fundraising against the odds: considerations for start-up private equity ...
FALL 2013 WWW.BDO.COM
THE NEWSLETTER OF THE BDO PRIVATE EQUITY PRACTICE
DID YOU KNOW... Of the 101 capital markets executives at leading investment banks surveyed in the 2013 BDO IPO Halftime Report, close to two-thirds (64 percent) anticipate that U.S. IPO activity will increase further in the second half of 2013. According to data from Dealogic, corporate boards are focusing on “certainty” following the financial crisis, resulting in more careful deal activity. So far in 2013, the number of withdrawn deals has represented only 2.1 percent of announced deals.
FUNDRAISING AGAINST THE ODDS: CONSIDERATIONS FOR START-UP PRIVATE EQUITY FUND MANAGERS Q&A with Steven Huttler, Partner with Sadis & Goldberg LLP
D
uring ongoing contact with leaders in the private equity community, BDO seeks to solicit feedback on hot topics. While the global fundraising environment is showing signs of life, fund managers continue to face significant challenges when raising new funds. In this issue of PErspective, BDO delves into the fundraising environment for start-up private equity fund managers with Steven Huttler, Partner with Sadis & Goldberg LLP. How would you describe today’s fundraising environment? In one word: tough. Despite signs of economic recovery, it’s still a very difficult time to raise investment capital.
We’re seeing a dearth of investments across the board, and when investors are hesitant to commit funds to short-term or hedge fund managers, there’s an even greater reluctance to commit capital to investment funds like private equity that require long-term lock-up periods. Adding to the challenge of raising new funds, limited partners that are willing to invest in private equity in today’s environment have become more discerning about when and where they make long-term fund commitments, focusing more than ever on general partners’ investment track record. LPs’ heightened reliance on track record to guide investment decisions has exacerbated the “chicken-or-the-egg” dilemma that many start-up fund managers face: they cannot Read more
Global fundraising reached $178 billion during the first half of 2013, as reported by Triago. At this pace, the full-year fundraising total should reach $356 billion, which would be the largest sum raised since 2008. According to the Emerging Markets Private Equity Association (EMPEA), fundraising by private equity funds for emerging market use decreased by 52 percent during the first half of 2013 from the same time in 2012, and capital investments in emerging markets has decreased by 11 percent. Private equity dealmaking in the second quarter of 2013 reached a new quarterly low since 2009, according to PitchBook. Private equity firms invested $71 billion across 318 deals, which was down from the first quarter of 2013 and significantly lower than the fourth quarter of 2012 where $141 billion was invested in 671 deals.
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FUNDRAISING AGAINST THE ODDS raise money without a track record, and they cannot establish a track record without a history of raising and successfully investing capital to generate a return. These fund managers also face a crisis of volume. Many institutional investors have limits on the maximum percentages that they can constitute—as well as minimum amounts that they can invest—in a fund. With limited funds to go around, this is a very tough nut for start-up fund managers to crack. But changes are afoot. The SEC voted in July to end its decades-old ban on “general solicitation,” which may open the door for start-up and middle-market fund managers previously hindered by their inability to discuss investment opportunities or publicize performance. There’s also an opportunity for new or smaller fund managers to target noninstitutional audiences and in doing so, establish alternative investment arrangements and partnership terms. What steps are start-up fund managers taking to raise new funds? To overcome the track record hurdle, many start-up fund managers are finding alternative ways to “get deals done” and begin to establish a history of successful investments.
One strategy currently on the rise is to focus on making investments on a deal-by-deal basis rather than raising a fund to invest from over time. I’m seeing this play out in two primary ways: First, through an expanded application of the concept of “club deals.” Private equity funds have long partnered up with their competitors and family offices to co-invest in transactions, as a means of allocating risk and nurturing relationships. Increasingly, however, nascent private equity managers have organized these club deals in lieu of launching new funds. For these would-be fund managers, marketing, organizing and managing club deals presents an opportunity to demonstrate and leverage past experience, and begin to establish a track record, without meeting the steep expectations of investors when asked to make the long-term commitments required to launch a whole new private equity fund. The expansion of club deals in this manner also dovetails with other developments in the institutional private equity market. The financial press has recently reported on a proposed move by some of the very largest institutional investors away from investing in funds, in favor of investing directly in transactions. This points to the possibility of turning the club deal model into a longterm alternative to launching and managing private equity funds, and not just as a tactic to develop contacts into a private equity fund business.
The second way that many start-up fund managers are successfully sourcing and closing deals without an established track record or fund is through “pledge funds.” These funds differ from traditional committed private equity funds in that investors provide a loose commitment of capital to an investment team, but then choose to invest—or not invest—on a deal-by-deal basis. The nonbinding nature of these limited partnership agreements alleviates concerns among LPs about being locked into a fund that’s overseen by managers without a long history of private equity investment experience. There are also a number of terms that startup fund managers can work into limited partnership agreements, regardless of the fund structure, that may increase their appeal to prospective non-institutional investors— shorter investment time horizons and very specific investment parameters and theses (e.g., sector-specific funds) are two that come to mind. Both can lessen the perceived risk to potential investors and help start-up managers overcome some of the challenges they face when raising new funds. Are there obstacles associated with “club deals” or “pledge funds” that managers should be aware of? Club deals and pledge funds provide great opportunities for start-up fund managers to generate capital and begin to complete deals, but they do not come without their own set of challenges. For one, the lack of capital committed up front can create liquidity issues at the fund level. Fund managers require a certain amount of initial capital to manage the investment process and sufficiently source deals. Without sufficient up-front capital, they may lose both access to high-quality deal flow and the ability to conduct the extensive due diligence required to fully vet investment opportunities. Perhaps more importantly, after raising the initial capital to close a deal, fund managers have no liquidity to pay the expenses of or invest additional capital into the acquired portfolio company. To circumvent this liquidity issue, fund managers may be tempted to overfund specific opportunities up front, which could diminish long-term returns.
