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Private equity and venture capital

The private equity industry can often seem like a maze to those new to the asset class. Levent Bosut of PDF Corporate Finance demystifies the workings of the industry.

Financial partnerships
‘Financial Partnerships', as we define, are long-term investments made by institutional investors like private equity and venture capital funds and by high net worth individual angel investors through the acquisition of equity or equity linked securities of companies, which have bright growth prospects but lack adequate financial funds. Venture capital and private equity investments have been the most rapidly growing means of financing.  Financial partnerships play a critical role in the transfer of funds into promising firms and projects specifically in the countries, where bank financing is scarce, capital markets are volatile or unavailable. In addition to their financing function, the funds also provide managerial support and business contacts to the investee companies. Funds diversify their risks by investing in a number of companies.

Private equity - venture capital
Considering the growth stage of companies and their financing reasons, the financial partnership investments can be made at different stages,  like seed financing, start-up financing, early stage financing, expansion financing, mezzanine financing, LBO and MBO. These stages sometimes mark the distinction between venture capital and private equity investments. Although the differences between venture capital and private equity investments are not apparent in many cases, seed, start-up or early stage companies with a business or product development plan are generally financed by venture capital funds whereas private equity funds prefer investments to ongoing businesses at later stages of growth via mezzanine or expansion financing. Private equity funds seek companies, which have reached a certain size (revenues exceeding $10m in Turkey), enjoy high operating profit, realise rapid growth, hold considerable market share, and create significant entry barriers in their sectors.

Companies, that cannot realise profitable investment opportunities because of lack of funding and those are financially distressed but operationally viable, are attractive candidates for financial investments. The value created can be shared between the investor and investee.

Risk and return
A widespread misconception concerning financial partnerships is that they provide cheap capital. On the contrary, the financial funds evaluate these investments as more risky compared with an investment into a quoted firm or a firm with financing capabilities and request a higher return to compensate for their investments. From the view of the investee company, the financing risk is less than debt financing. The banks have strict payment terms, whereas the financial funds share the upside potential of investee companies, are more flexible and do not put companies under rigorous obligations. The ultimate goal of the financial fund is to successfully capitalise its investment after an investment period of two to five years and accomplish a profitable exit through an IPO or a strategic sale. In rare occasions, assuming that the invested company has generated a significant cash flow, the sale of the shares to the shareholders might also be an exit strategy.

Structure of financial funds
Similar to the intermediary role of banks in the transmission of deposits and other resources to the industry in the form of credits, financial funds act as the intermediary between the investors and investee companies.

The relationship between the investor and the fund is established in accordance with the structure and terms of the fund. The most common form of these funds emerges as limited partnerships. For instance, to form a financial fund of $50m, the management company invests a capital of $1m as the major shareholder while the pension funds, insurance companies, and other fund management companies provide the remaining $49m as the limited partners. The management company receives two per cent of the fund as the annual management fee and is entitled to a success fee (carried interest) of around 20 per cent for a return exceeding a specific level of around ten per cent. If the $50m fund grows into $120m in four years after the payment of the management fee, the management company will receive a total management fee of $4m ($1m x 4), and a success fee of (120 - 50 (1.1)4)x0.2 = $9.3m. The management company will furthermore earn $2.2m in return for its investment of $1m. As a result, the management company will make a total return of $14.5m with an investment of $1m. The investors will earn a return of 220 per cent over an investment period of four years.

The limited partnership is the most ideal financial fund management structure avoiding possible conflicts of interest between the fund managers and limited partners, and aligning the incentives of the parties with each other. The fund managers will devote their best efforts to earn a satisfying return on their own investments and receive the highest success but more important than that, to appeal more investors for their subsequent funds. Apart from the widely approved limited partnership structure, there are also various financial funds managed by large conglomerates and/or open to the public.

