Private equity represents a class of investors, their funds, and their subsequent investments, which are made in private companies or in public companies with the goal of taking them private. Private equity investments are primarily made by private equity firms, venture capital firms, or angel investors, each with its own set of goals, preferences, and investment strategies, yet each providing working capital to the target firm to nurture expansion, new product development, or restructuring of the firms operations, management, or ownership. Aside from the outline of the private company life cycle below, this chapter will focus primarily on private equity firms, which represent the majority of the money in the private equity industry and characteristically invest in the buy-outs of mature companies and venture capital firms, which typically make high risk equity investments in seed, early, and growth stage private companies.
Stages of the Private Company Life-Cycle
The Father of Venture Capitalism
Although variations of private equity investment have existed for centuries, the first professional private equity investments date back to the American Research and Development Corporation. In 1946, the American Research and Development Corporation, led by Georges Doriot, Karl Compton, and Ralph Flanders, launched a $4 million fund. The fund was the first of its kind as it pooled money from both institutions and high net-worth individuals for investments in private companies. By the time that Doriot had retired in 1971, ADRC had made over 150 private company investments, including the first major institutional venture capital success when its portfolio company, Digital Equipment Corporation, provided a significant return upon exit in a 1966 initial public offering. Georges Doriot is now known as the “father of venture capitalism”.
Small Business Investment Act of 1958 & the First Venture-Backed Startup
A significant step towards fostering the private equity industry in the United States was the passage of The Small Business Investment Act of 1958, which provided access to federal capital to investment firms licensed as Small Business Investment Companies (SBICs) that could then be leveraged against private equity funds. As a result, private company investment practices and would-be venture capitalists began to develop. The first venture-backed startup, Fairchild Semiconductor, was funded in 1959.
The First Leveraged Buyout
The 1960s and 1970s witnessed the birth of a series of private equity and venture capital firms that would lay the foundations for the private equity industry that we have today. At the time, private equity deals primarily consisted of venture capital investments in early and mid-stage private companies but the first leveraged buyout transactions began with Lewis Cullman and Herb Weiner in what they called “bootstrap” operations.
Orkin Exterminating had recently undergone a generational change as founder Otto Orkin ceded the company to his children in 1960, which they then took public in 1961, selling roughly 15% of the company in the public market at $24 per share (PrivCo incorporates both generational and leadership change tags on its private company profiles, allowing subscribers to search for companies that have recently undergone a relevant change). By late 1961, the market had peaked and Orkin was trading at $30 per share, only to drop to $18 per share by mid 1962. Despite the fact that Orkin had annual revenues of $37 million, $6.7 million in EBIT, and $10 million in cash, the market had then valued the company at $43.2 million, down from the $72 million it had been less than a year prior. By modern day standards, Orkin Exterminating Company was an ideal buyout candidate.
As per Orkin’s report of earnings at $1.25 per share in October 1963, Cullman’s offering of $26 per share represented a P/E multiple of 20.8x. In June 1964, Lewis Cullman and Herb Weiner had brokered Rollins Broadcasting’s $62.4 million buyout of Orkin Exterminating Company, Inc. with a $40 million loan from the Prudential Insurance Company, $10 million equity from Rollins Broadcasting (via loan from Chase Bank), $10 million in sellers notes, $2.4 million cash on hand, and only $1,000 personal cash investment.
In July 1964, BusinessWeek called the Orkin Exterminating Company deal one that “truly captures the imagination”. Shortly thereafter, three Bear, Stearns, & Co. bankers would begin to replicate and, through trials and tribulations, began to perfect the leveraged buyout. Jerome Kohlberg, Jr., then head of corporate finance at Bear Stearns, and his protégés Henry Kravis and George Roberts, would leave Bear Stearns in 1976 to found private equity firm Kohlberg, Kravis & Roberts (KKR).
