Private Capital Investment: A Global Analysis Part I

By M. Isi Eromosele

Investors participate in private capital markets for two main reasons: they pursue increased investment return and portfolio diversification.

Private capital provides investors with the opportunity to pursue higher long-term returns and greater diversification than are available through public securities markets alone.

Private capital investments can be diversified by investment strategy, stage of development, vintage year (the year when a fund is raised or its first investment is made), industry, manager and geographic location.

There are three traditional sectors of private capital - venture capital, private equity and distressed capital, as well as natural resources (which is sometimes classified along with real assets and/or other inflation-protection investments).

Venture Capital

Venture Capital consists of investments in start-up and early-stage, high-growth private companies, principally in information technology and life sciences. Today venture capital is practiced around the world with the main centers of activity being certain well-established locations in the U.S. like Silicon Valley; more recently, venture capital is practiced in China, India, Israel and other parts of Asia and Europe.

The venture capitalist usually owns a minority stake in the company, but is actively involved with entrepreneurs over a period of years to develop strategy, recruit management, secure financing and set up customer or other strategic relationships with larger companies.

The main investment objective is to earn returns above those generally available in the public securities markets, achieved through long-term capital appreciation.

 Private Equity

Private Equity comprises investments in existing companies, most with positive cash flow or profit. Some private equity managers acquire a majority equity stake or buy the entire company, frequently utilizing financial leverage to do so, via transactions such as leveraged buyouts, management buyouts, recapitalizations, reorganizations, privatizations, restructurings and spin-offs.

Managers focusing on growth equity will typically concentrate on companies with high growth (with positive cash flow) and may use little to no financial leverage. They will often purchase a significant monetary stake with important governance rights. Returns are often driven by the potential for rapid growth.

The private equity opportunity set is global, including not only developed markets like the U.S. and the European Union but also emerging markets and other rapidly developing economies. Investors seek higher returns over longer periods of time than those usually available on international public securities exchanges.

While private equity investments made in developed economies outside the U.S. are similar to U.S. standards in both practice and return, those investments made in emerging markets can be more volatile. In addition, when investing outside of one’s home country, currency impact must be considered.

Distressed Capital

Distressed Capital is often considered a subset of private equity and generally involves identifying problem companies or troubled assets which managers believe can be significantly improved by implementing turnaround tactics and/or restructuring to unlock underlying value.

These companies or assets exist in varying degrees of distress, may already be in default, and may or may not be under bankruptcy protection. In the case of companies, investors may commit new capital in the form of debt or equity and often try to influence the process by which the issuer restructures its debt, hones its focus or implements a plan to turn around its operations.

Some investors will look for “non-control” investments, some of which are asset purchases (e.g., pools of bank loans, structured securities, trade claims, bankruptcy claims, etc.), where they do not seek control to benefit from restructuring or resolution of the distressed nature of the underlying asset, albeit still play an active role in approach to value creation and realization.

Natural Resources

Natural Resources include investments in oil- and natural gas-related companies and properties, as well as investments in alternative energy and in power-related companies. Underlying company investments can be made in more local currencies with the fund manager overseeing currency risk at that level.

Other natural resources related areas include minerals, mining, timber, agriculture and water. These investments offer the potential for enhanced return, powerful portfolio diversification and a hedge against inflation.

Related Investment Areas - Other investment strategies that lend themselves to private investing are mezzanine financing and private equity real estate.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group

Private Capital Investment: A Global Analysis Part II

By M. Isi Eromosele

The legal vehicle for investing in private companies is usually a “limited partnership.” The general partner (the investment manager) manages the enterprise and the limited partners (the investors) own interests in the partnership, which holds the portfolio companies, analogous to shares that are proportional to their investment.

A typical private capital limited partnership has a 10- to 12-year life. When the partnership is being formed, limited partners agree in advance to commit a defined amount of capital to the partnership.

The committed dollars are not invested all at once, but are drawn down, or “called,” by the manager over roughly the first half of the partnership’s life as the manager discovers, cultivates, negotiates and ultimately invests capital into private companies.

