When seeking new funds, beware the private equity trap

In the current economic climate, many smaller businesses may need outside investment. Bank loans appear less attractive when the future of the business is unclear, so management teams may be tempted to look elsewhere. When it comes to equity investment, all forms are not equal. One particular example, already widely in use for many years, is an instrument portrayed as equity but behaving as a mixture of debt and equity; preference shares. Preference shares are a favourite instrument used by many private equity firms and rank ahead of ordinary equity. In the event of the business being sold, preference shareholders rank ahead of the ordinary equity holders to be paid. In good times, this may not be an issue if there are sufficient funds for debt providers to get their money back and all equity holders to make a return. These are not good times however, and when returns excluding interest amount to less than repayments on any debt, the debt providers are paid first, and remaining proceeds split among the equity holders. Holders of preference shares receive payment in entirety before other equity holders receive a penny and attract interest on their debt element (typically anywhere from 4% to 10% p.a). The company is often required to service this on a regular basis, usually monthly, in addition to any bank debt. When trading is buoyant, many businesses may cope perfectly well with the cost of servicing their debt, including that carried in the preference shares. But in tougher trading environments they may struggle to generate free cash flow after profits are siphoned off by onerous debt obligations. Other than the obvious, the practical implications of this is that the company can be deprived of sufficient working capital, particularly in cases when it is intending to reinvest. What results is an unhealthy environment where management feels trapped and view their effort as simply serving obligations to the bank and the private equity firm. Understandably, many management teams loathe situations like this but there may be little they can do – other than to seek re-finance or vote with their feet. Negotiation is usually the best way out of this as long as both sides remain pragmatic. The debt and financial structuring of an investment in the business can, without proper scrutiny and controls, leave management in a worse state than before – not making enough money to re-invest in the business and unable to raise more, or sell. Our firm invests in mid-sized companies, and never injects equity in the form of preference shares. Instead we invest in businesses where we believe our operational experience can turn a company around or take it to the next level, allowing profits to be re-invested and deliver growth. We call this “Entrepreneurial Investment”, creating value by inputting not only finance, but experience, expertise and skills. We always work closely with management teams and want one another to succeed, which is also why we give higher equity stakes to the managers of our businesses than is the industry norm. These are difficult times in which being selective about the strings attached with new funding may become a luxury, but it is always worth a closer look. In our own experience, this can make a huge difference to the longer-term performance of a company.