Private equity and growth capital – a growing opportunity?
September 2016 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
Growth capital investments present a different set of opportunities and challenges to private equity investors. Not all houses are active or interested in this investment space (and indeed many may not be permitted to make such investments under their fund documentation), but those that are can and will seek investments which have often matured from the classic VC growth cycle and may be on the edge of achieving positive EBITDA, or which have achieved EBITDA but further investment is required to maximise growth opportunities.
Private equity will generally shy away from opportunities which are likely to be cash burning for the foreseeable future as there is very little appetite for either ongoing responsibility to fund general working capital and cash requirements or for knowingly investing where there is a foreseeable risk of future dilution.
It is not, however, the case that private equity requires a business to be free from capital requirements, with the investor’s investment going to the exiting shareholders as it would in a traditional buyout. While certain funds will almost certainly turn to the selling shareholders of any successful business, much of the investment may be new money for the business. For a typical growth capital investment, private equity will be looking for a business with a clear plan modelling out any capital requirements. These may be significant in quantum, but will generally need to be limited and specific, and the uses of such capital will almost always be focused on generating substantial EBITDA growth during the investment period. Typical examples include funding strategic acquisitions, international expansion, entry into new markets, increased capacity to achieve a critical mass and new product development.
Many growth capital investments take the form of significant minority investments. Unlike a traditional buyout or a traditional VC investment, there is no one form of documents that is commonly used in these circumstances. Some deals may structurally resemble a late stage VC investment whereas others may have many of the same features as a typical buyout, including funding via non-convertible loan notes. Much will come down to the negotiating position of the parties at the time but it will also be influenced by the private equity investor’s experience of minority investing; not all investors are entirely familiar with the dynamics of having less than a controlling interest and so seek contractual control rights whereas others rely to a greater extent on the strength of the relationship with management and forego many of their traditional protective rights.
Where control rights are sought they will generally be accompanied by the power to step in if things go wrong and to force an exit if one doesn’t otherwise occur within an agreed investment window (say, five years from the initial investment). There is often a friction here, particularly when the other shareholder is a strong and successful founder who has developed the business from an early stage. The investor will not want to jeopardise or unduly concern that person, who is often one of the key factors behind the investment case, but at the same time often cannot invest significant amounts without control rights and rights ultimately to realise its investment.
From a legal perspective, care needs to be taken with such matters and the parties need to ensure that they are clear what will happen if there is a falling out between the key stakeholders and what will happen if the founder ceases to be actively involved in the business. Any compulsory transfer provisions over the founder’s equity will likely be the key area of debate, but equally important are any ongoing shareholder protections and board rights for the founder if he or she transitions into a passive rather than an active role. If these are not dealt with adequately and, in particular, if the founder has the right to operational input and veto rights once in a passive role (rather than simply structural protections), the business itself is at risk of being hamstrung and badly damaged by the lack of clarity in decision making that may entail.
Majority interests and general issues
Majority interests in the growth capital space are perhaps less common, but they do nevertheless feature.
In such cases, the investment and its documentation will likely resemble that of a classic majority buyout but there are likely to be some differences, often around the operational features and capabilities of the investee company.
Many growth capital investee companies will simply not be as ready for the requirements of an institutional investor when compared with more mature buyout candidates. This is the case in a number of areas (which are equally relevant to minority investments). It is unlikely that any shareholder debt can be serviced during the early years of the investment, so loan note interest will generally roll up and likely compound (this in itself will of course have its own effect on the genuine equity value of the business going forward, so will need to be modelled carefully). There may not be the systems and practices (and perhaps even the personnel) in place to provide the detailed monthly financial reporting that private equity investors will expect and require. As failure to provide such information may well be a default under the investment documents with potentially very serious operational and economic consequences for the company and the management shareholders, care should be taken to permit a short but reasonable amount of time for such systems and practices to be put in place before the relevant sanctions start to apply. The founder shareholder may see the business as his personal business and, intentionally or unintentionally, treat it (and its assets) as such. In such circumstances, ensuring the necessary change in behaviour and attitude takes place at the time of the investment will be important to a successful relationship and business. Equally, the business is unlikely to be as polished as a mature company that has been operating on a profitable (or even stagnant) basis for many years. The investor may discover, often through a lengthy disclosure letter, that matters such as HR policies, full health and safety compliance, data protection policies, anti-bribery and compliance policies and the like are not as developed as they perhaps ought to be. These issues generally do not turn out to be deal breaking issues, but may require operational change.
Any private equity investor is ultimately interested in a profitable realisation of its investment, and growth capital investments can be particularly lucrative if the right business can be acquired at the pivotal point on its growth curve and managed well during the life time of the investment. The financial performance will be the key measure in this regard, but taking the opportunity to tidy up matters such as those mentioned above (as well as perhaps implementing, for example, a CSR programme and similar initiatives) as part of a cultural shift to develop the business will also enhance the prospects of a successful exit. An investment will have a smoother sale process or introduction to the public markets if it is a clean business on offer.
Private equity structures featuring in growth capital investments by trade buyers
An interesting trend in the market has seen corporate entities adopt private equity-style structures to secure key assets in the growth capital space.
These tend to be assets which the investor does not want to miss out on, but where the founder believes that the business has much more growth potential that he or she wants to deliver and earn the benefit of through retained share ownership. These deals therefore have many of the features of a secondary buyout, including from a commercial, legal and tax perspective.
There are, of course, a number of key differences from the fact that the investment is from a trade buyer as opposed to from private equity. These include the fact that there will likely be no sale of the investee business or other exit on the horizon for the trade buyer through which founders and managers can realise their ongoing investments. Related to this, is the importance to the founder of liquidity in the long term and his interest not losing value as a result of the future capital requirements of the business or of there being no exit in sight. This leads to detailed negotiations and agreements in such transactions for liquidity opportunities, valuation methodologies and agreed principles about the form and impact of any future capital requirements.
This is a complex area, but one we anticipate seeing more of as trade investors look to position themselves as desirable investors to the key founders and management stakeholders in growth capital investee businesses.
James Goold is a partner and Jonny Bethell is a senior associate at Taylor Wessing. Mr Goold can be contacted on +44 (0)20 7300 4207 or by email: firstname.lastname@example.org. Mr Bethell can be contacted on +44 (0)20 7300 7000 or by email: email@example.com.
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James Goold and Jonny Bethell