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| Risk & Reward |
Private Equity's Wide Embrace
Eileen Gunn
12/01/2004
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For those impressed by the returns a good private equity firm can generate,
but skittish about entrusting large sums of capital to another’s care for a
decade at a stretch, there is now an alternative that provides access to this
asset class without the long-term commitment. Investors can now purchase
publicly traded shares in business development corporations (BDCs; similar in
structure to closed-end mutual funds) that are backed by leading private equity
firms.
 At first blush, getting access to the investment expertise of Apollo
Advisors or Technology Investment Capital by simply calling a broker and buying
shares on an exchange sounds attractive. But these securities have several
drawbacks; indeed, investors’ concerns about their fees have caused a number of
private equity firms, including Evercore Asset Management and Blackridge
Investment, to scrap their plans to raise capital via BDCs.
A New Twist
While BDCs have been around for decades, private equity firms
only began to consider using them as capital-raising vehicles this past spring.
The Securities and Exchange Commission originally intended BDCs to facilitate
equity investments in small, illiquid companies by individual investors who
would otherwise be put off by the risks involved. Investors, the commission
reasoned, would find a diversified portfolio of such companies more compelling
than one company on its own.
Private equity firms see them as useful
vehicles for obtaining long-term capital from a wider investor base than is
possible through their normal route of raising funds via limited partnerships.
Also, the capital is permanent; it does not have to be returned to investors and
raised again, as does capital raised in more typical private equity fund-raising
exercises. “The environment for raising capital from institutional investors has
been hard since the Internet bubble. So the prospect of getting all your
committed capital right up front from a public offering is appealing to this
group,” notes Elizabeth Fries, a partner in the fund formation group at Goodwin
Procter in Boston, who has spoken with several private equity firms about
developing BDCs.
Most of these new funds plan to provide mezzanine debt
(so called because in bankruptcy proceedings the lender is paid after senior
lenders but before common-stock holders). This debt often has equity warrants or
options attached, so if the portfolio companies thrive, the private equity fund
benefits beyond merely having its loans paid back. (Click image to enlarge)
Most of the firms now
considering BDCs (see table, Above) plan to pursue a slightly different
approach than they use in their more well-known private funds, to avoid having
any of their existing funds compete with the BDCs for investment opportunities.
(The policies of many private equity firms do not allow them to manage two
different funds that invest in the same company; investors in both funds would
end up with an unappealingly large exposure to that portfolio company’s
fortunes.)
For example, according to Apollo’s prospectus, the firm has
traditionally focused on buyouts and distressed debt investments involving more
mature companies. However, its public Apollo Investment BDC, which raised $930
million in April, will invest in growing, midsize companies. “Firms like KKR
have normally done really big buyouts,” Fries explains. “So they’re moving
downstream to the smaller deals they often see but pass on because of the size.”
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