Category: Blog Articles

A Look Into the Growing Trend of Family Offices

Posted on by Taylor Webb

Private equity firms were reluctant to make deals in the first half of 2012, as the number of deals dropped 15 percent from last year. [1] A lack of large deals could create negative repercussions going forward, as firms address the need to deploy the large amount of cash that they have built-up. Firms currently hold about $1 trillion in cash, $200 billion of which will be handed back to investors if firms are unable to find large deals within the next year. [2] The increased need to find large deals will lift multiples for the larger target companies, providing less upside potential going forward. [3] Although well priced deals may be harder to find for some of the major private equity firms, some wealthy investors are beginning to seek out alternative ways to invest their capital. A growing number of wealthy families are beginning to make direct investments in companies, rather than investing in large private equity firms. [4]

As wealthy individuals look for new ways to invest after experiencing a period of low returns, some wealthy families have begun to hire top Wall Street talent to manage their investments.[5] Between 2006 and 2010, the share of private equity investments in multifamily investment portfolios rose from 3.8% to 10%. [6] Moreover, the current environment is ripe for investors who want more control over their investments because of the pressure some of the major funds are facing. [7] Not only does the idea of being closer to their investments appeal to wealthy investors, but it opens the door to numerous investments that may not be readily available when investing in large private equity firms. Investing in a family office allows investors to make investments with longer time horizons. Managers within family offices have found success in making long-term investments in a few platform companies with the aim of growing the companies through smaller acquisitions. [8] This holding company approach is just one example of the ability of family offices to be flexible in the type of strategies they employ.

Although family offices usually do not have the same amount of resources at their disposal as some of the major private equity firms, the resources they do have are streamlined.[9] The number of individual investors in any given family office is relatively small, with some offices starting out with only one family. [10] At the same time, some managers are drawn by the opportunity to work closely with clients, while being relived of worrying about marketing or spending time doing client development and have left large investment houses to work with these family offices. [11]

Running a family office also has the advantage of flexibility when it comes to the type of investments that are available for managers to consider. [12] Simply put, the size of many of these family offices allows managers to consider a broad spectrum of investments that may not be as appealing to many of the large private equity firms. Many of the family offices are able to invest in young, promising startups because they are dealing with a smaller pool of money. [13] In fact, some family offices seem to focus mostly on young startup companies, almost acting as a venture capital fund. [14]

As the industry continues to face challenges, investors continue to adjust their actions to seek out better rates of return. For those who seek greater control and a more personal atmosphere, investing in a multifamily office is an attractive alternative to investing with a major firm. At the same time, managers in family offices will also benefit from the small amount of investors they will be communicating with and the greater flexibility in the investments that are available to them. With the advantages of size, flexibility, and greater control, it is easy to see why family offices have become a favored alternative for wealthy investors and managers alike.

[1] Mohammed Aly Sergie, Survey Says: PE Flat in First Half, Eyes Carve-Outs in Second, Wall St. J. Blog (July 2, 2012, 4:57 PM) http://blogs.wsj.com/privateequity/2012/07/02/survey-says-pe-flat-in-first-half-of-2012-eyes-carve-outs-in-second-half/.

[2] Andrew Ross Sorkin, More Money Than They Know What to do With, N.Y. Times Dealbook (Oct. 1, 2012, 8:42 PM) http://dealbook.nytimes.com/2012/10/01/more-money-than-they-know-what-to-do-with/.

[3] Id.

[4] Azam Ahmed, Family Investment Funds Go Hunting for Wall St. Expertise, N.Y. Times DealBook (Apr. 4, 2012, 3:50 PM), http://dealbook.nytimes.com/2012/04/04/family-investment-funds-go-hunting-for-wall-st-expertise/.

[5] Id.

[6] Steven R. Strahler, Families Jump Into the PE Pool, Crain’s Chicago Business (May 28, 2012) http://www.chicagobusiness.com/article/20120526/ISSUE02/305269999/families-jump-into-the-pe-pool.

[7] Id.

[8] Id.

[9] Ahmed, Supra note 3.

[10] Strahler, Supra note 6.

[11] Ahmed, Supra note 3.

[12] Id.

[13] Id.

[14] Id.

Re-defining the Line between Public and Private

Posted on by Zach Paterick

In his new article, Revisiting “Truth in Securities Revisited”: Abolishing IPOs and Harnessing Private Markets in the Public Good, Adam Pritchard argues that the current transition between private and public company status is awkward and inefficient.[1] Pritchard suggests that these inefficiencies can be reduced through the implementation of a two-tier market system for transitioning from private to public status.[2] In this blog, I analyze the implications of Pritchard’s suggested system on the Private Equity Community.

