Corporate finance: Private equity cynosure

Like all things in life, a corporation or company, simply defined here as a business entity legally established for the purposes of profit-making, maximising shareholder value, consistent with the aspirations of its articles of association and objects, requires capital to thrive.

The rationale, from foundational economics, is that there is often a misalignment between ambitions and the means of accomplishing those aims in the real world.

Why? Because change, with humans, and human creations like corporate entities, is constant.

A company may start off operations in Year 1 as a newspaper business. In response to competitive pressures, changing consumer habits, technological innovations, and force majeure like the COVID- 19 pandemic, by Year 3, the same company may well evolve into a digital business with multiple offerings on a variety of online and technological platforms. That evolution invokes the necessity for business expansion, which necessarily comes at a price. Whereas company A may well be in a position to fund business expansion from its own resources, companies B, C and more, maybe impeded by insufficient capital to fund growth aspirations for what is an underlying viable business proposition.

The latter is the logic for corporate finance and is the attention of this analysis from a private equity angle. Corporate finance is therefore an entity’s funding mechanism and there are a number of ways in which that is configured. Private equity is one model. Others are debt, shares, co-finance, mezzanine finance which is a combination of gearing and equity et al.

What then is private equity? Essentially, it is a component of the asset management industry entailing investments in securities in private markets or alternative investment markets – where shares are not quoted in public companies.

The Nigerian Investment and Securities Act 2007 (as amended) defines securities as debentures, stocks or bonds, issued or proposed to be issued by a government or corporate entity; any right or option in respect of any such debentures, stocks, shares, bonds or notes; or commodities futures, contracts, options and other derivatives. It includes securities which may be transferred by electronic means approved by the Securities and Exchange Commission and which may be deposited, kept or stored with any licensed depositary or custodian company.

Private equity investments are usually made through special purpose vehicles (SPVs) with definitive lifespans focused on specific, measurable, actionable, realistic and timeous investment strategies. It offers significant advantages.

For example, firms seeking capital injection for key strategic and/or operational objectives may seek private equity investments. It offers an alternative to raising capital via initial public offers on public markets. Whilst attracting regulatory oversight, the reporting obligations are usually less onerous, although no less important, than they are for publicly quoted companies. Equally, private equity investments, subject to robust due diligence, are available to firms at different stages of their development life cycle.

Consequently, they could be open to business start-ups, small and medium-sized companies and very large corporates – with turnover exceeding N50 billion. As with any investment, private equity injection must be underpinned by a robust business case and sound due diligence. Also, private equity enhances a company’s liquidity position.

For one, it has access to capital, which it did not previously have. With effective leadership, corporate governance and financial metrics, this combination improves its credit reference profile globally. A corollary, therefore, is simplifying the corporate’s access to long-term funding at lower interest rates to fund the development of new products and services in profitable markets. Naturally, this heightens the potential for dividend payments to shareholders if the strategic choices are right.

On the flip side, private equity investment may entail a dilution of corporate ownership and diminution of shares. In other words, a necessary consequence therein could be the takeover of the company by private equity investors because the quantum of their investment will entitle them or their representatives to board positions; and thus, their ability to influence and /or completely reset the entity’s strategic direction. That is an unintended consequence of private equity investment which firms should always anticipate where they have no intentions of ceding ownership.

In addition, trite economics establishes that the value of investments in corporates rises and falls as the market context, unique circumstances of each firm, and the political, socio-economic, technological, environmental and legal dynamics change. As such, if private equity investments underperform, there is absolutely no question as to entitlement to dividends.

Reinforcing this point, in winding up proceedings, section 657 (6) (a) and (b) of the Companies and Allied Matters Act 2020, enunciates that secured creditors shall rank in priority to all other claims including any preferential payment; and equity holders shall rank last. Private equity investors by this statutory definition fall within the construction of the said “equity holders.”

The inescapable inference, therefore, is that significant risks attach to private equity investments and the investors only qualify for a residuum claim upon insolvency. It is partly on this logic that private equity is used interchangeably with risk capital in corporate finance circles.

