Understanding Shares and Private Equity Investments
Common Shares
Common shares represent partial ownership of a company and provide their holders with claims to future streams of income, paid out of company profits (dividends). Holders face larger risks than other stakeholders, such as bondholders and owners of preferred shares.
Payment Methods:
- Residual: Dividend payments come from the residual or leftover equity only after all project capital requirements are met. These companies strive to maintain the agreed-upon balance between equity and debt (D/E ratios).
- Stability: Companies may choose a cyclical policy, setting dividends at a fixed fraction of quarterly earnings, or a stable policy, where quarterly dividends are a fraction of yearly earnings.
- Hybrid: A combination of residual and stable dividend policies. Companies tend to view the D/E ratio as a long-term rather than a short-term goal (most common).
What determines the decision to issue equity versus debt?:
- Tax incentives
- Cost of distress
- Agency costs
- Signaling effect
Preferred Shares
Main Features:
- Represent an equity interest in a firm and usually do not provide voting rights.
- Hybrid instruments:
- Similar to debt: Investors receive a fixed contractual amount of dividends.
- Similar to equity: Payment is made only after payments to debtholders.
- A fixed-income instrument: Preferred stockholders typically receive a fixed contractual amount.
- Payment of dividends occurs before common shareholders.
- In case of liquidation, preferred shareholders receive assets before common shareholders.
- Usually, preferred shareholders do not participate in the net profit of the company (beyond the stated fixed annual dividend).
Private Equity (PE)
Private Equity firms invest mostly in companies that are not publicly traded. They raise funds by promoting PE investments in return for dividends and liquidation returns. These are illiquid investments (typically 8 years or more).
Elements considered by a PE fund to price a firm include the value of the company (market price), type of shares, call/put options, etc.
Steps in Private Equity:
- Take over the businesses.
- Manage and control the restructuring.
- Charge an annual management fee.
- Implement exit strategies.
Goal: Improve new or badly managed firms and exit at higher valuations after several years (PE firms typically buy and hold for periods longer than 8 years).
Types of PE Entry Strategies
- Leveraged Buyouts (LBOs): Acquiring public or private companies through highly debt-financed deals. Collateral includes future cash flows. Main LBO targets are firms with high cash flow, low debt, and undervalued or inefficient tangible assets. Financing sources include bank credit, high-yield bonds, and capital. Mezzanine financing involves debt or preferred shares linked to capital.
- Development Capital: Minority equity investments in mature firms raising capital to expand or restructure operations.
- Distressed Investments: Buying debt in mature companies experiencing financial difficulties due to temporary and non-permanent cash flow problems.
Types of Exit Strategies
- Trade Sale: Selling to a strategic competitor in an auction or private deal (proprietary deal).
- Pros: Immediate cash, fast and simple valuation, lower cost than an IPO, less disclosure of firm strategy.
- Cons: Manager opposition, unattractive to employees, may raise less money than an IPO.
- IPO (Initial Public Offering): Selling firm shares to investors on the stock market.
- Pros: Potentially raise more money, manager support, publicity, investor expectations for stock market listing.
- Cons: High transaction costs, affected by market risk, greater exposure (disclosure).
- Recapitalization: The private equity firm retains control but allows investors to withdraw funds (often when interest rates are low and the PE firm can pay dividends).
- Secondary Sale: Selling the firm to another private equity firm or other investors.
- Write-off: Liquidating the firm.