 |
previous: Funds under management
Private equity and venture capital - an introduction
Nature of private equity and venture capital The private
equity and venture capital industry covers three broad categories
of investment:
– Early stage investment (sometimes called “venture
investment”) – this is investment in early stage or start up
businesses, usually engaged in life sciences research or technology
development activities. Here, the investor (“the VC”) would usually
take a minority equity stake (i.e. less than 50% of the equity
shares) in the business as part of a syndicate of venture
investors; and the aim of the investment is to provide funding for
development or research expenditure through a series of investment
“rounds”. Progress and prospects are re-assessed ahead of the
provision of further funding.
– Growth capital (or development capital) investment
– this involves the provision of capital to accelerate the growth
of established businesses and generally involves the VC taking a
minority equity position. It is a “product” suited to a diverse
range of growth opportunities, including acquisitions, increasing
production capacity, market or product development, turnaround
opportunities, shareholder succession and change of ownership
situations.
– Buy-out investment – this involves the purchase of
an existing independent business or subsidiary or division of a
corporate group from its current owners. This category of
investment includes management buy-outs, management buy-ins,
institutional buy-outs, etc. Here, the equity in the post buy-out
business is usually shared between the management team and the VC,
with the VC usually holding a majority stake. The finance for the
buy-out would generally comprise around 60% of senior and mezzanine
debt (usually provided by banks and mezzanine providers), with
substantially all of the balance of the purchase price coming from
the VC and a relatively small amount coming from the management
team. In order to reflect the mismatch between the equity finance
provided by the VC and the management team and the equity stake
taken by each in the underlying business, a large part of the VC’s
finance is generally provided in the form of redeemable preference
shares or shareholder loans.
Investment objective Like any other investment, the
objective of the VC is to earn attractive returns on its investment
commensurate with the risk being taken. The returns come either in
the form of income (interest, dividends or fees) or capital gains.
The contrast with investment in quoted companies is that the VC
will usually prefer to crystallise its capital gain through a trade
sale (i.e. a sale to a corporate purchaser) or flotation on the
public markets of the underlying business. This preference tends to
make private equity and venture capital investment medium to
long-term in nature, since time is required to implement the value
growth strategy for the business and there will also be a wish to
optimise the timing of the “exit”.
The investment lifecycle The investment lifecycle for an
investment can be broken down into five distinct phases, with each
involving significant resource and capability on the part of the
VC:
– Origination – the ability to access and create
investment opportunities is critical to the VC’s business
model.
– Developing and validating the investment case –
this phase involves capability in the areas of judgment, knowledge
and experience within the particular business area in which the
opportunity lies; building a management team and working with them
to develop the value growth strategy; consideration of the exit
strategy; and due diligence on all significant assumptions and
inputs to the investment case.
– Structuring and making the investment – this phase
involves financial structuring, negotiation and project management
skills on the part of the VC. Relationships with banks, mezzanine
finance providers, intermediaries and others are also
important.
– Implementing the value growth strategy – this phase
involves “actually making it happen”, delivering value growth
between making the investment and exit. If the strategy involves
corporate acquisitions or mergers, restructuring the business,
achieving growth in turnover or operating profits, the VC would
need to have the required capability to ensure these are achieved.
As important is the ability to assess and strengthen the management
team as the life cycle proceeds – this might involve having access
to a pool of management talent in order to match a particular need
to a particular management skill-set.
– Exit – this phase generally involves a trade sale
or flotation of the underlying business. Exit prospects and
strategy should generally be reviewed on an ongoing basis during
the investment’s life – and the sale or flotation itself requires
resource and capability from the VC, since both are lengthy and
complex processes.
Types of investment vehicle The predominant vehicle in the
industry is the independent, private, fixed-life, closed-end fund,
usually organised as a limited partnership. These funds typically
have a fixed life of 10 years. Investments generally consist of an
initial commitment of capital which is then drawn down as the
investment manager finds investment opportunities. Capital is
returned to the investor via earnings distributions and sales of
investments.
Some investment vehicles are organised as captive or semi-captive
funds. A captive fund invests only for the interest of its parent
organisation (which may be a bank or investment bank, insurance
company, university, or whatever). A semi-captive fund mixes
capital from both outside investors and the parent organisation.
Both captive and semi-captive funds tend to be “evergreen” in
nature – income from investments and proceeds received on the
realisation of investments are substantially retained for further
investment rather than being returned to investors.
There are also a limited number of private equity and venture
capital investment companies, such as 3i, whose shares are listed
on a stock exchange. These tend to be evergreen in nature and offer
investors a relatively liquid exposure to private equity and
venture capital.
Drivers of private equity and venture capital investment Some
of the main drivers giving rise to investment opportunities are as
follows:
– Stock market conditions and M&A activity levels
– a strong stock market acts in many ways as an “engine” for
private equity and venture capital, since it allows acquisitive
listed companies to purchase businesses at attractive prices and
also is more receptive to businesses seeking a listing. The ability
of the VC to “exit” at reasonably high values is a key part of the
investment model, and exit assumptions will be a key input to the
pricing parameters at the time of investing. In addition, strong
activity levels in the M&A market (which will often follow from
good stock market conditions) tend to provide a source of
investment opportunities when the acquiring group disposes of the
unwanted parts of the business acquired.
– Restructuring by large corporate groups – as corporate
groups change strategic direction or focus on core activities, they
will often seek to sell unwanted or non-core subsidiaries or
divisions, providing a good source of buy-out opportunities.
– Entrepreneurial culture – this is to do with the
eagerness, across a society, of individuals to start up or grow
businesses or to give up a secure corporate job for the opportunity
to run or manage an independent business.
– Growth strategies – the pursuit of profits by
businesses will often involve the use of growth strategies. Whether
the strategy is to grow organically or through acquisition, there
will usually be a funding requirement, which can be met through the
provision of growth capital.
– Regulatory factors – regulatory factors will often act to
force corporations to sell off business units or to limit or
restrict courses of action by parties operating in the complex
world of business. Additionally, regulatory factors can act to
incentivise certain types of investment or courses of action.
Either way, regulation can give rise to investment opportunity for
private equity and venture capital.
– Technological developments and expenditure on information
technology – both of these factors act as engines for
investment in the early stage technology area, as entrepreneurs
seek to exploit the development and research opportunities
arising.
– Succession issues – especially in family-owned
businesses, succession issues can give rise to investment
opportunities.
|
|
