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A Primer on Buy-Out Groups & Corresponding Terms
by Mark Jordan
In today’s world of mergers and acquisitions, there are an ever increasing number of buyout firms. They take many different shapes and sizes. The goal of this article is to introduce you to some of the more common types of firms in the market place today along with their typical characteristics.
The first point to understand is there are two broad categories of groups that buy companies: strategic or industry buyers and financial buyers. Strategic buyers view the addition of a target company as creating synergy in many different areas. They generally plan on keeping the acquired company indefinitely.
Financial buyers see an opportunity to improve the value of the target company by enhancing management, improving access to capital, and implementing strategic planning. The goal, of course, if for these improvements to lead to increased value. The financial buyer will generally look to "exit" the company after holding it between four and six years. Most financial buyers fall into one of the following four categories.
Venture Capital Groups (VC’s)
They typically provide equity financing to young companies in order to fuel their growth. The VC buys stock in the company and generally occupies a seat on the board. They provide strategic direction and advice in an effort to influence shareholder value. The typical company securing VC funding is unable to attract traditional sources of capital. VC firms typically charge an annual fee of 2% on committed capital. They access the capital over several years and generally charge 20% of any realized profits.
The main goal of a VC is capital gain. The companies they invest in are generally unlisted. The typical fund size is $20 million to $30 million.
One specialized type of VC is the Small Business Investment Company (SBIC). SBIC’s can borrow money with a government guarantee of repayment because they are federally licensed. SBICs are able to raise money less expensively because of the guarantee, but they are required to meet certain parameters.
Private Equity Groups (PEGs)
These funds generally buy majority or minority stakes in established but unlisted companies. They are typically structured as private limited partnerships. Since PEGs deal with companies that have more stability and predictable growth rates, as compared to start ups, the returns required by them are typically lower than those required by VC’s. The Limited partners generally make their capital commitments available for draw-downs during a period of four to seven years. Their objective is to hold a portfolio company for a period of four to six years and then sell the company. Most PEG partnerships are liquidated after ten to twelve years. Total fund size may be several hundred million dollars.
Hedge Funds
According to The Hedge Fund Center, “a hedge fund is a private investment limited partnership that invests in a variety of securities. The term hedge fund is misleading in that a hedge fund does not necessarily have to hedge. The term "hedge fund" now means any type of private investment partnership.”
Hedge funds have a general partner and limited partners. The general partner handles the trading decision and operations of managing the hedge fund. The limited partners provide the capital but are not involved in the trading decision or daily activities.
Hedge funds generally charge 1% per year for assets under management and 20% of net profits. Hedge funds invest in both listed and non listed securities.
Leveraged Buyout Groups (LBO’s)
LBO’s focus on financing the purchase of existing companies. They generally put up a small amount of equity and borrow the bulk of the purchase price. They rely on the assets and cash flow of the company being purchased to collateralize the loan. In essence, the acquired company is paying the costs for its own acquisition.
Glossary of Common Industry Terms as compiled by Carnegie Mellon Venture Capital Club
Angel Investor: A person who provides backing to very early-stage businesses or business concepts. Angel investors are typically entrepreneurs who have become wealthy, often in technology-related industries.
Board seats: Venture firms often acquire positions on the board of directors of their portfolio companies. A board seat gives a venture firm a means of monitoring and managing a company they invest in.
Bridge financing: As the name implies, bridge financing is intended as temporary funding that eventually will be replaced with permanent capital. In some cases, lenders will provide buyout firms and venture capital firms with bridge loans so that they can begin investing, before they have closed on capital for their funds. Likewise, a buyout or venture firm might provide a portfolio company with a temporary financing until permanent financing is in place.
Capital Take-Down: The schedule by which the general partner of funds draws down capital from the limited partners to be used for investments. Most general partners today call down capital only as they require it, rather than in pre-set amounts according to a rigid timetable.
Carried interest: The general partner’s share of the profits generated through a private equity fund. The carried interest, rather than the management fee, is designed to be the general partner’s chief incentive to strong performance. A 20 percent carried interest—meaning that the remaining 80 percent reverts to the limited partners—has been the industry norm, although some firms now take 25 percent or even 30 percent, based on very strong performance on past funds.
