How Pension Funds Became Key Institutional Investors for Private Equity – Employee Retirement Income Security Act

Posted on 05/09/2013 by pelosophy

The main goal of pension funds is to provide pensions for employees. At the same time, pension funds must be profitable. To ensure a successful return, pension funds must generate stable, long term growth through outside investments. Due to the amount of capital they possess, pension funds are the largest institutional investors in the market.

Pension funds have always played a key role as institutional investors in private equity but, until 1974, there were no clear regulations concerning pension funds’ investment policies. Because of this, some pension funds were reluctant to invest in private equity.

In 1974, the United States government established the Employee Retirement Income Security Act (ERISA). The purpose of the Act was to introduce standards for pension plans to protect the interests of employees. One of the ways it ensured protection was to set up investment policy rules for pension funds. Under ERISA, pension funds were prohibited to engage in high risk investments. As a result, even more pension funds stopped investing in private equity.

This situation changed in 1979 when the US Department of Labor, under the “prudent man rule”, clarified the stipulations of ERISA concerning pension funds’ investment policies. As a result, pension funds received the green light to invest in private equity. This set the stage for the first private equity boom in the 1980’s and established a stable framework for investing in private equity. Today, this trend continues and has solidified the investment relationship between pension funds and private equity.

Managing Portfolio Companies

Posted on 04/24/2013 by pelosophy

Private equity (PE) portfolio management concerns managing takeover companies in order to meet specific investment goals. The main goal of management is to increase a takeover company’s efficiency to ensure its growth and, as a result, increase the value of the company.

Depending on the PE firm’s amount of shares in a takeover company and its internal policy, a PE firm may approach, i.e. to work closely with takeover company, become a board member, or to monitor key performance indicators. Regardless of the chosen approach, PE firms need to ensure that the company implements and imposes growth strategies.

We can distinguish three main PE firms’ strategies towards portfolio companies:

Financial engineering – using tools and solutions from computer science, statistics, economics, and applied mathematics to address current financial issues*

Cost cutting – addressing financial issues by cutting expenses and increasing profitability

Value approach – concentrating on increasing the worth of the whole company or its separate products or services by increasing their value

The decision, which strategy to choose, depends on the PE firm’s size, the PE firm’s fund size, and the conditions of the takeover company.

Takeover companies have a certain amount of time to improve their performance and boost growth. After that period, the PE firms must make a decision whether to exit the company (exclude from portfolio by one of exit strategies) or to keep in the portfolio.

*http://www.investopedia.com/terms/f/financialengineering.asp

American Research and Development Corporation – the First Venture Capital Firm

Posted on 04/12/2013 by pelosophy

American Research and Development Corporation (ARDC) was one of the first publicly owned venture capital firms. ARDC was launched in 1946 in New England to support the local economy. From the beginning, ARDC also invested in companies from Midwestern and Western USA and, finally, from Europe, Canada and even Australia. Its founders were: George Doriot (Harvard Professor and a director of U.S. Army’s Military Planning Division), Ralph Flanders (New England businessman, head of the Federal Reserve Bank of Boston, MIT trustee) and Karl Compton (former president of MIT). ARDC is a great example of the link between government trends to subsidize small companies and wealthy individual’s initiatives, the leading trend at that time.

The main aim of ARDC was to invest in companies created by soldiers returning from World War II and in companies that could lead to the creation of new industries. ARDC concentrated on assisting the establishment of new firms or helping firms to upgrade their technology or add new product lines; additionally, ARDC helped to commercialize technological innovations. At that time automobile and textile industries were being blamed for the growing unemployment rate. Moreover, these companies were willing to invest in R&D but only in terms of their own operation, which do not lead to the creation of new industries. The founders of ARDC agreed that information technology and electronics fields had the biggest potential for development. ARDC’s the most well know investment was Digital Equipment Corporation (DEC) a vendor of computers and software that grew from a $70,000 investment in 1957 to a $355 million return in 1971.

