Reacting to the view that the KG-model has to be replaced by alternative investment models to maintain Germany as a maritime location, Benjamin H. Baumann gives an overview of what private equity involvement requires
The reason for focusing on private equity investments is based on the partially made assertions that private equity participations in[ds_preview] ship-financing are appropriate solutions for substituting the KG-model. Moreover, the term itself is mainly used without a differentiated analysis for allocating certain types of this asset class to »its« respective target investment object. Hence, it is not surprising that private equity is supposed to be the philosopher’s stone, which shall substitute the KG model, replace bank financing and help surviving the shipping crisis in one go. This is a fallacy.
First of all: Private equity is one of the most expensive forms of finance and therefore it usually cannot be the first choice. Secondly: The involvement of private equity should serve the objective to reach a certain goal, which can be hopefully defined by a specified exit strategy. Thirdly: Specifying an exit strategy – there is more than the Initial Public Offering (IPO) – requires a sophisticated self-assessment of the current status in order to set the milestones, which have to be taken on the way. So the response to the question »Is it really necessary to allocate sources of private equity to a certain investment object or vice versa?« clearly has to be a »Yes!«. How else shall a capital seeker know whom to ask?
Since there is limited availability of information on the private equity market, this article is based on several scientific articles and findings published since 1995, which result from an analysis of the few accessible sources and which are supplemented by interviews and information being provided by market participants. The taxonomy is inspired by the type or the stage of the »seeking firm«, the so-called issuer, its size, its financial attributes, its reasons for seeking, the major source of private equity and the issuer’s access to the debt market or the public equity market.
New venture
Due to the lack of a standard definition of Venture Capital this financing type can be sub-classified into up to seven different classes. Nevertheless, firms seeking venture capital can usually be split into two development stages, the »Early-Stage New Ventures« and the »Later-Stage New Ventures«. Pursuant to the last named classification both types are characterised by a fast growth and the goal of going public or of being sold to another company. On the other hand they differ in their proven track record. While Early-Stage New Ventures run the risk of failure because their business model or their ability of successful placing on the market has not be proven yet, Later-Stage New Ventures already cleared that hurdle. Their risk arises from the ability of continuously successful market participation.
The volume of investment for Early-Stage New Ventures ranges from roughly 500,000$ to up to 2mill. $. The nature of investment is to be classified as long-term because the financing period covers the first stage of development in a company’s life-cycle. The possibility of access to the debt market is generally not given. As a consequence, the financing’s return requires a compensation for a high risk of failure combined with a low liquidity and a not established market position. The hurdle rate (discount rate) ranges from 35% p.a. to 70% p.a. (gross) including management fees and general partners’ carried interest.
In contrast, Later-Stage New Ventures generally make profit and want to sustain an already generated fast growth. Their need for capital results from cash-out of original investors in order to postpone going public or in order to restructure the capital structure among venture capital investors. The investments range from 2mill. $ to up to 5mill. $. Due to the fact that those ventures are closer to a possible exit, the holding period is shorter. In comparison to Early-Stage New Ventures the risk of failure is lower, the expectations for a successful exit are higher and the period to the exit is shorter. The possibility of access to the debt market is generally given. As a consequence thereof the hurdle rate is reduced to 25% p.a. to 40% p.a. (gross).
Middle-market private firms
Middle-market private firms are established market participants with a proven track record and give evidence that their revenues range from 25mill. $ to up to 500mill. $, their annual operating earnings are between 5mill. $ and 25mill. $ and their cash flow is stable as well as the growth rates are much lower. In contrast to venture capital they can provide a significant asset base which can be transferred as securities for debt financing. This means that they basically have access to the debt market. The targeted goal is to effect a change in ownership or capital structure or to finance an expansion (acquisition or purchase of single assets). The involvement of private equity is conditioned by closing the gap between available capital from debt financing and the required liquidity for reaching the goal.
The volume of investment for middle market private firms ranges from roughly 10mill. $ to up to 100mill. $. According to the high level of stability the hurdle rate is reduced to 15% p.a. to 20% p.a. (gross).
Firms in financial distress
Firms in financial distress should be split into private firms and public firms. Private firms in financial distress are in the focus of investors, who are specialized in turnarounds, in order to restore a firm to profitability and to sell it. Mostly the reason for distress is based on an overleverage of the firm, meaning that it cannot meet the provisions of their loan agreement. Some will even invest in firms which have a negative EBIT, if the reason for distress is reducible to specified operating or managing problems. A turnaround support is actively monitored by investors who guide the company to new markets if possible or who urge for a replacement of critical management positions. According to the risk level the hurdle rate is around 30% p.a. to 35% p.a. (gross). A public firm’s distress may be caused by the lack of issuing new equity on public markets without significant discounts. Procedure and conditions are similar to turnarounds in the private sector.
Public buyouts describes rather a procedure than a type of firm. After a public buyout firms typically have moderate to slow growth rates and stable cash flows.
Private equity in shipping
There may be many reasons for attracting private equity investors for shipping. If the findings are linked to a company’s lifecycle it is quite easy to link the stage of development to a certain private equity investor. There are many different business models which can become target investment objects. But therefore it is helpful to establish new strategies in shipping, e.g. venture capital may be a useful capital source for establishing professional and effective consulting services as link between banks and ship-owners. A further possibility for an involvement of private equity is focused on forming alliances or on buying other firms to reduce the number of rivals. But in the end all possibilities require a sophisticated analysis including the topics: self-assessment of the firm’s stage; defined goals for the future; exit strategies in case of private equity involvement; a self-assessment of the firm’s size and financial attributes as well as a precise analysis of the relevant private equity investors according to the firm’s allocation and a will to change processes, if required.
Benjamin H. Baumann