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FUNDRAISING Another important consideration is regulatory disclosure requirements. Fund managers face a higher regulatory threshold to disclose specific information about a company when soliciting investors on a deal-by-deal basis as opposed to for a blind pool. To comply with these additional regulatory hurdles, fund managers must commit significant time and money. How can start-up fund managers overcome these obstacles and differentiate themselves in the eyes of investors? In today’s fundraising environment, fund managers—new or established, large or small—face an uphill battle when trying to attract new capital commitments. But that’s not to say that the private equity marketplace is closed for business. To the contrary, startup fund managers can and have been quite successful at raising the capital required to source and close deals by targeting noninstitutional audiences. These investors are more likely to be attracted by the opportunity to take an entrepreneurial position in the fund management business and to be hands-on with the acquired companies, especially when the acquired company is in alignment with investors’ external expertise. To the extent a family office shares a sector background with a nascent manager, it’s also more likely to appreciate the value-add that start-up fund managers can provide based on their past experience. Perhaps most importantly, however, noninstitutional investors have the flexibility to structure limited partnership agreements in a way that will enable the investment team to overcome some of the key challenges new investors face and, ultimately, generate the highest returns for all parties. And for start-up fund managers with clear and viable investment strategies—or even better, highquality, proprietary deal flow—they’re often willing to do so.
Steven Huttler is a Partner and member of the Financial Services and Private Equity Groups of Sadis & Goldberg LLP. He has extensive experience in a wide array of private equity, corporate, investment fund and securities matters, ranging from formation and structuring matters to transactions. For more information, please visit www.sglawyers.com or contact Mr. Huttler at [email protected].
FASB ACCOUNTING STANDARDS UPDATE:
CLARIFYING INVESTMENT COMPANY STATUS & ACCOUNTING By Lee Duran
I
nvestment companies (i.e., funds) take on many forms—but the determination as to whether an entity is an “investment company” for accounting purposes is critical, as it significantly drives the accounting for its investments. As an example, if an entity is not considered an investment company, its controlled portfolio company investments may need to be consolidated in accordance with consolidation principles under U.S. GAAP. On June 7, 2013, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2013-08 1 to: (i) modify the guidance in Topic 946 for determining whether an entity is an investment company; (ii) update the measurement requirements for noncontrolling interests in other investment companies; and (iii) require additional disclosures for investment companies under U.S. GAAP. The amendments in this ASU are most important to those entities that may no longer qualify as investment companies as well as to entities that are not currently within the scope of Topic 946 but may now be investment companies. Real estate investment trusts continue to be excluded from Topic 946. Additionally, the FASB did not address the applicability of investment-company accounting for other real estate entities. The following are the three main provisions of this ASU that amend Topic 946.
(i) Assessment of Investment Company Status An entity regulated as an investment company pursuant to the Investment Company Act of 1940 (ICA) continues to be an investment company under Topic 946. Under the new guidance, an entity other than an ICAregulated entity must follow a two-tiered
assessment approach to determine whether it is an investment company under Topic 946. An entity should possess certain characteristics that are fundamental to being an investment company, but other characteristics, while present in typical investment companies, may not be present in all investment companies, and judgment is required in the assessment and evaluation. An investment company has both of the following fundamental characteristics: a. It is an entity that: 1. Obtains funds from one or more investors and provides the investor(s) with investment management services 2. Commits to its investor(s) that its business purpose and only substantive activities are investing the funds solely for returns from capital appreciation, investment income, or both b. The entity or its affiliates do not obtain or have the objective of obtaining returns or benefits from an investee or its affiliates that are not normally attributable to ownership interests or that are other than capital appreciation or investment income. An investment company also generally has the following typical characteristics: a. More than one investment b. More than one investor c. Investors that are not related parties of the parent (if there is a parent) or the investment manager d. Ownership interests in the form of equity or partnership interests e. Investments that are substantially managed on a fair value basis. It’s important that an entity considers its purpose and design when making its assessment of all of the characteristics of an investment company. An entity that does not possess the fundamental characteristics is not an investment company. However, if Read more
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FASB an entity does not have one or more of the typical characteristics, additional judgment is required to determine whether it is an investment company. The assessment of whether or not an entity is an investment company should be performed upon the entity’s formation, and only when there is a subsequent change in its purpose and design or if the entity is no longer regulated under the ICA.
(ii) Measurement of Noncontrolling Interests in Other Investment Companies Under the ASU, the prohibition of applying the equity method and consolidation to noninvestment companies continues to apply, i.e., investment companies under Topic 946 must record these investments at fair value. The one exception to this rule in which an investment company must use the consolidation and equity method principles to controlling and noncontrolling interests, respectively, is in an operating entity that provides services to the investment company (e.g., an investment adviser or transfer agent). The ASU, however, revises the measurement guidance in Topic 946 such that investment companies must measure noncontrolling ownership interests in other investment companies at fair value, rather than applying the equity method of accounting to such interests. This aims to reduce the complexity of reporting. Accounting for controlling interests has not changed, but is currently under discussion at the FASB.
