According to SEC spokesman John Nester, “The SEC will be able to stay open in the event of a funding lapse because we [the SEC] have carryover funds available.”1 According to Business Insider, “John Nester wouldn’t say how much cash the agency has,” however, the SEC issued a contingency plan for operating in the event…
Category: Blog Articles
The Dodd-Frank Act – Volcker Rule: More Strain on Foreign Banks Operating in the U.S. Today
The Dodd-Frank Act was enacted on July 21, 2010 after intense debate within the investment banking industry and the political realm in Washington D.C. to address the consequences of the “Lehman Shock” and other lessons learned from the 2008 financial crisis that affected the world economy.1 One area that congress did not consider in depth…
Not Just Another Face in the Crowd: OurCrowd’s Equity Crowdfunding Success
Crowdfunding is “the practice of funding a project or venture by raising many small amounts of money from a large number of people, typically via the Internet.”1 One of the most recognizable names in crowdfunding is Kickstarter. Kickstarter allows any person to create an account and donate any amount of money to a project they…
Investment Plus What? Sun Capital and the “Investment Plus” Standard
Earlier this year, the First Circuit Court of Appeals delivered its opinion in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund1, overturning a lower court’s decision and sending lawyers in the private equity industry scrambling to make sense of it.2 In short, Chief Judge Lynch’s opinion held that, in…
Double Bottom-Line Investing, In Brief
The first bottom-line in any investment is obvious: market-rates of return for banks, pension funds, foundations, and other financial investors.1 The second bottom-line consists of social or environmental returns.2 This can be realized in the form of job creation, community revitalization, or energy conservation, among others.3 As a growing number of investors express a desire…
What is in a Name? Private Equity Industry Considers Label Change
Entering 2012, expectations were high for the private equity industry. Firms were finally recovering from the 2008 financial meltdown and private equity executives were confident that transactions would only continue to increase.[1] To top it off, one of the field’s very own had a legitimate chance to become our nation’s next president. Despite this favorable outlook, 2012 resulted in such damage to private equity’s image that some are now insisting the industry needs a complete rebranding.[2]
While the private equity industry has shouldered the blame for economic problems in the past, public criticism rose to unprecedented levels in the past year. The most widespread vilification occurred during the presidential election, when both Democrat and Republican rivals of candidate Mitt Romney spent millions attacking his private equity background.[3] Around the same time, a federal class action was filed accusing some of the nation’s largest private equity firms of a wide conspiracy to rig deal prices.[4] Considering the very negative popular conception of private equity following these events, it was not surprising when the Security and Exchange Commission’s enforcement division continued the assault by announcing that a regulatory heavy-hand would soon be coming down on the industry.[5]
Historically, private equity firms have not found this type of publicity overly concerning. They have had little need or incentive to uphold their image because they have operated completely in the private sector.[6] However, with many of the big firms going public in recent years, high-level private equity executives now believe that the industry must be “widely trusted” and maintain a “pristine reputation.” [7]
Looking to save face, some private equity practitioners have proposed rethinking the name “private equity.”[8] Blackstone Group President Tony James dislikes the label’s clandestine connotation and feels that it “subliminally sends the wrong message.”[9] Others argue for change by citing the fact that the industry is no longer truly “private,” as it is now regulated by government agencies.[10]
The corporate world has seen this type of makeover before. In the 1980s, “corporate raiders” became symbols of Wall Street greed for their tendency to conduct hostile takeovers of large companies. When legal countermeasures were put into place to thwart these attacks, corporate raiders revised their approach and adopted a more politically correct name: “activist shareholders.”[11] Since the re-characterization, activist shareholders have enjoyed success despite continuing to shake up companies like the corporate raiders before them.[12]
But still, in order for a name change to work, the industry must settle on an appropriate moniker. Noting how Blackstone provides its limited partners with widespread access to its portfolio companies’ financials, James suggests that the name should be changed to “clarity equity.”[13] Other ideas such as “ long term capital providers” and “opportunity capital” suggest positivity and communicate an actual function of these firms.[14]
While altering a label has helped groups repair their image in the past, it is a difficult process that is by no means guaranteed to succeed. An effective approach would supplement the name change with an effort to better educate the public on the benefits of the industry. Regardless of what these investors call themselves, their increasingly important reputation is unlikely to improve significantly unless they first make some attempt to eliminate the negativity surrounding the term “private equity.”
