22.2.1 Venture Capital

Venture capital (VC), the best known of the private equity categories, is early-stage financing for young firms with high potential growth that do not have a sufficient track record to attract investment capital from traditional sources, like public markets or lending institutions. Entrepreneurs develop business plans and then seek investment capital to implement those plans, since start-up companies are unlikely to produce positive cash flow or earnings for several years. Venture capital typically represents senior equity stakes in firms that are still privately held and are therefore illiquid. VC is a large asset class that is often listed separately from other forms of private equity by investment managers.

The cash flows related to the operations of these nascent firms are typically expected to be negative for several years. The burn rate of young businesses describes the speed with which cash is being depleted through time and can be used to project when the organization will again require outside funding. For example, a company with $30 million of cash that has a burn rate of $2 million per month either will need new cash injections in 15 months or will have to reduce its burn rate, presumably by generating increasing revenues as the firm matures.

Banks, other lending institutions, and the public stock market are generally unwilling to provide capital to support business plans without collateral or without reasonably high probabilities of positive cash flows in the short run. As the source of equity financing to start-up companies, VC is risky, illiquid, and backed by unproven ideas. The strategy is to strive for very high rates of return to compensate for the considerable risks.

Venture capital securities are the privately held stock, or equity-linked securities, that venture capitalists obtain when investing in business ventures that are striving to become larger and to go public. Investors in venture capital securities must be prepared to invest for the long haul; investment horizons may be as extended as 5 to 10 years. During this time, venture capitalists often take active roles in providing managerial guidance and, to varying degrees, exercising managerial control. The ultimate goal of the venture capitalist is for the venture to be successful, usually to the point that the firm can exit the investment at a profit. Exits typically focus on going public (i.e., conducting an initial public offering of the company's securities), but can also include sales to acquiring firms or even a leveraged recapitalization, where the proceeds from the debt are paid to the venture capitalist. Successful start-up companies funded by venture capital include Cisco Systems, Google, Microsoft, and Genentech.

22.2.2 History of Venture Capital

Start-up ventures have been created and financed throughout history, but the first modern venture capital firm was American Research and Development, formed in 1946 as a publicly traded closed-end fund. The first venture capital limited partnership fund was formed in 1958, and the limited partnership form of organization eventually became the standard tool for investing in venture capital.

Institutional investing in venture capital remained limited, due in part to the so-called prudent person standard, or prudent man rule, in the United States. The prudent person standard is a requirement that specifies levels of care that should be exercised in particular decision-making roles, such as investment decisions made by a fiduciary. Prudent person rules were established to ensure competent investment decision-making with regard to the large and growing pension assets and liabilities of U.S. corporations.

The prudent person standard or rule as interpreted prior to 1979 effectively prohibited U.S. pension funds from investing in venture capital funds because of their illiquidity and risk. In 1979, a clarification of the prudent person rule in the United States indicated that venture capital and other high-risk investments should not be considered on a stand-alone basis but on a portfolio basis. Thus, an investment with considerable total risk may be prudent if the marginal contribution of that investment to the risk of the portfolio is reduced through diversification. In addition, the rule clarified that the prudent person test should be based on an investment review process, not on the ultimate outcome of investment results. Therefore, as long as a pension fund investment fiduciary follows sufficient due diligence in considering the portfolio effects of investing in venture capital, the prudent person test is met. The change in the prudent person standard allowed pension funds for the first time to wholly endorse venture capital investing, and therefore opened venture capital to a vast source of capital: retirement assets.

Virtually every attempt to start a new business is venture capital, from the smallest retail store to the largest energy exploration. In terms of numbers, most of these ventures are financed fully by their founders, with little or no capital from others. However, this book is about investing in institutional-quality alternative investments, which form the vast majority of the total financial value of venture capital. Today, venture capital investing is dominated by the ownership structure illustrated in Exhibit 22.1. Specifically, large private equity firms launch multiple private equity funds, which attract institutions as limited partners. The private equity funds deploy capital by purchasing private equity securities in underlying business enterprises, that are referred to as the portfolio companies.

22.2.3 Overview of Buyouts

The terms for purchasing partial or total control of a company are not universal or clearly delineated. Since this chapter is on private equity, the focus is on transactions that generate privately owned claims on equity or equity-like positions. The most broad and generic term for these transactions is buyouts.

In the context of private equity, buyouts are the purchase of a public company by an entity that has a private ownership structure. Buyouts are distinguished from mergers by the extent to which the firm that is bought out is intended to function as a stand-alone business rather than to be folded into the organization of the purchaser.

Buyouts typically use debt financing, either through bank loans or with newly issued bonds, to purchase the outstanding equity of the target company. Typically, these loans and bonds are secured by the underlying assets of the company being acquired.

The buyout is described as leveraged when, after the buyout, the debt-to-equity ratio is much greater than before the acquisition. In fact, the debt-to-equity ratio can be as high as 9:1, meaning the capital structure of the company after the buyout is 90% debt and 10% equity.

Distinctions between buyouts tend to focus on the purpose of the buyout and the management team that will operate the target firm. The largest type of buyout is a leveraged buyout, discussed in detail in Chapter 23 along with specific subcategories of leveraged buyouts.

22.2.4 History of Buyouts

Although buyouts began after World War II, it was not until the 1970s that their investment value became apparent. In 1976, a new investment firm, KKR, was created on Wall Street with just $3 million of its own funds to invest. The founders of KKR had previously worked at Bear Stearns Companies, where they helped pioneer buyout transactions as early as 1968. No firm has had a greater impact on the buyout market than KKR, which has conducted landmark transactions, such as the buyout of RJR Nabisco.

