Today we are going to go back to school for a few minutes.
The last 2 days I could not turn on the radio, the TV or open a newspaper without hearing or seeing some talking head or even politician sprouting off about venture capital and equity capital as if they actually knew what they were talking about.
Of course, the sound bites are filled with half-truths and downright lies designed to fool the public and are reliant on the general ignorance the people have of business activities.
Without at least a basic understanding of what this is all about, you will not be able to form a real opinion on what is going on. Hence today’s post.
Let’s start with understanding two terms that are seemingly thrown around as if they are the same thing….venture capital and equity capital.
The truth is that these are NOT the same things at all.
Venture capital is funds provided by a venture capital firm to companies that are in the start-up phase of their business. In return for the funding the venture capital firms receive shares. Venture capital investing can happen at several stages of a company’s start-up life….
- It can be real start-up money when the company is little more than a couple of guys with a good idea working in the basement of mom’s house
- it can be early stage…they have moved from the basement and are working on a prototype product and maybe have a few customers lined up
- It can be mid-stage….orders are coming in, sales are being made but not yet profitable
- It can be late stage…on the verge of profitability or maybe already profitable and needs extra capital to expand
Generally, the earlier a VC firm invests, the greater share of the company they take in stock. They are hoping to make a profit when the company IPO’s (initially lists its stock on a stock exchange) or is the target of a trade sale (eg. An IT start-up gets sold to Google).
In the case where there is an IPO, the Company sells 10% - 30% of its stock on Nasdaq or NY Stock Exchange etc. The company gets the money from this “initial” sale of stock. (When the investor who bought the stock resells it, the money goes to him, not the company). Following the IPO, the VC firm is able to sell the stock it holds through the stock exchange and makes it’s profit on that sale.
In the case of a trade sale, the VC sells it’s stock direct to the purchaser (in our example that would be Google) and that is how it makes it’s profit.
If the company fails, the VC loses its money.
Now for private equity firms….a totally different kettle of fish.
Private equity firms search for existing companies that are not operating at their full potential. They rarely consider start-up companies but look for established companies usually with strong brand names. These target companies may be underperforming due to bad management, stale brands, lackluster marketing or any number of things.
There are a number of attributes that make a target company appealing which I will cover in a minute, but first we will look at what the private equity firm does to make money.
The first thing is to find a target that is underperforming. Then the private equity firm will make an offer to buy all or substantially all of the stock of that company. It will always acquire enough to give it absolute control. Once the PE firm gains control of the company and the existing stockholders have been paid out, they then install their own management and set about creating value by making the company more profitable. In some cases this means closing divisions or selling parts of the company. In others it means injecting more money into the company for research and development etc. There are millions of possibilities and the PE firm will look at them all. They make their money by improving the company and then selling it in a trade sale or through an IPO in the same way that a VC does.
But there is another BIG difference.
A VC can make its money ONLY when there is some sort of exit (IPO and trade sale). With a PE firm, there are OTHER options available and this is what separates the real players from the pretenders.
When a PE firm is searching for a target, it has a number of attributes that is seeking. I have already mentioned one…an underperforming company. But there are others:-
- Companies that are worth more if broken up and sold than they are if they remain one company. In this case the PE firm buys the company and then simply sells off the parts immediately, eventually being left with a holding company shell full of cash. They then liquidate the shell and recover the cash profit.
- Companies that have significant unfunded pension liabilities. The unfunded pension liabilities tend to act as a drag on the performance of the company and prevent its ability to raise capital. It also keeps the share price depressed. Buying this company and then renegotiating the pension plan so that the unfunded liabilities reduce creates instant profits through stronger share prices.
- Companies that have big cash reserves and slowing revenues. The reduced revenues will keep the stock price lower notwithstanding the big cash reserves. It may be possible to acquire the company and get control of the cash reserves thereby reducing the cash outlay required to acquire the company in the first place.
- Companies that have pension funds with cash reserves. This was a favorite tool of the corporate raiders of the 70’s and 80’s. Acquire a company with a big pension fund containing cash…sell off or close down the company and the pension fund is no longer required thus enabling that cash to be liquidated back to the stockholders…being the PE firm.
