Most local entrepreneurs would attest that capital is considered the scarcest of the four basic factors of production, yet there exist a privileged few who argue capital is the most abundant factor.
Given the two tier structure of the domestic economy, it becomes clear both schools accurately report the state of affairs from their different vantage points. This article de-mystifies private equity and presents it as an alternative source of financing for certain Namibian businesses.
The two primary sources of funding for private businesses are either to take up debt or surrender equity (shareholding) in the company. For the purposes of this article, debt is an amount of money borrowed by one party from another while equity is defined as security representing an ownership interest.
The concept of debt is widely understood due to consumer participation in the debt market through commercial banks and instalment credit-based retail sales. Through the use of available facilities, it is common knowledge money has a time value and those who are able to extend debt require to be compensated by means of a predetermined rate of interest.
Clearly capital has a cost and while the cost of debt is interest, that of equity investment is a stake in the respective company. While the cost of debt is reflected as that of doing business and will impact profitability over the term of the loan, such instruments are designed to be amortised.
It is worth noting, while giving up equity may not impact finance costs in the income statement, it will dilute distributable earnings of all investors holding shares prior to the transaction.
Private equity remains broadly misunderstood by local business owners in general, despite ongoing domestic policy developments with regards to the asset class. In essence, it involves the buying of equity in an unlisted company. This could pertain to an individual, consortium or institutional investor.
Private equity funds are pools of privately-managed capital, formed for the purposes of making investments in private companies. They are typically managed by the promoter of a fund (or an affiliated party). This manager earns a fee for performing the investment management function, which may include a share of the profits generated by the fund.
Generally, investors in a private equity fund commit to invest a certain amount of capital when the fund is established and as the manager identifies suitable investments for the fund, these investors are required to advance the capital they have committed to invest.
A private equity fund invests its capital in companies identified by the investment manager, which are often referred to as “portfolio companies” or “portfolio investments”.
Average holding periods for private equity investments are less than five years, although the range of holding periods can be as much as 10 years. Given this term aspect of private equity investments, fund managers are always concerned about strategies to exit the investment.
Private equity fund managers have four principal roles:
1. Raise funds from investors to invest, principally in businesses that are [or will become] private companies.
2. Source investment opportunities and make investments.
3. Actively manage investments.
4. Realise capital gains by selling or listing those investments (exit).
Funds are raised from international investors, many of which are pension funds, banks, insurance companies and high net-worth individuals. By far, the largest investors in private equity are pension funds and insurance funds.
To protect the fund’s interest, private equity fund managers have to become hands-on supervisors of their investments. While they are not likely to exercise day-to-day control, it is essential they are actively involved in setting and monitoring the implementation of strategies. This is the basis of the argument that private equity has become an alternative model of corporate governance.
As far as realising investor gains is concerned, the industry generally talks of a three-to-five-year exit horizon. Meaning, the investment will be made with the explicit assumption that it will be sold or listed within that timeframe. This exit horizon is the source of the criticism that private equity is a short-term investment strategy. However, it must be considered as an opportunity for the promoters to buy into more of their business and risk adverse downstream investors to access the investment.
As all investors seek reward for their risk and the two are directly related private equity investors are generally characterised by a higher appetite for risk compared to conventional debt facilities, a penchant for higher returns should be anticipated. The typically punitive valuation is usually expressed in form of seemingly hefty demands for equity per dollar invested.
There are two principal determinants of how much equity the original promoter of the investment or management gets in a buy-out structure:
•The residual claimant in which case the maximum a management team can get is what is left after all the other providers of finance have received their returns; or
•The motivational minimum is offered to retain and incentivise management to deliver the business plan, hence generating the returns of all parties to the transaction.
In most buy-outs where management do not hold equity prior to the transaction, the amount of money that promoters or management has to invest rarely has a significant influence on the amount of equity they receive. In many buy-outs, they are required to invest what is often called ‘hurt money’ (money that is material in the context of the individual’s wealth).
Would my company be attractive to a private equity investor?
Many small companies are subsistence businesses whose main purpose is to provide a good standard of living and job satisfaction for their owners.
Private equity backed companies, on the other hand, grow faster than other types of companies. This is made possible by the provision of a combination of capital and experienced personnel input from private equity executives, which sets it apart from other forms of finance.
Furthermore, private equity firms often work in conjunction with other providers of finance and may be able to help you put together a total funding package for your business.
Private equity can help entrepreneurs achieve ambitions for their companies and provide a stable base for strategic decision making. The private equity firms will invariably seek to increase a company’s value to its owners, without taking day-to-day management control.
Although entrepreneurs may have a smaller “slice of cake”, within a few years, that “slice” should be worth considerably more than the whole “cake” was before. PF