate Growth (Raleigh-Durham chapter) and a member of the National Association of Corporate Directors.

John Wiley & Sons

Founded in 1807, John Wiley & Sons is the oldest independent publishing cormpany in the United Stares. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding.

The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more.

For a list of available titles, visit their Web site at http://www.WileyFinance.com/.

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* The Certified Merger & Acquisition Advisor (CM&AA) credential is granted by Loyola University Chicago and the Alliance of Merger & Acquisition Advisors.

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