Corporate raiders and asset strippers in the 70’s and 80’s were responsible for a lot of lost jobs as a result of closing companies down to get at the cash in pension funds.
This, my friends, is the dark underbelly of capitalism. Nothing explained above is illegal. The morality of closing a perfectly good company to get at its cash reserves is another question that I do not want to get into here. (Of course, if somebody knew that an offer was to be made for a company's stock and bought that stock based on that information - known as insider trading - that WOULD be illegal ....unless you are a member of congress in which case it is very legal and represents one of the ways congress critters create wealth very quickly after arriving in Washington. See my comments below about a lake of corruption.)
The good side of this is that companies learned. They learned how to protect themselves from such raiders. They learned how to make themselves poor targets…and as a result PE firms found that they had to spend more time looking for turnaround targets and less time wasted on asset stripping opportunities.
Today, asset stripping of this nature is very rare. Not because of government regulation but because of capitalism working.
SO…VC and PE are two very different animals. But where do they get the money to make their investments?
They get it from a number of places. Wealthy individuals could invest in the funds they run….but the largest investors are large funds like high risk mutual funds, and , believe it or not, unions and pension funds are the biggest investors. If you have a retirement fund, chances are that some of your money is invested in these terrible PE firms and VC firms.
Another thing to note is that usually less than 1 in 10 investments made by a VC firm ever return a profit. For PE firms, it is better…maybe 1 in 2 or 1 in 3. But in any event, the risks of losing the investment are high….but the rewards from a winning investment are much higher.
Now that we see the difference between venture capital and private equity firms, let’s look at this crap flying round about Romney.
Bain & Co is a private equity firm. It made plays based on trying to create value by improving the companies it invested in. Sometimes that meant closing down divisions, sometimes they failed and had to close down the whole company.
Sometimes people lost their jobs.
On the upside, sometimes the companies grew, creating new jobs. Sometimes the deal was hugely profitable…giving back massive returns to the investors who then reinvested in further deals, creating more jobs…
If people want to be critical of Romney for being a capitalist, they need to at least understand how it all works and how the flow of capital works.
Think of it this way…capital is like water….only instead of flowing to the lowest point, it flows to the most profitable point. Without capital, the economy would dry up and shrivel just like a tree without water.
It is only when government gets involved and tries to direct the flow of capital by introducing regulatory dams that capital backs up and becomes a lake of corruption for politicians to plunder.
And when that happens, the workers suffer…not because capitalism has failed but because the flow of capital has been restricted.
Now, back to Romney….
In my opinion it is inconceivable that ANY conservative should attack Romney on his record of success in the capitalist system. That should be applauded…always.
Even more disturbing to me is his willingness to try to soften the impact of his capitalist nature by claiming he did nothing different to what Obama did in Detroit. I understand that he was saying he had to cut some jobs and so did Obama…but hiding behind a Marxist as an argument for the actions you take as a capitalist is just pure unadulterated cowardice.
When will the Republicans stand up and tell the country what capitalism really is? When will they get past the guilt of being in the 1% and say…we got here and you can to…if you allow capitalism to do its job.
When will they stand up and say that the likes of Obama and his socialist policies are designed to keep them OUT of the 1%...designed to keep them poor…designed to keep them dependent on the government while the elite enjoy the caviar and champagne?
What is wrong with declaring WAR on socialism and offering a truly different solution?
Romney should have simply said that what he did at Bain was capitalism at its finest…he was a channel for capital to flow through to keep the economy growing. A conduit….one of many who believed in the power of capitalism to make everybody’s lives enriched. Isn’t that the right argument?
What will give people a better life? What will create growth? What will create the value that lifts standard of living? What creates wealth?
How can you argue that when you hide behind a Marxist?
Obama is laughing his ass of this morning because he knows that the Republican candidates are self-destructing.
Stupid is as stupid does….and today we are seeing plenty of stupidity from the candidates.