At that time, small companies faced the problem of limited access to bank loans. A mechanism that enabled them to raise money was needed. The founders of ARDC decided to launch a public listed company. As a listed firm, they raised money from a wide spectrum of investors: institution investors, public investment trusts, life insurance firms, and university endowment. During the first years, they raised $3,581,750 to invest in small companies.

ARDC did not have a standardized mechanism to finance companies. They chose them by evaluating each case separately; however, they were famous for portfolio management – “Doriot style”. ARDC’s employees joined the boards of directors of their portfolio companies to actively take part in their daily operations.

ARDC’s main competitor was Small Business Administration, which launched Small Business Investment Company Program (SBIC). SBIC provides loans to small enterprises that are subsided by government. Also, venture capital limited partnerships, a new organization structure at that time, were ARDC’s competitors due to their flexibility in investing.

At the beginning, the mechanism that helped in fundraising became an obstacle for the future ARDC growth. As a publicly owned company, ARDC was a close-end trust, which means it had to exit investments in a specified time. This condition was not adequate for startups. ARDC was not able to overcome this limitation. As a result, in 1973, it was sold to Textron and became its subsidiary.

Even though ARDC lost their status for venture capital in the end, its contribution to venture capital development was major. ARDC not only was the first company to invest in early stage companies, but also was a pioneer in terms of portfolio management.

Wealthy Families and Individuals as the First PE Investors

Posted on 03/09/2013 by pelosophy

According to the post “Trends overview prior to the 80’s” wealthy families and individuals were one of the bases of private equity. The main idea of their investments was to make minority investments in privately – held companies to help them grow and develop their business.

The table below lists the names of the most important wealthy families and individuals together with their influence on PE.

Family/ individual name	Range of actions	Influence on PE
The Péreire brothers – Émile (1800–1875) and Isaac (1806–1880)	As one of the first in the 19^th century, they created a financial institution that invested in railways, transatlantic steamship line, insurance, gas lighting, and newspapers.	The areas of their investment were the areas of first PE investments.
John Pierpont “J. P.” Morgan 1837 – 1913	“Morganization”* – the term reflects the reorganization of financially troubled companies to make them profitable. He was one of the pioneers in such approach to investing.	“Morganization” was the first model approach for PE investment.
Eric M. Warburg (1900 – 1990)	In 1939 he launched E. M. Warburg & Co. that in 1966 become Warburg Pincus.	This firm was as one of the first that conducted leveraged buyouts and venture capital investments.
John Hay Whitney (1904 – 1982) and Benno Schmidt (1913 – 1999)	In 1946 they established J. H. Whitney & Company – today’s Whitney & Co.	This firm was one of the first venture capital firms. Now it is specializing in leveraged buyouts, turnarounds, acquisitions, and recapitalizations of more mature companies
Georges Doriot (1899 – 1987), Ralph Flanders (1880 – 1970), Karl Compton (1887 – 1954)	In 1946 they introduced American Research and Development Corporation.	This firm was one of the first venture capital companies, and was acquired in 1976 by Textron.
The Rockefeller family (John Davison Rockefeller 1839 – 1937, William Avery Rockefeller, Jr. 1841 – 1922, and they descendants)	In 1969 Venrock was established to continue the Rockefeller family investment policy. Another company that was supported by Rockefeller family was AEA Investors, launched in 1968.	Venrock, as a venture capital company, invested in companies like Apple and Intel. AEA Investor specializes in leveraged buyouts.

*Timmons, Heather (November 18, 2002). “J.P. Morgan: Pierpont would not approve.”. BusinessWeek.

Apart from influence on the PE listed above, wealthy families and individuals also invested in sectors such as energy, real estate and infrastructure that are areas of investments of some specialized private equity funds.

