This is the first in a series of client advisories, webinars and other informational programs that discuss the manner by which private equity managers can access the public capital markets. These materials and presentations are intended to introduce you to the primary vehicles used to take private equity public as well as to provide you with information regarding the latest developments in this area. This client advisory provides a broad overview of the three primary public vehicles for private equity.
Introduction
Private equity fund investing has historically been the exclusive province of wealthy investors. Such funds have largely been structured as limited partnerships, with the investors as the "limited partners" or "LPs" and the private equity manager as the "general partner." In the United States, each LP of a private equity fund must generally be an "accredited investor," which is a person or legal entity that meets certain net worth and income qualifications. Regulation D of the Securities Act of 1933 permits accredited investors to invest in a private equity fund without the protections of a registered public offering under the Securities Act. However, this traditional private equity fund investment model is being transformed as private equity funds seek to access the public capital markets.
There are three primary ways for private equity managers to access the public capital markets:
- business development companies ("BDCs");
- special purpose acquisition companies ("SPACs"); and
- structured trust acquisition companies ("STACs").
In addition, the recent initial public offerings by affiliates of Kohlberg Kravis Roberts & Co. and Apollo Management, L.P. on the Euronext Amsterdam exchange may signal the arrival of a new paradigm for taking private equity public in Europe.
Business Development Companies
BDCs are a type of closed-end investment company regulated under the Investment Company Act of 1940. BDCs became part of the regulatory framework in 1980, as part of a Congressional initiative to funnel public dollars into small and growing businesses. Congress believed that BDCs would be a popular investment vehicle alternative from the outset. However, the anticipated deluge did not reach the SEC quite as quickly as anticipated by the proponents of the BDC model. Although there have been some highly successful entrants in the BDC field over the years, until very recently, these vehicles operated in relative anonymity, barely scratching the surface of the financial press.
In 2004, the BDC industry was thrust into the limelight. A spate of filings for IPOs by would-be BDCs sponsored by high-profile private equity managers brought a fundamental change to the landscape. The most significant BDC IPO completed during this time period was the $930 million IPO by an affiliate of Apollo Management, L.P. Since such IPO, there has been a continuous trickle of BDC IPOs. In this regard, there were only three active BDCs with combined assets of approximately $1 billion in 1997, while today there are approximately 20 active BDCs with combined assets totaling about $17.0 billion.
BDCs are the appropriate structure for making primarily non-control investments, or a combination of control and non-control investments, in private and smaller public companies through a public vehicle. If an issuer invests 40% or more of its assets in securities of companies in which it owns less than a majority of the outstanding voting securities, and does not qualify for an exclusion from the definition of an "investment company" under the Investment Company Act, it ordinarily would be subject to regulation under the Investment Company Act. Assuming an entity becomes subject to regulation under the Investment Company Act, the BDC provisions provide the most beneficial regulatory protocol.
BDCs are subject to most, but not all, of the provisions of the Investment Company Act to which other closed-end funds are subject. However, they are given more leeway to compensate officers and directors (if they are internally managed) and their investment adviser (if they are externally managed), and also have greater flexibility to borrow money for investing. In return for these advantages, BDCs generally are required to invest at least 70% of their assets in certain types of investments, most notably "eligible portfolio companies." While a clarification of the meaning of that term is currently subject to an SEC rulemaking effort, it generally is intended to apply to private and smaller public companies.
Unlike traditional closed-end funds, BDCs are required to register a class of securities under the Securities Exchange Act of 1934. They must file the periodic reports and comply with the other requirements applicable to issuers registered under the Securities Exchange Act. In addition, the requirements imposed on public operating companies pursuant to the Sarbanes-Oxley Act of 2002 and the corporate governance listing rules of the New York Stock Exchange, the Nasdaq Stock Market, Inc. and the American Stock Exchange generally apply to BDCs. Thus, from a securities regulatory perspective, BDCs are effectively a hybrid between an investment company and an operating company.
BDCs can also provide a significant tax advantage. Like registered mutual funds and closed-end funds, BDCs are eligible to elect to be taxed as "regulated investment companies" under Subchapter M of the Internal Revenue Code. Thus, to the extent they distribute at least 90% of their income and meet certain diversification and other requirements, BDCs can avoid having to pay corporate level income tax.
The vast majority of publicly traded BDCs today invest primarily in debt securities. The market has been more accommodating to BDCs specializing in these investments than BDCs that invest primarily in equity because, like their closed-end fund counterparts, the shares of equity-based BDCs historically have traded at a discount to their net asset values. On the other hand, many BDCs that invest primarily in debt securities tend to trade off their yield and have been able to trade above their net asset values in the current market environment.