U.S. Senate Committee Passes Expansion of Small Business Investment Company (SBIC) Program By Bryan Gendron
O
n July 17, 2013, the U.S. Senate Committee on Small Business and Entrepreneurship passed the Expanding Access to Capital for Entrepreneurial Leaders (EXCEL) Act*. The EXCEL Act would modify the Small Business Investment Company (SBIC) program to raise the amount of SBIC debt the Small Business Administration (SBA) can guarantee from $3 billion to $4 billion. It would also increase the amount of SBA guaranteed debt a team of SBIC fund managers who operate several funds can borrow from $225 million to $350 million. In 1958, Congress created the SBIC program to facilitate the flow of long-term capital to America’s small businesses. Under the SBIC program, the SBA licenses, regulates and helps provide funds for privately owned and operated venture capital and private equity investment firms. SBICs are licensed and regulated by the SBA. SBICs use their own private money, plus money borrowed with an SBA guarantee, to invest in small businesses. The U.S. Senate Committee’s passage of the EXCEL Act is the latest proposed addition to the SBIC’s new program that was introduced as part of President’s Obama’s Start-Up America Initiative. The goal of this program is to address the shortage of venture capital for emerging U.S. companies attempting to raise between $1 million and $4 million in funds. This new program, the first since 1994, allocates $1 billion over the next five years and is modeled on the SBIC debentures program. This program is less complex than the previous participating securities program introduced in 1994. Less complexity does not necessarily mean easier to obtain - a detailed application process, leverage ratios and distribution models are all in place. These are key aspects to the new programs and to its potential success within the venture capital and small business communities. *To learn more about the EXCEL Act, read the full bill text here: http://www.govtrack.us/ congress/bills/113/s511/text. Bryan Gendron is a Partner in the Private Equity practice at BDO. He can be reached at [email protected].
(iii) Additional Disclosures by Investment Companies Additionally, the ASU requires an investment company to make additional disclosures, which include, among other things, information about financial support provided by the investment company to any of its investees. For the financial support disclosure requirement, an investment company that provides financial support to an investee must disclose information about the type, amount and reason of the financial support that it was contractually required to provide and financial support that it was not previously
contractually required to provide. Similar disclosures are required for contractual commitments that have not yet been provided.
If a private equity or venture capital sponsor is looking to establish a new fund, it should consider the impact of this new guidance on the fund and its future portfolio companies.
u EFFECTIVE DATE
1
This ASU is effective for an entity’s interim and annual reporting periods in fiscal years that begin after Dec. 15, 2013. Earlier application is prohibited.
F inancial Services−Investment Companies (Topic 946): Amendments to the Scope, Measurement and Disclosure Requirements
Lee Duran is a Partner and Private Equity Practice Leader at BDO. He can be reached at lduran@bdo. com.
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THE STATE OF THE CAPITAL MARKETS – THE CALM BEFORE A SURGE? By Dan Shea
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iddle market M&A deal activity has slowed considerably since the end of 2012. Many of us recall the fourth quarter of last year when closings spiked by over 30 percent in advance of the thenpending 2013 tax hike. This dynamic most certainly brought forward transaction closings into 2012, consequently having a downward impact on closings in the first quarter of 2013. Surprisingly, a lower level of activity has persisted during the second quarter of 2013. Indeed, middle market deal volume during Q2 was down by 5 percent versus Q1 of 2013, a slow quarter by all measures, and was lower than the year-earlier second quarter of 2012 by 25 percent (source: Thomson Reuters). Where do we go from here? The Private Equity practice within BDO can be seen as a leading indicator of deal activity in the middle market. Our activities, particularly within our investment bank (BDO Capital Advisors, LLC) and our due diligence practice (BDO Transaction Advisory Services), involve assisting clients in getting deals done so we know, to a fair degree, what is about to happen in terms of closing trends. Our workload increased notably during Q2 and has continued into Q3, suggesting that closing levels should rise materially during the second half of 2013. How these pending results compare with corresponding 2012 levels is anyone’s guess, but the trend line is certainly positive. Is it a sellers’ or buyers’ market? The capital available for transactions remains high relative to the number of business owners looking for a liquidity event, making it a sellers’ market. Here’s why: Financial Buyers – Private equity firms raised $48 billion in aggregate new funding during the second quarter of 2013 - the highest quarterly level since the first quarter of 2009. In addition, the total amount of private equity capital available to be invested, the aptly called “PE Capital Overhang,” currently stands at $328 billion. While down considerably since 2008, it is worth noting that 26 percent of the current total was raised over five years ago and has yet to be invested (source: Pitchbook).
Strategic Buyers – Strategic buyers have excess capital available, too, and have expressed a greater interest in growth through acquisitions in recent periods. We routinely prepare an analysis using Federal Reserve data aimed at highlighting excess cash on public company balance sheets in the U.S. (excluding financial institutions). Recent analysis indicates that the cash within these companies is in excess of the 40-year average, currently totaling a notably high $290 billion. We believe it is reasonable to suggest that a material portion of this excess cash will be used for acquisition growth. Debt Markets – Lenders remain active and their appetite for middle market deals appears to be growing. Middle market loan volume during the first half of 2013 was up by over 40 percent when compared with the corresponding 2012 period. Also suggesting a strengthening appetite, the average middle market lending multiple during the first half of 2013 stood at 4.7 times EBITDA (including subordinated debt).