Meanwhile, venture capital firms began to grow in number. In 1973, the National Venture Capital Association (NVCA) was formed and after the economy recovered from a market downturn in 1974, venture capital witnessed its first significant fundraising year as VC firms collectively raised approximately $750 million in 1978. This crop of early venture capital firms would fund game-changing technology companies like Apple, Compaq, and Electronic Arts.
A small handful of true private equity firms like Warburg Pincus (1966) and Clayton, Dublier & Rice (1978) also emerged in the 1960s and 1970s, later to become buyout powerhouses in the 1980s. These first private equity firms began taking on the same limited partnership organizational structure we see today. In a limited partnership, the private equity firm acts as a general partner, managing investments from a fund composed of money that is contributed by limited partners, which may include pension funds, endowment funds, and high net-worth individuals. In what became known as “2 and 20”, limited partners are expected to pay an annual management fee to the general partner, usually around 2%, in addition to a performance fee, which is usually around 20% of the fund’s profits.
Below is an organizational chart of private equity firm Apollo Global Management, LLC (circa 2007).
Corporate takeovers grew to become an important facet of American business in the 1970s and 1980s as hostile takeovers and LBOs made the transition from small target firms to large and well-known public companies with the use of significant debt portions.
In 1982, former Secretary of Treasury William Simon’s Wesray Corporation bought Gibson Greetings, which was then a subsidiary of RCA, via leveraged buyout. The $80.6 million deal ($58 million in equity and $22.6 million in assumed debt. Within 18 months, Wesray Corporation exited on its investment with Gibson Greetings’ $330 million public offering in which Simon saw a personal return on investment of nearly $66 million. A take private LBO transaction where the target firm is later taken public again is known as a reverse leveraged buyout (reverse LBO).
The rise in LBO activity over the First Boom and Bust Cycle could be attributed to both regulatory and economic factors, including Delaware’s Anti-takeover Statute of 1982, the overall de-regulation of many industries, the laissez-faire antitrust policies of the Reagan administration, and the introduction of high-yield debt instruments known as junk bonds which provided private equity firms with a significant amount of financing capital. In response to the new trend, corporate managers lobbied for legal restrictions to help insure their ownership and control while increasing debt levels to restructure their companies and payout dividends shareholders.
While Wesray Corporation’s fairytale return on Gibson Greeting Cards in the early 1980s characterized the onset of a period of mega buyouts, the most notable buyout of the First Boom and Bust Cycle is by far private equity firm Kohlberg Kravis & Roberts’ leveraged buyout of RJR Nabisco in April 1989. Including the assumption of debt, the RJR Nabisco deal was valued at $31.1 billion, making it the largest leveraged buyout in history.
The RJR Nabisco deal originally began as a management buyout led by the company’s Chief Executive Officer, F. Ross Johnson and backed by Shearson Lehman Hutton and its parent company, American Express, at a proposed $17 billion, nearly half of the final deal value. At the time the MBO was announced in October 1988, RJR Nabisco was trading around $55 per share, making the $17 billion price tag or $75 per share, a significant increase and inadvertently advertising the potential for sky-high advisory fees to all of Wall Street.
The six-week bidding war that took place thereafter, which involved many of Wall Street’s big players and is recounted in Bryan Burrough and John Helyar’s book, Barbarians at the Gate: The Fall of RJR Nabisco, ended with KKR paying a supremely debt-laden $109 per share. RJR Nabisco, then loaded up with over $20 billion in debt, would require a $6.9 billion refinancing plan to stay afloat in 1991. In fact, many of the buyouts throughout the 1980s resulted in a bankrupt target company as a result of the sizable debts they were left with and thus the term “corporate raiders” became associated with private equity buyout shops.
Michael Milken, then head of investment bank Drexel Burnham Lambert’s high-yield bond division, is popularly cited for the development of the high-yield market which substantially led to the incredible fundraising capabilities in the 1970s and 1980s and, subsequently, the increased number of leveraged buyouts. In March 1989, Milken was indicted on 98 counts of racketeering and fraud by a federal grand jury and in April 1990 pleaded guilty to six counts of securities and tax violations. Michael Milken’s total fines of $1.1 billion and 10 year jail sentence (he ended up serving 22 months) aided in the collapse of the junk bond market and thus, the leveraged buyout boom. Drexel Burnham Lambert would file for Chapter 11 bankruptcy protection in 1990.