In light of the increased interest in BDCs after the $930 million IPO by an affiliate of Apollo Management, L.P., it is likely that we will continue to a steady stream of BDC IPOs in the coming years.
Special Purpose Acquisition Companies
SPACs have recently surged in popularity as an alternative to traditional acquisition vehicles due to their ability to raise funds through the public capital markets. More than 70 SPACs filed IPO registration statements with the SEC during 2005, compared with only 14 such filings during all of 2004. In addition, SPACs raised approximately $1.98 billion in 30 IPOs during 2005. During the first quarter of 2006, the pace has continued to accelerate, with SPACs raising an additional $843 million in 11 IPOs. Most recently, a SPAC formed by Michael Gross, a founder and former senior partner of Apollo Management, L.P., filed an IPO seeking to raise $300 million.
The recent upsurge in SPAC IPOs appears to be driven in part by increasing interest within the private equity community, which in turn has lead to the involvement of significantly larger investment banks, including Citigroup Global Markets Inc. and Deutsche Bank Securities Inc. The SPAC model can provide private equity managers with access to an alternative pool of capital to engage in the type of acquisition transactions they have traditionally targeted with institutional-based private equity funds.
SPACs are formed for the sole purpose of acquiring one or more operating companies. SPACs use the net proceeds they receive in connection with their IPOs to accomplish this goal. In connection with its IPO, a SPAC will typically issue units to the public at a set public offering price ranging from approximately $6.00 to $8.00 per unit. Units generally consist of one or more shares of common stock and one or more warrants exercisable for additional shares of common stock at a set exercise price. After the consummation of the IPO, the units will then trade publicly for a set period of time (usually one to three months), after which the common stock and warrants underlying the units will begin to trade separately.
Subsequent to their IPOs, SPACs generally will restrict their own activities, as well as those of their respective management teams, to provide protection for their investors. These restrictions generally include, among other things, the following:
- Business Combination Deadline – A SPAC must typically consummate a business combination within 18 months of its IPO, or within 24 months of its IPO if it enters into a letter of intent, agreement in principle or definitive agreement with a prospective target operating company within 18 months of its IPO. Some earlier SPACs also used 12- and 18-month time periods, respectively.
- Escrowing of Offering Proceeds – A fixed percentage (generally above 90%) of the proceeds from a SPAC’s IPO will usually be placed in an escrow account until the earlier of (i) the consummation of a business combination that has been approved by stockholders and (ii) the liquidation of the SPAC as discussed below.
- Limitation on Fair Value of Target Businesses – SPACs are typically required to acquire, in a single business combination, one or more operating businesses that have a fair market value in excess of 80% of the SPAC’s net assets or the balance of the escrowed offering proceeds at the time of the acquisition.
- Opportunity to Approve a Business Combination – SPACs are required to seek stockholder approval of a proposed business combination, and any business combination must be approved by at least a majority of the shares of common stock purchased in connection with the IPO.
- Conversion Right of Disapproving Stockholders – SPACs typically permit stockholders who vote against a proposed business combination (which is otherwise approved by the other stockholders) to convert their shares into a pro rata portion of the balance of the SPAC’s escrowed offering proceeds. If more than 20% of disapproving stockholders elect to convert their shares, a SPAC would be prevented from completing a proposed business combination.
- Liquidation Requirement – In the event that a SPAC fails to complete a business combination within the required time period, it typically is required to liquidate and distribute a pro rata share of the then escrowed funds to its stockholders.
The SPAC model provides an attractive platform for creating the equivalent of a private equity "buy-out" fund using publicly raised capital. Also, because a SPAC is a public company, it can be attractive to potential target businesses as an alternative means of "going public" in lieu of a traditional IPO. The use of public capital, however, subjects a SPAC to ongoing compliance with reporting and other requirements of the Securities Exchange Act after the completion of its IPO. In addition, SPACs are required to comply with the Sarbanes-Oxley Act and any corporate governance listing rules of the national exchange or association on which its securities are traded.
Structured Trust Acquisition Companies
STACs represent one of the more recent developments in efforts to manage and grow private equity investments as part of a public vehicle. Since the beginning of 2005, two STACs – Macquarie Infrastructure Company Trust and Compass Diversified Trust – have consummated IPOs, raising more than $700 million in equity capital, which was immediately used to acquire previously earmarked private businesses.
