Leveraged Buyouts: Safer Route for Banks' Venture Capital Units
Weiner, Lisabeth, American Banker
Leveraged Buyouts: Safer Route For Banks' Venture Capital Units
CHICAGO -- There are two sides to the financing of every leveraged buyout.
There's the bank side, which involves providing a loan. And then there's the venture capital side, which involves taking an equity position in a company through a combination of common stock and preferred stock financing. And some bank-owned venture capital companies are finding a bit of gold at the end of the leveraged buyout rainbow.
Take the case of First Chicago Venture Capital, a subsidiary of First Chicago Corp. Last year it registered an after-tax gain of $41.2 million from the leveraged buyout of just one firm, the Los Angeles-based Rokkor Industries.
Deals of that size are rare. But it is not rare to find leveraged buyouts becoming attractive investments for more and more bank-owned small business investment companies, or SBICs.
Venture Magazine reported a year ago that investments in leveraged buyouts by the top 100 venture capital firms rose 71.9% in 1984, to $481.6 million from $280 million. Leveraged buyouts accounted for 21% of the funds invested by the top 100 venture capital firms in 1984, compared with 14% in 1982 and 1983.
First Chicago Venture Capital made a conscious decision in 1981 to expand its buyout activity. "Now we have done over $300 million in buyouts and written off less than $5 million," company president John Canning says.
It is a way of putting out large amounts of money quickly, he says, yet it is less risky than early-stage deals because the company involved is already a known, functioning entity.
"And the nice thing about buyouts is you don't end up with zeros," he says. "In early-stage deals, four out of 10 fail."
The buyout market has benefited from a severe blow to the initial public offering market in 1982 and 1983. Venture capitalists had a hard time making money on their start-up investments and had difficulty finding places to invest new funds. Leveraged buyouts became a worthy substitute.
For First Chicago Venture Capital, leveraged buyouts have become essential. "Our strength is acquisition-oriented," Mr. Canning says. "We have done seed financings. But our real strength is our ability to select and finance buyouts."
It is no surprise, then, that buyouts now make up 55% of the venture portfolio at First Chicago Venture Capital, which is the dominant investor in leveraged buyouts among banked-owned SBICs. Start-ups account for 15% of its portfolio, 25% are later-stage financings, and 5% are in other ventures.
And First Chicago Venture Capital is successful. Its securities gains have averaged $60 million a year over the last four years, including $125 million in 1985.
Smaller Risk, Smaller Return
A major attraction of the buyout market is that while it offers an opportunity to place venture capital money, it is not as high-risk as seed or start-up venture capital. But the return is commensurate.
According to Andrew Kalnow, a partner in the venture capital firm of Alpha Capital Venture Partners and a former First National Bank of Chicago commercial lender, the benchmark compounded annual return on a leveraged buyout is in the 20%-to-35% range, while the benchmark return on an early-stage deal can be 60%.
Another appealing aspect of leveraged buyouts is that the deals pay a cash return immediately. This "current yield," as it is called, is generated from the preferred stock portion of the financing. The current yield, Mr. Kalnow says, gives the bank-owned SBIC the ability to gain current income from its venture investment program.
"Banks like that current return," he says. "With [leveraged buyouts] you have more predictable success. You have lower overall return, but you have the current return. Banks find that important and useful.
"Meanwhile, in an early-stage transaction, you don't get any return until you cash out, which can be five or seven years down the line. …