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[1] Hillary Canada, Survey Says: Glass-Half-Full Outlook For 1H 2012, Wall Street Journal Private Equity Beat (May 1, 2012, 7:08 PM), http://blogs.wsj.com/privateequity/2012/05/01/survey-says-glass-half-full-outlook-for-1h-2012/.
[2] William Alden, Rethinking the Term ‘Private Equity’, New York Times Dealbook (Jan. 31, 2013, 1:41 PM), http://dealbook.nytimes.com/2013/01/31/rethinking-the-term-private-equity/; Shasha Dai, Should Private Equity Industry Change Its Name?, Wall Street Journal Private Equity Beat (Feb. 1, 2013, 3:35 PM), http://blogs.wsj.com/privateequity/2013/02/01/should-private-equity-industry-change-its-name/.
[3] Tomio Geron, The Mitt Romney Effect on Private Equity and Venture Capital, Forbes (Sept. 21, 2012), http://www.forbes.com/sites/tomiogeron/2012/09/21/the-mitt-romney-effect-on-private-equity-and-venture-capital/.
[4] Don Jeffrey & Devin Banerjee, Blackstone, KKR, Bain, Accused of Agreeing Not to Compete, Bloomberg (Oct. 11, 2012), http://www.bloomberg.com/news/2012-10-10/investors-claim-kkr-told-equity-firms-not-to-bid-for-hca.html.
[5] See Bruce Karpati, Chief, SEC Enforcement Division’s Asset Management Unit, Private Equity Enforcement Concerns at Private Equity International Conference (Jan. 23, 2013) (transcript available at http://www.sec.gov/news/speech/2013/spch012313bk.htm).
[6] D.M. Levine, Carlyle and Oaktree Are Latest Private Equity Firms Expected to Go Public, The Huffington Post (Apr. 11, 2012), http://www.huffingtonpost.com/2012/04/11/private-equity-firms-go-public_n_1417734.html public_n_1417734.html.
[7] Alden, supra note 2.
[8] Id.; Dai, supra note 2.
[9] Dai, supra note 2.
[10] See id.
[11] Bob Moon, Corporate Raiders Morph Into Nice(r) Guys, American Public Media Marketplace (Nov. 26, 2012), http://www.marketplace.org/topics/business/corporate-raiders-morph-nicer-guys.
[12] See id.
[13] Dai, supra note 2.
[14] See id.
SEC – Roadblock to Equity Crowdfunding?
With such a promising name, what’s not for entrepreneurs, small businesses and venture capitalists to love about the Jumpstarting Our Business Startups Act (JOBS Act)?[1] Indeed, the Act was passed with bipartisan support in both houses and signed into legislation by President Obama on April 5, 2012. At its passage, the JOBS Act was widely proclaimed as a promise for growth for small businesses and start-ups because of the Act’s capacity to increase access to capital.[2] Despite this initial phase of promise, the JOBS Act has gotten off to a rather slow start in the realm of equity-crowdfunding.
One of the ways in which the Act is designed to help startups is by making it easier to obtain additional capital through equity crowdfunding. Although it has been a buzzword for the last few years, crowdfunding is not a new phenomenon. Traditional crowdfunding is defined as “the practice of funding a project or venture by raising many small amounts of money from a large number of people, typically via the Internet.”[3] In the United States, the Securities Act of 1933[4] and the Securities Exchange Act[5] restrict the potential means of generating funds via crowdfunding. These Acts prohibit entities from offering or selling securities to the public unless the offering is registered with the SEC, or unless there is an exemption from registration. Thus, the SEC registration requirements have limited crowdfunding to a means of generating capital from contributors without the prospect of financial return on investment (i.e., no equity offerings for funders). Accordingly, crowdfunding enterprises solicit funds by means such as offering prizes for donations or by offering funders the option to purchase a product prior to the product’s release on the market.[6] But even with the availability of numerous crowdfunding platforms[7] to incentivize offerings, many enterprises currently find it difficult to access substantial capital using traditional means of crowdfunding.