STACs borrow heavily from the concepts and principles present in existing investment structures but also implement innovative organizational and structural features to achieve specific business, operational, and financial objectives. As a result, STACs are best understood through their distinguishing characteristics, such as the following:
- Unlike other public operating companies, STACs are structured using a Delaware statutory trust and a Delaware limited liability company.
- Unlike other public operating companies, the day-to-day business and affairs of STACs are externally managed.
- Unlike BDCs, STACs are not subject to the Investment Company Act because they own more than a majority of the outstanding voting securities in the businesses they acquire.
- Unlike SPACs, STACs have specific target acquisitions that are consummated in conjunction with the completion of their IPOs.
STACs are structured using a newly formed Delaware statutory trust and Delaware limited liability company, and have four distinct elements:
- First, the trust, whose shares are issued to the public, will own interests in the limited liability company. These interests will comprise the trust’s property underlying the publicly issued shares.
- Second, the limited liability company will have one or more classes of interests, one of which will be held by the trust. A second class of interests may be issued to the external manager as a profit-sharing arrangement.
- Third, the limited liability company will be externally managed.
- Fourth, the limited liability company will own controlling interests in one or more operating businesses.
The use of a STAC offers several unique advantages over traditional investment vehicles, including:
- Tax Efficiency – Through the use of the limited liability company, STACs realize some of the benefits of partnership taxation and, therefore, avoid significant entity level taxation with respect to dividends and interest income that it receives from the businesses it owns. This benefit increases the potential return on investment for public stockholders. Likewise, through the use of the trust, the reporting of investment income is greatly simplified with the use of a single Form K-1 for partnership earnings.
- External Management – The use of an external manager allows a STAC to effectively outsource its management pursuant to a management services agreement that provides for the calculation and payment of a single management fee. This structure provides greater transparency to public stockholders over traditionally complicated compensation packages for corporate executives. At the same time, external managers have the flexibility to engage in other business activities that are unrelated to the SPAC.
- Alignment of Interests – Because the limited liability company is governed by an operating agreement, profit-sharing arrangements can be customized and implemented to align management’s interests with those of the public stockholders.
Without much operating and market history to draw upon, it is unclear the extent to which the STAC structure will gain widespread acceptance in the investment and financial communities. However, the STAC structure offers distinct benefits to investors and private equity managers who focus on making control investments over other vehicles. As a result, the STAC structure offers a unique perspective on the latest trend of using non-traditional means to take private equity public.
Euronext Amsterdam IPO
The recent IPOs on the Euronext Amsterdam exchange by investment vehicles affiliated with Kohlberg Kravis Roberts & Co. and Apollo Management, L.P. may signal the arrival of a new paradigm for taking private equity public in Europe. These investment vehicles raised a combined $6.5 billion in their IPOs for the purpose of making private equity-type investments.
In the wake of these IPOs, several other private equity firms have reportedly begun talks with investment bankers to form similar investment vehicles. These private equity firms, like Kohlberg Kravis and Apollo Management, will seek to take advantage of the less regulated securities markets in Europe as compared to those in the U.S. By listing on the Euronext Amsterdam exchange and severely limiting U.S. investor participation in the IPOs1, Kohlberg Kravis and Apollo Management avoided compliance with a litany of U.S. federal securities laws, including the Investment Company Act, the Securities Act, the Securities Exchange Act, the Sarbanes-Oxley Act of 2002 and the Investment Advisers Act of 1940. At the same time, these firms could take advantage of the comparatively looser regulatory and governance requirements of the Euronext Amsterdam exchange.
As a result, such foreign affiliated investment vehicles are subject to fewer legal restrictions, which results in greater control for management over governance, investment policy and, perhaps most importantly, over the flow of information to the public. However, some
commentators have expressed concern that such control comes at the expense of public investors who have no voting rights and receive distributions only at the discretion of the managing general partner of the investment vehicles.Moreover, commentators question what this all means going forward. Will the U.S. lose investment vehicles to foreign markets, or will these IPOs quickly fizzle out? Whatever the future may hold for these investment vehicles, one thing is clear: the allure of the public capital markets will continue to attract private equity managers.
Endnotes
1
For example, the securities offered in such IPOs could only be offered or sold to U.S. persons who were both (a) qualified purchasers (as defined in the Investment Company Act) and (b) either (i) qualified institutional buyers (as defined in Rule 144A under the Securities Act) or (ii) accredited investors (as defined in Rule 501(a) under the Securities Act).© 2006 Sutherland Asbill & Brennan LLP. All Rights Reserved.
This article is for informational purposes and is not intended to constitute legal advice.