BUS614: International Finance

For many companies – particularly in Europe and Asia – private equity together with retained earnings have been a sufficient source of capitalisation, allowing these companies to avoid listing on a stock exchange. (Retained earnings are the post-tax undistributed – i.e. not paid out in dividends – profits of a company.) The capacity to remain private has been assisted by the rapid growth of private equity in recent years. Private equity has been employed not just by newly established or small companies but also by large established entities that have access to a range of financing alternatives. In recent years the larger private equity companies have begun to dominate the mergers and acquisitions business.

As we will see in Section 1.6 private equity companies have now become active in buying existing public companies and returning them to private ownership.

Examples of private equity companies include the Carlyle and Blackstone Groups in the USA and 3i and Doughty Hanson in Europe. Most are supported by investments from banks and fund management companies including 'hedge funds'. The latter term incorporates a range of different types of alternative investment funds. Activities of these companies are global as highlighted in Case Study 1 below on 3i's activities in China.

(Note: while some hedge funds may pursue conservative or market-neutral strategies, many others take highly leveraged bets on the directions of currency or stock movements that are not offset by a corresponding hedged position, making them more speculative and risky undertakings: www.mlim.co.uk, accessed 19 April 2007. With their equity investments, hedge funds are typically looking for a return over the short term and may take less interest in the management of the companies they invest in than the private equity companies themselves.)

Activity 1

Locate the website of the Carlyle Group (www.thecarlylegroup.com, accessed 19 April 2007). From this site identify the various types of finance the group makes available to companies and the global areas in which the company is active.

Discussion

Carlyle is active in North America, Europe and Asia – so like many venture capital companies, its activities are multinational. Carlyle provides finance for management buyouts, leveraged finance, venture capital and real estate finance.

SAQ 2

For what reasons do companies use private equity as opposed to using a public offering of shares to raise finance?

Answer

There are two major benefits. First, equity finance may simply not be available through the ‘public’ route. This may be because the company is too small or because it does not have an established financial track record. Alternatively it may have too high a business risk profile to be attractive to a wide investor base through a public share offering. Second, private ownership usually means a less onerous compliance and corporate governance environment for a company and the avoidance of the costs and management time involved in maintaining a public listing. Additionally, by remaining private, the company is less exposed to predatory attacks by those wishing to take it over – a fact that supporters of Manchester United Football Club might have reflected upon following the hostile takeover of the company in May 2005 by the US businessman, Malcolm Glazer.

The benefit to companies that provide private equity finance – particularly those providing venture capital – is the prospect of higher returns from their investments than through conventional investments in shares listed on the stock exchange. The spread of returns is, though, likely to be far wider than that resulting from stock exchange investments.

SAQ 3

Why are the returns from venture capital investments more diverse and volatile than those from shares issued by public companies?

Answer

Venture capital investments tend to be riskier than investments in listed companies because the latter are more mature and less leveraged than the companies financed by venture capital. The greater risk for venture capital investments results in more volatility in respect of the returns to the investor.

Case Study 1: Venturing into China – plenty of alarm bells!

In December 2004, 3i invested €16m in China's leading domestic fire alarm systems provider GST Holdings Ltd. GST is primarily engaged in the manufacturing and distribution of fire alarm systems and products. It also produces related products such as video entry security systems, building automation systems and electronic power meters.

Founded in 1993, in the space of only twelve years, GST grew to become the number one domestic fire alarm systems supplier in China, with a 20% market share by revenue, twice that of its closest competitors.

GST was looking for an injection of capital to fund further expenditure and wanted to broaden its shareholdings in preparation for a potential IPO in 2005. It chose 3i above other investors because of its ability to execute the deal swiftly within a tight time frame. Furthermore, GST believed 3i's international network and reputation would strengthen the company's status and raise its profile in the run up to a potential IPO.

In addition, 3i introduced GST to its contacts in the industry to discuss the company's international expansion strategy and explore potential strategic partnership opportunities.

Jiacheng Song, chairman and CEO of GST, said: 'With GST growing at a pace, we saw the introduction of an international investor as our next strategic step. The investment from 3i is another endorsement of our strength and we will be working closely together as we expand both domestically and internationally'.

Source: The Open University, https://www.open.edu/openlearn/money-business/accounting-finance/equity-finance/content-section-1.2
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