After achieving such a negative, greed-ridden connotation in the 1980s, the private equity buyout industry returned in the 1990s, after a short dormancy, with less use of leverage and a stronger focus on the target firm’s long-term development. Despite its relative lack of growth when compared to the buyouts market in the 1980s, venture capital had begun to take center stage by the mid-1990s. The turning point for VC was largely due to the mass appeal of the information age, the low interest rates of the late 1990s, and the overtly successful IPOs of many high-tech companies that are now household names like Google (www.google.com), Yahoo! (www.yahoo.com), E-bay (www.ebay.com), and Amazon (www.amazon.com).
Interest rates in the United States are targeted by the Federal Funds Rate, which is governed by the Federal Open Market Committee (FOMC). The Federal Funds Rate is the interest rate that depository institutions charge to lend balances at the Federal Reserve Bank to other depository institutions. When the Open Market Committee wishes to increase interest rates, government securities are purchased and the economy’s money supply goes down. Since deposit institutions are required by the Federal Reserve to maintain above a minimum reserve requirement, typically 10% of demand accounts (the total funds that the deposit institution holds in the form of checking accounts), deposit institutions often borrow money from other deposit institutions to cover increases in outgoing loans. The economics of supply and demand suggest that a decreased supply leads to an increase in price, which, in this case, is an increase in the interest rate that banks charge each other when the supply of money decreases and thus the interest rates they must charge to make loans to other institutions and individuals.
In the early 1990s, interest rates were incredibly low, in part to help stimulate spending and pull the United States out of a recession (the 22.6 percent collapse of the Dow Jones Industrial Average in October 1987, which was larger than the crash in 1929 that lead to the Great Depression, is referred to as “Black Monday”). When the economy began to grow rapidly with the dot-com bubble of the late 1990s, the Federal Open Market Committee responded to curb growth by increasing the Federal Funds Rate—a total of six times 1999 and 2000.
In the end, the surge of interest in the Internet led to a large number of irresponsible business strategies and irresponsible investments, almost as if anyone with a reasonably interesting idea and a dot-com address could receive VC money. Internet companies with little to no profits were going public and enjoying significant stock price increases often based solely on industry speculation. On March 10, 2000, the NASDAQ stock market dropped 83.9 points and the dot-com bubble began to burst. By April 4, 2000, the NASDAQ fell to 4369. In the two years that followed, venture capitalists unloaded many of their investments at a loss.
With the passage of the Sarbanes-Oxley Act of 2002 (SOX), in part to prevent financially unhealthy and cash poor companies from reaching an IPO as they had in the 1990s, the costs of reporting and governance that are associated with being a public firm grew significantly, helping make a go private transaction appealing to many public companies. Since privately held firms are not heavily regulated by governmental agencies like the Securities and Exchanges Commission or regulations such as SOX (also known as the, “Public company Accounting Reform and Investor Protection Act” and the “Corporate and Auditing Accountability and Responsibility Act”), this freedom can have major advantages. Without these strict regulations, private companies have greater operational flexibility and can focus more on long-term goals rather than quarterly earnings.
By the time that the economy had recovered from the burst of the dot-com bubble, interest rates dropped to historically low numbers. Private equity firms were raising funds that were larger than ever before. For the larger private equity buyout shops, what was once a $5 billion fund became a $15-20 billion fund, allowing them to complete leveraged buyouts with deal sizes that rivaled and surpassed KKR’s $31 billion buyout of RJR Nabisco, which was previously the largest buyout on record.