What impact does this have on purchase price? While purchase price multiples vary widely in any given period depending on a host of factors including economic forces, industry focus and business profile of the subject company, the average multiples have been relatively steady for the past 1 ½ years. The average purchase multiple currently stands at approximately six times EBITDA (source: S&P Capital IQ). By and large, buyers have maintained a disciplined approach to valuation since the recession. Efforts to avoid overpaying have created stability in the market which bodes well for the medium- and long-term health of the M&A marketplace.
BDO Capital Advisors, LLC, a FINRA/SIPC member, is a separate legal entity and an affiliated company of BDO USA, LLP, a Delaware limited liability partnership and national professional services firm. Dan Shea is a Managing Director with BDO Capital Advisors, LLC and a member of the Private Equity practice at BDO. He can be reached at dshea@bdo. com.
Digital Content Spotlight: New Deemed Asset Sale Structuring Alternatives under Section 336(e) BDO’s PErspective content continues online with an exclusive digital article from Randy Schwartzman, Eric Mauner and Patricia Brandstetter – all members of BDO’s Northeast Transaction Advisory Services practice – on the expanded types of stock dispositions that can result in an asset basis step-up for tax purposes, as a result of the final regulations under Section 336(e). This is a change from the existing asset sale election that has been in place for more than 25 years, and introduces an important new tool for M&A tax practitioners when structuring corporate acquisitions. This tax alert will give a detailed overview of: • Situations where an election under Sec. 336(e) would be available (and not otherwise allowable under Sec. 338(h)(10)) • Requirements to qualify for an election under Sec. 336(e) • Comparative analysis of situations where Sec. 336(e) versus Sec. 338(h)(10) could be used • New tax planning considerations and opportunities as a result of Sec. 336(e) The informative article prepared by Schwartzman and his team will be available to those who subscribe to BDO’s PErspective and Tax content, and online at bdo.com/ privateequity in the coming weeks. If you’re interested in staying informed, sign up for future PErspective newsletters and more at subscriptions.bdo.com.
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MARK YOUR CALENDAR The following is a list of upcoming conferences and seminars from the leading private equity associations and business bureaus:
SEPTEMBER September 12 Best Practices for Overseeing PE Fund Administration & Compliance New York, N.Y. September 26-27 Dow Jones Private Equity Analyst Conference Waldorf Astoria New York, N.Y.
OCTOBER October 2-3 PEI Energy Investment Summit 2013 The Yale Club New York, N.Y. October 3 Best Practices for Overseeing Private Equity Portfolio Companies New York, N.Y. October 7-9 Buyouts West The Ritz-Carlton Half Moon Bay Half Moon Bay, Calif.
October 8-9 M&A East Pennsylvania Convention Center Philadelphia, Pa. October 22 Midwest ACG Capital Connection McCormick Place, West Building Chicago, Ill.
NOVEMBER November 6-7 Florida ACG Capital Connection Hyatt Regency Grand Cypress Orlando, FL November 12-13 EuroGrowth 2013 London, UK November 14-15 PEI PE / VC Finance & Compliance Forum 2013 The W San Francisco Hotel San Francisco, CA November 21 Raising Private Equity Funds from Institutional Investors New York, NY
CONTACT: LEE DURAN, San Diego 858-431-3410 / [email protected] SCOTT HENDON, Dallas 214-665-0750 / [email protected] KEVIN KADEN, New York 212-885-8000 / [email protected] RYAN GUTHRIE, Costa Mesa 714-668-7385 / [email protected] SCOTT CACURAK, Los Angeles 310-557-0300 / [email protected] MARK ELLENBOGEN, Washington, D.C. 202-904-2402 / [email protected] JERRY DENTINGER, Chicago 312-239-9191 / [email protected] MATT SEGAL, Chicago 312-616-4630 / [email protected] TODD KINNEY, New York 212-885-7485 / [email protected] JOE BURKE, McLean, VA 703-770-6323 / [email protected] MICHAEL WHITACRE, Atlanta 404-979-7116 / [email protected]
BDO PRIVATE EQUITY PRACTICE Strategically focused and remarkably responsive, the experienced, multidisciplinary partners and directors of BDO’s Private Equity practice provide value-added assurance, tax and consulting services for all aspects of a fund’s cycle, wherever private equity firms are investing. ABOUT BDO USA BDO is the brand name for BDO USA, LLP, a U.S. professional services firm providing assurance, tax, financial advisory and consulting services to a wide range of publicly traded and privately held companies. For more than 100 years, BDO has provided quality service through the active involvement of experienced and committed professionals. The firm serves clients through 49 offices and over 400 independent alliance firm locations nationwide. As an independent Member Firm of BDO International Limited, BDO serves multinational clients through a global network of 1,204 offices in 138 countries. BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms. For more information, please visit www.bdo.com. Material discussed is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual circumstances. To ensure compliance with Treasury Department regulations, we wish to inform you that any tax advice that may be contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or applicable state or local tax or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. © 2013 BDO USA, LLP. All rights reserved.