Background

Pritchard argues that the separate enactment of the Securities Act and the Exchange Act created a mismatched dividing line between public and private status.[3] The Securities Act draws the line in a manner that focuses explicitly on investor protection, while the dividing line under the Exchange Act reflects the attempt to balance investor protection, interests in capital formation, and practical ease of application.[4] Congress has shifted the point at which companies must go public through the JOBS Act, which gave the SEC new authority to exempt offerings from the requirements for registered offerings and authorized the SEC to adopt less demanding periodic disclosure from companies who benefit from this new offering exemption.[5] Pritchard contends that the JOBS Act reforms have the potential to create a lower tier of public companies and to blur the line between private and public companies.[6]

The Two-Tier System

Pritchard offers a different solution; one he believes unifies the public/private dividing line under the Securities Act and Exchange Act. Pritchard’s solution involves a two-tier market for both primary and secondary transactions, where the primary market would be limited to accredited investors, while the public market would be accessible to all.[7] Under this regime, all public offerings would be seasoned offerings with a price informed both by full disclosure and a pre-existing trading market. Issuers would be able to choose whether to sell in the primary or secondary market and companies would become eligible for the primary market after reaching a certain quantitative benchmark (he suggests $75 million in market capitalization, the threshold currently used by the SEC for shelf registration).[8]

Under this system, issuers below the quantitative benchmark would be limited to selling their securities to accredited investors. However, contrary to the current system, those securities could not be freely resold after a minimum holding period, but would instead be sold to other accredited investors on an established secondary market (similar to SecondMarket or SharesPost except expanding eligible purchasers from Qualified Institutional Buyers to all accredited investors).[9]

Elevation to the public market would be completely voluntary.[10] Issuers unable or unwilling to meet the obligations associated with access to the public market would be allowed to remain private. Once a company chose to go public, a seasoning period would follow with the filing of requisite 10-Q’s during which the shares would continue to be traded in the private market.[11] This seasoning period would allow the trading price in the public market to be informed by the prior trading in the private market as well as the new information required to initiate the “going public” process.[12] Only after the company graduated to having its shares traded in the public market would the company be free to sell equity to public investors.[13] This two-tier system relies on the pricing efficiency of the markets.

Impact on Private Equity

Pritchard’s suggested model would impact the private equity market in multiple dimensions. First, companies looking for late stage investment to expand their brand could continue to seek private capital, without having to cross the public divide. Consequently, the amount of firms seeking private equity would likely expand, creating more opportunities for private investment.

Additionally, Pritchard’s plan would essentially create a liquid market for private equity investors. While similar markets already exist, see SecondMarket and SharesPost, these markets are limited to “qualified institutional buyers” (investors with more than $100 million under management). Pritchard’s secondary markets would include accredited investors, individuals with at least $200,000 in annual income or $1 million in assets. This increased participation in the secondary market would allow the market to establish a trading price.

Lastly, Pritchard’s plan would eliminate the need for marketers to create demand when a firm decides to go public. Instead, the secondary market, supplemented by the required filings to go public, would establish a trading price. The underpricing dilemma of IPOs would essentially disappear. Thus, private equity holders participating in the company’s transition from private to public would receive greater returns.

In summary, Pritchard’s two-tier market plan would create new opportunities for private equity investment, create a liquid trading platform, and help ensure that investors exiting the market when a firm elects to go public receive proper returns. Such a market system would be advantageous to private equity investors; it should be given serious consideration.

________________________________________
[1] Adam C. Pritchard, Revisiting “Truth in Securities Revisited”: Abolishing IPOs and Harnessing Private Markets in the Public Good (University of Michigan Law & Econ Research, Paper No. 12-010, 2012), available at http://ssrn.com/abstract=2103246 .

[2] See id. at 5.

[3] Id. at 3.

[4] Id.

[5] See Revisiting “Truth in Securities Revisited” at 4.

[6] Id.

[7] See id. at 30.

[8] See id.

[9] See id. at 31.

[10] Id. at 33.

[11] Id.

[12] Id. at 34.

[13] See id.

Cyber Security Start-Ups

Posted on by Rachel Shapiro

Enterprises and consumers alike have experienced two recent and rapid technological innovations that will continue to alter the tech landscape: the rise of cloud computing and a mass move to mobile devices and applications. “‘We are on a shift that is as momentous and as fundamental as the shift to the electrical grid,’ said Andrew R. Jassy, the head of [Amazon Web Services]. ‘It’s happening a lot faster than any of us thought.’” [1] Indeed, recent research concludes that paid cloud services are expected to double among small and midsize businesses in five years. [2] Computing giants Microsoft, Google, and Amazon, each with its own set of cloud offerings, will compete to meet this growing demand.

Cloud computing, which promises substantial cost-savings for businesses via “pay-as-you-go access to sophisticated software and powerful hardware,” [3] also poses certain security risks that derive primarily from the security, or lack thereof, of the channel by which information travels to the cloud and that of the data itself while on the server and in use by the cloud service. [4] When it comes to mobile devices, the risks are no less. In fact, the frequency of mobile threats doubled between 2010 and 2011 and the volume of malware targeting smartphones increased 155 percent in 2011 alone. [5] The rash of hacks on mobile devices and public and private networks by “pranksters, criminal syndicates or foreign governments” [6] illuminates the disconcerting reality that “[n]o one is immune to the threat posed by cyber criminals.” [7]

From an economic standpoint, the risks posed by potential security breaches are great: a typical breach might cost a business more than a half million dollars to rectify.[8] Likewise, such an occurrence might have a detrimental psychological effect, reducing the confidence of customers in a particular company or, worse, chilling the transition to cloud and mobile services overall, since no sector is impervious to the security threats.

