There is no denying that, due to a combination of circumstances, financial investors have billions (if not trillions) of capital ready to deploy.
Their main problem, however, is insufficient investment opportunities. What should an entity seeking institutional capital to expand its business (we will call this entity a business) know about dealing with these types of investors in the future?
Given the enormous liquidity and insufficient investment opportunities, we have outlined seven considerations for companies looking to maximize the benefits of non-public institutional capital in the current climate.
1. Funder or partner?
A company with a good business case can, in general terms, be selective about the type of investor it wishes to deal with. A threshold question is whether to consider potential financial investors as mere providers of capital or as financial partners who can bring something more – for example, geographic reach, operational expertise, distribution, opportunities for expansion (including through acquisitions), exit opportunities, and love.
In the latter case, the financial investor’s track record of portfolio investments (including exits) should help determine whether he has been successful in developing particular types of businesses.
2. Assess the benefits of auctions.
Not surprisingly, financial investors hope to avoid competing with other investors for closing investment opportunities and consider proprietary opportunities to be the holy grail of the investment world.
Armed with the answer to the threshold question identified above (funder or partner), a savvy company will carefully consider which process is most likely to yield an optimal outcome. Increasingly – given the liquidity/investment opportunity dynamic – we would expect to see more companies exploring whether they can push a “pay to play” agenda with financial investors (e.g., pay to play). opportunity to engage in proprietary opportunities).
While financial investors may need to compete hard for good investment opportunities, governance conditions remain of paramount importance to investors. In the Australian context (particularly following the Royal Commission on Financial Services), we would expect that, in light of the growing attention to the fiduciary responsibility of investors’ capital, the governance conditions of investments only become more important, particularly as investors move up the risk curve in order to provide better returns to members and investors.
Firms will need to have a clear idea of the governance arrangements they are prepared to offer to financial investors and similarly should have an idea of the expectations of investors given the proportion of institutional capital they are seeking (e.g., minority or majority positions). A view of the expectations of financial investors can begin with an assessment of how they represent themselves in the market – some will say very clearly, for example, that their investment mandate and philosophy is to take control positions. Our financial investor clients tell us that alignment of stakeholder interests (including alignment with governance expectations) is key to successful investing.
4. Understand the range of capital opportunities.
More and more financial investors are able to invest at multiple levels of a “capital stack” within investment mandates. Therefore, it is important to understand the capital injection options available to your potential financial investors – for example, common stock, preferred stock, mezzanine financing, convertible debt, PIPE (i.e. i.e. the sale of publicly traded common stock or any form of preferred stock or convertible securities to private investors). investors), among others.
Some forms of investment are likely to be better suited than others to a company’s long-term growth plans. Clearly, a comparison of equity financing options with other “traditional” financing alternatives – for example raising public capital or traditional debt financing markets – will be necessary.
5. Understand the investment cycle of potential investors.
The anticipated duration (and therefore also the governance conditions) of an institutional capital investment will depend on various economic considerations, but may also be determined by the structures and extensive investment mandates of financial investors. Because they can be selective when attracting capital, companies need to understand the various implications that could arise from the structure and mandate applicable to an investor. For example, managed investment funds are generally structured into two types – “open” (or “permanent”) and “closed”. The first category can raise capital continuously and can theoretically hold investments indefinitely.
Private equity funds and other privately managed investment funds that invest in private entities are generally closed-end – the life of the fund is defined upfront. There are a few exceptions, particularly in the case of infrastructure funds in Australia, which are also often open-ended or open-ended. A typical 10-12 year closed-end fund life structure might include a five-year investment (capital deployment) phase (including a one-year initial capital-raising phase) and a of achievement from 5 to 7 years. Accordingly, a company must understand:
- the nature of the fund making the investment (or to whom the investment opportunity is allocated);
- the timing of its investment cycle (particularly if it is closed); and so
- the time horizon in which the fund could be called upon to liquidate.
6. Capacity for follow-up investments.
Beyond the initial investment, companies need to understand the ability of the financial investor to provide additional capital as opportunities for expansion arise (and without relying solely on external leverage to grow the business).
This question is very relevant for closed-end funds, as they generally allow “follow-on investments” even during the execution phase (when new investments are not allowed), but are often subject to rules and limits and to available uninvested capital. Companies should understand the fund’s ability to participate in expansion opportunities.
7. Environment, social and governance (ESG) are real.
The ultimate source of capital managed by professional fund managers is very often retirement savings managed by superannuation and retirement funds, which are often created (and influenced by) law or public policy. It should come as no surprise 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 s ensure that their investments (and therefore the beneficiary Corporates) comply with ESG policies and rules.
Companies should understand that ESG compliance is likely to be high on the list of considerations for financial investors’ investment committees.