Public Institutions as an Early VC Mechanism

Posted on 02/27/2013 by pelosophy

As we know from the post “Trends overview prior to the 80’s” the government’s subsidization was the second major trend prior to the 80’s. The government launched institutions whose main task was to distribute the means (mainly loans) to the companies that could significantly influence economic growth.

The system that was introduced in 1918 by establishing the War Finance Corporation is continuing until now through the Small Business Administration. The graph below shows how major institutions influence themselves.

Shortly I am going to present each of these and outline the effects that they had on each other and VC.

War Finance Corporation (WFC)

This was created in April 1918 by the War Finance Corporation Act to distribute necessary funds during wartime. The main beneficiaries were enterprises connected to war industries; however, this term was treated very broadly, and in practice, non-war industries could also obtain financial aid. Money was transferred to banks, bankers, and trust companies that distributed it to the final beneficiary. Only in certain cases, the WFC transferred funds directly to the individuals. The life of the corporation was primarily limited to 10 years; however, it was formally abolished in July 1939.

Reconstruction Finance Corporation (RFC)

Established by Herbert Hoover in January 1932 in response to the Great Depression, the RFC was modeled on the WFC and its main aim was to provide aid to state and local governments, as well as loans to banks for further distribution and directly to institutions and enterprises. The RFC also continued its operation also during World War II to support economy in wartime. The RFC was abolished in 1953 by merging it with the Department of Treasury.

Smaller War Plants Corporation (SWPC)

The wartime corporation established in 1942 to provide direct loans to small private enterprises employing fewer than 500 employees. After the war the SWPC was taken over by the RFC.

Small Defense Plants Administration (SDPA)

This wartime corporation was established in 1950 to provide direct loans to small private enterprises during the Korean War. After the war the SDPA was taken over by the RFC.

Small Business Administration (SBA)

The SBA was launched in July 1953 by President Eisenhower to continue the efforts of the RFC and “aid, counsel, assist and protect, insofar as is possible, the interests of small business concerns.” In the 1954 SBA started to provide direct loans and guaranteeing bank loans. What is more, the SBA advised company owners in terms of management and provided training. The SBA continuous its activity today.

Small Business Investment Company (SBIC)

A Federal Reserve study made in the early 50’s showed that small businesses had problems with obtaining bank loans for its growth. As a result, in 1958 a Small Business Investment Company Program was launched. Thanks to it, SBA was allowed to distribute funds to venture capital investment firms. The program continues today.

References:

http://www.sba.gov/about-sba-services/our-history

IPO – Initial Public Offer

Posted on 02/14/2013 by pelosophy

Initial Public Offer (IPO) is the process of selling a certain amount of the shares of a privately held company for the first time in order to raise additional funds and diversify the equity. To go public, a company should be ready. In other words, it should be profitable enough to attract investors and able to last in the public market. In terms of PE, IPO is one of the ways in which PE firm exits its investments to obtain return on investment.

We can distinguish four main phases of IPO:

1. Pre IPO

The first step in going public is to improve financial performance – not only in terms of meeting generally accepted standards like GAAP (Generally Accepted Accounting Principals) or IFRA (International Financial Reporting Standards) but also such as SEC’s (Securities and Exchange Commission) requirements. Secondly, a company should provide an internal team experienced in conducting IPO. This may require changing the members of the board.

When these two factors are ensured, a company can choose an investment bank to provide underwriter services. The role of an underwriter is to supervise the due diligence, prepare the prospectus (the document that describes the company, its strategy, its financial position, a biography of the board members and any other important information for IPO), evaluate the share price and conduct a marketing of IPO. In terms of marketing IPO, the company’s management often goes on a road show to present the company and its future value to the potential investors.

2. Pricing

The most common way of determining the price of a share is a book building. The idea of a book is to gather all potential offers in one place. The chosen investment bank manages the “book”. The first step is to set the price. This is done by the underwriter and then announced. Potential investors subscribe to be in the book. When they subscribe, they have to announce number of shares they want to buy and the price that they want to pay. The final price of the shares is a price that allows the selling of all shares provided for IPO.