Investment Process
Financial funds keep the following route in the investment process:

• Project search
• Project pre-elimination
• Project evaluation
• Negotiations, pricing
• Deal structuring
• Due diligence
• Closing
• Audit, managerial support
• Exit

The financial funds would evaluate the firms, which they identify or approached by the firm directly. However they usually prefer firms presented by respected intermediaries and financial consultants, which have pre-evaluated the opportunity, prepare the company for the process and present the deal in a well-structured format. The financial consultants provide assistance to the companies in the preparation of the business plan and related selling documents, computation of the firm value on which the negotiations will be based and in all the other stages until closing. The financial consultancy services in Turkey are offered by corporate finance departments of several commercial and investment banks, accounting firms, and consultancy firms.

A financial fund reviews roughly 100 projects in a year; around ten projects proceed to the negotiation stage while only one to two of them are finalised. Therefore, it's rational to approach several funds simultaneously while seeking capital for a firm/project to increase the possibility of success.

The financial funds have varying expectations, investment criteria, and concentration areas. Some funds look for IT and telecom firms, some search for companies manufacturing to the end-users, and some are concentrated in the service business.

It is of significant prominence to present the company/the project to the financial fund in a thorough and well-conceived format since there will barely be a second chance considering the large number of projects presented. The preparation stage might take some weeks or extend to a couple years in some cases. The preparations for the final presentation of the firm will take a couple of weeks assuming that the company is already structured for the process. The companies would rather establish an effective MIS system and keep their records properly since there is always a possibility that the company might need the support of a financial fund in the future.

The arrangement of a company profile analysing the sector, company's operations, facilities, production, products, suppliers, customers, financials, and projections is a crucial step in the presentation of the firm to the financial fund. The history and current status of the company should be emphasised no less than the future of the company in the selling documents, company profile, info memo, and financial analysis. Concerning a newly established firm, the company profile will be much like a business plan stressing the prospects. It should also be noted that financial funds assign more emphasis on a proficient management than a bright idea or a promising sector.

The companies, which could stand out in the pre-evaluation phase will follow through a long due-diligence and negotiation process. This stage might continue for months and will be a tough period for the company. The company should be aware that it has to commit considerable management time and some of its resources for the project.

The company valuation is executed via discounted cash flow and comparative analysis with market indicators. In some cases, the funds base their pricing on the exit projections. To exemplify, if the net profit of a company at the end of the third year is forecasted as $5m and a P/E ratio of ten is a reasonable estimate for a public offering, a fund with an investment of $10m and an annual return expectation of 30 per cent will have 43.9 per cent of the company (The expected value of investment after three years/ The expected value of the company after three years = 10x1.33 / 5 x 10).

After the parties have agreed on the price, legal, financial and technical due-diligences are performed. In the closing stage, obligatory approvals, like anti-competition, foreign investment should be received. In the meantime, share purchase and shareholder agreements are drafted and finalised, articles of association are revised, and related employment, non-competition and confidentiality agreements are signed with the management. The cash transfers and deal structuring should be made in a way that minimises the risks and tax obligations. The contracts and deal structure are as important as the price in many deals.

In this tough process, the companies should cooperate with prominent financial and legal consultants to negotiate the rigorous terms proposed by some funds. For example, the risk profile of the project will totally change if the fund will have the right to sell back its shares after a certain period at a pre-determined return or will have the right to sell its shares to another investor without restrictions.

Although the contracts are the major guides in the resolution of disputes, funds and companies establish partnerships based on mutual trust. It's important to stress that both parties will share the same interest and prospects after the establishment of a partnership.

Pursuant to the closing and injection of the funds into the company, the relationship between the fund and the company will enter a new period. The fund will continue to monitor the company closely to protect its rights and contribute to the performance of the company. The fund will keep representatives in the board of directors, the company will regularly inform the fund regarding the operations, and consult for specific decisions. The funds are usually not involved in the daily operations of the company but focus on long-term performance.

