Private equity law
From Advocatespedia, The Law Encyclopedia
Private equity refers to a class of assets in a company that are not publicly traded on a stock exchange and are contributed by outside private equity firms (or individuals). The private equity firms carry on a primary business of acquiring a stake in or sometimes even buying out a company by investing in its shares. Once an investment is made in a company, attempts are made to increase the share value and promote growth of the company by expanding its business and furthering expansion efforts after which the stake acquired is sold off at a profit. Private equity law is that branch of law which regulates the investments made by the private equity funds and ensures that the procedure followed throughout the process is in line with the general law. Private equity lawyers help private equity firms negotiate the terms on which they make certain investments in a company. They provide sound legal advice both to the private equity firms and to the companies.
|Private equity law|
|Published on||17 July 2019|
According to uslegal.com, Private Equity "is a source of investment capital from wealthy individuals and institutions for the purpose of investing and acquiring equity ownership in companies." This is a simplistic and accurate definition of the basic purpose behind the idea of private equity. Since the purpose of investment is creation of value, it is imperative that all the transactions are done in accordance with the law.
According to Wikipedia, "Private equity is, strictly speaking, a type of equity and one of the asset classes consisting of equity securities and debt in operating companies that are not publicly traded on a stock exchange. However, the term has come to be used to describe the business of taking a company into private ownership in order to restructure it before selling it again at a hoped-for proﬁt." This is a comprehensive definition which establishes the legal status of the private equity investments. It is important to understand that, as a matter of practice, the term "private equity" which actually refers to only the investments made, is used to include even the private equity firms which make the investments in its ambit. It is an inclusive definition which broadens the meaning of the word "private equity."
Private equity law is a component of the larger corporate law field which exclusively deals with the investments made by private equity firms, venture capitalists and angel investors. Bloomberg Businessweek has called "private equity" a rebranding of leveraged-buyout ﬁrms after the 1980s. In a typical leveraged-buyout transaction, an investment is made by a private equity firm into an existing or mature company. Apart from this, some other investment strategies in private equity include venture capital, growth capital, distressed investments and mezzanine capital.
Private Equity Law in Practice
Private equity firms pool the investments of anybody who is willing to part with their money for a particular period of time. These firms then manage these investments and undertake systematic purchase of the share capital of companies and thus acquire a significant or a controlling stake. It must be noted here that the investment strategy followed by the firms is a result of inputs from private equity experts, accountants and lawyers who are well-versed with the existing PE scenario.
The private equity firms use both equity and debt to finance its investments. The word "equity" refers to cash obtained from individuals or organizations. Debt refers to the loans which the firm takes from banks to finance investment into companies. The purpose of raising this money is in order to buy out companies entirely or acquire some of the assets with the goal to sell them (ie: the entire or the relevant share) at a higher price in the market. The most common type of private equity strategy is called a Leveraged Buy-Out (LBO). In this, a significant amount of bank debt is used to buy out the entire company. The assets of the target company are used as leverage to obtain the huge loan from banks. This means that, in case the loan amount is not paid back to the bank in time, it can sell off the assets to realize the amount.
A private equity fund is essentially an investment entity. An entity which has a manager (also known as investment advisor, fund manager or sponsor) who manages the funds and formulates the investment strategy. This means that the individuals/organizations providing the money are passive investors and only contribute the money according to the calls made by the private equity firm. They do nothing more. It is the fund manager who has to decide the method and manner in which the investments will be made by the firm. That is why an investment fund is managed by experts in the field of private equity who are corporate professionals with a matured understanding of the market and the legal regime within which it operates as a whole.
Additionally, private equity funds are often “blind." The investors do not know in advance what their money will be used for. Further, they are also anonymous as no investor will know about the identity of other investors in the fund.
The fund managers charge a fee (which is a percentage of the total value of the fund) for managing the funds on behalf of the investors. Additionally, they also take home a share of the profit made by the private equity fund. This serves as a motivating factor and promotes higher effort expended by the managers.