It is perhaps of little surprise that, against this backdrop, “big companies are expected to spend $32.8 billion on computer security this year, up 9 percent from last year. Small and medium-size businesses will spend more on security than on other information technology purchases in the next three years.”[9] The “white hat” cyber security professionals, whose challenge is to “foster a faster and more open exchange of valuable information [while striving to] stay a step ahead of technically advanced, well-financed cyber criminals,” [10] are not only security powerhouses like McAfee, but also obscure security start-up companies, such as Imperva, Splunk, and Palo Alto Networks. [11] The remarkably strong stock performances that these companies have enjoyed since going public, with shares ranging from 26 to 65 percent above their offering price, has piqued the interest of the venture capital world. Not to be understated, venture capital contributions to these tech security start-ups reached $935 million in 2011, nearly doubling 2010 venture capital investments in the same genre. [12]

Most security start-ups seeking venture financing are focused on one of the following areas of weakness: mobile devices, authentication, intrusion detection, or “big data.” [13] For example, Bit9 is a start-up that blocks malware, Zenprise brings enterprise-level security to consumer mobile devices, and Solera Network tracks breaches in real time. Each of these companies has recently raised tens of millions of dollars in investment rounds led by top-tier venture capital firms, including Sequoia Capital and Intel Capital.[14]

Though this infusion of capital into the cyber security realm is likely spurred on by the potential for big monetary gains for venture capital firms and not altruistic motives, the ultimate security outcome, if the start-ups are successful, will be highly beneficial for many, if not all. Given the positive externality that seems to ensue from this particular type of investment in this age of increasing cyber crime, I can only hope that the unusual risks borne by investors of security companies, such as death threats and aggressive cyber counterattacks by criminals, [15] will not dampen its popularity going forward.
__________________________________________________

[1] Quentin Hardy, Active in Cloud, Amazon Reshapes Computing, The New York Times (Aug. 27, 2012), http://www.nytimes.com/2012/08/28/technology/active-in-cloud-amazon-reshapes-computing.html?ref=technology .

[2] 2012 Microsoft/Edge Strategies Cloud Adoption Study, http://www.edgestrategies.com/component/k2/item/117-just-released-2012-microsoft-edge-technologies-smb-cloud-adoption-study.html (last visited Oct. 13, 2012).

[3] Jeff Beckham, The Top 5 Security Risks of Cloud Computing, Cisco Blog (May 3, 2011, 8:36 AM), http://blogs.cisco.com/smallbusiness/the-top-5-security-risks-of-cloud-computing/ .

[4] Id.

[5] Ian Paul, Mobile Security Threats Rise, PCWorld (Sep. 7, 2012, 9:36 AM), http://www.pcworld.com/article/262017/mobile_security_threats_rise.html .

[6] Nicole Perlroth & Evelyn M. Rusli, Security Start-Ups Catch Fancy of Investors, The New York Times (Aug. 5, 2012), http://www.nytimes.com/2012/08/06/technology/computer-security-start-ups-catch-venture-capitalists-eyes.html .

[7] Kevin Johnson, CIOs Must Address the Growing Mobile Device Security Threat, Forbes (Aug. 16, 2012; 7:55 PM), http://www.forbes.com/sites/ciocentral/2012/08/16/cios-must-address-the-growing-mobile-device-security-threat/ .

[8] Id. (citing cash outlays, business disruptions, and revenue losses as elements of the cost of a security breach).

[9] Perlroth & Rusli, supra note 6.

[10] Johnson, supra note 7.

[11] Nicole Perlroth & Evelyn M. Rusli, Security Start-Ups Catch Fancy of Investors, The New York Times (Aug. 5, 2012), http://www.nytimes.com/2012/08/06/technology/computer-security-start-ups-catch-venture-capitalists-eyes.html .

[12] Id.

[13] Id.

[14] Id.

[15] Id.

Regulatory Oversight in Private Equity

Posted on by Kail Jethmalani

Late last year, the Securities and Exchange Commission (SEC) announced an informal inquiry [1] into private equity funds. This investigation has at least three goals: (1) understanding alleged systemic risks posed by private equity funds; [2] (2) ascertaining whether valuation, due diligence, and related compliance controls are in place and adequate; [3] and (3) rooting out potential fraud. [4] However, some commentators have expressed the belief that the SEC is concerned with the valuation and compliance processes in place at smaller funds and so called “zombie”[5] funds, as opposed to the major players. [6] Indeed, neither the Blackstone Group nor KKR—both major players and publically traded—received the SEC’s first wave of informal inquiry requests in February, [7] and it is unclear if they have since received a request in a subsequent wave. Comments by the Bruce Karpati of the SEC’s enforcement division confirm this narrow view: “[the agency] is looking at zombielike funds that have potentially stale valuations.” [8]

The SEC’s espoused goals thus seem inconsistent: in contrast to large funds, small funds or zombie funds are unlikely to cause the systemic risks that would warrant investigation. Although valuations for zombie funds might raise concerns of fraud, [9] systemic fraud in private equity valuations seems unlikely due to countervailing incentives: private equity funds might want to overvalue assets to attract new investors, [10] but they want to maximize the difference between purchase and sale price [11] which could incentivize undervaluing assets. Reputation, which directly affects investor confidence, is another check on fraud. [12] Additionally, private equity investments involve sophisticated investors, [13] and as a matter of policy the SEC limits oversight of sophisticated investors. Increased regulatory oversight chips away at the notion that sophisticated investors can and should bear the economic risks of their investments themselves.

