CFM11190 - Understanding corporate finance: raising finance: private equity investment and funding

Buy-outs and private equity investments

A buy-out involves the purchase of a company. Where this involves the managers of a company buying the company they work for, usually in conjunction with other investors, this may be described as a management buy-out.

Increasingly the management of a business may not be the initiators of such transactions. There has been an increasing tendency for the equity in businesses to be held by private equity funds. They look for suitable investments which may be businesses at an early stage of development and in need of funding which might not otherwise be available (the venture capital model, see below), subsidiaries of quoted groups carrying on non-core businesses, entire quoted groups which are ‘taken private’, or companies previously held by a different private equity fund. Often the private equity investors will insert a degree of new experienced top-level management for the acquired business, for instance a new Chief Executive Officer, to widen the skill base and ensure that the management’s objectives are aligned with those of the fund.

The aim of the fund is to achieve as much growth in value of its investment, to be realised by a future share sale. To maximise the potential growth in value of its shareholdings, the groups tend to be highly leveraged by debt financing. Some of the fund’s investment may also take the form of debt or debt-like securities.

To incentivise the management, they are likely to become entitled to shareholdings depending on the performance of the business. The fund management will be incentivised in a broadly similar manner. The structures used have been complex and have sometimes been heavily influenced by tax considerations. Legislation has been introduced to counter such arrangements, for instance on the disguised fee income of investment managers - ITA09/S809EZA+ - and “carried interest” -TCGA92/S103KA+ and ITA09/S809FZA+. The details of the structures and applicable tax rules are not described further here.

One notable feature of private equity structures and real estate investment structures is that there tend to be tiers of holding companies. The lowest tier will carry on the actual business and the senior lenders will lend at this level. They will have direct security over business assets. At a higher level there will be another company with ‘mezzanine debt’. Such debt has a higher interest and has weaker security, for instance in the shares of an intermediate holding company which directly holds the shares in the company holding the business.

In cross-border private equity structures there may be a further tier of UK company holding debt ultimately provided by the investors but most likely via offshore intermediaries. There may be more of a tax element in the design of this part of the structure. The shareholder debt typically bears a very high rate of interest. The securities may well be ‘PIK’ notes (payment-in-kind) on which interest is often settled by ‘payment in kind’, that is the issue of further similar securities. One reason for such a structure is that they can be a means of returning cash to investors, once the investment in an investee business is realised by a share sale; at this point there will be cash to allow some or all PIK notes to be repaid. The investors may well expect that much of the interest on the PIK noes will be deductible because the paying group is so ‘thinly capitalised (see INTM511015) with little equity in relation to its debt.

Venture capital

Venture capital funds are an early example of the wider class of private equity investors. Investors in businesses at an early stage of development may be ‘venture capital capital funds’ which may have links to financial institutions such as banks and insurance companies. They can be formed as companies or, perhaps most commonly, as limited partnerships. They attract money from third party investors, then lend money on to businesses which might find it difficult to raise funds. This might be because the business is new, so has no track record, or the company might be carrying on a risky business.

Venture capitalists invest primarily by subscribing for shares in the new company but they may also lend money to the company or provide a mixture of both debt and equity finance.

The shares may be ordinary shares or, more typically, preference shares. Preference shares ensure that the venture capitalists get a priority call on the profits of the company in the form of dividends. They hope to get an ongoing reward for investing in the company.

Normally venture capitalists will not be looking to invest in the company for the long term, nor to control the company. The aim will be to realise or sell their investment when the time is right. If the company is very successful it might seek a stock exchange listing, at which point the venture capital investors can easily sell their shares as might the original managers. More likely, the shares will be sold to another investor, perhaps a private equity fund. Assuming the company has increased in value large profits can be made at this point.