Sources of Private Equity
Private equity investment comes primarily from individuals and organizations who possess the financial ability to part with huge amounts of money for extended periods of time. Most of the private equity industry consists of large institutional investors, such as pension funds, and large private equity firms funded by a group of accredited investors. Apart from these firms, it includes venture capital firms and angel investors. Venture capital firms are primarily engaged in the very business of making investment in promising ventures. They specialize in building high risk financial portfolios. With venture capital, the venture capital firm gives funding to the startup company in exchange for equity in the startup. This is most commonly found in high growth technology industries like biotech and software. Angel investors make investments at the ideation stage itself. They help the beginners and assist them financially. Most of them readily invest into startups when they find ideas which are out-of-the-box and appealing, thus aptly termed as "angels" who support a good idea with financial aid. Finally, the individuals who contribute to the private equity funds are high net-worth individuals (HNI's) who are capable of making large scale equity investments.
Scope of Private Equity
The need for private equity is immense in an economy like that of India. It can play a very important role in salvaging the economy from serious distress. The bankruptcy resolution of the Indian banks presently calls for a large amount of capital infusion. These banks are being forced to sell off their assets at a price which is much lower than their replacement cost in order to gain access to funds. Private equity can flush the banking system with much required financial means.
Lets take the telecom sector as an example. With the entry of Jio, there took place an immense disruption in the status quo. India has become the world's largest consumer of data. All the existing telecom companies have been pushed into debt which keeps piling up continually. In such a scenario, the new government policy which lowered the levy the government collects from the telecom companies as spectrum usage charges has come as a great relief. In this scenario, the telcos have a great chance of expansion and profits as the telecom revolution has brought the rural population into the mainstream. But in order to make full use of this opportunity, these companies need to upgrade their networks to 5G. A huge amount of investment is required for the above which can be supplied by the private equity sector.
Nature of Private Equity
Private equity is an illiquid investment vehicle. This is because generally, it is difficult to liquidate the funds in a private equity because of the mismatch in the supply and demand. Unlike in the public markets, where sets of buyers and sellers with matching needs are readily available, the private equity market lacks this luxury. It is very difficult to find and pinpoint a buyer for a company. Consequently, a firm has to undertake a detailed search for a buyer in order to make a sale of its investment.
As we already know, the share price of publicly-listed companies is determined by the market forces of demand and supply. On the other hand, the share price of a company in private equity is determined by the negotiations between the buyers and sellers and hence assumes a complex and subjective character in contrast to the objectiveness of the interplay of market forces.
Similarly, the rights of the shareholders in a public company are determined by the principles of corporate governance and accountability. These same rights, in the case of private equity shareholders, are determined by negotiations between the parties and also vary from one transaction to another (case-to-case basis).
Types of Private Equity Strategies
There are 5 basic strategies which all the investors should be aware of.
1) Venture Capital
Venture capital is a private equity strategy in which investment is made into companies which are fresh ventures and do not have any record of profitability. Their promising future prospects propel such investment with the intention of a high valued exit.
2) Real Estate
Private equity real estate means when investment is specifically done to acquire interest in certain real estate properties. This can be done in 4 different ways. "Core investment" which is a low-risk-low-return strategy. "Core plus" which is contains moderate risk. "Value added" which is in the medium-to-high risk and return strategy and finally a high risk and high return strategy known as "opportunistic."
3) Growth Capital
Growth capital private equity investments are made into mature and established companies. These are companies which have a proven track record and need funds for further expansion.
4) Mezzanine Financing
This is an alternative to growth capital which can be used by established and reputed companies who have a history of profitability and a clear expansion plan. In this, both equity and debt financing is used to further a company's expansion. The company takes debt capital (from bank) and the creditor is given an option to convert the debt into an ownership or equity interest in case the loan is not paid back in time.