The 1980s witnessed the rise of a key element of the growth in buyouts: financing of the buyouts using bonds with low credit ratings, known as junk bonds. Junk bonds are debt instruments with high credit risk, also referred to as high-yield, non-investment-grade, or speculative-grade debt. Bonds with low credit ratings previously existed, primarily as a result of a decline from an initial investment-grade rating. Michael Milken of Drexel Burnham Lambert helped pioneer the use of high-yield debt as a financing tool by issuing junk bonds to finance buyouts.

Fueled by junk bond financing, buyout deals reached an initial peak in 1989, when KKR bought the giant food conglomerate RJR Nabisco Inc. for $31 billion in a deal that was documented in the book and movie Barbarians at the Gate.² This buyout would stand as the largest buyout for many years, until KKR surpassed the RJR Nabisco deal in 2006 with its bid for TXU Corporation, a major Texas-based utility company. The subsequent large debt load of Energy Future Holdings, the holding company successor to TXU, led to its bankruptcy in 2014. The bankruptcy is also attributed to the company's heavy reliance on coal-fired generation facilities, which struggled to compete with natural gas power production due to the depressed prices of natural gas and the increased supply of natural gas from improved production techniques (e.g., fracking).

In the 1990s, buyout activity declined for two reasons. First, the recession of 1990–91, that affected most major world economies, briefly pushed credit spreads to high levels and thus dampened the attractiveness of junk bond financing for buyouts. Second, in 1998, the Russian government defaulted on its sovereign bonds, which once again sent credit spreads spiraling upward. Whereas debt represented as much as 95% of the financing of some buyout deals during the 1980s, by the end of the 1990s, buyouts financed with more than 75% debt were viewed as unattractive.

The new millennium started quietly for the buyout market, but availability of credit increased in the United States and elsewhere, leading to an unparalleled boom in buyouts from 2003 into early 2007. This buyout boom culminated in the largest buyout ever: the $45 billion buyout of TXU Corporation. But by late 2007, the liquidity bubble had burst, leading to the credit problems of 2008 and the swift decline of buyout activity. Thus, buyout activity is driven not just by economic growth but also by interest rates and credit spreads.

Buyout activity was previously thought to take place in a segmented market. Segmentation in this context denotes the grouping of market participants into clienteles that focus their activities within specific areas of the market, rather than varying their range of activities more broadly throughout all available opportunities. When a market is segmented, the valuations in that market can vary based on the preferences of the clienteles that dominate the particular segments. For example, it is often argued that the fixed-income market is segmented based on the maturity ranges in which different investors (clienteles) prefer to invest. Thus, short-term yields might be argued to be driven by money market investors, whereas longer-term yields are driven by pension and insurance firms in a segmented market.

Buyout activity was also previously thought to take place in an inefficient market. Inefficiency refers to informational inefficiency, the idea that transactions take place with relatively large divergences between the actual prices of the transactions and the true underlying values of those transactions based on all available information. Segmentation can lead to informational market inefficiency.

However, substantial buyout activity has caused the evolution of the market for buyouts into a more efficient, auction-driven asset class, in which greater competition has reduced abnormal profit opportunities.

22.2.5 Merchant Banking

Merchant banking is so closely related to buyouts that it is sometimes difficult to distinguish between the two. Merchant banking is the practice whereby financial institutions purchase nonfinancial companies as opposed to merging with or acquiring other financial institutions. Most major banks have merchant banking units. These units buy and sell nonfinancial companies for the profits that they can generate, much as in the case of buyouts. In some cases, the merchant banking units establish limited partnerships, similar to buyout funds. At that point, there is very little distinction between a merchant banking fund and the buyout funds discussed earlier, other than that the general partner is a financial institution.

Merchant banking started as a way for investment banks and money center banks to establish an equity participation in the enterprises they helped fund. If a bank lent money to a buyout group to purchase a company, its merchant banking unit also invested some capital as equity capital and received an equity participation in the deal. Soon, the merchant banking units of investment banks established their own buyout funds and created their own deals.

Whereas merchant banking is designed to earn profits for the bank, it also allows the bank to expand its relationship with the buyout company into other money-generating businesses, such as underwriting, loan origination, merger advice, and balance sheet recapitalization. All of this ancillary business translates into fee generation for the investment bank.

22.3.1 Mezzanine Debt

Mezzanine debt contains both equity-like and debt-like features and is referred to as mezzanine because it is inserted into a company's capital structure between the floor of equity and the ceiling of senior secured debt. Mezzanine debt is often viewed as a form of private equity because of its high risk and because it often comes with potential equity participation, although it appears as debt on an issuer's balance sheet. More often than not, mezzanine debt represents a hybrid, meaning a combination of debt and equity.

Typically, mezzanine financing is constructed as an intermediate-term bond, with some form of equity kicker thrown in as an additional enticement to the investor. An equity kicker is an option for some type of equity participation in the firm (e.g., options to buy shares of common stock) that is packaged with a debt financing transaction. The equity kicker portion provides the investor with an interest in the upside of the company, whereas the debt component provides a steady payment stream. Exhibit 22.2 illustrates the location of mezzanine debt in the capital structure of a firm relative to other financing sources. The gap that mezzanine finance fills can be quite large and include several tranches of junior debt or preferred equity.

Mezzanine financing is generally not used to provide cash for the day-to-day operations of a company. Instead, it is used during transitional periods in a company's life. Frequently, a company is in a situation in which its senior creditors are unwilling to provide any additional capital, and the company does not wish to issue additional stock. Mezzanine financing can fill this void. Additionally, mezzanine debt is closely linked to the buyout market, since it is often used to finance buyouts.

