07 May 2019
It is undeniable that, due to a confluence of circumstances, financial investors have capital in the billions (if not trillions) at their disposal, ready to deploy.
Their main problem, however, is insufficient investment opportunities. What does an entity seeking institutional capital to expand its business (we will call this entity a Corporate) need to know about how to deal with these types of investors going forward?
Given enormous liquidity and insufficient investment opportunities, we’ve set out seven considerations for Corporates looking to maximise the benefit of non-public institutional capital in the current climate.
1. Funder or partner?
A Corporate with a good business case can, in broad terms, be selective as to what type of investor it wishes to deal with. A threshold question is whether to view potential financial investors as simply providers of capital, or as capital partners that can provide something more – for example, geographical reach, operational expertise, distribution networks, expansion opportunities (including through acquisition), exit opportunities and the like.
If the latter, the financial investor’s track record of portfolio investments (including exits) should help identify whether they have been successful in growing particular types of businesses.
2. Weighing up the benefit of auctions.
Not surprisingly, financial investors hope to avoid competing with other investors to close investment opportunities, and consider proprietary opportunities as the holy grail of the investment world.
Armed with the answer to the threshold question identified above (funder or partner), a well advised Corporate will consider carefully what process is more likely to yield an optimum result. Increasingly – given the liquidity / investment opportunity dynamic – we would expect to see more Corporates exploring whether they can push a ‘pay to play’ agenda with financial investors (for example, paying for the opportunity to engage in proprietary opportunities).
While financial investors may need to compete hard for good investment opportunities, governance terms remain of paramount importance to investors. In the Australian context (particularly following the Financial Services Royal Commission) we would expect that, in light of the increasing focus on fiduciary responsibility for investor capital, governance terms for investments will only become more important, particularly if investors move up the risk curve in order provide better returns to members and investors.
Corporates will need to have a clear picture of what governance arrangements they are prepared to offer to financial investors, and equally, should have a view about investor expectations in light of the proportion of institutional capital they are seeking (for example, minority versus majority positions). A view about financial investor expectations can start with an assessment of how they represent themselves in the market – some will make it very clear, for example, that their mandate and investment philosophy is to take control positions. Our financial investor clients tell us that alignment of interest among stakeholders (including alignment on governance expectations) is key to a successful investment.
4. Understand the range of capital opportunities.
Increasingly, more and more financial investors are able to invest at multiple levels of a ‘capital stack’ within the terms of investment mandates. Accordingly understanding the capital injection options available from your potential financial investors is important – for example, common equity, preferred equity, mezzanine funding, convertible debt, PIPE (i.e. selling of publicly traded common shares or some form of preferred stock or convertible security to private investors), amongst others.
Certain forms of investment will likely suit the Corporate’s longer term growth plans better than others. Obviously a comparison of capital funding options with other ‘traditional’ funding alternatives – for example public capital raising or traditional debt funding markets – will be necessary.
5. Understand the investment cycle of potential investors.
The anticipated duration (and therefore also the governing terms) of an institutional capital investment will be driven by a variety of economic considerations, but can also be driven by the wide-ranging structures and investment mandates of financial investors. To the extent that they can be selective when attracting capital, Corporates should understand the various implications that might flow from the structure and mandate applicable to an investor. For example, managed investment funds are structured broadly as two types – ‘open-ended’ (or ‘evergreen’), and ‘closed- end’. The former category can raise capital on an ongoing basis and can theoretically hold investments indefinitely.
Private equity funds and other private managed investment funds that invest in privately-owned entities are typically closed-end – the fund life is defined at the outset. There are some exceptions, especially in the case of infrastructure funds in Australia, which are also often open-ended or evergreen. A typical closed- end 10-12 year fund life structure might comprise a five year investment (capital deployment) phase (including an initial one year capital raising phase) and a 5-7 year realisation phase. Accordingly, a Corporate needs to understand:
6. Capacity for follow-on investments.
Above and beyond the initial investment, Corporates should understand the capacity of the financial investor to provide further capital as and when expansion opportunities arise (and without relying only on external leverage to grow the business).
This question is highly relevant for closed-end funds because they will typically allow ‘follow-on investments’ even during the realisation phase (when new investments are not permitted), but often subject to rules and limits and available uninvested capital. Corporates should understand the capacity of the fund to participate in expansion opportunities.
7. Environmental, social and governance (ESG) is real.
The ultimate source of capital managed by professional fund managers is very often retirement savings managed by superannuation and pension funds, which are frequently creatures of (and influenced by) public law or policy. It should not be surprising that these funds – whether as direct investors in Corporates, or through the managed investment funds in which they invest – are increasingly exerting real pressure to ensure that their investments (and therefore the investee Corporates) comply with ESG policies and rules.
Corporates need to understand that ESG compliance is likely to be high on the list of considerations of the investment committees of financial investors.
The content of this publication is for reference purposes only. It is current at the date of publication. This content does not constitute legal advice and should not be relied upon as such. Legal advice about your specific circumstances should always be obtained before taking any action based on this publication.