Therefore, to even investigate zombie funds is a marked policy shift for the SEC. By subjecting zombie funds to regulatory oversight, as opposed to leaving them to private resolution, the SEC has imposed not-insignificant regulatory compliance costs onto all private equity funds. [14] Simply put, the industry-wide costs imposed by the SEC’s new regulatory scheme could substantially outweigh the costs [15] associated with private resolution of zombie funds. Although investors might face significant losses through private resolution, private equity is a field for sophisticated investors that are capable of bearing investment risk. Consider a hypothetical pension fund that has invested into what has become a zombie fund. The fund must only take steps to leave the investment and absorb the associated losses. [16] In contrast, the SEC must first identify the zombie fund by reviewing valuation and compliance procedures, likely a costly and inefficient endeavor. Every private equity fund subject to SEC oversight must thus bear the cost of regulatory compliance, rather than limiting the costs to investors in zombie funds. A more efficient solution might be to work directly with aggrieved investors to investigate only particular funds. Upon receiving a complaint from an investor, the SEC can launch a targeted investigation that does not impose unnecessary costs onto the industry. The SEC already maintains a complaint reporting system, and expanding that system to include zombie funds is potentially a better use of the Commission’s finite resources.

Further, some commentators also question whether the SEC should devote any resources to valuation methods. [17] Conventional wisdom holds that valuing a private entity is an art, not a science; there is inherent uncertainty in valuation. [18] Industry groups argue that valuations are not as important to private equity funds as they are to other alternative investments. [19] Hedge funds, for example, charge fees based on changes in valuation, whereas the majority of fees due to private equity firms are based on the difference between the entrance and exit prices. [20] Although the SEC contends that smaller private equity funds might be incentivized to overvalue assets to attract greater investment and management fees, [21] they also face the countervailing incentive to minimize their asset valuation to maximize the delta between entrance and exit price. As previously noted, the private equity industry serves sophisticated investors capable of bearing investment risk, and the SEC’s resources might be better used to protect lay investors rather than to regulating an uncertain-by-nature practice.

This is not to suggest that greater regulatory oversight does not lead to benefits for the firms themselves. For example, some small and midmarket funds have retained outside firms to analyze and test their compliance practices, with the goal of understanding vulnerabilities. [22] Funds have already seen benefits from these reviews, by discovering that their internal controls with regard to data security were not up to SEC standards. [23] Nevertheless, these benefits must be weighed against the broad inefficiencies imposed by the regulatory scheme. Small and midmarket funds must already consider how to efficiently use their relatively limited resources. Rather than imposing costs across the industry, a much narrower regulatory scheme implemented through the existing complaint system is more likely to limit costs. Risk aversion will still lead to the creation of elaborate compliance schemes and mock reviews given that many compliance groups have “little or no experience with an SEC inquiry[,]” [24] or may not understand how to handle an SEC investigation. However, because fewer funds will be in the spotlight at any given time through the use of the complaint system—there at least 200 zombie funds, compared to more than 10,000 private equity funds generally— [25] it will be easier to contain industry-wide costs.

______________________________________________________

[1] Letter from Securities and Exchange Commission to Certain Private Equity Funds (Dec. 8, 2011), available at http://online.wsj.com/public/resources/documents/SECInquiry.pdf.

[2] Shaun Gittleman, U.S. SEC Set to Monitor Private Equity Funds, Official Says, Reuters (May 8, 2012), http://blogs.reuters.com/financial-regulatory-forum/2012/05/08/u-s-sec-set-to-monitor-private-equity-funds-official-says/ (due to new regulations implemented under Dodd-Frank, private fund advisers must report potentially systemic risks through the SEC and Commodity Futures Trading Commission).

[3] Carlo V. di Florio, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, Address at the Private Equity International Private Fund Compliance Forum (May 2, 2012), available at http://www.sec.gov/news/speech/2012/spch050212cvd.htm.

[4] Id .

[5] Zombie funds are those where investors must continue to pay management fees, even though the funds are inactive or not actively managed. Often, the zombie fund’s assets are difficult to value or sell. Thus, investors are locked into these funds—which continue to accrue management fees—without the prospect of future payoff. According to one estimate, as much as $100 billion is tied up in zombie funds, and investors stand to lose substantially if they try to sell their stake: private markets value those investments at 30-40% of the stated value. See David P. Abel, Investors Beware of Zombie Funds, Motley Rice Blog (June 7, 2012),http://blog.motleyrice.com/investors-beware-of-zombie-funds/; see also Susan Pulliam and Jean Eaglesham, Investor Hazard: ‘Zombie Funds’, Wall St. J. (May 31, 2012), http://online.wsj.com/article/SB10001424052702304444604577339843949806370.html .

[6] See Dan Loeser, SEC Investigates Private Equity Valuation Methods, Colum. Bus. L. Rev. (Feb. 27, 2012), http://cblr.columbia.edu/archives/11980.

[7] Joshua Gallu and Cristina Alesci, SEC Review of Private Equity Said to Focus on Smaller Firms, Bloomberg Bus. Wk. (Feb. 14, 2012), http://www.businessweek.com/news/2012-02-14/sec-review-of-private-equity-said-to-focus-on-smaller-firms.html .

[8] Pulliam & Eaglesham, supra note 5.

[9] Abel, supra note 5 (there is “concern about the possibility of private equity firms manipulating the value of investments to prop up these zombies.”)

[10] See Gallu & Alesci, supra note 6; see also Jonathan E. Green and Lindsay S. Moilanen, SEC Scrutiny Focuses on Asset Valuation and Private Equity Funds, Inv. Funds Group Newsletter (Kaye Scholer, New York, N.Y.), Summer 2012, at 8, available at http://www.kayescholer.com/news/client_alerts/Investment-Funds-Newsletter-Summer2012/_res/id=sa_File1/Investment-Funds-Group-Newsletter-Summer2012.pdf .
[11] See Loeser, supra note 6.