Mezzanine debt has become increasingly popular, as banks and other senior debt lenders have become less aggressive about providing capital, and there are fewer major lending institutions in the bank market. Still, mezzanine financing is a niche market, operating between so-called story credits and the junk bond market. A story credit is a debt issue with credit risk based on unusual circumstances, and may involve special aspects, such as corporate reorganizations, that distinguish their analysis from more traditional circumstances and as such involve a story. Generally, story credits are senior secured financings of firms with good credit. However, not all firms that issue mezzanine debt have good credit or interesting stories. In fact, firms for which the debt is their only viable source of financing may issue mezzanine debt.

Mezzanine financing is often described as a middle-market vehicle. The middle market refers to companies that are not as large as those companies that have ready access to the financial markets but are larger than companies seeking venture capital. Companies in this middle-market category form an important sector of most developed economies and generally have a market capitalization in the range of $200 million to $2 billion. These middle-market companies often use mezzanine financing in the range of $5 million to $50 million to complete small acquisitions, although higher amounts are common for other purposes.

22.3.2 Distressed Debt

Distressed debt investing is the practice of purchasing the debt of troubled companies, requiring special expertise and subjecting the investor to substantial risk. These troubled companies may have already defaulted on their debt, may be on the brink of default, or may be seeking bankruptcy protection. Like the other forms of private equity previously discussed, this form of investing requires a longer-term horizon and the ability to accept the lack of liquidity for a security for which often no trading market exists.

Similar to the mezzanine debt just discussed, the returns to distressed debt tend to depend little on the overall performance of the stock market. This is because the value of the debt of a distressed or bankrupt company is more likely to rise and fall with the fortunes of the individual company, which in turn are driven mostly by idiosyncratic factors. In particular, the company's negotiations with its creditors have a much greater impact on the value of the company's debt than does the performance of the general economy.

The key to distressed debt investing is to recognize that the term distressed has two meanings. First, it means that the issuer of the debt is troubled; the face value of its liabilities may exceed the value of its assets, or it may be unable to meet its debt service and interest payments as they come due. Therefore, distressed debt investing almost always means that some workout, turnaround, or bankruptcy solution must be implemented for the bonds to appreciate in value. Second, distressed refers to the price of the bonds. Distressed debt often trades for pennies on the dollar. This affords a savvy investor the opportunity to earn extraordinary returns by identifying a company with a viable business plan but a short-term cash flow problem.

Distressed debt investors are often referred to as vulture investors or just vultures because they are alleged to feast on the remains of underperforming companies. They buy the debt of troubled companies, including subordinated debt, junk bonds, bank loans, and obligations to suppliers. Their investment plan is to buy the distressed debt at a fraction of its face value and then seek improvement of their position through major changes in the assets, capital structure, or management of the company.

Both hedge funds and private equity funds invest in distressed debt. The goal of hedge funds in the distressed debt space is mainly to earn short-term trading profits from their event-driven strategy, typically waiting for a catalyst from the resolution of issues in the bankruptcy court. Private equity investors in distressed debt typically have a longer time horizon. In fact, many private equity investors may take control of a company's equity through their distressed debt position, or even hold publicly traded equity that may be distributed through the bankruptcy process.

22.3.3 Growth of the Distressed Debt Marketplace

Distressed debt originates at a higher credit quality and declines to a more speculative credit level because of the subsequent financial difficulties of the borrower. Distressed debt does not have a single clear and rigid definition. The credit quality that indicates distressed debt is often expressed with different criteria. One simple definition of distressed debt is any liability that trades at less than half of its principal value. Thus, a coupon-bearing bond with a face value of $1,000 is considered to be distressed debt if it trades for less than $500. Another definition is that its yield to maturity is 1,000 or more basis points over the riskless rate (e.g., a U.S. Treasury rate of comparable maturity). Finally, if rated, the rating of distressed debt is usually CCC from Standard & Poor's, Caa from Moody's Investors Service, or lower.

Credit markets appear to follow a cycle. During periods of great economic expansion, credit use expands, credit standards loosen, and yield spreads tighten. During this expansion, the seeds for distressed debt are planted. When a recession or credit crisis occurs, the perceived quality of existing debt tumbles, as indicated by credit ratings; new credit becomes scarce, and yield spreads widen. The quantity of distressed debt soars as recessions deepen, credit markets deteriorate, and operating firms suffer.

Factors other than general economic performance also drive the size of the distressed debt market. The distressed market grew dramatically in the first decade of the new millennium through expansion of innovative financing. First, the types of commercial loans available for resale rose. In addition to the traditional industrial loans that were routinely bought and sold in the secondary market, there were many new types of charge-off loan portfolios brought into the secondary market. Charge-off loans are the loans of a financial institution or other lender that have been sold to investors and written off the books of the lender at a loss. These loans included auto deficiencies, credit card paper, medical and health-care receivables, personal loans, retail sales agreements, and insurance premium deficiencies, as well as aviation, boat, and recreational vehicle loans.

Second, many more banks and other lenders began managing their assets from a larger portfolio perspective, as opposed to an account-level basis. Proactive bank risk management techniques are being applied that prune or groom a portfolio to achieve a desired risk-return balance. The result is that banks are increasingly willing to sell nonperforming and underperforming loans into the market at large discounts to get them off their books.

Third, debt loads have generally risen through the years. In particular, the volume of very low-quality debt, CCC (Caa) or below, as a percentage of total high-yield bond issuance (BB, Ba, or below) has grown substantially in recent years.

