The Economist, in its January 30, 2020 edition espoused the reasons why everyone now believes that private markets are better than public ones, based on their research, but called for caution. In the article, the paper attributed this general view to the large and growing share of assets allocated by big pension funds, endowment and sovereign-wealth funds into private markets through private equity, venture capital, private debt, etc. In the report that, according to JPMorgan, worldwide, pools of private capital, including private equity and private debt, as well as unlisted real-estate and hedge-fund assets, grew by 44% in the five years to the end of 2019. Also, that a quarter of Wall Street firms that specialize in managing private investments for clients, their total managed assets have risen by 76% in the past five years, to $1.3trn. Private-debt markets, venture capital, etc., all have funnelled funds into unlisted startups. The influx of funds into the private market is believed to rest on the fact that they will outperform public ones, maybe based on historical evidence that best run private-capital managers have beaten the returns from public markets. Some of the reasons adduced for this are reduced “agency costs”, growth in passive investing, regulation, intellectual revolution, other private-equity benefits such as continuous use of leverage. On regulation for example, in America, regulation has played a major role. Legislation in the mid-1990s made it easier to set up large pools of private capital. After the financial crisis of 2007-09, the industry has come under increased government scrutiny with new rules. But how the Nigerian regulators have played it in such a way as to boost private capital in Nigeria is for another discourse.
In Nigeria, a shortage of capital is still considered as one of the major constraints to the private sector. SMEs are often constrained due to inadequate access to capital. In fact, according to International Financial Council data, up to 68% of formal SMEs in developing countries are un-served or under-served financially. In real terms, the conventional method of sourcing funds from banks is difficult as banks are wary to give out loans to SMEs despite the increase in loan to deposit ratio. Most of these entrepreneurs, startups, etc., lack the required assets to secure the loan, no bankable feasibility studies, poor sales pitch, low cash reserves, no historical data, etc. Worst, is the excessive banks’ lending interest rates. It is therefore important to have funds moved into the private market as in developed countries. These funding companies add value to the firms they own. They raise efficiency, revenue growth and profitability. More so, PEs, VCs, Angel investors and crowdfunding are significant drivers of economic growth since they take a high level of risk to support new organization. The Private market is a highly effective model for providing capital and growing businesses sustainable through private equity, venture capital, angel and crowd funding schemes/firms. These forms of private market differ and equally have some similarities based on their features, structuring, mode of funding or the type of companies they fund.
Established companies such as Google, PayPal, etc. had started with the help of this type of investment. So the question arises as to which investor to look for when starting a new business or for expansion apart from the public market. For instance, if you require limited cash outlay, less intrusion, seed financing with no proven data such as revenue stream, angel investment is more ideal and suitable unlike when you need large amounts. Some of the players in the Nigerian private market include Leadpath Nigeria, Henshaw Capital Partners Ltd, TLcom Capital LLP, Kord Capital Limited, Lighthouse Investment Ltd, Cordros Capital Ltd, Microtraction, EchoVC Partners, Growth Capital Fund, Synergy Energy Capital, etc. Now let us look at this private market forms more.
PRIVATE EQUITY FIRMS
The Private equity industry has come a long way and has been increasingly active, spreading across the globe to Europe and emerging markets. In the USA, for example, the private equity sector has experienced a surprising turnaround since the economic sloop in 2008 largely due to a surplus of money flow, with the highest global investment since 2007. Report has it that, majority of the world’s PE assets (57%) is in North America, followed by Europe with 24% and Asia with 13%. Some of the large global PE firms are; The Carlyle group, Kohlberg Kravis Roberts, Goldman Sachs Principal Investment Group, The Black Stone Group, Bain Capital, and Sycamore Partners. The globalization of PE forms shall continue in the future.
Private equity firms sometimes seek to fund companies with significant potential that are seeking capital to improve their cash flow positions or expand. The importance of having this type of funding is that they tend to be more patient. Private equity funds can be structured as a closed-end investment vehicle; comprising of general partner and limited partner. PE funds are brought in by the general and limited partners. Deals are structured after negotiations with the investee company and funding type (common stock and/or convertible preferred stock) are taken as agreed based on certain factors. For instance, Microtraction, a Nigerian firm which focuses on technology entrepreneur, invests $65,000 in 2 stages; $15,000 for 7.5 equity stake, followed by additional $50,000 convertible note at a $1 million valuation in companies that show significant progress after initial investment.