[12] Id.

[13] See Gallu & Alesci, supra note 7; see also Loeser, supra note 5.

[14] See Loeser, supra note 6.

[15] Which are perhaps more accurately characterized as investment losses.

[16] Private resolution is likely to lead to losses upon exiting the investment. See Abel, supra note 5 for a description of some potential private remedies.

[17] See, e.g. , Loeser, supra note 6 (discussing the inefficiencies arising from greater SEC oversight in the context of the Commission’s already overextended resources).

[18] Id . (citing European Private Equity and Venture Capital Ass’n, Int’l Private Equity and Venture Capital Valuation Guidelines (2006)).

[19] Gregory Zuckerman, How Scared Should Private Equity Be Under SEC Microscope?, Wall St. J. (Feb. 27, 2012), http://blogs.wsj.com/deals/2012/02/27/how-scared-should-private-equity-be-under-sec-microscope/ .

[20] Id . Note, however, that private equity funds do derive some fees from fund valuation (typically 2%) but receive far greater fees from profits or “carry” (typically 20%). This fee arrangement is commonly referred to as “2 and 20.”

[21] See supra note 10.

[22] Laura Kreutzer, PE Firms Learn to Live with Dodd-Frank, Dow Jones Private Equity Analyst (Aug. 27, 2012), available at http://pevc.dowjones.com/article?an=DJFPEA0020120827e88refmxe&from=alert&pid=22

[23] Id .

[24] Id.

[25] Pulliam & Eaglesham, supra note 5.

Health Care and Venture Capital: An Uncertain Outlook

Posted on by Sumit Gupta

When most people hear “health care” today, their minds automatically pivot to the national health care debate dominating the election season. Many venture capitalists, however, are thinking about their next target in the broad health care and biotechnology industry. Investment in the sector, which includes companies developing “medical devices, diagnostic [platforms], technology based healthcare services, life science tools,”1 and pharmaceuticals, has been on the rise. In 2011, venture capital investment in biotechnology reached $4.82 billion, with medical devices and healthcare services financings realizing gains of 17% and 41%, respectively, year-over-year. 2

What’s behind the uptick in a sector “long shunned by venture-capital investors?”3 Two key explanations are optimism over “new U.S. laws that could speed up drug approval in key areas”4 and the increasing role of software in health care. The current regulatory climate makes it a difficult and lengthy process to receive FDA approval for pharmaceuticals and medical devices.5 As the founder of a short-lived medical device startup, I can attest to the difficulties that FDA approval can bring a similarly-based business – our startup’s projections, for example, indicated that simply becoming eligible for 510(k) clearance (which is necessary to market certain categories of medical devices in the United States) would cost $20 million and take at least 5 years. The FDA has since established the Center Science Council to improve the predictability of its decision-making on new innovations,6 and the response from venture capitalists has been cautiously positive.7

Entrepreneurs remain hopeful, as increased software penetration, beyond electronic medical records, exposes new opportunities in the field. Venture firms have begun “broadening the types of businesses they consider part of the life-sciences field”8 to include those creating software solutions to many of healthcare’s most pressing problems. These firms aren’t comparable to those such as Google or Facebook when they were still startups, but that’s a good thing – venture capitalists such as Kevin Kinsella of Avalon Ventures recognize that “every therapeutic idea or product is a big idea”9 and has a better chance of disrupting a field still relatively foreign to the Internet. Cyrus Massoumi, founder of ZocDoc, a startup which allows users to find and book appointments online, finds the current financing landscape superior to that of years prior. In 2007, the reaction to ZocDoc’s pitch was “less, ‘Good idea,’ and more, ‘Good god, you’re crazy.’”10 In the five years since, Massoumi and his team have raised $95 million, culminating in a $75 million Series C last year with DST Global and Goldman Sachs.11

While some parties are optimistic for biotech’s resurgence, “[p]ricing pressures, slower economic growth and greater regulatory scrutiny”12 continue to make investment difficult to come by. Ernst & Young’s global life sciences practice released a report two weeks ago finding capital harder to come by for younger companies in the sector.13 According to their numbers, venture capital investment in biotechnology remains substantially lower than the $5.40 billion peak reached in 2006-2007,14 and the situation may not be improving to the degree that 2011’s numbers suggest. The data available so far for 2012 support their pessimistic stance. In Q2 2012, biotech companies received $697 million, or 42% less money in deals than the same quarter a year prior, the lowest amount seen by the National Venture Capital Association “since the first quarter of 2003.”15 Most affected by these trends are the small, young startups hurting for cash, especially those on the software-side of things. While more established companies, such as Merck, who launched its own $250 million venture fund in 2011, “invest in [early-stage] innovation with a portion of the dollars they would have invested in their own R&D,”16 these dollars end up at companies immersed in the pharmaceutical sector – the bread and butter of companies like Merck. Nevertheless, the experience of ZocDoc and others in the field show that substantial venture money is still out there – only now it’s being packaged in smaller, but smarter, deals.17

