Brighter Outlook for Private Equity Funding for Small Firms

The turmoil in the world’s financial markets last year seems to have done nothing to limit the supply of private equity capital in the U.S.--good news, overall, for solid businesses in need of outside financing.

Consider these numbers, compiled by the Private Equity Analyst, a newsletter published by Asset Alternatives Inc. in Wellesley, Mass., which tracks fund-raising by private equity groups nationwide:

* Last year, private equity firms raised $85.3 billion from wealthy individuals and institutional investors, setting a record for the fifth year in a row. The total represents an increase of about 53% over the $55.8 billion raised in 1997.

* The firms raised about $17.3 billion--one-fifth of the total--as venture capital to back start-ups, including a great many in California.

* They raised most of the rest--$54.8 billion, or about two-thirds of the total--to finance leveraged buyouts, acquisitions, expansion programs, and similar efforts.

Don’t let the magnitude of the numbers mislead you, however. The good news is not that $54.8 billion will end up in the coffers of small and mid-sized businesses in California or anywhere else. In fact, of the 289 U.S.-based private equity groups raising capital in 1998, a mere 22 raised something like $40 billion all by themselves, or almost half of the $85.3 billion raised by all private equity groups last year.

And it’s a sure bet that the 22 groups in control of that money chase big-ticket deals, ignoring the opportunities among small and mid-sized businesses because they can’t capitalize on them.

For the other 267, controlling maybe $25 billion, California offers plenty of opportunity--and the good news is that some of that capital will reach small and mid-sized businesses here this year, and the supply may actually increase.

“There are fewer firms involved in investing private equity in small and mid-market businesses in California than there are on the East Coast,” says Kelly DePonte, managing director of Pacific Corporate Group Inc. in La Jolla.

“California is extremely dynamic in generating new businesses, and although there’s a tremendous opportunity here, it has not attracted private equity groups to concentrate their efforts.”

The result? The owners of solid small and mid-sized businesses in California still work hard to round up outside capital to make their companies grow.

“A lot of the money in private equity goes to the big groups doing big transactions,” DePonte says. “Not much of it gets to small and mid-sized businesses.”

There are signs, however, that this may change, DePonte says.

For one thing, investors no longer like highly leveraged deals like the Kohlberg Kravis Roberts buyout of RJR Nabisco in 1989, he says. Instead, they worry about the volatility of their public equity holdings, and they see equity in privately held companies as a hedge.

For another, if commercial banks and other lenders pull back on loans to small and mid-sized businesses, the demand for outside financing increases, and this may attract equity financing, he adds.

To be sure, the business owner who attracts that capital must give up the perks that come with sole proprietorship, DePonte says. Private equity investors want at least a minority interest, and sometimes majority control, of the companies they back, and all want to share in the upside of any business they help to grow.

That makes private equity financing costly, even onerous to many business owners. But business owners don’t get to set the rules in the financing game. They get to play by them--and if they do, the payoff is the growth of what they have created.

“In many ways I think it’s easier for the small or mid-market business to get outside financing now than it was in the 1980s,” DePonte says. “At that time, most of the private equity money went to buyouts where the original owners sold out altogether. Now, certain equity groups take minority interests, but they still see opportunity.

“Everybody realizes that the law of gravity hasn’t been repealed. Private equity investors want a cushion against the volatility of the public markets, and when you have a privately held company that can grow its profits through good products and good management, you have an extremely attractive situation.”

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Columnist Juan Hovey can be reached at (805) 492-7909 or via e-mail at jhovey@gte.net.