Equity crowdfunding in the United States, however, would enable enterprises to issue equity in return for crowdfunders’ contributions. The prospect of return on investment would entice many would-be-funders to take the financial leap-of-faith and support startups. Equity crowdfunding can also be particularly useful to small-business owners who have been unable to secure adequate funding through more traditional means like small business loans. To date, many foreign countries, particularly member states of the European Union and Hong Kong, have already capitalized on the potential of crowdfunding by permitting startups to issue equity to investors.[8]
The JOBS Act recognizes the potential for equity crowdfunding and amends the provisions of the Securities Act of 1933 and the Securities Exchange Act that foreclose the opportunity to crowdfund due to SEC registration requirements.[9] The “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012,”[10] in particular, addresses the conflict by creating an exemption for unregistered securities offered by private companies via the “crowdfunding exemption”[11].
But still, further government action is necessary before the crowdfunding exemption can go into effect. In an effort to protect investors from the potential of fraud that equity crowdfunding entails, the Act requires the SEC to issue rules governing the crowdfunding provisions.[12] The Act provides a period of 270 days from the date of enactment[13] in which the SEC is to issue these rules. On December 31, 2012, this 270-day period expired without any such rules having been announced.
Although it has been nearly a year since the legislation was enacted and three months since the expiration of the deadline, there is no indication the rules will be issued any time soon. Factors that may be contributing to this delay include a rulemaking-backlog (created largely from the 2010 Dodd-Act mandates) and a still-pending change in chairmanship at the SEC.
So when can we expect equity-crowdfunding to go into effect? It depends on whom you ask, but the prognosis generally is not good. Many fear it will not be any time soon,[14] while others claim at earliest next year.[15] Even worse, some believe that even if the SEC does issue rules, the rules may be so complicated as to preclude the opportunity to equity crowdfund in practice.[16]
In the meantime, small businesses and would-be entrepreneurs are feeling the hit. But they are hardly waiting idly by. Crowdfunding organizations are seeking the media’s attention through venues such as the National Press Club in Washington DC, as well as speaking with the SEC directly to inform the Commission of the industry’s current investor protection mechanisms.[17] Members of the Crowdfunding Professional Association, for example, have already met with the SEC more than thirty times.[18] Despite the industry’s efforts to push-start the crowdfunding exemption into action, the wait continues. If and when the SEC finally issues the rules, the crowdfunding exemption has enormous potential to help small businesses.
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[1] Jumpstart Our Business Startups Act (JOBS Act), Pub. L. No. 112-106 (2012).
[2] See, e.g., JOBS Act Promises to Improve Access to Capital, Husch Blackwell (Apr. 5, 2012), http://www.huschblackwell.com/jobs-act-promises-to-improve-access-to-capital/.
[3] Tanya Prive, What Is Crowdfunding and How Does it Benefit the Economy? Forbes (Nov. 27, 2012, 10:50AM) http://www.forbes.com/sites/tanyaprive/2012/10/12/top-10-benefits-of-crowdfunding-2/.
[4] Securities Act of 1933 §5, 15 U.S.C. §77e (2006).
[5] Securities Exchange Act 15 U.S.C. §78d.
[6] See generally Thaya Brook Knight et. al., A Very Quiet Revolution: A Primer on Securities Crowdfunding and Title III of the JOBS Act, 2 Mich. J. Private Equity & Venture Captial L. 135, 135-36 (describing four current methods of crowdfunding in the United States).
[7] See generally Devin Thorpe, Eight Crowdfunding Sites for Social Entrepreneurs, Forbes, http://www.forbes.com/sites/devinthorpe/2012/09/10/eight-crowdfunding-sites-for-social-entrepreneurs/ (providing an overview of top crowdfunding platforms).
