Private Equity Industry: Southwest Firms Draw on Regional Expertise by Alex Musatov and Kenneth J
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Private Equity Industry: Southwest Firms Draw on Regional Expertise By Alex Musatov and Kenneth J. Robinson The private equity industry Neiman Marcus, Harrah’s, Petco, J. five years or so are spent managing, advis- Crew—these well-known names are among ing and improving the portfolio of compa- runs the gamut from small the holdings of companies owned or co- nies. owned by private equity (PE) firms in the The final stage of the private equity venture-capital investments Federal Reserve’s Eleventh District. The cycle—the exit stage—entails divestiture, region is home to more than 175 PE firms, with the acquired firms typically operation- in startup companies including the world’s third-largest, Fort ally stronger and more valuable, reflecting Worth-based TPG Capital.1 Together, these the PE sector’s benefits to the economy. to multibillion-dollar entities have raised more than $109 billion Exits can take the form of an initial public over the past 10 years and sit on $31 billion offering of shares or a sale to a corporate buyouts of well-known pending investment.2 buyer or another PE firm. The full cycle While the PE business model goes often requires a 10- to 15-year commitment public corporations. back to the times of early seafaring enter- from investors, highlighting the long-term, prises funded by limited private partners, generally illiquid characteristics of private its modern U.S. iteration dates back to the equity financing. 1950s and the first venture capital funds. More recently, the industry and its some- Nonpublic Funding times opaque operations have come under The PE industry runs the gamut from increased regulatory scrutiny amid concern small venture-capital investments in startup about their riskiness and systemic impor- companies to multibillion-dollar buyouts of tance to the financial system. Although de- well-known public corporations. They all tailed data are hard to come by, regionally share a nonpublic funding structure under based PE firms are distinguished from their the leadership of a professional general counterparts nationwide by the sectors they partner who deploys capital raised from favor. limited partners. The PE universe is most often segmented by the life-cycle stage of What ‘Private Equity’ Means target companies—from startups to mature The term “private equity” is used very operations. broadly—often inconsistently—because it “Venture capital” firms invest almost encompasses a vast range of strategies for exclusively in young companies, often be- investing in companies whose shares are fore their first revenues materialize. Venture not publicly traded. In its simplest form, a capitalists are often willing to lose their en- PE firm consists of a team of professional tire principal on most investments in order investors who declare their intent to raise to hit a home run with one potentially revo- a fund of specified size with an expressed lutionary technology or business method investment strategy. The team solicits ac- that reaps enormous returns. The earlier credited investors—primarily institutional the stage targeted, the higher the risks and money managers and high-net-worth indi- the greater the potential rewards. In addi- viduals—to raise the targeted amount. tion to capital, venture capital entities often Once a fund is closed to additional in- provide technical know-how and industry vestors, the firm deploys its capital through expertise to their portfolio firms. Google, a series of acquisitions, generally occurring Microsoft and Apple are some of the most over a period of up to three years. The next illustrious venture capital success stories. SouthwestEconomy 10 FEDERAL RESERVE BANK OF DALLAS • FOURTH QUARTER 2011 “Growth equity” and “mezzanine debt” markets for financing. The banking industry funds target companies in later stages plays a key role in LBOs. As of June 30, than venture capital. These PE participants U.S. banks reported $115.4 billion in lever- provide capital—either equity or debt—to aged loans and securities on their books. young but stable businesses that require In addition to these primary styles, bridge financing between venture capi- PE firms pursue various specialized invest- tal and public financing.3 PE firms in this ment strategies. This “other” group includes particular segment hope to capitalize on firms that invest exclusively in financially rapid growth and typically exit the invest- distressed businesses and companies on the ment once the firm can access bank loans brink of bankruptcy (or already in bankrupt- or public equity markets. Mezzanine debt cy proceedings) and PE firms that invest in refers to cases when a PE fund opts to lend other PE firms, so-called secondaries. to, rather than provide equity in, a growing Funds committed to LBOs account for firm. The loans typically have very flexible the largest relative amount of PE capital terms but rank below senior debt in the available for investment in