Strategically, the private equity market can be split into buyout funds and venture capital funds. Organisationally, buy-out funds and venture capital funds have similar configurations relative to their management fee structures and longevity. Nevertheless, their divergence is often manifested in their investment strategies. For instance, buyout funds usually focus on mature companies, in their latter development life cycles, rather than start-ups and tend to use mezzanine financing models, a combination of debt and equity finance, especially in mega transactions.

Venture funds are, as the name implies, broadly skewed towards risky undertakings. Risky in the sense that they are often novel, start-ups, young and high-growth businesses. Their financing models are usually devoid of gearing because they are oftentimes untested. In the main, private equity fund managers seat on the boards of buyout and venture capital funds, taking an active operational role in the affairs of the portfolio firms they invest in and overseeing the execution of their agreed delivery plans. Generally, successful investments would see to the execution of these delivery plans and the eventual exit of the private equity investor after 3 to 7 years approximately.

An important distinction worth highlighting is that unlike co-financing and debt finance, private equity affords the investor huge latitude in the control of portfolio companies. So, private equity investors shape the strategic directions of the entities they invest in plus, in buyout funds, they elect an optimum capital structure to suit the unique opportunities and challenges of the company in question. This degree of control wielded by private equity fund managers necessarily encompasses extensive due diligence of these companies and access to key management and commercially sensitive information.

Globally, private equity firms managed approximately $ 2.5 trillion worth of assets and committed capital in 2010 according to City UK. Some of the largest investors in the pension funds asset class are pension funds, which provide the capital to the various special purpose vehicles that make the actual underlying investments. Over a decade later in 2021, Statista affirmed that the dry powder of private equity companies reached $ 3.4 trillion, up $300 billion from 2020. Reference to dry powder here simply means hypothecated investment capital commitments and distinguished from specific allocations.

In Nigeria, relevant statutes governing private equity funds include the Companies and Allied Matters Act 2020, the Companies Regulations 2021, the Investment and Securities Act 2007 (as amended), the Federal Competition and Consumer Protection Council Act (FCCPC) 2018, the FCCPC Foreign Merger Guidelines 2019, Securities and Exchange Commission (SEC) Regulations, Pensions Reform Act 2004 et al.

The FCCPC provisions, for example, regulate the acquisition of shares or other assets in Nigeria leading to a change of control of a business, part of a business or any asset of a business in Nigeria. These are extremely wide provisions extending to “all undertakings and all commercial activities within or having effect within Nigeria,” which shall be subject to FCCPC approval. So, an American private equity firm seeking to invest in a Nigerian digital start-up is caught by these provisions.

The National Pension Commission also regulates private equity and investments through its regulations and guidelines, which prescribe the kinds of private equity funds in which Nigerian pension fund assets may be invested.

Section 1.1.2 of the National Pension Commission’s Operational Framework for Co-Investment by Pension Fund Administrators, issued pursuant to the Pension Reform Act 2004 (as amended), establishes that one of the asset classes with the lowest asset allocation by pension funds is Private Equity (PE).

“The asset class has remained significantly below the maximum limits of 10% for Fund I and 5% for Funds II & VI Active, respectively. Consequently, investing in specific transactions under a Co-Investment arrangement has been identified as a viable option to improve pension funds’ allocation to this asset class. Co-Investing alongside the main PE Fund is expected to provide PFAs flexibility and greater choice in the type of projects/companies in which pension funds are invested, thereby further enhancing returns and increasing exposure to PE.”

From the foregoing, are these emerging concluding observations. Private equity is a viable proposition for corporate financing notwithstanding its inherent risks. This assertion is corroborated by the intense regulatory oversight it is accorded by the FCCPC, Pension Commission and SEC. Patently, from financial, reputational and strategic risk management perspectives, it is eminently reasonable to safeguard public confidence and investors’ funds in corporate financing models as well as to rightly impede criminal money laundering efforts. Counterbalancing is the valid question as to whether so many agencies ought to regulate corporate finance mechanisms? Whether the multiplicity of agencies regulating private equity strikes the optimal balance, relative to the ease of doing business is still an open question.

Ojumu Esq. FBR, MBA, B.L, LL. B (Hons) is Principal Partner, Balliol Myers LP, a firm of legal practitioners, based in Lagos, Nigeria.