Private Equity

01-31-2014
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Private Equity

DCA is looking to make new investments into great companies with bright futures and talented management teams through our Private Equity fund, DCA Capital Partners.  Having managed a fund since 2005, we have come to realize there is a good deal of confusion and misconception about Private Equity,  so I thought I’d put together a brief synopsis that will hopefully help any of you who are curious about whether or not it might be a good solution for your Company’s financing needs…

 

First, it is helpful to understand Private Equity from the investors’ perspective. Most large Institutional investors, pensions funds (like CalPERS), foundations and endowments (like Stanford, Harvard, etc.) allocate about 15% of their assets into some form of Private Equity vehicle.  The main reasons that these sophisticated investors allocate
funds to Private Equity are primarily the following:

  • Long history of beating stock market returns
  • Favorable tax treatment (less critical for tax exempt investors)
  • Less volatile than publicly-traded securities

The primary downside to a Private Equity investment is that it is not very liquid.  While there is a secondary market for selling a Private Equity limited partnership interest to another investor, potential investors should not go into a Private Equity investment thinking it is a liquid investment and that they can get their money out of it whenever they may need it.

 

So how does it work?  Typically a General Partner with considerable investment experience (like DCA) will form the Fund and act as the Manager of the Fund making all investment decisions.  The Fund is structured as a limited partnership with the Manager serving as the General Partner (GP) and the investors are Limited Partners (LPs).

 

When a person makes a decision to invest, they make a “capital commitment”, which is a definitive commitment to invest a certain amount of money into the Fund over the life of the Fund.  However, unlike most investments, the full amount of the capital commitment is not contributed all at once.  Instead, the capital is contributed to the Fund only as needed to make actual investments in portfolio companies or to cover its operating expenses.  For example, an Investor who makes a $1 million capital commitment is likely to actually only invest $200,000 into the Fund over each of the first 4 years ($800,000 total), with the remainder paid in slowly over the balance of the (typically 10 year) Fund life.  As a result, LP capital is only contributed into the Fund when the Fund makes an investment. Private Equity is a very efficient investment vehicle.

 

Once the capital is accumulated from investors, the Manager works to identify, conduct due diligence, negotiate terms, and close investments into (typically) privately-held companies where the Manager believes it can produce a roughly 3x cash on cash return over a 5 year period.  There are several different “flavors” of Private equity Funds, which generally fall into the following categories:

 

  • Venture Capital – High risk capital typically invested in earlier stage, less mature companies, often at a pre-revenue stage. These are typically “swing for the fences” types of investments
  • Buyouts – Capital invested to acquire a controlling or 100% interest in a larger businesses. Oftentimes Buyout funds finance a large portion of the acquisition using debt, so the Companies they invest in must have significant, stable cash flows to service the debt. A portion of the returns on these investments comes from principal reduction over time. In this case, these Investor controls the Company.
  • Restructuring – Capital invested to shore up a Company’s balance sheet or to provide a bridge across some unforeseen downturn in Company performance.
  • Mezzanine Debt – An investment structured as debt which serves as an augmentation and subordinate to bank financing. Typically, Companies will have to service a portion of the debt on a quarterly basis, with a portion of the interest deferred until the payoff date, thereby reducing the near-term cash flow burden. Often Mezzanine Debt deals will contain warrants to acquire Company stock, or some other equity-like mechanism to help bolster investor returns. There are often financial covenants, typically a 5-7 year balloon payment required on any unpaid balance, and a redemption provision to sell the warrants or equity “kicker” back to the Company
  • Growth Capital – This is cash invested in a Company to fund continued growth of a Company.  These are generally minority (less than 50% of the Company acquired) investments, allowing the current ownership to remain in control of the Company and the Board. The capital is often used to fund geographic, product line, or sales and distribution expansion initiatives, as well as acquisitions.

DCA Capital has the flexibility to invest in any of the above forms except for Venture Capital, though most of our investments fall into the ‘Growth Capital’ category.

 

During the 5 year investment holding period, the Manager will typically sit on the Board of Directors of each portfolio company, and work hand-in-hand with management to help the Company increase its value; then at the end of the holding period, will help the Company to effect a sale at an attractive valuation.  Often times, good Private Equity firms will have either a geographic or industry focus, allowing them to better add value (beyond the cash) to the Companies into which they invest. DCA, for example, is regionally-focused. When Companies struggle, good Managers roll up their sleeves and help Company management work through their issues.  When done right, the Manager is largely an extension of the Company’s management team without day-to-day operational responsibilities.

 

GPs have their interests aligned with those of their LPs.  GPs generally receive a fixed 2.0% - 2.5% management fee per year which is used to cover the expenses associated with running the Fund (including their personal compensation).  Then, the LPs typically receive a minimum Preferred Return on investment (often 5-8%) before the GP has an opportunity to share in the profits from the Fund investments.  Once the Fund produces total returns (net of all fees and expenses) in excess of the Preferred Return, then the net profits are allocated 80% to the LPs and 20% to the GP - producing a strong alignment of financial interests between the LPs and the GP.

 

As stated previously, the first 4 years of a Fund’s life are typically characterized by Investor cash outflows as the Fund makes investments in portfolio companies. That trend typically reverses by year 6 (often sooner) as capital calls become nominal, and portfolio companies begin to be sold, with the proceeds from such sales returned to the Investors.  These sales are typically taxed at long-term capital gains rates, making Private Equity investing quite tax efficient.  In addition, many Private Equity funds are structured to allow people to invest in them through qualified retirement plans (like IRAs), which are generally illiquid investments to start with, thereby eliminating one of the primary downsides (illiquidity) of Private Equity investing.

 

While there are many more nuances, and a bit more complexity in the details, hopefully the above description is enough to answer some questions and help you determine if one or more forms of Private Equity might be a good solution for your business’ needs.

 

 

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