3. Transaction

The first day of the debut on the stock exchange shows whether stocks were overpriced (the price was too high) or underpriced (the price was too low). Typically, the price over the first day is similar to the IPO price.

If the price fluctuates after the debut, the underwriter has the possibility to stabilize the price of the shares and keep it above IPO price. This right is called “green shoes” and relies on selling up to 15% additional shares within 30 days from the debut by the offering price.

4. Post IPO

The main goal after IPO is to fulfill the promises from the Pre IPO phase to maintain the price of their stock.

The Limited Partnership Agreement

Posted on 02/02/2013 by pelosophy

As we know from the article “Who is GPs and LPs?” a Limited Partnership Agreement (LPA) is an agreement signed between GPs and LPs to establish a PE Fund. The main purpose of this document is to regulate terms and conditions of cooperation among the Partnership and set the guidelines for investments. In my article today I will discuss the main parts of a LPA.

1. Definitions

Usually this is the first part of each agreement. The purpose is to bring all parts of the agreement to a common understanding of the terms used in the agreement. Thanks to that the risk of misinterpretation is minimized.

2. Basic regulations

This part briefly describe:

Compliance of agreement with other documents, especially with applicable law
Name of the Fund
Purpose of the partnership
Commencement and duration of the partnership
Principal place of business and investments – which is always specified place
Minimum and maximum size of the Fund

3. Rights and duties of the Manager

Each Fund has to have its own Manager elected by all the Partners. In some cases GP itself acts as Manager. This section regulates a Manager’s authority, his powers and replacement. Additionally, it can regulate the powers and duties of a GP who is responsible for the supervision of the Manager. A management fee is paid to the Manager for his work. Fees and expenses are divided by reference to total commitment of each of the Partners.

4. Capital contribution

This section describes the contribution of the Partners, especially the schedule of payment for LPs as well as the Fund closing regulations. It also determines the conditions for Manager/ GP to raise additional capital and the provisions for LPs who do not meet the schedule.

5. Investment policy guidelines

This paragraph is related to point 3. It regulates a Manger’s/ GP’s investment policy. Guidance may concern place of investment, type of investee company (mainly sector), conditions under which there is no investment allowed and others such as concerning compliance with applicable law.

6. Allocation of liabilities, profits and losses

The aim of this paragraph is to set the rules of allocation of liabilities, profits and losses. Most important is the allocation of income, capital, and losses, but also expenses and tax credits. A paragraph determines the order of allocation between the Partners. What is more, this paragraph stands for limited liability of Limited Partners.

7. Distribution

Distribution concerns allocation of liabilities, profits and losses. Primarily, set a time and conditions of distribution for each of the Partner.

8. Assignment of interests

This section regulates the condition under which each of the Partners can sell, assign, transfer, exchange, pledge, encumber or other disposition, or grant of any participation of all or any part of their interest in the Partnership. As a rule a General Partner is not allowed to divest of his interest. Limited Partners are allowed to do it, however, only if they receive written Manager/ GP permission.

9. Termination and liquidation

Termination means the expiration of the Partnership. This part lists conditions that cause termination. Typically it is certain period of time, e.g., 10 years after Initial Closing Date (last day of raising the capital for the Fund) or others like, e.g., circumstances like bankruptcy, insolvency, dissolution, liquidation, resignation, and withdrawal of the Manager/ GP.

Liquidation refers to the endings of the affairs of the Partnership, and to dividing the Partnership Assets among the Partners. The part sets conditions of conducting this liquidation.

10. Meetings of LPs and the Advisory Board

The agreement schedules the meeting of LPs with the Manager and GP. Generally it is at least two times per year. If Partnership has an Advisory Board (represent the interests of LPs), this section also schedules their meetings and tasks, e.g., reviewing annual Fund valuation or reviewing investment objectives, strategy, and performance.