During the second half of the partnership’s life, capital is returned to the limited partners in the form of distributions. These most often result from a manager’s decision to exit an investment, usually through either an initial public offering (IPO) or by selling the investment to a larger company, often referred to as a “strategic buyer,” or another private capital firm, often referred to as a “financial buyer.”

Distributions to investors can also result from a recapitalization of and subsequent dividend by a portfolio company. Distributions can be in cash or stock, referred to as “in-kind” distributions, reflecting an investor’s pro rata share of a particular company’s stock.

The commitment stage of a partnership may vary in duration and pace, depending on the availability of attractive investment opportunities. In the same way, the distribution phase may vary according to the viability of the exit markets (for example, the quality of the IPO and mergers and acquisitions markets).

Secondaries

 

Investors may also look to gain exposure to the private equity markets by purchasing existing interests in funds raised during prior vintage years and therefore different investment cycles. This practice is called “secondary investing” and is the way in which investors buy an interest in a previously raised fund.

Secondary interests come about when an investor wishes to sell or exit all or a portion of their fund commitment prior to the normal liquidation period of the fund.

This practice enables prospective buyers to acquire funds with greater visibility of the underlying portfolio companies that have been purchased to date, sometimes at handsome discounts from their current net asset value (NAV). Secondary interests can also help to moderate the “J-curve” in the early period of the investment cycle, since the underlying assets are typically more mature and closer to realization. Secondaries are a natural complement to a primary investing effort.

Co-Investments 

A co-investment is a direct equity investment in a company by a limited partner alongside a private capital manager (or general partner). Limited partners typically engage in co-investments in situations where they believe they have a preferred relationship with a general partner and access to the general partner’s full set of information about the company, its management team and prospects.

The risk associated with co-investments is that of greater concentration in one particular company in contrast to a partnership investment where limited partners get broad exposure to multiple portfolio companies.

The primary benefits for limited partners include an opportunity to invest more capital with talented managers and, in many cases, to invest parri passu with the general partner often without the cost of paying either management fees or a carried interest charge. Co-investment programs can complement fund investment programs but do require a different set of resources and skills from partnership investing.

Risk of Loss 

In spite of the potential for high returns from private capital investments, venture capital investors in particular should be prepared for partial or total losses on a significant number of the underlying companies in their portfolio.

This is because any single start-up or early-stage investment carries a material risk that it may not develop into a sustainable business. Loss ratios in other private capital strategies are considerably lower, primarily because investments are made in more seasoned companies that are generally cash-flow positive and further along in their development.

Outside the U.S., returns from developed economies are anticipated to be similar to those in the U.S., while returns from emerging markets can be more volatile. Risk factors, including the political and economic environment and, in some cases, the relatively nascent infrastructure for private capital investing, need to be considered.

The Importance of Diversification 

Attractive private capital results are earned when returns on winners in a diversified portfolio amount to multiples of the amount invested, while losses are limited to the amount invested. For this reason, it is important not only that a manager diversify their investments within a partnership portfolio, but that an investor also diversify their private capital portfolio by type of investment strategy and vintage year.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group

Capital Cost In Alternative Investments

By M. Isi Eromosele

Investments made by sophisticated individual and institutional investors in private investment companies like hedge funds and private equity funds are referred to as alternative investments.

These investments are frequently combined with financial leverage to bear risks that may be unappealing to the typical investor or that require flexibility that public investment funds may not provide.

It is often misunderstood that there is a real possibility of a complete loss of invested capital. Moreover, the aggregate performance of these unappealing positive net supply risks tend to be correlated with aggregate economic conditions, such that losses are more likely when other positive net supply assets are also experiencing losses.

An interesting implication is that investors relying on traditional analyses for benchmarking alternatives are likely to be attracted ex ante to strategies and historical return series that are highly levered investments in safe assets that will turn negative in the event of a market crash.

The Risk Profile Of Hedge Funds

To compute the required rate of return or cost of capital for an allocation to hedge funds, one must first characterize the risk profile of a typical investment. Rather than examine risk exposures of individual funds or strategies, one should focus on the aggregate risk properties of the asset class.

Consequently, the cost of capital derived can be thought of as applying to an investor in a diversified hedge fund portfolio (e.g. a fund-of-funds, or an endowment holding a portfolio of alternative investments).