[8] Ralf Hooijschuur, Crowdfunding in Different Countries – Legal or Not? Squidoo http://www.squidoo.com/crowdfunding-in-different-countries2 (last visited Mar. 18, 2013).
[9] Securities Exchange Act 15 U.S.C. §78d.
[10] JOBS Act, Pub. L. No. 112-106 §301 “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012.”
[11] Id. at §302
[12] Id.
[13] Id.
[14] See, e.g., Destiny Bennett, SEC Stalls in Setting Rules for Crowdfunding, AGBeat (Feb. 21, 2013), http://agbeat.com/finance/sec-continues-stalling-in-setting-rules-for-crowdfunding/.
[15] Kathleen Pender, Crowdfunding Awaits Key Rules from SEC, SFGate (Feb. 8, 2013, 6:58PM), http://www.sfgate.com/business/networth/article/Crowdfunding-awaits-key-rules-from-SEC-4264631.php
[16] Marco Santana, Entrepreneurs Await Rules for Crowd-Funding Clause, USA Today (Jan. 20, 2013, 10:03PM), http://www.usatoday.com/story/money/business/2013/01/20/crowd-funding-clause-startups/1566496/ (worrying that the rules the SEC ultimately provides will render the crowdfunding clause impracticable.).
[17] Catherine Clifford, Crowdfunders Step Up Lobbying for SEC Rules, Entrepreneur (Feb. 19, 2013), http://www.entrepreneur.com/article/225863.
[18] Id.
Private Equity and the Leveraged Buyout: Taking a Public Company Private
What is a Leveraged buyout?
A leveraged buyout (LBO) is a form of a business acquisition. However, it differs from an ordinary merger and acquisition (M&A) deal in many ways. First, the acquirer in an LBO is not a traditional corporation as in other acquisitions. Instead, the acquirer is a newly formed non-operating company, made up of the private equity firm and often the party who will manage the daily activities of the business.
Additionally, LBO’s are heavily debt financed, often with as little as 10 to 20% of the purchase price coming from equity investment.[1] In order to secure the large amount of debt necessary to complete the deal, the non-operating company is forced to borrow against the physical assets of the acquired business.[2]
Once the terms of the LBO are agreed to, current shareholders will be compensated with an agreed upon per share price and the ownership will be transferred to the non-operating company (the private equity firm and all other investors).
Why take a company private through an LBO?
Private equity firms are motivated to take the targeted company private in order to unlock potential synergy gains[3]. These synergy gains might come from financial restructuring, change in control, or increased coordination in decision-making.[4]
Firms often create synergy gains through financial restructuring. As discussed before, leveraged buyouts involve heavy debt financing. Debt has a tax benefit not available from equity investment, in that the interest owed on current outstanding debt decreases taxable income, resulting in higher cash flow available to all stakeholders.[5] In other words, debt creates a tax-shield equal to current interest expense multiplied by the effective tax rate.[6] Therefore, increasing the amount of debt within the financial structure of the firm can create value.
Additionally, Private equity firms often look to unlock synergy gains by eliminating the waste associated with inefficient management. By taking the company private, the firm no longer has to seek shareholder approval of management, but instead, can self select the new leadership team.[7] The idea is that the new management team will make better business decisions, increasing revenues and decreasing the associated costs.
Moreover, even if current management is efficiently running the company, there are coordination advantages from taking a company private. Public companies face a folly A/folly B problem. The company wants long-term success. In other words, it wants to make investments that result in the greatest net present value in the long run. However, companies have to respond to shareholders, who reward short-term performance, which results in increased stock price, over long term performance.
By taking the company private, management has flexibility in its decision-making and can focus on long-term performance without having to worry about shareholder repercussions. Also, public companies are often slow to act because there is a shareholder coordination problem. The company must provide information on major changes to all shareholders and must convince owners of a majority of the shares to vote collectively. By taking the company private, ownership is concentrated in a few individuals/entities who can act swiftly.