Another factor in the growth of the distressed market has been the explosion of covenant-light (cov-lite) loans. Covenant-lite loans are loans that place minimal restrictions on the debtor in terms of loan covenants. Covenants are promises made by a debtor to the creditor that strengthen the perceived credit quality of the obligation. Loan covenants may be required by creditors to protect their interests, or they may be offered by debtors to negotiate better terms. Negative covenants are promises by the debtor not to engage in particular activities, such as paying dividends or issuing new debt. Positive covenants are promises to do particular things, such as maintain a specified cash level. Loans with minimal covenants tend to be more likely to become distressed, everything else being equal.

Another distinction between covenants is incurrence covenants versus maintenance covenants. Incurrence covenants typically require a borrower to take or not take a specific action once a specified event occurs. For instance, if an incurrence covenant states that the borrower must maintain a limit on total debt of five times EBITDA (earnings before interest, taxes, depreciation, and amortization), the borrower can take on more debt only as long as it is still within this constraint. A borrower that breaches this covenant by incurring additional debt is in default of the covenant and the loan. However, if the borrower found itself above the five times EBITDA limit simply because its earnings and cash flow had deteriorated (without having incurred additional debt), it would not be in violation of the incurrence covenant and would not be in default. Cov-lite loans have bond-like incurrence covenants, much like high-yield bonds.

Maintenance covenants are stricter than incurrence covenants in that they require that a standard be regularly met to avoid default. Returning to the previous example of a covenant wherein the debt is limited to five times EBITDA, in the case of a maintenance covenant, the borrower must pass this test each and every quarter, regardless of whether it added more debt or its earnings and cash flow deteriorated. Thus, the covenant would be triggered if the borrower's earnings and cash flows eroded, even if the firm did not issue new debt. Clearly, maintenance covenants are much stronger than incurrence covenants. Without maintenance covenants, lenders do not have the ability to step in at an early stage to reprice risk, restructure the loan, or shore up collateral provisions.

A factor in the size of the distressed debt market is the level of mergers and acquisitions (M&A) and buyout activity. Many acquisition and buyout deals go bad and turn into distressed debt situations. Consider the acquisition of Lyondell Chemical Company by Basell in 2007. The terms of the deal resulted in a purchase price of almost $20 billion. To finance the deal, a total of $20 billion of first, second, and third lien loans were issued by a variety of large banks, including Goldman Sachs, Citigroup, ABN Amro, UBS, and Royal Bank of Scotland. Unfortunately, the global economic slowdown led Lyondell to file for chapter 11 bankruptcy in January 2009. Hence, the debt generated by the deal became distressed debt within two years of the acquisition. At that time, Lyondell loans were trading at 21 to 25 cents on the dollar, and Citigroup, for example, wrote down the value of its loan to Lyondell from $2 billion to $600 million, a 70% haircut on its debt. In finance, the term haircut usually refers to a percentage reduction applied to the value of securities in determining their value as collateral. However, the term can also be used to refer more generally to any percentage reduction in financial value.

22.3.4 Leveraged Loans

Another asset class of fixed-income securities that private equity firms have moved into is leveraged loans. Leveraged loans are syndicated bank loans to non-investment-grade borrowers. The term syndicated refers to the use of a group of entities, often investment banks, in underwriting a security offering or, more generally, jointly engaging in other financial activities. Loans made by banks to corporations can be divided into two general classes: (1) those made to companies with investment-grade credit ratings (BBB or Baa and above), and (2) those made to companies with non-investment-grade credit ratings (BB or Ba and lower). This second class of loans refers to leveraged loans.

A leveraged loan is made to a corporate borrower that is leveraged—that is, a company that is not investment grade, often due to excess leverage on its balance sheet. Thus, the word leveraged refers to the use of leverage by the borrower. The loan has a second lien interest after other senior secured loans. The second lien loan market is often viewed synonymously with the leveraged loan market.

Exact definitions of a leveraged loan vary. Generally, a loan is considered leveraged if (1) the borrower has outstanding debt that is rated below BBB by Standard & Poor's or lower than Baa by Moody's, or (2) the loan bears a coupon that is in excess of 125 to 200 basis points over the London Interbank Offered Rate (LIBOR). A leveraged loan for a firm without a rating is identified by having a coupon that is in excess of LIBOR by a particular number of basis points, which varies through time and by source. The standard for that spread should be linked to the spreads observed in credit markets for loans rated BB (Ba) or lower. In other words, a leveraged loan for an unrated firm would have a credit spread similar to the credit spreads on bank loans of firms with non-investment-grade credit ratings.

In many respects, leveraged loans are similar to high-yield debt or junk bonds in terms of credit rating and corporate profile. Many non-investment-grade corporations have both high-yield bonds and leveraged loans outstanding. Since private equity firms are accustomed to dealing with banks and other fixed-income investors to finance their buyouts, leveraged loans provide a natural extension of their financing business.

22.3.5 Growth of Leveraged Loans

The growth of leveraged loans has been driven by the development and expansion of their secondary market. Secondary trading of leveraged loans improved substantially with the introduction of their credit ratings by recognized rating agencies. For example, Moody's began to assign credit ratings to bank loans in 1995 and has rated trillions of dollars of bank loans since. An active secondary market has encouraged banks to issue loans and has motivated institutions to invest in those loans. With the entry of institutional investors into this market through private equity vehicles, leveraged loans have become an accepted form of investing, and the rate of issuance of leveraged loans has surpassed that of high-yield financing.