THE NEWSLETTER OF THE BDO PRIVATE EQUITY PRACTICE
DID YOU KNOW... Of the 101 capital markets executives at leading investment banks surveyed in the 2013 BDO IPO Halftime Report, close to two-thirds (64 percent) anticipate that U.S. IPO activity will increase further in the second half of 2013. According to data from Dealogic, corporate boards are focusing on “certainty” following the financial crisis, resulting in more careful deal activity. So far in 2013, the number of withdrawn deals has represented only 2.1 percent of announced deals.
FUNDRAISING AGAINST THE ODDS: CONSIDERATIONS FOR START-UP PRIVATE EQUITY FUND MANAGERS Q&A with Steven Huttler, Partner with Sadis & Goldberg LLP
D
uring ongoing contact with leaders in the private equity community, BDO seeks to solicit feedback on hot topics. While the global fundraising environment is showing signs of life, fund managers continue to face significant challenges when raising new funds. In this issue of PErspective, BDO delves into the fundraising environment for start-up private equity fund managers with Steven Huttler, Partner with Sadis & Goldberg LLP. How would you describe today’s fundraising environment? In one word: tough. Despite signs of economic recovery, it’s still a very difficult time to raise investment capital.
We’re seeing a dearth of investments across the board, and when investors are hesitant to commit funds to short-term or hedge fund managers, there’s an even greater reluctance to commit capital to investment funds like private equity that require long-term lock-up periods. Adding to the challenge of raising new funds, limited partners that are willing to invest in private equity in today’s environment have become more discerning about when and where they make long-term fund commitments, focusing more than ever on general partners’ investment track record. LPs’ heightened reliance on track record to guide investment decisions has exacerbated the “chicken-or-the-egg” dilemma that many start-up fund managers face: they cannot Read more
Global fundraising reached $178 billion during the first half of 2013, as reported by Triago. At this pace, the full-year fundraising total should reach $356 billion, which would be the largest sum raised since 2008. According to the Emerging Markets Private Equity Association (EMPEA), fundraising by private equity funds for emerging market use decreased by 52 percent during the first half of 2013 from the same time in 2012, and capital investments in emerging markets has decreased by 11 percent. Private equity dealmaking in the second quarter of 2013 reached a new quarterly low since 2009, according to PitchBook. Private equity firms invested $71 billion across 318 deals, which was down from the first quarter of 2013 and significantly lower than the fourth quarter of 2012 where $141 billion was invested in 671 deals.
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FUNDRAISING AGAINST THE ODDS raise money without a track record, and they cannot establish a track record without a history of raising and successfully investing capital to generate a return. These fund managers also face a crisis of volume. Many institutional investors have limits on the maximum percentages that they can constitute—as well as minimum amounts that they can invest—in a fund. With limited funds to go around, this is a very tough nut for start-up fund managers to crack. But changes are afoot. The SEC voted in July to end its decades-old ban on “general solicitation,” which may open the door for start-up and middle-market fund managers previously hindered by their inability to discuss investment opportunities or publicize performance. There’s also an opportunity for new or smaller fund managers to target noninstitutional audiences and in doing so, establish alternative investment arrangements and partnership terms. What steps are start-up fund managers taking to raise new funds? To overcome the track record hurdle, many start-up fund managers are finding alternative ways to “get deals done” and begin to establish a history of successful investments.
One strategy currently on the rise is to focus on making investments on a deal-by-deal basis rather than raising a fund to invest from over time. I’m seeing this play out in two primary ways: First, through an expanded application of the concept of “club deals.” Private equity funds have long partnered up with their competitors and family offices to co-invest in transactions, as a means of allocating risk and nurturing relationships. Increasingly, however, nascent private equity managers have organized these club deals in lieu of launching new funds. For these would-be fund managers, marketing, organizing and managing club deals presents an opportunity to demonstrate and leverage past experience, and begin to establish a track record, without meeting the steep expectations of investors when asked to make the long-term commitments required to launch a whole new private equity fund. The expansion of club deals in this manner also dovetails with other developments in the institutional private equity market. The financial press has recently reported on a proposed move by some of the very largest institutional investors away from investing in funds, in favor of investing directly in transactions. This points to the possibility of turning the club deal model into a longterm alternative to launching and managing private equity funds, and not just as a tactic to develop contacts into a private equity fund business.
The second way that many start-up fund managers are successfully sourcing and closing deals without an established track record or fund is through “pledge funds.” These funds differ from traditional committed private equity funds in that investors provide a loose commitment of capital to an investment team, but then choose to invest—or not invest—on a deal-by-deal basis. The nonbinding nature of these limited partnership agreements alleviates concerns among LPs about being locked into a fund that’s overseen by managers without a long history of private equity investment experience. There are also a number of terms that startup fund managers can work into limited partnership agreements, regardless of the fund structure, that may increase their appeal to prospective non-institutional investors— shorter investment time horizons and very specific investment parameters and theses (e.g., sector-specific funds) are two that come to mind. Both can lessen the perceived risk to potential investors and help start-up managers overcome some of the challenges they face when raising new funds. Are there obstacles associated with “club deals” or “pledge funds” that managers should be aware of? Club deals and pledge funds provide great opportunities for start-up fund managers to generate capital and begin to complete deals, but they do not come without their own set of challenges. For one, the lack of capital committed up front can create liquidity issues at the fund level. Fund managers require a certain amount of initial capital to manage the investment process and sufficiently source deals. Without sufficient up-front capital, they may lose both access to high-quality deal flow and the ability to conduct the extensive due diligence required to fully vet investment opportunities. Perhaps more importantly, after raising the initial capital to close a deal, fund managers have no liquidity to pay the expenses of or invest additional capital into the acquired portfolio company. To circumvent this liquidity issue, fund managers may be tempted to overfund specific opportunities up front, which could diminish long-term returns.
