While most people in the United States are familiar with buying stocks and bonds (and mutual funds which are conglomerates of stocks and bonds) on the open market, there is confusion in the minds of many as to what “private equity” is and how it relates to the standard purchase or sale of stock publicly traded.
In reality, most of the money for most of the business in the United States is raised by “private equity.” Almost all stock and property ownership in the United States is owned privately, which means it cannot be sold publicly on the typical large stock exchanges such as the New York Stock Exchange or NASDAQ.
But it can be sold. While an attorney and accountant are usually necessary to draft the relevant documents for the sale of the stock or interest, and while careful disclosures must be made and due diligence achieved by the buyer, the simple fact is that more equity sold is private than public. And a recent phenomenon is the increasing use of private equity to purchase what used to be publicly traded stock for reasons discussed below.
This article shall briefly describe the role of private equity in United States business. The reader should also review our articles on Limited Liability Entities and Corporate Struggles: Who Has Power When Push Comes to Shove?
PRIVATE EQUITY: A MAJOR FORCE IN CAPITAL RAISING
When someone decides to start a company, they often need cash. Assuming they do not want to borrow it from a bank, the normal source is asking friends, family and others to invest directly into the Company being formed, either by purchase of interest (stock or limited liability company units) or loans (either Notes or Bonds). If the number of people is below the strict limits set by California and Federal law, it remains a private offering and not subject to rigorous State and Federal registration and disclosure requirements. If the offering is seeking above a certain amount of money from over a certain number of people, it is a “public offering” which is time consuming and expensive. The typical public offering takes about a year, costs hundreds of thousands of dollars in accounting and attorney’s fees, and remains subject to close scrutiny by federal and state authorities.
The fiduciary duty applies to corporate officers and directors whether or not a company is public. The major difference is that the procedural requirements and scope of fiduciary duty (and criminal sanctions) become significantly greater for a public offering.
The techniques for creating a private offering include creating a full prospectus and business plan and good legal advice is still required even for a private offering. The danger in not fulfilling these requirements is a later action brought by the investors for failure to follow the State and Federal requirements for a private offering and for securities fraud. Any good lawyer or certified public accountant experienced in business can assist in creating that package and that package should be created before accepting the first dollar.
But the world of private equity goes far beyond the Mom and Pop business now. Even the largest entities that were once public are going private (buying back all their shares) and much money being raised for new entities or to purchase new subsidiaries now stems from private investment. Many entities exist precisely to buy stock or other ownership in other entities and these are called private equity firms. Most venture capitalists (famous in High Tech) are actually merely private equity firms.
For example, no sooner had Maytag received one buyout offer from a private equity firm (Ripplewood offered $1.125 billion plus debt-assumption for the beleaguered washer-dryer maker on May 20), it received a second such offer. (This one announced by Maytag on June 21 from a consortium consisting of Chinese appliance maker Haier and private equity firms Bain Capital (which already bought Toys "R" Us and tried to buy the currently still on-ice National Hockey League) and the Blackstone Group, which offered $1.28 billion plus debt-assumption). When private equity deals make CNBC in the morning, you know they have worked their way onto the public radar. Private equity has mushroomed to a greater than $350 billion annual alternative investment vehicle.
WHAT IS PRIVATE EQUITY?
So what is this private equity? At its most basic, it is simply a security that is exempt from the registration requirements of the securities laws because it is not issued in connection with a public offering. People invest in private equity for the same reasons they invest in anything else...to make money. But whereas stock market investors tend to try and buy the best and brightest, private equity investors will often seek out the untested and even downtrodden at bargain prices. And the returns from private equity have tended to beat those of traditional equity and debt investments, hence the surging popularity.
The private equity market "is an important source of funds for start-up firms, private middle-market firms, firms in financial distress, and public firms seeking buyout financing." See The Economics of the Private Equity Market, Board of Governors of the Federal Reserve System, December 1995, at 1. Why does private equity find itself focused on these kinds of entities? Well, "issuers generally are firms that cannot raise financing in the debt market or the public equity market." Id. at 3.
A company like Maytag finds the private equity market attractive because its place in the public markets has been eroded by competitive pressure that makes a return to its former glory, i.e. growth, a difficult, long-term proposition, something investors in the public equity markets don't always have the patience for. In a case like Maytag's, private equity firms provide capital to buy out the public holders of the company (hence taking it private), and they also assume outstanding debt, after which they attempt to remake the company, hoping to resell it several years down the line, either to another private investor or via an IPO. Private equity investors are not seeking short-term gain.
The primary intermediaries between private equity issuers and private equity investors are limited partnerships and firms like Bain Capital and Blackstone Group that manage huge funds that engage in private equity investing. They collect investment monies from pension funds, wealthy families and individuals, endowments, foundations, insurance companies, investment banks and so on and then scour the markets for private companies that need seed money for research or an infusion of capital to fund product development or expansion, or they will search for private companies whose initial or current investors are looking to cash out in part or to exit the scene entirely. And as in the case of public companies like the Maytags of the world, they will look for distressed entities where management is actively seeking a buyout because the company, while maintaining an established business, cannot make a go of it in its current, public incarnation. The hope is that the private equity investors reinvigorate the brand. And to the extent that Maytag sticks around and thrives, not to mention Burger King, Domino's Pizza and other companies benefiting from the latest hot trend, you can thank the private investors.
AVAILABLE FOR NEW BUSINESSES?
While getting an investment of five thousand dollars from Uncle Joe to start your new restaurant is actually a private equity investment requiring the techniques and contracts of any other type, many new companies seek far larger funds in the private equity market, seeking “Angels” or “VCs” or “Venture Capitalists” to get them on their way. Such funds ARE available but are not easy to get and when negotiating with these professionals it is vital to be fully prepared for some tough bargaining.
A complete business plan; realistic projections; and a good team of lawyers and accountants are vital if one is to succeed either in raising money or in raising money without giving away control of the entire business. Or, as one new business owner told this writer after several months of very tough negotiations with some very smart VCs, “These guys know what they are doing and know how to get it. If I can sell to them, I can sell to anyone…but who would have thought I’d have to jump through so many hoops?”
He ended up raising some money but he later commented that creating his invention was easier than raising the money to promote it.
Using private equity is what allows the Unites States to remain ahead of most other nations in its quest for newer and better business and is the source of most funding for most new businesses. But before you walk down that path, be sure to learn how the game is played and be ready for some very tough examination of your business plans.