The historically low interest rates of the early 2000s were soon combated by monetary policy tactics of the Open Market Committee, which would raise the Federal Funds Rate 17 times between 2004 and 2007. In order to remain competitive in lending to massive buyout firms, banks began to offer less restrictive terms on the debt-servicing capabilities of the PE firms and their targets due to their significant bargaining power. These covenant-lite loans provided increased loan repayment flexibility for the borrower yet increased risk for the lender as typical covenants that signaled a company was in trouble such as a requirement to report EBITA or loan to value ratios were not included in the loan agreement. Commonly, banks would hedge their increased risk in credit derivatives. In September 2007, Kohlberg, Kravis & Roberts closed a $26.4 billion LBO of First Data Corp.—a deal which included a record $14 billion in covenant-lite loans. In hindsight, covenant-lite loans have not seemed to perform worse than loans with covenants.
In October 2007, a consortium of investors led by Kohlberg, Kravis & Roberts, the Texas Pacific Group, and Goldman Sachs Private Equity took TXU (since renamed as Energy Future Holdings) private via leveraged buyout for $48 billion, making it the largest private equity buyout in history. Just three years prior, in 2004, KKR and TPG had participated in a $3.6 billion buyout of Texas Genco, which they had sweetly returned a $4.9 billion profit on in 2005. In the Energy Future Holdings deal, which had required considerable lobbying efforts as nearly one-fifth of the United States’ energy production was at stake, the debt holders and private equity firms have since taken a loss and, although Energy Future Holdings generates a significant amount of cash, the company has considerable interest payments and a tower of debt due in 2014.
A lot had changed in the private equity scene within those three years, most notably that the economy had been weakened by the onset of the global credit crisis in the summer of 2007, making what was once cheap and plentiful debt harder to come by. Although partly due to the credit crisis, many of the large pre-credit peak buyouts left the target companies unable to support their debt and either defaulting or falling into financial distress.
Over the following few years, there was a large drop in the number of leveraged buyouts that were completed as well as some notable changes that were made in deal term practices which were aimed to increase the accountability of the buyout firms, including the weighted importance of reverse termination fees, exclusive remedy provisions and specific performance provisions, financing outs, and sponsor guarantees. Capital infusions, or cash injections from the buyout firms into the target company, grew rare and when used were done mostly to avoid covenant violations rather than reducing the debts that targets were buckling under.
Due to the high costs associated with being a public firm, take private transactions have become a modern day phenomenon. By taking a company private, a firm is able to reduce or eliminate the burdens of the Sarbanes-Oxley Act, increase corporate control and strategy mobility, and focus on long-term strategy without worrying about shareholders, filings, and quarterly results&mdas;not to mention that the process can be incredibly lucrative for the private equity firm that initiates the take private transaction and takes advantage of the large value gap. A value gap represents the difference between a company’s value under its current management policies and an expected higher company value given policy changes, restructuring, and a redeployment of assets that may not directly align with the company’s core operations. The value gap itself is arguably affected by the debt-intensive means of taking the company private which forces the company into a period of financial distress after the transaction, thus forcing its management to restructure the firm, making strategic decisions that enhance the company’s value, and trim out unprofitable or low payoff business components.
Even to raise the most basic Angel Investor funding, it’s very important that private companies follow securities laws, make full written disclosure to investors of the terms of the offerings and how risky the investment is (all the things that could go wrong and why the investor may lose their entire investment), and to raise money primarily or solely from sophisticated investors (knows as “accredited investors”).
The purpose of the Private Placement Memorandum (PPM) is to make full and thorough disclosure to the prospective investors so that the private company is protected from later investor “sour grapes” if the private company goes under and the investor loses his or her investment. The PPM contains detailed information about the private company’s products and services, its financials (including the private company’s income statement, balance sheet, and statement of cash flows — see PrivCo Private Company Knowledge Bank “Terms and Definitions”), and especially what are known as Risk Factors. The section on Risk Factors details everything that could possibly go wrong — from key employees quitting to competition to even acts of war and terrorism disrupting the business. In a nutshell, it can sometimes read like a parade of horrors.