The potential downside of an LBO
While there are certainly numerous potential sources of synergy gains associated with an LBO, the form of acquisition is not without its risks. When levering a company to such a high debt to equity (D/E) ratio, the company must be able to produce enough cash flow to make its periodic interest payments on the outstanding debt. As a result, the risk of bankruptcy increases and the possibility of receiving the tax shield decreases. Additionally, banks will require higher returns to compensate for the risk associated with the debt. Therefore, private equity firms partaking in LBOs are continuously confronting the issue of how much leverage to implement in the deal.
Additionally, in an LBO, there is a constant conflict between shareholders and bondholders. Shareholders are incentivized to take risk, whereas bondholders prefer sound investments that will allow the company to pay back its debt. Therefore, when securing debt, private equity firms might lose some financial flexibility due to bank-imposed constraints on spending. If not managed properly this can counteract some of the benefits associated with making the move to a private company.
Lastly, by taking a company private, the investors lose access to a liquid market. As a result, it may take longer to recoup the investment. Research has indicated that the median LBO is still in private equity ownership around 9 years after the initial buyout transaction.[8]
Who is a good LBO target?
Given the potential risks associated with an LBO transaction, private equity firms must be careful when deciding whom to target. Private equity firms should look at targets from a three-value driver perspective: leverage, change in control and private-public.[9] The ideal target should be underlevered, inefficiently managed, and should be incurring large costs from staying public.[10] Additionally, companies with large assets and stable free cash-flows (cash cows) can support more debt, making them an attractive target. At the same time, private equity firms want to avoid using an LBO to purchase companies in highly cyclical industries and industries with rapid product obsolescence.[11] Companies in these industries are prone to periods of low to negative free cash-flows, which in turn increases the probability that they will be unable to meet their debts as they come due.
Summary
LBO’s are a form of private equity acquisition, in which the investors form a non-operating company and purchase a public company by implementing primarily debt financing. Taking a public company private can create gains in a multitude of ways, including increased tax shield free cash flows, elimination of inefficient management, and increased coordination of decision making. At the same time, there are many risks associated with an LBO. The risk of bankruptcy increases immensely, resulting in higher lending rates and loss of some financial flexibility. Consequently, private equity firms must be strategic about when to implement an LBO acquisition and realize that it is not always the proper tool.
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[1] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013); Note on Leveraged Buyouts. Center For Private Equity and Entrepreneurship at 1, available at http://pages.stern.nyu.edu/~igiddy/LBO_Note.pdf.
[2] Steven N. Kaplan & Per Stromberg, Leveraged Buyouts and Private Equity, Journal of Economic Perspectives, American Economic Association 23(1), 2009.
[3] Here, synergy gain is a proxy for a long term financial benefit
[4] See Note on Leveraged Buyouts at 2.
[5] Grant Houston, Tax Advantages of a Leveraged Buyout, Chron, http://smallbusiness.chron.com/tax-advantages-leveraged-buyout-24006.html
[6] See id.
[7] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013).
[8] See Kaplan, supra note 2, at 130.
[9] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013).
[10] Id.
[11] Id..
