AN INTRODUCTION TO PRIVATE EQUITY FUNDS FOR ENTREPRENEURS AND NEW VENTURES
ARCHIE FALLON AND JEFF MALONSON, KING & SPALDING, HOUSTON
WHEN entrepreneurs leave behind careers at large oil and gas companies to start new ventures, they are faced with exciting opportunities and special challenges. One of these challenges is to raise capital for strategic plans like acquisitions or development plans. For a new venture that has limited assets, borrowing enough money for those strategic plans from a bank may not be possible. Instead, the new venture may seek capital from a private equity sponsor, which may offer strategic insight and be able to take more risk than a bank, but which expects a commensurately high return on its investment and certain controls over key business decisions to preserve the value of its investment.
This article provides an introduction to the economic structure of a private equity fund for entrepreneurs who have not previously worked with private equity. It also identifies three practical considerations for a new venture to prepare itself for a private equity investment: maintaining a flexible capital structure, minimizing conflicts, and developing a strategic philosophy regarding long-term equity program participation.
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BASIC ECONOMIC STRUCTURE OF PRIVATE EQUITY FUNDS
Some very sophisticated management teams are unfamiliar with the economic structure of a private equity fund because they have worked in large energy companies most of their careers. The cost of capital for a private equity sponsor is typically 7-8% per annum (the so-called "hurdle rate" for distributions to limited partners). Once the fund repays the capital and returns the hurdle rate to limited partners, the sponsor receives an amount of "catch-up" distributions equivalent to the amount of profits previously distributed to the limited partners in respect of the hurdle rate. Only after the sponsor receives such catch-up distributions will the sponsor be entitled to carried interest distributions, which for most sponsors is 20% of remaining profits.
There are a variety of carried interest distribution structures: for example, a "European-style" waterfall requires amounts that would otherwise be distributable to the sponsor as catch-up and carried interest distributions from a successful investment to be used to return capital and the hurdle rate to limited partners in respect of unrealized or written off investments.
An "American-style" waterfall instead allows the fund to calculate carried interest on an "investment by investment" basis, so that the sponsor may receive carried interest distributions from a successful investment notwithstanding other unrealized investments (though even in such a waterfall, the sponsor is typically subject to a clawback obligation that allows the limited partners to clawback carried interest distributions if at the end of the fund's term they have not recouped their capital and the hurdle rate).
Additionally, a sponsor will charge a management fee equal to between 1.5-2% per annum of capital committed to a fund during an investment period which typically lasts from 4-5 years. After the investment period ends, then the basis of the management fee typically converts to invested, rather than committed, capital.
THREE PRACTICAL CONSIDERATIONS FOR PREPARING FOR PRIVATE EQUITY INVESTMENT
Focusing on the new company and minimizing conflicts - A private equity sponsor will generally have a process to confirm that the management team is not bound by restrictive covenants in favor of a prior employer that could impact performance for the new company. For example, if a team member has agreed to a non-compete covenant with a prior employer in a particular basin, that team member may need to be screened from activities of the new company in that particular basin, at least during the "tail period" of the restrictive covenant. Further, if a team member learned about an opportunity while working for another company, then the new company may not be able to exploit or even receive information regarding that opportunity from the team member if such action would violate the terms of the team member's covenants to that prior employer (either through an employment agreement, employee handbook, on-line policy, or separation letter).
Further, most private equity sponsors will require each team member to make prospective commitments to the new company regarding allocating time and opportunities. For example, an individual may be asked to sign an employment agreement committing substantially all of his or her business time to the company, and potentially agreeing to bring forward to the company all new opportunities discovered while employed by the new company. If an individual intends to maintain a role in another business while working for the company, the company typically requires that individual to at least disclose the terms of such role so that the company can evaluate potential conflicts of interest. (Notwithstanding such time allocation commitments, an individual should be permitted to spend time on charitable activities, participate on boards of directors of other companies, make passive investments in public companies, and otherwise manage personal finances.)
From the management team's perspective, it is important to understand the size of and conditions to the private equity sponsor's capital commitment. For example, if the sponsor wants to condition its capital contributions on a project or development plan reaching certain milestones that de-risk the opportunity, then those milestones need to be specifically defined in the company's operating agreement. Further, if the company has a project that requires more capital than the sponsor's fund has available, then the company should understand whether the sponsor has investors that may want to co-invest alongside the fund in a project. Early discussions between the management team and sponsor regarding the strike zone of investments will optimize the likelihood that when the company seeks capital from the private equity sponsor, the sponsor is ready to invest.
Keeping initial capital rounds straightforward and flexible - Sometimes a new company is initially capitalized by the entrepreneurs and their friends or family before the private equity sponsor starts negotiating with the company. It is critical in those circumstances for the company to maintain flexibility in its capital structure to accommodate the private equity sponsor's economic model and assumptions. Given competition in the market for capital, it is unlikely that the sponsor will allow its investment to, for example, be subordinate to historic equity holders in terms of distributions or in a liquidation. Further, if the company has already given certain initial investors the ability to block the company from making certain strategic decisions (like selling the business), the sponsor may view this as a fatal flaw. Consequently, in an initial capital round that precedes a private equity investment, it is important that the company maintain flexibility to amend organizational agreements to it to issue to a sponsor new securities with terms acceptable to the sponsor, likely including pre-emptive rights, drag-along rights, registration rights, and potentially others.
Aligning LTIP participation with value creation - Key executives typically participate in a carried interest program at the company level, sometimes called a long-term incentive plan (or LTIP). Participants become entitled to distributions of profits after the sponsor and other capital interest owners receive an agreed rate of return (the company level "hurdle rate"), and those LTIP distributions are typically structured to qualify for capital gains tax treatment. Private equity sponsors have different views on features of these programs, such as vesting terms, the hurdle rate, and sharing percentages. However, a management team should, particularly at the outset of the venture, have a view on issues such as who will qualify to participate in the LTIP, both in terms of sophistication standards and expected contribution to the value of the business. Further, if someone leaves the company, should the company or perhaps the remaining team members have an option to buy out the departing member's interests at a value established by the company, an appraiser or by another process? Finally, if the company wants to issue further LTIP interests which qualify for capital gains treatment once the initially issued interests are "in the money" and entitled to distributions of available cash, the company should determine whether it will have the right to create a new "tranche" of LTIP interests that share only in incremental value of the business that arises after the date the new "tranche" is issued.
ABOUT THE AUTHORS
Denis A. Fallon (Archie) is a partner at King & Spalding representing private equity funds and their portfolio companies. He represents funds in fundraising transactions, co-investments, corporate finance transactions, leveraged buyouts, sale transactions, and corporate governance issues, mostly in the oil and gas (both upstream and midstream) sector.
Jeffery K. Malonson (Jeff) is a partner at King & Spalding who advises energy clients, including private equity funds and their portfolio companies, in capital market transactions. He represents issuers and underwriters in connection with IPOs, secondary offerings, "shelf" offerings, "at-the-market" offerings, Rule 144A offerings, and tender offers. He also advises public company clients on mergers and acquisitions, SEC reporting, corporate governance issues, and other corporate/securities matters.
