Making the Most of Other People's Money
Castle, John K., Chief Executive (U.S.)
Enron Capital & Trade Resources, an integrated energy company, recently used private equity to secure long-term funds for expansion. Graphite producer UCAR International used it to re-engineer itself. Quantum Restaurant Group used it to build itself up for a public offering. Citicorp used it to shore up its capital position.
There's no shortage of companies trolling for private equity limited partners to provide affordable, timely financing to upgrade production equipment, expand capacity, acquire businesses, reduce debt load, position the firm for sale, or enable it to buy out an ownership stake.
What's behind this resurgence of a financial strategy that has been around for decades and was the basic engine of economic growth before the evolution of efficient, well-regulated stock markets? For starters, the pool of available equity capital has grown substantially in recent years to roughly $100 billion, according to the Federal Reserve, as pension funds and banks such as Chemical Bank, Bank of Boston, and Bank America now are joining the traditional ranks of insurance companies, "buyout" firms, and wealthy individuals who use private equity investments to reap higher returns. For example, CalPERS, the nation's largest public pension fund, has earmarked for private equity investments 2 percent of the $95 billion it manages on behalf of California public employees.
From corporate America's standpoint, this wellspring of capital provides businesses with an attractive alternative to inflexible bank debt, expensive senior notes and subordinated debt with sinkingfund requirements, and costly preferred stock.
One of the first private equity limited partnerships was Donaldson, Lufkin & Jenrette's "Sprout Group," which I ran from its inception in 1969. The approach took hold in the 1970s and accelerated in the 1980s. Today, despite huge daily volumes of trading on the major exchanges and a flood of initial and secondary public offerings, companies continue to reap the advantages of private equity financing, including:
NO FIXED OBLIGATORY INTEREST AND PRINCIPAL PAYMENTS. This means the company can use the revenue it generates to grow rather than to repay the debt on a rigid schedule. Private equity investors naturally expect to receive a good return, but are prepared to accept a five-year investment horizon, realizing it may take time for any growth strategy to play out. Thus, the timing and terms of the deal can be designed to meet the specific needs of both the company and the investing partnership.
In 1994, Enron Capital & Trade Resources saw an opportunity to leverage its long-term growth strategy by acquiring or investing in independent oil and gas producers, so it worked out an agreement with CalPERS, under which the pension fund made a private equity investment of $250 million. Enron avoided the burden of debt repayment and gained a savvy, corporate-governance-minded investor. CalPERS got an investment with a potential return well above the average returns on its investments in publicly traded stock. Enron continues to use the CalPERS investment and other resources to pursue its expansion strategy.
When Citicorp needed to improve its capital position in 1991, it negotiated an 5,OO million private equity investment-in the form of convertible preferred stock-from Prince Alwaleed, a nephew of Saudi Arabia's King Fahd. The prince, known as a shrewd but flamboyant investor, has attracted widespread attention for investing millions to shore up EuroDisney. Citicorp strengthened its balance sheet without adding to debt, at a lower cost than borrowing and more successfully than attempting a common stock offering at that inopportune time. The prince benefited from significant dividend income and large investment gains, as Citicorp stock later climbed, while becoming the largest single holder of common stock in America's biggest bank.
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