Capitalism is a highly dynamic system in which corporations have to constantly anticipate market needs and shifts. The pace of change has seemingly increased, notably with a wave of deregulation and liberalisation in the 1970s and 1980s. Conglomerates and monopolies were forced to focus and broke up into smaller entities. These focused entities then started to merge to create significant players in their markets. New companies were created to address emerging needs.
However, the sources of financing were not particularly adapted at that time. Indeed, whenever a company needed financing, two solutions came to mind: the stock exchange and bank loans. The stock exchange provides a limited solution. It provides only access to additional funding for medium- and large-sized companies that meet specific criteria (sales figures, total of balance sheet, minimum number of years of existence, etc.). Newborn start-up companies did not qualify.
Nor did they take out a loan to fund their early growth or later engage in cross-border development and acquisitions. The conditions for taking out a loan are strictly defined. Risks are assessed through a scoring system, through which banks compare the situation and project of a company with past projects from similar companies. If past projects were not successful, such as funding young companies, or too complex to have been financed, such as a cross-border acquisition, then the financing is declined. Even if the project fits the criteria of the scoring system, the company still must prove its ability to pay back the bank in fixed instalments. For that it must demonstrate its ability to generate stable and strong cash flows, and also have limited debts. It also has to provide some form of collateral for the loan. If the loan is not paid, the bank will seize the assets pledged as collateral, sell them and hence get paid back thanks to the proceeds of this sale. This assumes that the value of the collateral is high enough to cover the debt, the interests due and the cost of the procedure.1
If neither the stock exchange nor banks finance business creation and development, then who, or what, does? Where does the money come from to finance the transmission or take-over of family companies, for example? Or to restructure an ailing business? To help a business further focus and optimise its operations and financial structure? From āprivate marketsā for that matter, that is to say, āprivate equityā, āprivate debtā and āprivate real assetsā.
Private equity supports companies at every stage of their development, from inception (seed capital), to early-, mid- and late-stage development (venture capital), growth (growth capital), transfer of ownership (LBO) and restructuring (turn-around capital). Interestingly, banks were some of the first institutions to engage in this type of activity through their āmerchant bankingā activities.
Private debt finances companies where banks do not. Lending is actually being reshaped. This movement started with the switch in the USA from an economy essentially supported by banks to an economy supported by financial markets.2 It has slowly permeated other countries, notably in Europe. Under the pressure of regulations (such as the Basel III Agreements), and as a consequence of the last financial crisis, banks have been retreating from specific financing operations, such as lending to small and medium-sized businesses. This has paved the way for the rise of ānon-bank finance companiesā: direct lending. If companies engage in operations which cannot be scored or which go beyond the usual daily activity, they have to resort to this type of financing. Some projects, such as mergers and acquisitions, require more flexible forms of financing than a standard loan. Subordinated debt, such as mezzanine financing, can support this type of project. In specific jurisdictions, such as the USA and the UK, acquiring an ailing business to restructure it becomes easier under the bankruptcy procedure. This is the purpose of distressed debt investing.
As companies had to refocus, they had not only to master the delicate equilibrium between equity and liabilities, but also work on the structure of their assets. They started to dispose of real estate, infrastructure, energy and other assets, sometimes to rent them back (in a sale-and-lease-back operation, for example). Management teams have often associated an asset-heavy balance sheet as a slow-moving target for more agile competitors. These assets represented a reserve of value that could be monetised to engage in acquisitions or to refocus the firm further. As these assets were sold to private real-asset specialists, dedicated strategies emerged to handle these assets in whatever shape and state, ranging from plain vanilla, or even trophy assets, to derelict ones.
Private equity represents the bulk of private markets, with 60% of the documented private market funds activity, private real assets representing 25% and private debt 15%. It will therefore be at the centre of this book, while addenda will be made whenever possible to include private debt and private real assets. We will therefore start by explaining private equity as an economic driver (Chapter 1), to then include its further developments (Chapter 2).