Many large commercial banks have changed their business model from that of a traditional lender, in which the bank loans are kept on their balance sheets, to that of an originator and distributor of debt. These commercial banks are in the fee-generation business more than the asset-management business. Origination and distribution of bank loans allows these banks to both collect fees and manage their credit risk. In short, these commercial banks are capitalizing on their strengths: lending money, collecting loan fees, and then divesting the loans into a secondary market. The subsequent management of the resulting assets (the leveraged loans) is left to institutional investors who acquire the loans through the secondary market.

22.4.1 Business Development Companies

Business development companies (BDCs) are publicly traded funds with underlying assets typically consisting of equity or equity-like positions in small, private companies. BDCs use a closed-end structure and trade on major stock exchanges, especially the NASDAQ.

BDCs are investment companies with a primary purpose of pooling financial assets and issuing pro rata claims against those assets. The key to investment companies is that they can avoid the double taxation of corporate profits discussed in Chapter 13. Investment companies holding listed financial assets were authorized in the United States by the Investment Company Act of 1940. Legislation in the United States allowing BDCs to qualify as investment companies and enjoy a pass-through income tax status originated from amendments to the '40 Act in 1980. However, BDCs did not become popular until much later (approximately 2012).

To be classified as a BDC and enjoy the accompanying benefits, such as avoiding corporate income tax, a BDC must provide significant managerial assistance to the firms that it owns and must invest at least 70% of its investments in eligible assets, as specified by the Securities and Exchange Commission (SEC).

BDCs enable liquid ownership of pools of illiquid private equity, just as REITs can be used to provide liquid access to illiquid private real estate. The shareholders are subject to income tax on the distributed profits. Any profits retained at the BDC level are subject to corporate income tax. Therefore, most BDCs distribute almost all profits to shareholders to avoid the income tax on retained earnings.

Recent figures indicate that there are more than 40 BDCs in the United States, with over $30 billion of combined market value. A few of the largest BDCs fall into the mid-cap category in terms of total market capitalization. Over 90% of the BDCs fall into the small-cap category.

BDCs are tracked by several indices and ETFs, including at least one ETF that is leveraged. The indices and ETFs use market weights or modified market weights and tend to cover virtually all listed U.S. BDCs. As discussed in the next section, the market prices of BDCs reflect their underlying closed-end fund structure.

22.4.2 Business Development Companies as Closed-End Funds

BDCs use a closed-end fund investment structure that transforms ownership of underlying fund assets into shares (tradable pro rata claims). A major attribute of a closed-end structure is that it facilitates liquid ownership of illiquid pools of assets much better than would an open-end structure. Closed-end funds are especially popular in facilitating ownership of municipal bonds, international stocks, and illiquid instruments.

As detailed in Chapter 15, an open-end mutual fund has serious flaws with regard to providing liquid access to investors when the fund holds large quantities of highly illiquid pools of assets. Open-end funds must redeem shares on a regular basis, which can be difficult when holding illiquid assets, such as those held by BDCs. The primary distinction of closed-end funds relative to open-end funds is that the closed-end investment company does not regularly create new shares or redeem old shares in order to meet the desire of investors to invest in the fund or divest from the fund. Therefore, closed-end funds avoid the problems caused in open-end funds by using inaccurate net asset values (NAVs), as measured by the investment company, to create and redeem shares. However, closed-end funds introduce another problem: When investors transact in the secondary market, the price per share that they receive or pay may be highly subject to short-term supply and demand factors in the secondary market.

When there is a surge in demand for closed-end fund shares from investors who wish to establish or expand positions in a particular closed-end fund, the market price of the closed-end fund must rise until the supply of shares meets the demand. The price rises to encourage increased supply of shares from sales by existing shareholders and to discourage demand for shares from prospective shareholders. Similarly, when there is a surge in supply of closed-end fund shares from investors who wish to exit their holdings, the market price must decrease to restore a balance between the supply and demand for the fund's shares in the secondary market.

Closed-end fund share prices are often viewed relative to the net asset value per share that is reported by the investment companies. For example, a closed-end fund that reports a net asset value of $20 per share is said to be selling at a 5% premium if the market price is $21. If the market price of the closed-end fund is $18.50, the closed-end fund shares would be said to be selling at a discount of 7.5%. The formula for the premium (or discount if negative) of a closed-end fund share price is shown in Equation 22.1:

(22.1)

The left-hand side of Equation 22.1 is typically expressed as a percentage and is termed a discount if the value is less than 0%.

As illustrated in the example, large temporary changes in supply and demand can cause substantial dislocations of the market price of a closed-end fund. Investors with positions in closed-end funds bear the risk that they will liquidate their shares at a time when the market price of the shares has been substantially reduced by selling pressures. Thus, returns from investing in closed-end fund structures are driven both by the returns of the underlying assets and the premiums or discounts of the fund shares when positions are established and closed.

During periods of severe illiquidity caused by a financial crisis or another major event, closed-end fund discounts have been observed to reach extreme levels. Owners of closed-end fund shares needing to exit their investment in a liquidity crisis experience the double loss of selling not only when NAVs are down but also when the market price of the closed-end fund is at an extreme discount to its NAV. Thus, investors in BDCs are potentially exposed to especially large losses in the event of liquidations during periods of severe illiquidity. Note that an open-end mutual fund with listed equities as underlying assets would allow liquidation at NAVs based on market prices.

Finally, it should be noted that for many closed-end fund structures, the underlying assets are market traded, and the computation of the fund's NAV is straightforward. The premium or discount of such funds tends to be a simple and effective indicator of the attractiveness of the fund's market price. However, in the cases of BDCs, REITs, and other funds with unlisted underlying assets, the reported NAVs are based on non-market valuations, such as professional appraisals or accounting standards. When the NAVs are based on subjective valuation methods rather than current market prices, the premiums or discounts of the closed-end fund shares may be poor indicators of the attractiveness of the fund's shares, because the NAVs themselves may be flawed indicators of the actual underlying values.