each of the ma- event the company defaults. For this added jor strategies (Chart 1). risk, mezzanine funding comes with rela- Within each segment, PE firms special- Narrow industry specialization tively high interest rates. ize primarily by industry and size of target The “leveraged buyout,” or LBO, is by firm. With the exception of the largest PE has been shown to produce far the largest and most recognized private firms, which tend to diversify across indus- equity strategy. Many think of PE and LBO tries, fund managers prefer to acquire firms higher returns, and as synonymous. LBOs are often involved in within very specific subsegments, often le- the acquisition of famous brands, combin- veraging one portfolio firm to help another industry participants— ing equity with large amounts of borrowing one grow or even merging related business to employ significant leverage and gain into a single entity. Narrow industry special- including potential acquisition control of target companies. ization has been shown to produce higher Debt is a key component of this busi- returns, and industry participants—includ- targets—prefer private equity ness model because the leverage employed ing potential acquisition targets—prefer PE can amplify the returns generated by an firms with deep experience in a particular firms with deep experience initial equity investment. Buyout firms target sector.4 companies that have strong, predictable in a particular sector. cash flows since those will be needed to re- Surviving the Financial Crisis pay large borrowings. This makes the buy- The PE industry has largely recovered out segment highly dependent on the debt from the recent global economic turmoil, Chart 1 Leveraged Buyouts Are Largest Share of Private Equity Available Capital Percent of PE available capital 100 90 80 70 60 50 40 30 20 10 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 Venture capital Growth equity and mezzanine debt Leveraged buyouts Other NOTES: “Available capital” refers to capital not yet invested at year-end. 2011 data are through second quarter. SOURCE: Preqin. FEDERAL RESERVE BANK OF DALLAS • FOURTH QUARTER 2011 11 SouthwestEconomy reflecting the long-term nature of its model, they had already built up (Chart 2). with investors committing funds for 10 to In response, some PE firms diversified 15 years and anticipating a lack of interim outside of their standard business models, liquidity. The industry, therefore, tends to pursuing alternative investment strategies experience less instability than equity and that include hedge funds and real estate fixed-income markets.5 Still, with the onset funds. In addition, the relative health of of the financial crisis, PE capital declined corporate balance sheets has increased steadily as the inflow of new investment competition for purchase targets. Corpora- funding slowed; capital peaked at almost tions now periodically outbid PE firms in $900 billion globally in 2008.6 auctions for business acquisitions.9 The industry has also been placed under increased regulatory scrutiny. The Dodd– Southwest Private Equity Frank Wall Street Reform and Consumer While PE is global in most respects— A large portion of the capital Protection Act, signed into law in July 2010, U.S. investment interests can raise money requires that PE and hedge funds as well as from a European pension fund and invest attracted during the 2005–08 other private pools of capital with at least it in Asia—individual firms tend to cluster $150 million in assets under management near hubs of their target industries. Proxim- peak years remains dormant register with the Securities and Exchange ity allows fund managers to build industry Commission.7 The law also imposes new relationships, identify potential targets and because of limited profitable record-keeping and disclosure requirements manage a company more actively after its that will give financial supervisors information acquisition. Also, PE firms prefer to hire investment opportunities. to evaluate both individual firms and the state insider experts directly from their target in- of the overall market, closing a regulatory gap dustries—and expert staff is often reluctant that had existed in this sector of the financial to relocate. marketplace.8 Proximity can be especially important The economic downturn and heightened for venture capital firms, which must often investor risk aversion affected the industry’s identify promising investments even before dynamics. A large portion of the capital at- a formal company exists. Out of 29 PE firms tracted during the 2005–08 peak years re- in Austin, for example, 19 focus on high-tech mains dormant because of limited profitable venture capital. Largely due to the presence investment opportunities. Although investors of prominent high-tech companies such as curbed some incremental commitments, and Dell and a large university population, Austin total funds raised contracted after 2008, PE is home to almost one-third of all venture firms couldn’t spend the large cash positions capital firms in Texas. Chart 2 Ready Capital in U.S.