5) Leveraged Buyouts (LBO)
As mentioned previously in the section "Private equity law in practice", in an LBO, a significant amount of bank debt is used to buy out the entire company. The assets of the target company are used as leverage to obtain the huge loan from banks. This means that, in case the loan amount is not paid back to the bank in time, it can sell off the assets to realize the amount.
Structure of Private Equity Firms
Most of the private equity firms are set up as limited partnerships or limited liability companies and have a life of (generally) 10 years. They are typically made up of:
1) Limited Partners (LP's) 2) General Partners (GP's)
LP's are investors who are outsiders to the firm. They provide the capital and consist of institutional investors such as banks, insurance companies, endowment funds, family investment offices, pension funds and also high net worth individuals. They are called limited partners because their liability is restricted only to the amount of capital they have contributed.
GP's are the experts and the professionals who manage the private equity firms. They are seasoned investors who prepare a blueprint of how the pool of capital is going to be utilized and what is going to be the pattern of investment. Then, they implement the plan keeping in mind various relevant market factors. They are the ones who run the investment cycle ranging from sourcing the deal to the actual making of investment, from structuring the transaction to portfolio management and even determining the exit strategy.
Every firm will have its own operating expenses like salaries, data and research services, deal sourcing services, oﬃce leases, marketing, travel and administration costs. In order to cover for them, the GP's charge a management fee. This fee is deducted from the capital contribution made by the LP's. In addition to the management fee, a portion of the proceeds from the fund is also received by the the LP's. The proceeds can be from the sale of portfolio companies or even in the form of dividends. These proceeds are split between the LP's and the GP's in accordance with an agreement. The basic purpose behind this is for the LP's to recover 100% of the capital they have invested after which the proceeds are split between the LP's and GP's in the ratio of 4:1.
History of Private Equity
A) History of Venture Capital
Before the World War 2, venture capital investments were primarily the domain of high net worth individuals and wealthy families. The origin of private equity happened with the establishment of 2 venture capital firms namely American Research and Development Corporation (ARDC) and J.H. Whitney & Company in 1946. The first leveraged buyout was done by J. P. Morgan in 1901 when it successfully acquired Carnegie Steel Company using private equity. The establishment of the idea of private equity as we know it today is credited to Georges Doriot who is known as the "father of venture capitalism." He is the founder of ARDC and also the INSEAD. In his time, money was raised from institutional investors in order to fund the business ventures of soldiers who were returning from the World War 2. ARDC is yet again the platform where the first venture capital success story happened. This happened when ARDC invested $70,000 in Digital Equipment Corporation (DEC) in the year 1957 and in 1968, this investment was valued at over $355 million when DEC conducted its maiden initial public offering. Also, the first venture-backed startup is Fairchild Semiconductor which was funded by an organization which later came to be known as Venrock Associates.
B) History of Leveraged Buyouts
The first LBO is believed to be the purchase of Pan-Atlantic Steamship Company by McLean Industries in January 1995. Subsequently, McLean Industries also purchased Waterman Steamship Company in May 1955. Under the Waterman LBO, McLean Industries took a loan of $42 million and raised $7 million through issue of preferred stock. In the 1960s, a new trend was popularized by the likes of Warren Buffet and Victor Posner. In this, portfolios of investments in corporate assets were acquired by the use of publicly traded holding companies as investment vehicles. These investment vehicles are often considered to be the forerunners of the later private equity firms. In fact, the term "leveraged buyout" has been coined by Posner himself.
The leveraged buyout boom took place in the 1980s. This boom has been credited to corporate financiers Jerome Kohlberg Jr. and his protégé Henry Kravis. At that time, both were working at Bear Sterns. They, along with Kravis' cousin George Roberts began a series of investments which they called "bootstrap" investments. Many of the companies in which they invested did not have an attractive exit as the founders did not want to sell them to competitors and these companies were too small to be taken public at that time. Thus, a sale of these companies to a financial buyer looked most attractive, thus giving birth to the concept of leveraged buyout.