22.4.3 Extending Closed-End Fund Pricing to Illiquid Alternatives

As detailed in the previous section, the premiums and discounts of closed-end fund share prices are generally perceived as varying, based on both large purchases by entities attempting to enter positions and large sales by entities attempting to exit positions. The direct application of these supply and demand pressures to BDCs is straightforward, since BDCs use a closed-end fund structure. However, the principles may be even more applicable to the transaction prices of illiquid alternatives. For example, when the limited partner of a private equity partnership or other illiquid alternative investment wants to exit an investment, how much of a “discount” might that seller be forced to offer in order to entice a prospective buyer to purchase the position?

Careful observation and understanding of the behavior of closed-end fund share prices provide indications of the effect of illiquidity on transaction prices. In the previous section, there was an example of a closed-end fund moving from trading at a 10% premium to a 12% discount. Although the transaction prices and underlying net asset values of private partnerships are usually not quoted on a daily basis, the concept of illiquid assets trading at premiums and discounts applies. Simply put, the realized returns of private equity investors who must liquidate their positions may be low when liquidity is poor, whether or not the investment uses a closed-end structure.

22.4.4 Are Liquid Private Equity Pools Diversifiers?

Most private equity is not directly listed or publicly traded. Private equity is often described as offering substantial diversification benefits. However, the lack of market prices on private equity makes substantiation of such claims difficult. Prices for private equity based on illiquid trading data or professional judgment can be argued to be smoothed (as discussed in Chapter 10), and therefore analysis based on those data should be expected to underestimate true volatilities and correlations.

However, listed BDCs provide an opportunity to observe market prices of private equity. As in the case of real estate and REITs, the market data on liquid alternatives can be analyzed to provide evidence regarding the correlations and volatilities of the underlying illiquid assets. A critical underlying issue is how the returns of liquid private equity (e.g., BDCs) compare to the returns of illiquid private equity (e.g., private partnerships) when the underlying assets are similar.

Exhibit 22.3 indicates the volatilities and correlations of three ETFs based on total returns over the 38 months from the start of May 2011 through the end of June 2014. BDCS represents a large ETF that tracks the U.S. BDC sector. SPY is a massive ETF tracking the S&P 500 Index, and IWM tracks the Russell 2000. The Russell 2000 is an index dominated by small-cap U.S. equities with perhaps less than 10% exposure to mid-caps.

As indicated in Exhibit 22.3, the BDCS ETF had high correlations of monthly returns with the monthly returns of both SPY and IWM. The correlation of BDCS with the small-cap index (IWM) was slightly higher. As observed in numerous analyses of REITs, the liquid alternatives appear to take on correlations more closely with small caps than with large caps. The BDCS ETF had a volatility of monthly returns approximately midway between the volatilities of SPY and IWM. In theory, the volatility of BDCS should be driven by the volatilities and correlations of the returns of the small business ventures that underlie all BDCs.

The results in Exhibit 22.3 are roughly analogous to the results for REITs, based on numerous studies involving a variety of time periods. Simply put, listed liquid alternative investment companies appear to exhibit return performance that is highly correlated with listed equities in general. In particular, performance is most highly correlated with equities of similar capitalization size. Exhibit 22.3 therefore provides evidence that BDCs do not serve as effective diversifiers relative to listed equities.

22.4.5 Are Liquid Private Equity Pools Return Enhancers?

Exhibit 22.3 lists the mean monthly returns of the three ETFs: BDCS, SPY, and IWM. The mean monthly returns indicate that BDCS underperformed the S&P 500 ETF and the Russell 2000 ETF. Performance in Exhibit 22.3 is measured over 38 months, a performance period that is too short to develop firm conclusions on mean returns. Nevertheless, it should be pointed out that investors in BDCS incur two levels of fees. First, BDCS imposes fees at the ETF level and has an expense ratio substantially higher than the expense ratios of many large ETFs, such as SPY. Second, the portfolio companies (i.e., the underlying BDCs) also have potentially large expense ratios.

Private equity accessed through private limited partnerships is also subject to substantial management fees, including incentive fees. Perhaps the critical determinant of long-term private equity performance is the quality of the management teams. Therefore, a key issue in determining whether liquid private equity funds such as BDCs can provide return enhancement is whether the BDCs offer superior management teams that can successfully acquire and manage underlying business enterprises.

22.4.6 Other Liquid Investments in Private Equity

While there is not a large availability of private equity strategies in the liquid alts world, those strategies that are available fit best in the closed-end fund format, as the relatively permanent capital matches the constrained liquidity of the underlying investments. Some investors will proxy private equity investments by investing in the publicly traded shares of private equity asset management companies, such as Carlyle, Blackstone, Apollo, Oaktree, or KKR. As these companies earn larger carried interest from high returns to their private equity fund offerings, their earnings per share are likely to increase and drive the stock prices higher, which gives investors an indirect exposure to the returns of the private equity industry.

Direct exposure can be achieved through listed companies, such as Onex, that hold stakes in a large number of private companies. It should be noted that these stocks might trade at a premium or discount to the estimated values of the underlying holdings, as there is no arbitrage mechanism that converges the daily liquid price of the shares of the holding company toward the stated NAV of the private holdings.