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FUNDRAISING Another important consideration is regulatory disclosure requirements. Fund managers face a higher regulatory threshold to disclose specific information about a company when soliciting investors on a deal-by-deal basis as opposed to for a blind pool. To comply with these additional regulatory hurdles, fund managers must commit significant time and money. How can start-up fund managers overcome these obstacles and differentiate themselves in the eyes of investors? In today’s fundraising environment, fund managers—new or established, large or small—face an uphill battle when trying to attract new capital commitments. But that’s not to say that the private equity marketplace is closed for business. To the contrary, startup fund managers can and have been quite successful at raising the capital required to source and close deals by targeting noninstitutional audiences. These investors are more likely to be attracted by the opportunity to take an entrepreneurial position in the fund management business and to be hands-on with the acquired companies, especially when the acquired company is in alignment with investors’ external expertise. To the extent a family office shares a sector background with a nascent manager, it’s also more likely to appreciate the value-add that start-up fund managers can provide based on their past experience. Perhaps most importantly, however, noninstitutional investors have the flexibility to structure limited partnership agreements in a way that will enable the investment team to overcome some of the key challenges new investors face and, ultimately, generate the highest returns for all parties. And for start-up fund managers with clear and viable investment strategies—or even better, highquality, proprietary deal flow—they’re often willing to do so.
Steven Huttler is a Partner and member of the Financial Services and Private Equity Groups of Sadis & Goldberg LLP. He has extensive experience in a wide array of private equity, corporate, investment fund and securities matters, ranging from formation and structuring matters to transactions. For more information, please visit www.sglawyers.com or contact Mr. Huttler at [email protected].
FASB ACCOUNTING STANDARDS UPDATE:
CLARIFYING INVESTMENT COMPANY STATUS & ACCOUNTING By Lee Duran
I
nvestment companies (i.e., funds) take on many forms—but the determination as to whether an entity is an “investment company” for accounting purposes is critical, as it significantly drives the accounting for its investments. As an example, if an entity is not considered an investment company, its controlled portfolio company investments may need to be consolidated in accordance with consolidation principles under U.S. GAAP. On June 7, 2013, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2013-08 1 to: (i) modify the guidance in Topic 946 for determining whether an entity is an investment company; (ii) update the measurement requirements for noncontrolling interests in other investment companies; and (iii) require additional disclosures for investment companies under U.S. GAAP. The amendments in this ASU are most important to those entities that may no longer qualify as investment companies as well as to entities that are not currently within the scope of Topic 946 but may now be investment companies. Real estate investment trusts continue to be excluded from Topic 946. Additionally, the FASB did not address the applicability of investment-company accounting for other real estate entities. The following are the three main provisions of this ASU that amend Topic 946.
(i) Assessment of Investment Company Status An entity regulated as an investment company pursuant to the Investment Company Act of 1940 (ICA) continues to be an investment company under Topic 946. Under the new guidance, an entity other than an ICAregulated entity must follow a two-tiered
assessment approach to determine whether it is an investment company under Topic 946. An entity should possess certain characteristics that are fundamental to being an investment company, but other characteristics, while present in typical investment companies, may not be present in all investment companies, and judgment is required in the assessment and evaluation. An investment company has both of the following fundamental characteristics: a. It is an entity that: 1. Obtains funds from one or more investors and provides the investor(s) with investment management services 2. Commits to its investor(s) that its business purpose and only substantive activities are investing the funds solely for returns from capital appreciation, investment income, or both b. The entity or its affiliates do not obtain or have the objective of obtaining returns or benefits from an investee or its affiliates that are not normally attributable to ownership interests or that are other than capital appreciation or investment income. An investment company also generally has the following typical characteristics: a. More than one investment b. More than one investor c. Investors that are not related parties of the parent (if there is a parent) or the investment manager d. Ownership interests in the form of equity or partnership interests e. Investments that are substantially managed on a fair value basis. It’s important that an entity considers its purpose and design when making its assessment of all of the characteristics of an investment company. An entity that does not possess the fundamental characteristics is not an investment company. However, if Read more
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FASB an entity does not have one or more of the typical characteristics, additional judgment is required to determine whether it is an investment company. The assessment of whether or not an entity is an investment company should be performed upon the entity’s formation, and only when there is a subsequent change in its purpose and design or if the entity is no longer regulated under the ICA.
(ii) Measurement of Noncontrolling Interests in Other Investment Companies Under the ASU, the prohibition of applying the equity method and consolidation to noninvestment companies continues to apply, i.e., investment companies under Topic 946 must record these investments at fair value. The one exception to this rule in which an investment company must use the consolidation and equity method principles to controlling and noncontrolling interests, respectively, is in an operating entity that provides services to the investment company (e.g., an investment adviser or transfer agent). The ASU, however, revises the measurement guidance in Topic 946 such that investment companies must measure noncontrolling ownership interests in other investment companies at fair value, rather than applying the equity method of accounting to such interests. This aims to reduce the complexity of reporting. Accounting for controlling interests has not changed, but is currently under discussion at the FASB.