Other deal structuring methods include convertible debt, reverse merger, participating preference stock, multiple liquidation preference, warrants, options, full ratchet. For instance, an investee company that is already in operation and profitable, or have reached break even, debt financing with an equity kicker would be preferable. With equity kicker, a certain percentage of shares of the investee company are issued to the investor to cover the loan. Also, full ratchets, can be used as a good protection in case the investee company decides to issue future shares at a lower price than the existing preferred shares as the price of the preferred shares can be adjusted downward to the new lower price.
VENTURE CAPITAL FIRMS
George Doriot, the founder of American Research Development Corporation is regarded as the father of venture capitalism. VCs are investors who support young companies in the process of expanding or providing the capital needed for a startup venture, they believe have great potential of giving good return on investment. Venture Capital firms pool the funds from individuals, corporations, pension funds and foundations. Apart from funding, VC takes an active part by being part of the board of directors of the investee company; recruiting senior management and advising the top management in their strategic decision. Just like Private Equity firms, most VCs are structured in the form of a partnership where the venture capital firm serves as the general partners and the investors as the limited partners. The limited partners may include insurance companies, wealth persons, pension funds, university endowment funds and foundation, while the general partners may include private equity fund managers. However, some analysts believe that from a technical point of view, venture capital could be regarded as just a subset of private equity. For instance, two key investment strategies of private equity firms are venture capital investment and leveraged buyout. In leveraged buyouts, a target firm is bought out by a private equity firm. The target firm is financed or leveraged through debt which is collateralized by the target firm’s operations and assets. But under venture capital investment strategy, equity investment is taken in a young firm in a less mature industry, but with long term growth potentials. Some take only minority interest in the company they are investing in. What they look for differs. Some consider the passion of the founders/managers of the business they are investing in. Some also look at turnover range – N5million – N100 million for example.
Angel investments are the investments which are made by informal investors having a high net worth. Angel investments are usually the earliest investments made in startups by wealthy investors who potentially contribute to their new business through advice and experience apart from their own funds. Angel investors when valuing investment focus on qualitative factors like the background of investee founders, the reason for business success, product market fit, etc., because most startups attracting their attention do not have much stable qualitative metrics to rely on. But venture capital takes more concrete metrics into consideration like revenue growth, customer lifetime value. This is to help justify their choice and investment as they have greater responsibility. For companies that do not want too much meddling in the running of their business, angel investment is better as angel investors in addition to funding, provide mentoring guidance to the startup owner. Angel investment is suitable for companies looking for equity financing as deal structure is by equity and/or SAFE (simple agreement for future equity), but for companies looking for hybrid of debt and equity, venture capital investment is better.
For crowdfunding, the ’crowd’ in it refers to the people, or organizations that provide money. It is a way people, entrepreneurs, businesses and charities raise money. Individuals, organizations, donate money for a project they believe will give them commensurate return. Crowdfunding makes use of vast networks of people through social media and crowdfunding websites to bring investors and entrepreneurs together. When an individual or an organization wants to raise funds through crowdfunding, the companies have to raise a pitch for it by posting details of the project, business or idea on a crowdfunding website. Crowdfunding can be investment-based, loan-based, donation-based or reward-based. Loan-based crowdfunding also known as peer to peer lending involves lending to individuals or companies in return for a set of interest rate. Investment-based crowdfunding is similar to equity investment, where you take a stake in the form of shares in the investee company. For the investor, crowding funding is very risky and it is advisable you invest money you can afford to lose. There are many crowdfunding websites. The popular ones are Kickstarter, Indiegogo, GoFundMe, Causes, LendingClub, Patreon, RocketHub, GoGetFunding, Ulule, CircleUp, and in Nigeria, we have NaijaFund. It is important to peruse these websites and find out the type of business/project the fund, the cost, as well as the type of crowdfunding. Kickstarter, for instance, is more of a reward-based crowdfunding and funds more creative projects. At Kickstarter, projects need to be 100% funded in order for the investee company to collect the money and the cost is about 8.5% of the sourced fund.