Another risk metric popular among practitioners is the drawdown, which measures the magnitude of the strategy loss relative to its highest historical value or high watermark.

The performance of hedge funds as an asset class is not market-neutral. For example, hedge funds experience severe declines during extreme market events, such as the credit crisis during the fall of 2008. During the two-year decline following the bursting of the Internet bubble, hedge fund performance was flat.

There are structural reasons to view the aggregated hedge fund exposure as being similar to short index put option exposure. Many strategies explicitly bear risks that tend to be realized when economic conditions are poor or when the stock market is performing poorly.

For example, the aggregate merger arbitrage strategy is like writing short-dated out-of-the money index put options because the underlying probability of deal failure increases as the stock market drops.

Hedge fund strategies that are net long credit risk are effectively short put options on

firm assets structural credit risk model such that their aggregate exposure is similar to writing index puts.

Other strategies (e.g. distressed investing, leveraged buyouts) are essentially betting on business turnarounds at firms that have serious operating or financial problems. In the aggregate, these assets are likely to perform well when purchased cheaply so long as market conditions do not get too bad. However, in a rapidly deteriorating economy, these are likely to be the first firms to fail.

The downside exposure of hedge funds is induced not only by the nature of the economic risks they are bearing, but also by the features of the institutional environment in which they operate.

In particular, almost all of the above strategies make use of outside investor capital and financial leverage. Following negative price shocks, outside investors make additional capital more expensive, reducing the arbitrageur’s financial slack, and increasing the fund's exposure to further adverse shocks.

In extreme circumstances, the withdrawal of funding liquidity (i.e. leverage) to arbitrageurs can interact with declines in market liquidity to produce severe asset price declines.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group

Capital Structure

By M. Isi Eromosele

There is a cost of doing business that must serve as your benchmark for how you invest in long-term assets. This cost is called Cost of Capital. Cost of Capital is the rate you pay who invests money in your business.

You can think of Cost of Capital as the rate of return investors require for incurring risk whenever they invest in your company. Cost of Capital applies to long-term funding of assets as opposed to short-term funding of working capital.

Why is Cost of Capital so important? It is so because you have to earn an overall rate of return on your assets that is higher than your cost of capital. If not, you end-up destroying

value. So how do you calculate Cost of Capital?

The most popular approach is called the Capital Asset Pricing Model or CAPM. CAPM estimates your cost of equity by taking a risk free rate and adjusting it by risks that are unique to your company or industry. Long-term government bonds are often used to estimate risk free rates while overall market premiums run around 6%.

CAPM is not perfect since it has many unrealistic assumptions and variations in estimates. For example, sources (Bloomberg, S & P, etc.) for reporting market risks of specific companies provide very different estimates. Additionally you might find simple estimates are just as accurate as CAPM.

For example, simply adding 3% to your cost of debt may provide a reasonably accurate estimate of your cost of capital. You can also look at companies that are very similar to your company. In any event, you need to calculate your cost of capital since it is an extremely important component in your financial management decision making.

Calculating Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC) is the overall costs of capital. WACC is

based on your current capital structure. Market values are used to assign weights to

different components of capital.

It should be noted that market weights are preferred over book value weights since market values more closely reflect how you raise your capital. Market weights are calculated by simply dividing the market value for each component by the sum of market values for all components.

Capital Structure Theory

The theory behind capital structure is to find the right mix of long-term funds that minimizes the costs of capital and maximizes the value of the organization. This ideal mix is called the optimal capital structure. It can be argued that an optimal capital structure really doesn't exist since changing the mix of capital will not change values.

However, four approaches can be used to find the optimal capital structure. They are Net Operating Income (NOI), Net Income (NI), Traditional, and Modigliani-Miller.

The NOI approach holds that costs of capital is relatively the same regardless of the degree of leverage. The NI approach takes the opposite view; costs of capital and market values of companies are affected by the use of leverage.

The Traditional Approach is a mix of both the NOI approach and the NI approach. Finally, the Modigliani-Miller view is that costs of capital and market values are independent of your capital structure.

In practice, there are lots of factors that influence capital structure. They include growth in sales, asset composition, risk attitudes within the organization, etc. The best approach seems to be to focus on a range of capital structures in managing the organization.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group