__________________________________________
1ARBORETUM VENTURES, http://www.arboretumvc.com/about.php.
2 Sarah McBride, Venture firms see signs of rebirth in life sciences, REUTERS (Sep. 24, 2012, 2:42 PM), http://www.reuters.com/article/2012/09/24/us-venture-capital-life-sciences-idUSBRE88N0UG20120924.
3Id.
4 Id.
5 Kate Greenwood, Venture Capitalists Complain of ‘Regulatory Challenges,’ FDA Responds, HEALTH REFORM WATCH (Dec. 20, 2011), http://www.healthreformwatch.com/2011/12/20/venture-capitalists-complain-of-regulatory-challenges-fda-responds/ (“The venture capitalists blame ‘regulatory challenges,’ primarily ‘the hostile FDA.’”).
6 See CDRH Center Science Council FAQs, U.S. FOOD AND DRUG ADMINISTRATION (Mar. 31, 2011), http://www.fda.gov/AboutFDA/CentersOffices/OfficeofMedicalProductsandTobacco/CDRH/CDRHReports/ucm249249.htm.
7 See Greenwood, supra note 5.
8 McBride, supra note 2.
9 McBride, supra note 2.
10 Cyrus Massoumi, Healthcare Momentum: Our Shared Responsibility, THE HUFFINGTON POST (Oct. 4, 2012), http://www.huffingtonpost.com/cyrus-massoumi/appointment-booking-tech-startup_b_1939854.html.
11 ZocDoc, TECHCRUNCH, http://www.crunchbase.com/company/zocdoc.
12 Susan Kelly, Venture capital for medical technology harder to come by: report, REUTERS (Oct. 2, 2012, 1:23 AM), http://www.reuters.com/article/2012/10/02/us-medtech-investing-idUSBRE89104D20121002.
13 Id.
14 Id.
15 John Carroll, New biotech deals scrape record low as VC groups lose steam, FIERCEBIOTECH (July 19, 2012), http://www.fiercebiotech.com/story/new-biotech-deals-scrape-record-low-vc-groups-lose-steam/2012-07-19.
16 McBride, supra note 2.
17 See McBride, supra note 2.

The Legitimacy of the Entrepreneur

Posted on by DJ Hill

It certainly seems like a special thing that our modern world has reached a turning point in which all stereotypes (regardless of their occasional accuracy) are generally considered offensive and are a simple indication of poor social posture. For the most part, this is good news. Be that as it may, obviously this was not always a familiar attitude. There is no question that prejudice and unjust group classifications used to be entirely acceptable modes of thought, even in our own recent past. In spite of this new war on labels, however, there is still one group upon whom an unofficial “open season” has been declared: the entrepreneur. Specifically the private equity community, who not long ago was likened to a “swarm of locusts.”1 This seems to be a shared sentiment among many.

Private equity firms are simply not seen as innovators. They are not seen as providers of capital. They are “greedy” because they own or control a disproportionate share of “society’s” wealth. There are dozens of obvious examples of this lazy characterization.2 The common joke, of course, is that “business ethics” is an oxymoron and the two concepts – business and ethics – are at a fundamental tension with one another. This confusion in moral and economic thinking can be seen by the fact that little moral sanction is granted to private equity firms, and many of the individuals are often accused of carrying around “more guilt” than the average person.

In fact, the two concepts are not mutually exclusive, but rather they have a very special ability to go hand in hand. The quest for success and knowledge is a simple, ontological desire, and an undeniable part of our human constitution. Regardless of a person’s skills, interests, or occupation, the pursuit of excellence is always a motivating force. While private equity firms don’t deserve unfair criticism, it’s important to note that they also don’t deserve to be treated like victims of unfair discrimination. That being said, their chosen profession certainly deserves to be legitimized by the people. The only way this can be accomplished is by acknowledging the value of private equity firms, the talent it takes to be a part of one, and the tangible benefits that are conferred onto society by them.

If private equity firms are indeed valuable, why the powerful divide? How is it that well meaning, generally “moral” people have difficulty grasping the moral fortitude or basic principles of a free economy? Most likely it is due to an alarming lack of economics training. Private equity is about producing wealth, not redistributing it. There is no zero-sum game. Entrepreneurs make money – they don’t simply collect it. The only way this can happen, though, is for them to offer something of value in exchange for payment. In other words, some party upstream has to actually pay them. “Greed” alone is nothing more than an attitude and can’t add even one cent to a person’s income. And even though it’s probably more accurate to characterize private equity investment as wealth creation rather than job creation, the obvious reason for this is that no business could survive with the chief goal of creating jobs. For example, Mitt Romney was recently criticized for only seeking net profits rather than job creation, and that “any job creation [at Bain Capital] was accidental.”3 Indeed, he amassed great wealth for Bain Capital, but isn’t it the goal of every single commercial enterprise to be profitable?

Another likely reason for the vitriol toward wealth is the unavoidable mass-media exposure to the terrible poverty that exists here and around the world. Strong emotional reactions to poverty are entirely proper, and morally incumbent on those who have the ability to assist. A problem develops, however, when this good sentiment is combined with the economic ignorance explained above to fabricate a sort of cause and effect relationship between the wealthy class and existing poverty. This reaction is understandable but mistaken. People who react this way fail to recognize that the most successful method for bringing people out of poverty is through a free market and wealth production.4

Moreover, private equity deals are never a guaranteed success. These firms put their money, time, and property on the line to ensure security for their investors and the companies they are creating efficiency for. These benefits necessarily run through to the entire market they are being supplied to, which includes individual consumers and employees. Only people with the competence, creativity, and guts to undertake such massive risks succeed.