22.5.1 The Private Equity Partnership Secondary Markets

In this section, secondary trading of other private equity interests is discussed. Many private equity interests are organized as limited partnerships. A limited partnership (LP) interest in a private equity fund is a security for purposes of securities laws, such as those of the United States. However, these LP interests are unregistered; that is, they are privately negotiated and privately traded securities; they are not listed on an exchange and not required in the United States to be registered with the SEC. The lack of registration and public trading makes the purchase and sale of LP interests less liquid than public market stock or other registered securities. Investors in private equity are typically subject to a 10-year lockup period, during which they see a return of capital only once an exit has occurred. Investors wishing to liquidate their investment before these exits have been realized will need to access the secondary market.

Most investors considering the acquisition of an investment take into account its liquidity, which means the ability to sell the investment without needing to offer a substantial discount from the value that would be obtained in a liquid market. There are three primary reasons that a private equity investor may need to sell part of a portfolio:

1. To raise cash for funding requirements: For example, a pension fund may need to generate cash to fund retirement benefits for pension recipients.
2. To trim the risk of the investment portfolio: During the credit and liquidity crisis that began in 2007, many large investors decided that they needed to strategically adjust the risk profiles of their investment portfolios.
3. To rebalance the portfolio from time to time: This is a form of active portfolio management, mainly for institutional investors, in which allocations to asset classes are sometimes decreased, resulting in a partial liquidation of an asset class.

These three reasons are about the strategy and the structure of the selling investor. The motivation to sell secondary private equity interests is typically not about the value of the underlying investment. Without a secondary market, these liquidity needs might be more difficult or expensive to meet, leading an institution to allocate less to private equity or to demand higher expected returns in compensation. With an active secondary market, the institution not only can meet liquidity needs at lower costs but also can better understand and manage its risk exposure through the information and opportunities provided by the market and its prices.

General partners usually do not like to see their investors sell their limited partnership interests to outside third parties. Therefore, a key risk is that once a limited partner sells its stake in a private equity fund in a secondary market transaction, the general partner of the fund is unlikely to invite that limited partner to join in future private equity funds that the general partner sponsors.

From a buyer's perspective, there are several advantages to a secondary purchase of private equity limited partnerships: (1) the investor might gain exposure to a portfolio of companies with a vintage year that is different from the investor's existing portfolio; (2) secondary interests typically represent an investment with a private equity firm that is further along in the investment process than a new private equity fund and may be closer to harvesting profits from the private portfolio; (3) purchasing the secondary interest of a limited partner who wishes to exit a private equity fund may be a way for another investor to gain access to future funds offered by the general partner; and (4) the buyer may see greater potential for cash flows from the secondary portfolio than current primary investments. Simply stated, this is opportunistic buying, especially when the discounts to NAV are large.

22.5.2 Private Investments in Public Equity

Private investments in public equity (PIPE) transactions are privately issued equity or equity-linked securities that are placed outside of a public offering and are exempt from registration. Investors purchase the securities directly from a publicly traded company in a private transaction. In other words, the “public” part of the name reflects that they are vehicles for publicly traded companies to issue additional equity shares (or other securities) in their firms. The “private” part of the name reflects that the securities are sold directly to investors, who usually cannot trade them in secondary markets for a specified period of time. The greatest advantage for the issuing company is that it can quickly raise capital without the need for a lengthy registration process, which can take up to nine months, whereas a PIPE transaction can be completed in just a few weeks.

In the United States, PIPE issuers can be anything from small companies listed in the OTC market to large companies listed on the New York Stock Exchange (NYSE). Some PIPE transactions involve small, nascent corporations of the type that interest venture capitalists. They are also often issued by small to medium-size firms that may face difficulties, expenses, or delays in using public security offerings. The typical profile is a company with a market capitalization of under $500 million that seeks an equity infusion of between $10 million and $75 million. However, some PIPE transactions involve established public companies, the domain of the buyout market. Larger companies view PIPEs as a cheaper process for raising capital quickly, especially from a friendly investor. Further, the management of the company does not need to be distracted with the prolonged road show that typically precedes a public offering of stock. Management can remain focused on the operations of the business while receiving an equity infusion that strengthens the balance sheet. Last, the documentation required for a PIPE is relatively simple, compared to a registration statement. Typically, all that is needed is an offering memorandum that summarizes the terms of the PIPE, the business of the issuer, and the intended uses of the PIPE proceeds.

With the bull stock market of the 1990s, PIPEs surged in popularity. The advantages that PIPE deals offer investors and the variety of securities that can be issued include the following:

• PRIVATELY PLACED COMMON STOCK: The greater the illiquidity, the greater the discount on the PIPE's issue price.
• REGISTERED COMMON STOCK: The advantage to the investor is that it can acquire a block of stock at a discount to the public market price for the registered common stock. This is particularly appealing for private equity firms that have large chunks of cash to commit to companies.
• CONVERTIBLE PREFERRED SHARES OR CONVERTIBLE DEBT: Conversion prices embedded in preferred stock and convertible debt tend to be lower than the conversion prices on publicly traded instruments. In addition, the issuer of the PIPE usually commits to register the equity securities within the next six months. This feature is particularly appealing for private equity firms, as they are able to purchase cheap equity with a ready-made exit strategy.
• EQUITY LINE OF CREDIT: An equity line of credit (ELC) is a contractual agreement between an issuer and an investor that enables the issuer to sell a formula-based quantity of stock at set intervals of time.

Another reason private equity firms are interested in PIPEs is that they allow the private equity firm to gain a substantial stake in the company, even control, at a discount. This is very enticing to private equity firms, which normally have to pay a premium for a large chunk of a company's equity.