Catch-up: This is a common term of the private equity partnership agreement. Once the general partner provides its limited partners with their preferred return, if any, it then typically enters a catch-up period in which it receives the majority or all of the profits until the agreed upon profit-split, as determined by the carried interest, is reached.
Co-investor: Although used loosely to describe any two parties that invest alongside each other in the same company, this term has a special meaning in relation to limited partners in a fund. By having co-investment rights, a limited partner in a fund can invest directly in a company also backed by the fund managers itself. In this way, the limited partner ends up with two separate stakes in the company; one, indirectly, through the private equity fund to which the limited partner has contributed; another, through its direct investment. Some private equity firms offer co-investment rights to encourage limited partners to invest in their funds.
Consolidation: Also called a leveraged rollup, this is an investment strategy in which an LBO firm acquires a series of companies in the same or complementary fields, with the goal of becoming a dominant regional or nationwide player in that industry. In some cases, a holding company will be created, into which the various acquisitions will be folded. In other cases, initial acquisitions may serve as the platform through which the other acquisitions will be made.
Direct investment: See co-investor
Distributions: Cash or stock returned to the limited partners after the general partner has exited from an investment. Stock distributions are sometimes referred to as “in-kind” distributions. The partnership agreement governs the timing of distributions to the limited partner, as well as how any profits are divided among the limited partners and the general partner.
Due diligence: A process of inspection that a venture capital or other private equity firm carries out before closing on a deal. Venture capitalists, for example, might review a company’s accounting practices and managerial structure.
Evergreen fund: A fund in which returns generated on investments are automatically returned to the general pool, with the aim of keeping a continuous supply of capital on hand for investments.
Exit: The means by which a private equity firm realizes a return on its investment. For venture capitalists, this typically comes when a portfolio company goes public, or when it merges with or is acquired by another company.
Fund raising: The process through which a firm solicits financial commitments from Limited partners for a private equity fund. Firms typically set a target when they begin raising the fund, and ultimately announce that the fund has closed at such-and-such amount, meaning that no additional capital will be accepted. Sometimes, however, the firms distinguish between interim closings (first closings, second closings, etc.) and final closings. The term cap is used to describe the maximum amount of capital a firm is willing to accept into its fund.
General partner: In addition to being used as a title for top-ranking partners at a private equity firm, general partner (or general partnership) is used to distinguish the firm managing the private equity fund from the limited partners, the individual or institutional investors who contribute to the fund.
General partner clawback: This is a common term of the private equity partnership agreement. To the extent that the general partner receives more than its fair share of profits, as determined by the carried interest, the general partner clawback holds the individual partners responsible for paying back the limited partners what they are owed.
General partner contribution: The amount of capital that the fund manager contributes to its own fund in the same way that a limited partner does. This is an important way in which limited partners can ensure that their interests are aligned with those of the general partner. The U.S. Department of Treasury recently removed the legal requirement of the general partner to contribute at least 1 percent of fund capital. However, a 1 percent general partner contribution remains common, particularly among venture capital funds.
Initial public offering (IPO): When a privately held company—owned, for example, by its founders and its venture capital investors—offers shares of its stock to the public.
Lead investor: The firm or individual that organizes a round of financing, and usually contributes the largest amount of capital to the deal.
Leveraged roll-up: See consolidation.
Limited partners: Institutions or individuals who contribute capital to a private equity fund. Limited partners typically are pension funds, private foundations, and university endowments. However, private equity firms themselves may serve as limited partners in other firms’ funds, as, for example, when a large buyout firm channels money to a fund managed by a venture capital firm. See also general partner.
Limited partner clawback: This is a common term of the private equity partnership agreement. It is intended to protect the general partner against future claims, should the general partner or the limited partnership become the subject of a lawsuit. Under this provision, a fund’s limited partners commit to pay for any legal judgment imposed upon the limited partnership or the general partner. Typically, this clause includes limitations on the timing or amount of the judgment, such as that it cannot exceed the limited partners’ committed capital to the fund.
Management buyout: The acquisition of a company by its management, often with the assistance of a private equity investor.
Market capitalization: The overall value of a publicly traded company, derived by multiplying the total number of shares by the share price.