U.S. Senate Committee Passes Expansion of Small Business Investment Company (SBIC) Program By Bryan Gendron
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n July 17, 2013, the U.S. Senate Committee on Small Business and Entrepreneurship passed the Expanding Access to Capital for Entrepreneurial Leaders (EXCEL) Act*. The EXCEL Act would modify the Small Business Investment Company (SBIC) program to raise the amount of SBIC debt the Small Business Administration (SBA) can guarantee from $3 billion to $4 billion. It would also increase the amount of SBA guaranteed debt a team of SBIC fund managers who operate several funds can borrow from $225 million to $350 million. In 1958, Congress created the SBIC program to facilitate the flow of long-term capital to America’s small businesses. Under the SBIC program, the SBA licenses, regulates and helps provide funds for privately owned and operated venture capital and private equity investment firms. SBICs are licensed and regulated by the SBA. SBICs use their own private money, plus money borrowed with an SBA guarantee, to invest in small businesses. The U.S. Senate Committee’s passage of the EXCEL Act is the latest proposed addition to the SBIC’s new program that was introduced as part of President’s Obama’s Start-Up America Initiative. The goal of this program is to address the shortage of venture capital for emerging U.S. companies attempting to raise between $1 million and $4 million in funds. This new program, the first since 1994, allocates $1 billion over the next five years and is modeled on the SBIC debentures program. This program is less complex than the previous participating securities program introduced in 1994. Less complexity does not necessarily mean easier to obtain - a detailed application process, leverage ratios and distribution models are all in place. These are key aspects to the new programs and to its potential success within the venture capital and small business communities. *To learn more about the EXCEL Act, read the full bill text here: http://www.govtrack.us/ congress/bills/113/s511/text. Bryan Gendron is a Partner in the Private Equity practice at BDO. He can be reached at [email protected].
(iii) Additional Disclosures by Investment Companies Additionally, the ASU requires an investment company to make additional disclosures, which include, among other things, information about financial support provided by the investment company to any of its investees. For the financial support disclosure requirement, an investment company that provides financial support to an investee must disclose information about the type, amount and reason of the financial support that it was contractually required to provide and financial support that it was not previously
contractually required to provide. Similar disclosures are required for contractual commitments that have not yet been provided.
If a private equity or venture capital sponsor is looking to establish a new fund, it should consider the impact of this new guidance on the fund and its future portfolio companies.
u EFFECTIVE DATE
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This ASU is effective for an entity’s interim and annual reporting periods in fiscal years that begin after Dec. 15, 2013. Earlier application is prohibited.
F inancial Services−Investment Companies (Topic 946): Amendments to the Scope, Measurement and Disclosure Requirements
Lee Duran is a Partner and Private Equity Practice Leader at BDO. He can be reached at lduran@bdo. com.
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THE STATE OF THE CAPITAL MARKETS – THE CALM BEFORE A SURGE? By Dan Shea
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iddle market M&A deal activity has slowed considerably since the end of 2012. Many of us recall the fourth quarter of last year when closings spiked by over 30 percent in advance of the thenpending 2013 tax hike. This dynamic most certainly brought forward transaction closings into 2012, consequently having a downward impact on closings in the first quarter of 2013. Surprisingly, a lower level of activity has persisted during the second quarter of 2013. Indeed, middle market deal volume during Q2 was down by 5 percent versus Q1 of 2013, a slow quarter by all measures, and was lower than the year-earlier second quarter of 2012 by 25 percent (source: Thomson Reuters). Where do we go from here? The Private Equity practice within BDO can be seen as a leading indicator of deal activity in the middle market. Our activities, particularly within our investment bank (BDO Capital Advisors, LLC) and our due diligence practice (BDO Transaction Advisory Services), involve assisting clients in getting deals done so we know, to a fair degree, what is about to happen in terms of closing trends. Our workload increased notably during Q2 and has continued into Q3, suggesting that closing levels should rise materially during the second half of 2013. How these pending results compare with corresponding 2012 levels is anyone’s guess, but the trend line is certainly positive. Is it a sellers’ or buyers’ market? The capital available for transactions remains high relative to the number of business owners looking for a liquidity event, making it a sellers’ market. Here’s why: Financial Buyers – Private equity firms raised $48 billion in aggregate new funding during the second quarter of 2013 - the highest quarterly level since the first quarter of 2009. In addition, the total amount of private equity capital available to be invested, the aptly called “PE Capital Overhang,” currently stands at $328 billion. While down considerably since 2008, it is worth noting that 26 percent of the current total was raised over five years ago and has yet to be invested (source: Pitchbook).
Strategic Buyers – Strategic buyers have excess capital available, too, and have expressed a greater interest in growth through acquisitions in recent periods. We routinely prepare an analysis using Federal Reserve data aimed at highlighting excess cash on public company balance sheets in the U.S. (excluding financial institutions). Recent analysis indicates that the cash within these companies is in excess of the 40-year average, currently totaling a notably high $290 billion. We believe it is reasonable to suggest that a material portion of this excess cash will be used for acquisition growth. Debt Markets – Lenders remain active and their appetite for middle market deals appears to be growing. Middle market loan volume during the first half of 2013 was up by over 40 percent when compared with the corresponding 2012 period. Also suggesting a strengthening appetite, the average middle market lending multiple during the first half of 2013 stood at 4.7 times EBITDA (including subordinated debt).
