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Raising private capital

Philip Macalister explains what private capital is, how it works and who should invest in it.

Thursday, December 2nd 1999, 12:00AM

by Philip Macalister

Private capital is all the buzz in the investment world these days - but what is it and why has it so fashionable?

The concept behind private capital is quite simple. A group of people pool their capital together and then use it to invest in unlisted companies to help fund their growth. Normally it is done through third parties which provide the target company with additional skills in the management and marketing areas.

Private capital isn't a new concept, but it's one which has come to the surface during the year with the launch of a number of funds. New Zealand's largest funds manager AMP Asset Management has recently launched its Private Capital Fund which aims to raise $25 million, the New Zealand Stock Exchange is establishing a New Capital Market, former Brierley executive Paul Collins has established Active Equities and Jenny Morel runs the Number 8 fund. Other managers who have been operating in this area are former listed company Direct Capital Partners, Caltech Capital Partners, Todd Capital and Pencarrow Private Equity which runs the Greenstone Fund.

A key difference between private capital and the stock exchange is that listed companies generally have more shareholders and their shares are easily traded.

Pencarrow Private Equity chairman Mark McGuinness says listed companies also have different pressures, such as complying with listing rules.

Such pressures can result in management being focussed on dealing with such issues, rather than concentrating on long term goals and objectives.

"Unlisted companies can take a longer term view and focus on the future," he says.

The emergence of a fledging private capital market illustrates two things. Firstly the New Zealand sharemarket has become a tad boring and its overall performance has been poor. The second being that many businesses find it immensely difficult to find new capital for their businesses, thus their options for growth and expansion are limited.

Much of the blame here is often sheeted back to the banks which have developed a reputation for funding big established business and property ventures, but not small and medium sized enterprises.

McGuinness says that criticism is a little bit harsh on banks, as they are not private capitalists and they have different goals.

He says private capital plays a valuable role as a bridge for companies which are too small for the sharemarket to grow.

Diversified Investment Strategies director Norman Stacey says investors are keen to embrace private capital vehicles because it offers better growth prospects than shares listed on the New Zealand Exchange.

Also, they offer investors a way of supporting New Zealand companies.

"Kiwis love to support Kiwi ventures," he says.

The risks associated with private capital are reasonably high, but if things go right the rewards are rich.

AMPAM is saying that it is targeting a return of five per cent above the NZSE40. While this may not sound like sufficient reward for the risks taken, AMPAM points out returns from the private capital sector offshore have been significantly higher.

For instance a comparable AMPAM offering in Australia has averaged 18.6 per cent annually, while compound returns from 1980-1995 in the United States and the United Kingdom have been 18 per cent and 16 per cent respectively.

One of the major downsides of private capital are that there is a lack of liquidity, therefore an investor wanting out has to sell on a secondary market and that price is generally at a discount. Also, the funds generally have a set life and are closed. For instance the AMPAM fund is for 10 years.

AMP Asset Management managing director Murray Gribben says private capital has higher risk than most other types of investment.

"Business risk and financial risk of individual private capital investments can be very high depending on the nature and stage of the investment. This is not an investment for the risk adverse investor wanting guaranteed, regular returns."

A third downside factor is that it is very difficult to measure a fund's performance against a benchmark such as the NZSE40 as the money flow is varied. With the AMPAM fund the minimum investment, or commitment, is $30,000 and subscriptions are made by instalment when the money is needed. Conversely, if the fund sells a business before the 10 year period is up the money is returned to investors.

With all its risks and rewards private capital is generally something for the big boys.

It's like dynamite really. It can go off with a big bang. The effect of the bang depends on how the dynamite is placed.

Gribben says there are three key elements to making sure private capital is successful.

Firstly, the fund needs to buy well.

He says this stage of the business cycle presents good opportunities to acquire businesses at good prices

In many ways the launch of AMPAM's Private Capital fund is the company saying that it thinks the New Zealand economy is going to experience a period of good growth.

"You wouldn't want to do this heading into a recession," he says.

The second key element in a successful private capital transaction is that the businesses acquired have to be managed well. While a firm like AMPAM provides the financial and capital structure expertise, the management expertise comes from a number of places.

Firstly, a transaction will only take place if the fund has faith in the company's management team. Often in these cases, particularly like management buyouts, there is strong management skills in place.

As part of the deal management are offered significant kickers to make sure they get the runs on the board.

In AMPAM's case it also has built strategic alliances with the three leading private capital teams in New Zealand, namely; the Pencarrow Fund, Direct Capital and Caltech.

Each of these firms have been in the private capital area for sometime and they have plenty of experience.

Gribben says the third element that makes private capital successful is having an exit strategy.

Generally when a firm like AMPAM decides to provide capital to a business it already has an exit strategy broad thought out. This can include a myriad of options ranging from listing on the sharemarket, a trade sale, or a merger with another company.

"You've got to get all these three ingredients right to make money," Gribben says.

Gribben says the risk between venture capital and the other two types of private capital is that the former is much more risky as it's backing and idea, rather than an established business.

With expansion and MBO capital the companies are already in existence and are looking for money to fund growth.

Who does private capital appeal to?

Private capital is generally a form of investment for the sophisticated investor with a significant portfolio.

In the case of AMPAM's fund the minimum entry fee is $30,000. Gribben says private capital is a subset of the equities asset class, and it can account for between 5 per cent and 10 per cent of a portfolio's equity exposure.

He says someone wanting to go into a fund like this needs to have a minimum portfolio of about $200,000-$250,000.

If you can't afford that the NZ Stock Exchange has its own major private capital venture, the New Capital Market (NCM), in the pipeline.

The NCM is being modelled on markets created overseas by exchanges in such places as Alberta, Canada, the UK, France and Germany.

Its aim is to encourage and promote the development of new growth orientated businesses, which will (hopefully) ultimately list on the exchange.

The NCM is due to kick off on March 10, 2000, and details are currently being finalised.

It will work like this. A shell company with cash, but no assets is listed as the capital raising vehicle. The company will then undertake a capital raising and its shares will be traded in its NCM board.

The company will then have 18 months to complete what is called a "key transaction" to the value of at least $1 million. Once the transaction has been completed the company may elect to become fully listed.

While private capital is attractive, it has its risks, McGuinness says. "People have to go into it with their eyes open."

"Frankly, it's not the faint-hearted," he says.

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