As a free people, we have a moral obligation to attack uncertainty in an enterprising way. The private equity entrepreneur is a shining example. They look courageously into the future with a great sense of opportunity. They create newer, more efficient enterprises which allow more people to choose the way the earn income and develop their skills. Immoral behavior is at least as prevalent, if not more so, in any other industry. What’s important, though, is that categories of immoral behavior aren’t applied to the private equity community with more fervor than any other industry or trade. Particularly, the assertion that private equity firms are motivated by nothing more than “greed.”

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1 Op-Ed, Marx or Markets: German Politicians Debate the Dangers of Capitalism, SEIGEL ONLINE, May 5, 2005, http://www.spiegel.de/international/anti-capitalism-debate-marx-or-markets-german-politicians-debate-the-dangers-of-capitalism-a-354733-druck.html.
2 See, e.g., WALL STREET (Twentieth Century Fox 1987), AMERICAN PSYCHO (Lions Gate Films 2000), Dallas (Warner Horizon Television 2012).
3 Steven Rattner, Tall Tales About Private Equity, N.Y. TIMES, May 22, 2012, at A23.
4 Mary Tupy, Capitalism Will Eliminate Poverty In Africa, CATO INSTITUTE, Apr. 20, 2012 http://www.cato.org/publications/commentary/capitalism-will-eliminate-poverty-africa

The National Hockey League and Private Equity

Posted on by Kevin Badgley

For the second time in seven years, there is a real possibility that an ongoing labor dispute will prevent the puck from ever being dropped on the National Hockey League season. Hockey has become an afterthought, a professional sport that is lucky to receive a minute of airtime on the nightly Sportscenter broadcast. While reports have estimated that the NHL has lost as much as $240 million in the last two seasons,1 diehard hockey fans do still exist. And while they would probably rather spend their time smuggling octopi into Joe Louis Arena, they may find hope in reading a recently published piece by Bloomberg Businessweek that asks, “Could Private Equity Solve Pro Hockey’s Problems?”

The article lays out a number of qualities that would make the NHL attractive to private equity firms. Among the qualities listed are:

• “Weak management
• Underachieving revenue
• Opportunities to expand while taking on debt
• Problems that are driving down value, but could be solved by a fresh set of outside managers.”2

These undesirable characteristics have plagued the NHL for years, and PE firms have taken notice. In 2005, Bain Capital surprised many with an offer to buy the entire league for $3.5 billion.3 Bain’s proposal reflected the classic PE business-model: by combining all 30 teams into a single business entity, it would be possible to streamline operations, boost TV revenue, and slash player salary from a position of absolute leverage.4 This single ownership strategy is the model that Major League Soccer, a league that started as an afterthought in the crowded American sports market, has employed (to at least limited success).5

As a dispassionate third party, Bain would focus solely on making money—it would not be blindsided by the emotions that undoubtedly come with owning a pro sports team. Yet those emotions are what ultimately doomed the deal, as Bain failed to muster the required majority approval from team owners.6 Given that most of these owners are independently wealthy and are not in the business for the money, it is unlikely that this type of transaction would ever be agreed upon.

Even if a firm like Bain were somehow able to overcome this hurdle, they would still be faced with an even larger issue: the players themselves. During a PE takeover, labor is often one of the first areas in which costs are cut. Technological improvements or cheaper workers typically replace longtime employees. However, sports are unique in that the laborers are the products. The NHL could recruit inexpensive, second-rate talent, but it certainly would not improve economic conditions considering that the league currently employs the top players in the world and still struggles to make a profit. The alternative—convincing the current players to take a significant pay cut—is extremely unrealistic given the lucrative contracts that foreign franchises would assuredly offer the NHL’s stars.

At first glance, the NHL and PE may seem like a perfect match. However, a closer look reveals that some major issues would have to be resolved in order for the relationship to be profitable. But still, if an entire season is lost and teams continue to operate in the red, the league would be wise to at least reconsider a PE model that has helped save so many similarly distressed companies in the past.

_______________________________________
1 Dirk Hoag, NHL CBA 2012: How can the league, as a whole, be losing money?, ON THE FORECHECK (Sept. 4, 2012, 4:55 PM), http://www.ontheforecheck.com/2012/9/4/3292168/nhl-cba-2012-league-losing-money-ha-ha-ha.
2 Nick Summers, Could Private Equity Solve Pro Hockey’s Problems?, BLOOMBERG BUSINESSWEEK (Sept. 11, 2012), http://www.businessweek.com/articles/2012-09-11/could-private-equity-solve-pro-hockey-s-problems.
3 Id.
4 Id.
5 See http://majorleaguesoccertalk.com/2009/11/27/mls-and-its-players-third-party-ownership-player-and-club-rights-non-existent/; see also, Fraser v. Major League Soccer, 284 F.3d 47 (1st Cir. 2002) (MLS central-ownership structure not an anti-trust violation).
6 Id.

JOBS Critics

Posted on by Luke Rachlin

As the JOBS Act awaited President Obama’s signature this week, critics, emboldened by accounting issues at the recently public Groupon, continued to take aim at provisions alleged to roll back crucial investor protections. Passed by strong majorities in both the House and Senate, the principle purpose of the JOBS Act is to promote capital raising among startups by easing their paths toward an IPO. Opponents of the Act, however, claim that its relaxed financial disclosure standards invite a reemergence of Enron-era accounting fraud.