The biggest distinction between PIPEs is that of traditional PIPEs and structured PIPEs. The large majority of PIPE transactions are traditional PIPEs, in which investors can buy common stock at a fixed price. Most traditional PIPE transactions are initiated using convertible preferred stock or debt with a fixed price at which the securities can be converted into common stock. The conversion price is the price per share at which the convertible security can be exchanged into shares of common stock, expressed in terms of the principal value of the convertible security. The conversion ratio is the number of shares of common stock into which each convertible security can be exchanged. The conversion ratio and the conversion price are inversely related measures of the same concept.

Having a fixed conversion price or conversion ratio limits the amount of dilution to existing shareholders. Also, the convertible preferred stock or debt may provide the investor with dividends and other rights in a sale, merger, or liquidation of the company that are superior to the residual claims of the existing stockholders.

Structured PIPEs include more exotic securities, like floating-rate convertible preferred stock, convertible resets, and common stock resets. These PIPEs have a floating conversion price that can change depending on the price of the publicly traded common stock. They are sometimes referred to as floating convertibles because the conversion price of the convertible preferred stock or debt floats up or down with the company's common stock price.

The structuring of PIPEs can lead to the financial situation of a toxic PIPE or a so-called death spiral. A toxic PIPE is a PIPE with adjustable conversion terms that can generate high levels of shareholder dilution in the event of deteriorating prices in the firm's common stock. Floating convertibles received a bad reputation because, unlike standard convertible bonds or preferred stocks, which get converted at a fixed conversion price, the conversion price for toxic PIPEs adjusts downward whenever the underlying common stock price declines. The drop in stock price leads to a drop in the conversion price, which can lead to a substantial dilution of shareholder value.

For example, under a structured PIPE, if the stock price of the issuer declines in value, the PIPE investor receives a greater number of shares upon converting the PIPE. Expressed differently, the conversion price of the PIPE declines commensurately with the underlying stock price. This can lead to a situation that is potentially poisonous to the issuing company's financial health. A toxic PIPE can generate the following sequence:

• A company goes public before it has a chance to fully establish its business strategy.
• The company quickly burns through its IPO cash and needs more capital to continue its growth.
• Due to the company's unstable balance sheet and uncertain cash flows, the public stock market is not viable for further public offerings of its common stock.
• Private equity investors agree to provide more capital in return for structured PIPEs that can be converted into stock at a floating conversion rate and at a discount to the common stock price.
• The stock price of the company falls. The price decline may be triggered by private equity investors short selling the publicly traded stock of the company to hedge their purchase of the PIPE, by a decline in the company's profitability, or both. A large downward movement in the stock price is the catalyst that turns a structured PIPE into a toxic PIPE.
• The downward pressure on the company's common stock price triggers larger and larger conversion ratios for the PIPE investors (i.e., lower conversion prices), resulting in greater and greater dilution of the common stock of the company.
• Prospects for greater dilution of the company's stock drive the market price of the stock further downward. The lower stock price again forces the company to reduce the conversion price for the PIPEs into common stock at lower and lower prices.
• The process of lower conversion prices, greater dilution, and lower share prices repeats in a downward death spiral.
• Ultimately, the PIPE investors exercise their conversion rights at greatly depressed conversion prices and either sell their converted shares (obtained at a large discount) or take control of the company using the large number of new shares.

Although this scenario sounds improbable, more than one PIPE transaction has led to poisonous results for a company. From the viewpoint of the issuing company, structured PIPEs can be toxic. However, the investor also takes a considerable risk that the stock price will decline substantially after the PIPE transaction is completed. Although structured PIPEs still exist, both investors and companies receiving PIPE financing have become much more sophisticated regarding the details and floating conversion rates in toxic PIPEs. The learning experiences of the late 1990s and early 2000s led to a PIPE market with more sensible deals and less likelihood of perverse incentives.

22.5.3 Hedge Funds and Private Equity

Hedge funds were highly proficient at attracting capital prior to the financial crisis that began in 2007. Hedge funds are increasingly competing with private equity firms in the purchase of corporate assets in the search for attractive opportunities in which to invest capital. Other reasons that hedge funds are moving into private equity investing include their interest in expanding into new areas for diversification, their desire to apply their skills to new areas, and the more favorable fee structure for hedge fund managers compared to that for private equity fund managers. The following list summarizes the six major differences between typical hedge fund incentive fees and typical private equity fund incentive fees:

1. Hedge fund incentive fees are front loaded. Private equity fund fees tend to be collected at the termination of deals.
2. Hedge fund incentive fees are based on changes in net asset value. Private equity fund fees are based on realized values.
3. Hedge fund incentive fees are collected on a regular basis, either quarterly or semiannually. Private equity fund incentive fees tend to be collected at the time of an event, such as exit.
4. Investor capital does not need to be returned first to collect incentive fees in a hedge fund. Private equity funds typically do not distribute incentive fees until the original investor capital has been repaid.
5. Hedge funds usually have no provisions for the clawback of management or incentive fees. Private equity funds typically have clawback provisions requiring the return of fees on prior profits when subsequent losses are experienced.
6. Hedge funds rarely have a preferred rate (hurdle rate) of return (e.g., 6%) that must be exceeded before the hedge fund manager can collect an incentive fee. Most private equity funds have a hurdle rate.

In sum, the deal terms for a hedge fund are much more favorable to managers than are those for private equity fund managers. Another consideration is that hedge funds with hurdle rates tend to have lower hurdle rates than private equity funds in the computation of incentive fees. Most private equity funds target returns in the 20% range, whereas hedge funds aim to beat a cash index plus some premium (e.g., LIBOR plus 6%). This provides hedge fund managers with a competitive advantage against private equity firms when bidding for operating assets, since lower hurdle rates provide hedge fund managers with an incentive to bid more aggressively than private equity firms.