What impact does this have on purchase price? While purchase price multiples vary widely in any given period depending on a host of factors including economic forces, industry focus and business profile of the subject company, the average multiples have been relatively steady for the past 1 ½ years. The average purchase multiple currently stands at approximately six times EBITDA (source: S&P Capital IQ). By and large, buyers have maintained a disciplined approach to valuation since the recession. Efforts to avoid overpaying have created stability in the market which bodes well for the medium- and long-term health of the M&A marketplace.
BDO Capital Advisors, LLC, a FINRA/SIPC member, is a separate legal entity and an affiliated company of BDO USA, LLP, a Delaware limited liability partnership and national professional services firm. Dan Shea is a Managing Director with BDO Capital Advisors, LLC and a member of the Private Equity practice at BDO. He can be reached at dshea@bdo. com.
Digital Content Spotlight: New Deemed Asset Sale Structuring Alternatives under Section 336(e) BDO’s PErspective content continues online with an exclusive digital article from Randy Schwartzman, Eric Mauner and Patricia Brandstetter – all members of BDO’s Northeast Transaction Advisory Services practice – on the expanded types of stock dispositions that can result in an asset basis step-up for tax purposes, as a result of the final regulations under Section 336(e). This is a change from the existing asset sale election that has been in place for more than 25 years, and introduces an important new tool for M&A tax practitioners when structuring corporate acquisitions. This tax alert will give a detailed overview of: • Situations where an election under Sec. 336(e) would be available (and not otherwise allowable under Sec. 338(h)(10)) • Requirements to qualify for an election under Sec. 336(e) • Comparative analysis of situations where Sec. 336(e) versus Sec. 338(h)(10) could be used • New tax planning considerations and opportunities as a result of Sec. 336(e) The informative article prepared by Schwartzman and his team will be available to those who subscribe to BDO’s PErspective and Tax content, and online at bdo.com/ privateequity in the coming weeks. If you’re interested in staying informed, sign up for future PErspective newsletters and more at subscriptions.bdo.com.
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MARK YOUR CALENDAR The following is a list of upcoming conferences and seminars from the leading private equity associations and business bureaus:
SEPTEMBER September 12 Best Practices for Overseeing PE Fund Administration & Compliance New York, N.Y. September 26-27 Dow Jones Private Equity Analyst Conference Waldorf Astoria New York, N.Y.
OCTOBER October 2-3 PEI Energy Investment Summit 2013 The Yale Club New York, N.Y. October 3 Best Practices for Overseeing Private Equity Portfolio Companies New York, N.Y. October 7-9 Buyouts West The Ritz-Carlton Half Moon Bay Half Moon Bay, Calif.
October 8-9 M&A East Pennsylvania Convention Center Philadelphia, Pa. October 22 Midwest ACG Capital Connection McCormick Place, West Building Chicago, Ill.
NOVEMBER November 6-7 Florida ACG Capital Connection Hyatt Regency Grand Cypress Orlando, FL November 12-13 EuroGrowth 2013 London, UK November 14-15 PEI PE / VC Finance & Compliance Forum 2013 The W San Francisco Hotel San Francisco, CA November 21 Raising Private Equity Funds from Institutional Investors New York, NY
CONTACT: LEE DURAN, San Diego 858-431-3410 / [email protected] SCOTT HENDON, Dallas 214-665-0750 / [email protected] KEVIN KADEN, New York 212-885-8000 / [email protected] RYAN GUTHRIE, Costa Mesa 714-668-7385 / [email protected] SCOTT CACURAK, Los Angeles 310-557-0300 / [email protected] MARK ELLENBOGEN, Washington, D.C. 202-904-2402 / [email protected] JERRY DENTINGER, Chicago 312-239-9191 / [email protected] MATT SEGAL, Chicago 312-616-4630 / [email protected] TODD KINNEY, New York 212-885-7485 / [email protected] JOE BURKE, McLean, VA 703-770-6323 / [email protected] MICHAEL WHITACRE, Atlanta 404-979-7116 / [email protected]
BDO PRIVATE EQUITY PRACTICE Strategically focused and remarkably responsive, the experienced, multidisciplinary partners and directors of BDO’s Private Equity practice provide value-added assurance, tax and consulting services for all aspects of a fund’s cycle, wherever private equity firms are investing. ABOUT BDO USA BDO is the brand name for BDO USA, LLP, a U.S. professional services firm providing assurance, tax, financial advisory and consulting services to a wide range of publicly traded and privately held companies. For more than 100 years, BDO has provided quality service through the active involvement of experienced and committed professionals. The firm serves clients through 49 offices and over 400 independent alliance firm locations nationwide. As an independent Member Firm of BDO International Limited, BDO serves multinational clients through a global network of 1,204 offices in 138 countries. BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms. For more information, please visit www.bdo.com. Material discussed is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual circumstances. To ensure compliance with Treasury Department regulations, we wish to inform you that any tax advice that may be contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or applicable state or local tax or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. © 2013 BDO USA, LLP. All rights reserved.