C) The Private Equity Boom of 1980
In the January of 1982, Gibson Greetings, a producer of greeting cards was purchased by a group of savvy investors (including former United States Secretary of the Treasury William E. Simon) for $80 million (the investors contributed only $1 million). During mid-1983, when only 16 months had passed since the purchase, Gibson Greetings called for an IPO and was valued at $290 million. Simon made a personal fortune of almost $66 million. This great success story attracted the attention of the media to the boom in the leveraged-buyout sector. Just in a span of a decade, from 1979 to 1989, more than 2000 successful leveraged buyouts valued in excess of $250 million happened.
The landmark buyout of the 1980s was the KKR (Kohlberg Kravis Roberts) takeover of RJR Nabisco. It was, at that time, the largest leveraged buyout ever and it held that distinction for 17 subsequent years. In 1989, KKR purchased RJR Nabisco for a whopping $31.1 billion. This event was even featured in the book and later the movie "Barbarians at the Gate: The Fall of RJR Nabisco." Apart from KKR, the others who were also in the race to acquire RJR Nabisco were Shearson Lehman Hutton and Forstmann Little & Co. In fact, Shearson had made the initial offer of taking RJR private at $75 per share. Later KKR and Forstmann entered the fray and there ensued an intense battle to acquire RJR. KKR initially introduced a tender offer at $90 per share. In response to this, the management of RJR working along with Shearman and the Salomon Brothers submitted a bid for $112 per share in an effort to thwart the threat from KKR which finally made an offer of $109 per share. Unexpectedly, the board of directors of RJR Nabisco accepted the deal offered by KKR even though it was a lower dollar figure as compared to the $112 being offered by Shearman. This marked the end of the huge battle which became the largest LBO in history.
D) 2005-2007: The Age of Humongous Buyouts
There are some factors which assist or bring about a successful private equity transaction. These factors flourished in this period thus making major buyouts a common occurrence. These were factors like decreasing interest rates, loosening lending standards and regulatory changes for publicly traded companies. Marked by the acquisition of Dex Media in 2002, high yield debt financing could once again be obtained by large LBO's in the United States. By 2004 and 2005, huge acquisitions like that of Toys "R" Us, The Hertz Corporation, Metro-Goldwyn-Mayer and SunGard took place. By the beginning of 2006, the record of "largest ever buyout" was set and surpassed many times. At the end of 2007, 9 out of the top 10 buyouts were completed in 18 months or less beginning in 2006 and going through the middle of 2007. In 2006 itself, 654 U.S. companies were bought by private equity firms for $375 billion. This figure was almost 18 times of what it was in the year 2003. Also, the U.S. based equity firms raised capital (from investors) to the tune of $215.4 billion. This surpassed the previous record set in 2000 by 22 percent and it was 33 percent higher than the fundraising total of 2005. In the following year, even though a turmoil took place in the credit markets, $302 billion worth funds were raised to 415 funds. This is all to show the real extent of the LBO boom which happened during this period.
It was only in 2007 that the turmoil in the mortgage market affected the high-yield debt market. By July and August, a slowdown in the high-yield and leveraged loan markets happened. Uncertain market conditions put the companies and investment banks on their guard and most of them decided to wait for the summer to end to issue fresh debt.
The Private Equity Index and Region-wise Performance
Venture capital and private equity (VC/PE) professionals need an environment which supports them and promotes their objectives. In this regard, quintessential questions like which countries offer the most promising markets, strongest institutions, most entrepreneurial support, best protections and strongest corporate governance practices that make investing attractive arise. The countries which answer this question in the affirmative most emphatically are the United States, the United Kingdom, Canada, Singapore and Japan (in the order of ranking in the charts of the 2015 Venture Capital and Private Equity (VC/PE) Country Attractiveness Index.
This index analysed 120 countries based on many important data points. Then it ranked them in accordance with their attractiveness to the VC/PE investors. It used six key drivers to rank these countries. It is a very comprehensive tool in order to assess the risk-and-return profiles around the globe and also to spot the emerging market winners. It is also used in helping the regulator of an economy formulate policies in a more effective manner so as to better attract the VC/PE money in future.