The Private Placement Memorandum also must discuss the private company’s competition (PrivCo.com can of course be helpful in preparing this section of the PPM by allowing you to quickly compile real and potential competitors using our proprietary PrivCo Industry Classification System (PICS) codes). A full and honest discussion of the private company’s strengths and weaknesses versus its actual and potential competition is recommended, as is listing many of these competitors by name. This can be done under Risk Factors: Competitors, or as a separate section on Competition.
In the United States, state and federal securities laws require filing a legal document on the offering when stock in a private company is sold or transferred. Federal law applies in every case no matter where the private company is headquartered in or where the investor is based. In addition to that, there are state securities laws that vary by state (these are known as Blue Sky Laws — see PrivCo Private Company Knowledge Bank Terms and Definitions). With the Blue Sky Laws, each state has its own unique securities registration requirements which include registration by exemption, coordination, and private offerings. Under Blue Sky Laws, each state may also have different limitations on the number of private investors from that state who invest in the private company.
Federal and state registration (and providing the written Private Placement Memorandum containing full disclosure) is critical for a private company raising funding, even small amounts from Angel Investors. Failing to register can:
As discussed in the section of the PrivCo Private Company Knowledge Bank on the various types of private market investors, the private company’s most likely avenue for raising private investment capital is often from Angel Investors. This is especially in the earlier stages of a private company (the start-up company phase), Because of securities laws, private companies are strongly advised to raise money mainly or only from Accredited Investors. As defined by Rule 501 of Regulation D of the Securities Act of 1933, these private investors need to meet one of the following requirements:
Securities laws strictly limit the number of non-sophisticated investors participating in the investment round (depending on the size of the investment). Raising money from non-Accredited Investors can result in exposure of the private company to lawsuits from them demanding the return of their investment, especially if things go wrong. So doing so is like giving these investors a free option: in a nutshell, heads they win, tails they break even by simply demanding their money back. So it’s most advisable for a private company to only raise angel or other private investment capital from Accredited Investors.
Venture capital is a subset of private equity. Therefore all venture capital is private equity, but not all private equity is venture capital. Venture Capital is the early stage form of private equity where investors focus on investing in startup (highly risky) ventures. Private equity refers to the holding of stock in unlisted private companies — private companies that are not quoted on a stock exchange. The funds raised through private equity can be used to develop new products and technologies, to expand working capital, to make acquisitions, or to strengthen a private company’s balance sheet.
Venture Capitalists invest in high-risk, high-return investments, with an investment horizon of six or seven years. The venture capitalist’s final goal is to either take the private company public (Initial Public Offering) or Trade sale. Venture capital manages risk typically with staged investments in which the private company has to meet certain milestones before qualifying for additional rounds of financing.
A Term Sheet is a document that outlines key financial data and other terms of a proposed investment by a venture capital firm into a private company. Investors use a Term Sheet to arrive at a preliminary and conditional agreement. Those key terms will be used to form the basis for drafting the investment documents. With the exception of certain clauses (commonly those dealing with confidentiality, exclusivity, costs and break-up fees) provisions of a Term Sheet are not intended to be legally binding. The Term Sheet is negotiable before it is transferred to the final legal document. A Term Sheet will usually contain certain conditions which need to be met before the investment is completed — these are known as conditions precedent.
The Subscription Agreement contains details of the investment round, including the number and class of shares subscribed for, payment terms, representation of shareholders and warranties about the condition of the private company and its key assets. These representations and warranties will usually be qualified by a disclosure letter and supporting documents that specifically point out any issues that the founders believe the investors should know prior to the completion of the investment.
The Shareholders’ Agreement will usually contain investor protection clauses; including consent rights, rights to board representation and non-compete restrictions. The Constitution will include the rights attached to the various share classes, the procedures for issuance, transfer rights of shareholders and board meeting procedures. Once agreed upon by all parties, lawyers use the Term Sheet as a basis for drafting the investment documents. The more detailed the Term Sheet, the fewer the commercial issues that will need to be agreed upon during the drafting process.
Once the provisions of the Term Sheet have been negotiated and agreed upon, a Subscription and Shareholder’s Agreement is drafted that outlines the provisions in a legally-binding document.
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