11. Miscellaneous

This paragraph is at the end of each agreement. Generally it collects all records that cannot be assigned to other parts but has to be contained in the agreement. For example:

Investment opportunities – regulates relation with other investments/ investors
Confidentiality
Warranties
Governing Law

Trends Overview – in the 2000′s

Posted on 01/21/2013 by pelosophy

The 2000’s are so far the most diverse decade of PE – from the PE crash of the early 2000’s, though the third PE boom and Golden Age, and finally to another slow down. At that time PE firms entered new path – they went public.

The beginning of the 2000’s brought decrease to venture capital due to the overvaluation of their new technology investments. Also, the LBO market noted a decline due to telecommunication investments. Meanwhile, as some PE funds started to exit from their investments, the secondary market no longer was seen as a minority trend.

In 2003 the third PE boom had begun. Favorable economic conditions allowed PE firms to conduct a series of mega buyouts – billion dollar LBO investments. That leading PE trend ended in the middle of 2007 when the financial crisis influenced leveraged financing. PE firms started to search for new ways of investing the capital gathered in the funds, mostly focusing on buying public equity or debt in current leveraged buyout transactions.

Then the PE sector started a debate about the future role of PE – whether to become asset managers or to focus on specific sectors. However, the biggest changed brought the decision of the largest PE firms to go public.

In the category “PE in the 2000’s” I will focus on presenting the diversity of PE. In addition, I will give an economic overview of the 2000’s.

Trends Overview – in the 90′s

Posted on 01/14/2013 by pelosophy

After a decade of very aggressive investments, the 90’s have brought a turning point in the strategy of PE firms. During that decade we observed a second PE boom, mainly in venture capital. However, the beginning of 90’s did not herald it.

First of all, from 1990 until 1992 PE activity declined. That first PE “recession” changed the acquisition strategy of PE companies. They started to acquire companies with the aim of long-term holding and lower involvement with leverage financing. PE firms became partners in business and started to play an active role in management boards of companies they invested in.

The nature of venture capital was much different from leverage buyout from the beginning. By investing in a company at an early stage, mainly a new technology one, PE firms worked from the very beginning to improve the operations of portfolio companies in the long-term rather than searching for new opportunities to invest in. As a result, in 1995 we observed the beginning of the second PE boom as PE portfolio companies became highly profitable. That boom would last until the 2000’s.

In the category “PE in the 90’s”, I will focus on main venture capital investments as well as write about other PE investments. However, I will start by giving you a short description of the economic situation of the 90’s.

Trends Overview – in the 80′s

Posted on 01/10/2013 by pelosophy

The 80’s were the first decade in which PE appeared as a separate financial sector. This period was also known as the first private equity boom, especially in terms of leverage buyouts and venture capital. Both strategies became leading trends during that time. In today post, I would like to present the main factors and reasons why the 80’s became a breakthrough for PE.

First of all, as we know from “PE prior to the 80’s” category, we observed overall economic slowdown in the 70’s. At the end of the 70’s and at the beginning of the 80’s several legal and regulatory changes where introduced to stimulate growth. Some of them directly influenced PE in the 80’s. Private equity rapidly became an attractive alternative for investment. That sudden interest influenced the investor’s attitude. Their first aim was to obtain a fast return on investment. As a result PE in the 80’s is associated with hostile acquisition strategies due to the fact that most of them were unwelcomed by companies being taken over. Meanwhile, technological growth of the 50’s and 60’s, in line with venture capital investment success in the 70’s, differentiated and established venture capital as a PE strategy that concentrated on start ups and companies in the early stage connected with new technologies. The 80’s became a natural continuation of that trend which led to rapid increase in the number of venture capital companies and their investments.

In the category “PE in the 80’s”, I will describe the most famous but also not widely known cases of buyouts and venture capital investments. Before that, however, I will briefly describe the economic situation of the 80’s.

PElosophy

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