Emerging countries and the BRICS
Private equity investors generally set their sights on emerging markets with the object of finding new transactions with satisfying risk-reward ratios. In 2015, China ranked 21 among the BRICS (Brazil, Russia, India, China and South Africa) countries. Even though China has remained relatively stable ranking-wise, it has maintained its attractiveness due to robust economic growth, capital markets development and favorable taxation practices for entrepreneurs. Despite the fundamental economic soundness of the emerging economies (like Mexico, Indonesia, the Philippines, Nigeria and Turkey which have large populations and a strong economic potential) and also the BRICS countries, investor protection and the indicators of proper corporate governance (with the exception of South Africa) still remain obstacles.
Despite all this positivity surrounding the emerging markets, one must be on guard. This is due to the fact that investors generally are too optimistic about the prospects in emerging markets and they, as it is aptly said, "do not want to miss the train." In reality, it is difficult even for the investors to determine the real deal-making opportunities in these economies. Therefore, before making any long term financial commitment, investors would be much better off interpreting the data from the index mentioned previously and also estimating the fundamental values of VC/PE country attractiveness therefrom.
Trends from 2011 to 2015 internationally
It must be noted that the indexes which are prepared prefer to take five-year long data in order to reach a definitive conclusion about anything. Year-on-year change in figures do not help much as they reflect only the short term volalitily.
With this as the backdrop, at the top of the rankings, there is relative stability. In case of the United Kingdom, due to an expected rise in the GDP and many entrepreneurial opportunities (which was a result of ever-growing innovation and research & development), it climbed 2 spots to number 2 thus returning back to where it was (for VC/PE attractiveness) before the onset of the financial crisis. The reverse happened in case of Singapore which dropped 2 spots to land at number 4. This happened due to lower than average expected GDP growth. The biggest gains within the top 20 during this period belonged to New Zealand - which climbed from number 15 to number 9 - and Malaysia - which climbed from the 18th spot to the 12th. Post the top-20 performers, the most surprising improvement was in the case of Phillipines which jumped an impressive 22 places (from 64th in 2011 to 42nd in 2015). It scored particularly well on economic indicators and had impressive growth projections for the future. On the flip side, Cyprus dropped 28 places in the five year period. The crisis-hit Mediterranean island has been ranked 65th overall and ranked at the bottom of the pile at 120 for its ratio of non-performing bank loans to total gross loans. It's overall growth prospects also don't look promising.
These were the significant country wise change in the private equity prospects. Now, let us analyse the heat map which is a color-coded map reflecting the private equity sector scenario globally. On the map, Africa is mostly red which indicates that it's markets are still in the development stage. On the African continent, South Africa and Morocco are at the top with ranks 37 and 50 respectively. Over this period, South Africa was demoted 5 places and Morocco gained 6 spots due to improvement in its corporate governance practices and protection of property rights. At the same time, North America and Europe are largely green reflecting an immensely positive private equity scenario.
It was mentioned previously that in this index, the countries are ranked according to 6 key drivers. These are the 6 drivers which are measured by 65 individual indicators.
1) Economic activity of the country including its GDP and expected GDP growth.
2) Depth of the country's capital markets.
3) The taxation regime which includes incentives given to businesses and the ease of filing returns.
4) Corporate governance and investor protection (this includes the legal protection also).
5) The social environment prevailing in the country. This refers to the standard of education and its efficacy in improving the lives of citizens, labor regulations and improvement in the overall labor conditions and also measures to prevent corruption.6) Entrepreneurial opportunities which include promoting research and development, harbouring a culture of innovation and the ease of beginning, carrying on and closing a business.
- Retrieved from A Short (Sometimes Profitable) History of Private Equity, Wall Street Journal, 17 January 2012, Last visited by author on 18 February 2019.
- Retrieved from https://www.pbs.org/wgbh/theymadeamerica/whomade/doriot_hi.html, Last visited by author on 18 February 2019.