Open letter on capital access

Editor’s note: The following letter was sent to Jim Roche, president of the Business and Industry Association of New Hampshire, Dave Juvet, vice president of the BIA, Department of Resources and Economic Development Commissioner George Bald and Fred Kocher, executive director of the New Hampshire High Tech Council.

Dear Dave, Jim, George, Fred:

As president of HGI, I am writing to address the No. 4 concern selected in the recent BIA Membership Survey’s Economic Development section, namely “Business Unable to Access Capital.”

As you know, HGI is a management consulting company which co-invests with private equity groups. As such, I am dealing with capital access on a regular basis.

My perspective is that it is true that capital from some sources has been, and continues to be, constrained. Large national banks still are dealing with toxic assets on their books and continue to lend sparingly. The reports of some of these institutions abruptly canceling lines of credit, thereby creating a financing crisis for businesses, are true.

In the equity investment firm sector, investments in new acquisitions are down some 40 percent from last year at this time, even though the commitments by investors to equity investor firms currently stand above a trillion dollars.

Investments are particularly not being made at the “seed” or early-stage levels, since investor firms are uncertain about the economy and the ability of these firms to rapidly grow.

“Angel investors,” those making investments of $100,000 to $1 million-$2 million, have been impacted by the decline in the stock market and other investments, and they are making relatively few investments at this time.

Many larger and well-known, billion-dollar funds are not investing due to the difficulty of sourcing the debt component of deals from large banks and institutions which are still dealing with toxic portfolios of loans. Finally, many investment funds are shoring up their portfolio companies that are not faring well in this economy and using monies that would otherwise be targeted for acquisitions to do it.

Many of these businesses are highly leveraged, having been bought in 2006-2007, when debt money was readily available, including mezzanine debt. These loans were made to equity investor funds making acquisitions with high interest rates attached — for example, mezzanine financing at 21 percent interest was almost a norm. In order to avoid defaulting on loan covenants, equity investor firms have been forced to renegotiate the loans, which has resulted in more stringent loan terms and extended debt payback horizons.

In many cases, to renegotiate loans, equity investor groups have had to put more equity money into their portfolio companies to satisfy the lender. Where banks are unwilling to renegotiate loans, and in the absence of other sources of funding, many portfolio companies are either in, or headed for, Chapter 11 bankruptcy. So, access to capital by businesses is a real concern in these situations.

Yet there are notable exceptions to the above. State-chartered banks are lending, renewing lines of credit. This seems to be the case nationwide, and is certainly true in New Hampshire.

Reasons offered by these banks are that they did not participate in the subprime lending spree and have few or no toxic assets on their books. Also, they have a better feel for the businesses to which they lend because of the established nature of the relationship with the business and its track record in previous downturns. And they are welcoming new customers daily.

There are also exceptions in the private equity investment firm arena. Some startup and early-stage investment firms are actively investing. These are usually non-control investments of $1 million-$3 million made as “seed,” first round or expansion capital investments. The successful firms at this level have carefully vetted the companies in which they’ve invested in the past, and they continue this practice. The same is true for the angel investors who are still lending — they invariably have in-depth knowledge of the business, its management team, and its technology before investing.

Some angels are investing now, and more will do so if the stock market continues to improve over the next several months.

In the $10 million-$500 million sales range, some private equity groups are continuing to buy businesses aggressively. To be sure, several recent acquisitions have been of distressed or underperforming businesses. In other cases, businesses acquired were non-strategic units of large corporations, or private companies where the owner has decided to retire, has health issues, has divergence among family members regarding business forward strategy, or has need of outside investment to continue growth of the company and will continue to run it.

In the deals in this range, the private equity firm seeks majority control and will pay based on the current valuation of the business. This payment is often now supplemented by an agreement whereby the owner can participate in the profitability growth of the business when demand fully resumes.

Deals above the $500 million sales level are harder to find, but some are being done, but deals in the $100 million-$500 million range are being transacted often and aggressively now. For example, one equity group with which I work and has done three acquisitions in fourth quarter 2008, two in the first quarter of 2009, one in June and one in July. In this business-size range, there are funds whose capital comes from private, high net-worth families and individuals which are not dependent on outside funding to do acquisitions/capital infusions. They are relatively few in number, but they are now actively investing.

Most private equity firms derive capital for investments from institutions, banks, insurance firms, high net-worth individuals and providers of debt financing. These firms are able to continue investing in this economic environment because they have a track record of meeting investors’ desired return on investment levels, and they have established excellent relationships with their debt-lender partners. They also tend to be savvy and flexible when structuring deals, working closely with the seller to optimize valuation levels, tax implications of the deal, and forward strategies for organic growth and acquisitions. They are actively investing.

Steve Hudson is president of HGI, Bedford.