Mezzanine fund: Used to provide a middle layer of financing in some leveraged buyouts, subordinated to the senior debt layer, but above the equity layer. Mezzanine financing shares characteristics of both debt and equity financing.
Management fee: This annual fee, typically a percentage of limited partner commitments to the fund, is meant to cover the basic costs of running and administering a fund. Management fees tend to run in the 1.5 percent to 2.5 percent range, and often scale down in the later years of a partnership to reflect the reduced work load of the general partner. The management fee is not intended to be the primary source of incentive compensation for the investment team. That is the job of the carried interest.
PIPEs: An acronym for “private investing in public equities.” See private placement.
Portfolio company: A company in which a venture capital firm or buyout firm invests. All of the companies currently backed by a private equity firm can be spoken of as the firm’s portfolio.
Preferred return: The preferred return is a minimum annual internal rate of return sometimes promised to the limited partners before the general partner shares in profits. In effect, the preferred return ensures that the general partner shares in the profits of the partnership only to the extent that the investments perform well. Once the preferred return is met, there is often a catch-up period in which the general partner receives the majority or all of the profits until it reaches the agreed upon profit-split, as determined by the carried interest.
Preferred stock: This is one of the most common classes of shares for venture capital and buyout firms to hold. Preferred stock pays dividends at a set rate, and holders get paid before common stock holders in the event of a liquidation. Convertible preferred stock is convertible into common stock at a pre-determined price per share.
Private equity advisor: An outside firm hired by an institutional investor, such as a state retirement system, to handle the selection, negotiation and monitoring of private equity funds. An advisory assignment can be non-discretionary, in which the institutional investor retains the final say on investment decisions, or discretionary, in which the advisor has the legal authority to make investment decisions on the client’s behalf.
Private placement: This term is used specifically to denote a private investment in a company that is publicly held. Private equity firms that invest in publicly traded companies sometimes use the acronym PIPEs to describe the activity—private investing in public equities. Occasionally, private investors will acquire 100 percent of the shares of a publicly traded company, a process known as a “going-private” deal.
Seed-stage fund: A pool of money used to back companies too small to attract mainstream venture firms.
Spin out: A division or subsidiary of a company that becomes an independent business. Typically, private equity investors will provide the necessary capital to allow the division to “spin out” on its own; the parent company may retain a minority stake.
Venture capital rounds: Portfolio companies typically receive several rounds of venture capital before going public. The first round is usually smaller than subsequent rounds, and likely to involve fewer investors. Note that first-round funding does not necessarily mean that the company has received no previous outside backing. The term “first round” is still appropriate if previous backing consisted of, say, $500,000 from an angel investor. A first round typically is the first round involving participation by a venture capital firm.
Warrant: An option to purchase stock in a company, typically exercised over an extended period.
Funding Stages
Seed – Concept or idea stage. Money needed to research market and concept feasibility.
R&D – Financing R&D of new technology or product.
Start-up – Pre-operational financing of a new business.
First Stage – Business is operational but needs capital to hire employees, purchase equipment, and roll out product and marketing program.
Second Stage – Initial sales results are encouraging. Now, additional capital is needed to expand production and marketing.
Mezzanine – In a start-up company this is the round of financing that immediately precedes an initial public offering. In a Leveraged or Management Buyout, this is a layer of subordinated debt below the senior debt and above the equity.
Bridge – Temporary financing between major funding rounds.
Consolidation – Strategy of acquiring several companies in the same line of business to build a larger industry leader. (Often called “Buy and Build” strategy)
Management Buyout – Purchase of an operation by its management, often with the assistance of a venture capital or private equity firm.
Recapitalization – The restructuring of a company’s balance sheet by either increasing or decreasing the amount of corporate debt.
Bankruptcy – Investment in a company that has sought legal protection from its creditors in bankruptcy court.
Distressed Debt – The purchase of senior or junior debt instruments or trade credits of a company in financial difficulty though the company might not yet have filed for bankruptcy protection.
Mark Jordan is Managing Partner of Vercor. Mark brings a unique, multi-disciplined approach to the mergers and acquisitions arena by drawing on his advanced tax strategies, estate, and financial markets knowledge. He also holds an MBA, BS in Business Administration, and numerous designations. He can be reached at 770-399-9512 or mark@vercoradvisor.com.
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