Private Equity Firms Accused of Misleading Buyer
Japanese beer and beverage maker Asahi Group has filed a lawsuit in Australia against two private equity firms who sold Asahi a liquor company for $1.3 billion USD. The suit claims that Australian-based Pacific Equity Partners and Hong Kong-based Unitas Capital—the previous owners of New Zealand’s Independent Liquor—presented inflated earnings figures during the sales process.[1] As a result of this “misleading and deceptive conduct,” Asahi feels that it grossly overpaid for the premixed cocktail distributor and that it deserves compensation.[2]
At the heart of Asahi’s complaint is the allegation that Independent Liquor’s earnings before interest, tax, depreciation, and amortization (EBITDA) figures were embellished.[3] EBITDA is often used to value a company for purposes of buying it, and has been called the “single most important financial contributor to buyout performance.”[4] The complaint alleges that Independent used creative accounting techniques such as ‘channel stuffing’—“a practice where a supplier forward sells stock on extended terms to retailers in order to account for significant ‘one off’ sales in a particular period”—to wrongfully include income and exclude expenses.[5] Asahi claims that these practices inflated Independent’s EBITDA by $NZ42 million,[6] and made it appear as if Independent was growing at the time of the sale when normalized calculations show that it was actually declining.[7] These inconsistencies likely had a significant impact on the negotiated purchase price, as Asahi claims it “conducted due diligence thoroughly and in good faith and relied on [the EBITDA figures] provided.”[8]
Although this dispute will be resolved in an Australian court, it is factually similar to a case arising out of Delaware a few years ago. In ABRY Partners v. Providence Equity,[9] the buyer, ABRY Partners, accused the private equity seller, Providence Equity Partners, of knowingly presenting a portfolio company’s misstated financials in connection with a sale.[10] The purchase agreement contained provisions designed to insulate Providence from liability for representations made by its portfolio company.[11] Specifically, the warranty that ABRY claimed was breached was “by its plain terms . . . [a warranty] made only by the [portfolio company] and not by [Providence].”[12] The agreement also contained a $20 million indemnification cap.[13] The Delaware Court of Chancery ultimately found that the indemnification cap would be honored if Providence did not lie.[14] However, it found that ABRY could collect damages in excess of the cap if it could prove that Providence knew its portfolio company made false representations or if Providence itself made such representations.[15]
If the Australian court takes a similar approach, the purchase agreement will be crucial in determining the level of culpability Asahi must prove and the amount of damages that they can recover. ABRY suggests that a properly drafted agreement can insulate PE firms from fraud committed by their portfolio companies in connection with the sale as long as the firm was not aware of it. If such a term were contained in this agreement, it would force Asahi to prove that these companies knew Independent was manipulating the EBITDA figures. While this is a seemingly heavy burden, the Asahi complaint suggests that they would be able to prove knowledge through email correspondence they have obtained.
Regardless of the outcome, this case evidences the importance of (1) conducting thorough due diligence; (2) understanding ways in which EBITDA can be manipulated; and (3) thinking carefully about future liability when drafting purchase agreements.
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[1] Neil Gough, Asahi Sues 2 Private Equity Firms Over $1.3 Billion Deal, N.Y. Times (Feb. 14, 2013, 5:13 AM), http://dealbook.nytimes.com/2013/02/14/asahi-sues-2-private-equity-firms-over-1-3-billion-deal/.
[2] Id.
[3] Asahi Alleges ‘Channel Stuffing’ At Beer Firm, The New Zealand Herald (Feb. 18, 2013, 11:45 AM), http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10866101.
[4] Nicolaus Loos, Value Creation in Leveraged Buyouts 229 (2006).
[5] Adele Ferguson, Japanese Brewer Up in Arms Over Purchase Price, Newcastle Herald (Feb. 26, 2013, 5:00 AM), http://www.theherald.com.au/story/1326151/japanese-brewer-up-in-arms-over-purchase-price/?cs=9.
[6] See id.
[7] Asahi Alleges ‘Channel Stuffing’ At Beer Firm, supra note 3.
[8] Gough, supra note 1.
[9] ABRY Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006).
[10] See Ruling in ABRY Partners v. Providence Equity Case Has Lessons for Buyers and Sellers, Goodwin Proctor LLP (Mar. 14, 2006), http://www.goodwinprocter.com/~/media/Files/Publications/Newsletters/Private%20Equity%20Update/2006/Ruling_in_ABRY_Partners_v_Providence_Equity_Case_Has_Lessons_for_Buyers_and_Sellers.pdf.
[11] See id.
[12] ABRY Partners, 891 A.2d at 1042.
[13] See Ruling in ABRY Partners v. Providence Equity Case Has Lessons for Buyers and Sellers, supra note 10.
[14] See id.
[15] See id.
Is the 2013 Private Equity Boom Sustainable?
2013 has seen an early resurgence in the volume of mergers and acquisitions conducted globally. Since January, there have been in excess of 1000 deals with an aggregate value of over $160 billion,1 the fastest start since 2005.2 This boom has been anchored by several large, and sometimes unprecedented, buyouts, including the $23 billion takeover of…