The major distinction between private equity, venture capital funds and other financing alternatives is the assistance provided by funds in management, recruitment, institutionalisation, strategic planning, and the establishment of contacts with customers, suppliers, bankers, and lawyers. Incubators also offer office, equipment, legal and financial support to project owners and cooperate with them to present their projects to venture capital funds. Some incubators function as venture capital funds.

A profitable exit constitutes the final step of the investment process. The main exit mechanisms are IPO and strategic sale. The heightened interests of foreign investors to Turkey, advancement of capital markets, increasing market capitalisation, and favourable IPO prospects will facilitate the exit procedure and enhance returns. Therefore, the interest of funds to the Turkish market is closely related with the politic and macroeconomic developments.

Benefits for the company
The financial partnership will enable the company to strengthen its capital structure, get rid of risky and high cost loans, satisfy working capital requirements, undertake the deferred investments, and to act more flexible and aggressive in M&A activities. The conventional argument that the funds, after a thorough analysis, invest into reliable and promising companies will promote the image of the company in the eyes of the banks, customers, and suppliers and release positive signals to the market. The pace of institutionalisation will accelerate; establishment of effective financial and operational reporting systems together with improving transparency will make the company more attractive for other investors in the future. The managerial support and contacts provided by funds will speed up this process.

Need for economies of scale and scope, increased global competition are putting a pressure on smaller firms to grow, to make international and local partnerships. The companies isolated from capital markets and financial funds will encounter a stiff competition, their market positions will be ruined and long-term survival will be jeopardised. The prominent companies will be selected by the financial funds, as well as capital markets, while the others will gradually vanish. Thus funds will help the consolidation process either via roll-ups merging a number of small firms with each other or by strengthening the selected ones relative to others.

Global private equity and venture capital activities
As previously mentioned, financial funds expand at a groundbreaking rate. The resources channelled to the venture capital funds increased from $3bn in 1990 to $10bn in 1996, and boosted to $55bn in 1999. The swift fund accumulation is primarily attributable to the spectacular returns of venture capital funds. The average venture capital investment returns in the period between 1994 and 1999 are 44 per cent, 34 per cent, 28 per cent, 18 per cent, and 147 per cent. These returns are extremely high in comparison to other investment alternatives. The underlying reason behind the high returns is the rally of hi-tech firms in the stock exchanges and appetite of investors for technology IPOs in NASDAQ, especially the IPO of firms with no bottom-line performance but great expectations. In 1990, 80 per cent of the firms offered to the public were profitable in the previous year before the IPO, whereas this ratio steadily declined to 59 per cent in 1998 and 20 per cent in 1999. From another point of view, the abundance of venture capital funds allowed these companies to realise public offerings.

Until recent years, the growth of private equity funds outperformed that of venture capital funds. The total size of private equity funds was less than the total size of venture capital funds in 1980 but private equity funds doubled venture capital funds in 1994. A review of the European and emerging markets reveal that the venture capital investments fall behind private equity investments. The funds have a material size and prefer companies with a track record.

The major reasons mentioned for the rapid growth of private equity funds and particularly outside the US are the risk averse nature of investors, fund managers with finance backgrounds, who lack entrepreneurship, the lower level of managerial support, less manager time committed in private equity projects, and the higher efficiency ratio due to the larger size projects. Furthermore, the weakness of a legislative framework, inadequate protection of minority rights, and lack of entrepreneurship and technological development hamper early stage venture capital investments. This trend reverted in the recent years with the boom in technology and the rise of technology focused venture capital funds is followed in US and other markets.

Copyright © 2003 PDF Corporate Finance

Established in 1995, PDF is a financial advisory firm specialised in providing a broad range of corporate finance services to Turkish and international clientele. PDF's business activities encompass mergers and acquisitions, private equity, project finance and other financial analysis and advisory services. PDF is the exclusive member of M&A International since 1998, an established network of 41 independently owned merger & acquisition consulting firms and private investment banking firms located in key financial centres throughout Europe, North and South America and the Pacific Rim. For more information please visit www.pdf.com.tr