Recent news on internet startup Groupon has stoked much of that criticism. Last Friday, in response to an auditor’s determination of a “material weakness in internal controls over financial reporting,” the company revised fourth-quarter earnings down by $14.3 million.1 Had the Act been in place, Groupon’s revisions would not have been a product of adjusted reporting requirements; the relevant JOBS provisions apply only to companies with less than $1 billion in annual revenue and $700 million in market cap, while Groupon earned 1.6 billion in 2011.2 Nonetheless, critics contend that events at Groupon highlight the risks associated with easing financial disclosure requirements, generally. Had the Act been law before Groupon went public last year, some point out, its annual revenue of less than $1 billion would have made it eligible for relaxed reporting requirements and the company’s questionable accounting methods may not have drawn the attention that they are getting now.3

Among the specific provisions targeted by the Act’s opponents is that which allows emerging companies on the verge of an IPO to have “private conversations with the S.E.C. about planned disclosures,” not to be made public until 21 days prior to an offering.4 Andrew Ross Sorkin of NYTimes Dealbook wrote recently that the provision, which allows companies to avoid “embarrassing public gaffes,” may benefit those seeking to go public who would otherwise be discouraged by accounting scrutiny, but is “awful for the investors, who rely on the transparency of the process.”5 Had the Act applied to Groupon’s public offering, Sorkin explained, “it is unlikely the public would have found out in time about a series of questionable accounting gimmicks and metrics that the company had hoped to employ to bolster its numbers investors.”6

The same day that Sorkin’s comments were published, The Wall Street Journal’s Michael Rapoport weighed in on the 21-day provision, characterizing it as permitting companies to “iron out disagreements with regulators behind closed doors before they go public.”7 This practice, Rapoport agreed, “might have prevented investors from finding out about Groupon’s early accounting questions until after they had been resolved.”8

Others, however, are less concerned. Joel Trotter, a Latham & Watkins attorney on the task force responsible for devising ways to make it easier for companies to file publicly, was quoted by Rapoport claiming that “three weeks is an extremely long time in assessing information relevant to an investment decision.”9 AOL Founder Steve Case has similarly responded that, while the bill is “not perfect,” it will ultimately “strike the right balance” between encouraging IPOs and maintaining appropriate disclosure standards.10

Opinions are clearly divided and the debate surrounding a 21-day notice provision barely scratches the surface of that division. If the last major adjustment to financial disclosure standards (See SOX 2002) provides any indication, it does not appear that the debate will be ending anytime soon.

_________________________________________
1. http://dealbook.nytimes.com/2012/04/02/jobs-act-jeopardizes-safety-net-for-investors/
2. http://online.wsj.com/article/SB10001424052702304023504577317932455874856.html?mod=googlenews_wsj
3. Id.
4. http://dealbook.nytimes.com/2012/04/02/jobs-act-jeopardizes-safety-net-for-investors/
5. Id.
6. Id.
7. http://online.wsj.com/article/SB10001424052702304023504577317932455874856.html?mod=googlenews_wsj
8. Id.
9. Id.
10. http://dealbook.nytimes.com/2012/04/02/jobs-act-jeopardizes-safety-net-for-investors/

Ann Arbor has the Right Stuff

Posted on by Joseph R. Morrison, Jr.

Jason Mendelson (@jasonmendelson) and his partner, Brad Feld (@bfeld), visited Ann Arbor and UofM back in the fall. They made the rounds of TechArb, the University Office of Tech Transfer, and even stopped by a Ross School of Business Class taught by Dr. David Brophy that pairs students with budding companies trying to land Angel or VC funding. I was enrolled in the class and I got to pitch Jason on my company… WHAT a great experience! I was REALLY impressed with both of them and I love their dedication to cultivating a culture of entrepreneurship in Boulder, Ann Arbor, and throughout the US more generally. It is definitely something that helped stoke my entrepreneurial fire. However, the best thing I heard was at a lunch talk at the Law School. Both gentlemen raved about Ann Arbor and, while I am way overdue in sharing, this recent post encouraged me to mention their trip.

I thought I would share this blog entry, written by Brad, since it has a number of good thoughts and links to some of the other posts from their visit. Enjoy!

http://startup-communities.com/2012/02/28/action-in-ann-arbor-mi/

LLC Fiduciary Duties in Delaware Private Equity and Venture Capital

Posted on by Justin Taylor

In its January 27th decision of Auriga Capital Corp. v. Gatz Properties, LLC, the Delaware Chancery Court put to rest any ambiguity in its reading of the Delaware LLC Act as it applies to establishing default fiduciary duties in the LLC context. (1) Although the topic had been addressed in a number of recent cases, none approached the depth and breadth of analysis exhibited by the Court in Auriga. (2) In his opinion, Chancellor Strine definitively establishes that a manager or member of an LLC owes the default duties of care and loyalty to all other members, unless an LLC agreement effectively expands, limits, or eliminates these duties.

Auriga Capital v. Gatz Properties

The dispute in Auriga centered on Gatz Properties, LLC’s management of property held by Peconic Bay, LLC. William Gatz, as the sole actor for Gatz Properties, formed Peconic Bay with Auriga Capital Corporation in order to develop land held by the Gatz family into a golf course. Peconic Bay then leased the golf course land from Gatz Properties. While the LLC Agreement required dual class majority approval for any “major decision affecting the company,” Gatz was effectively able to approve his own decisions as Manager without interference from minority members due to majority control of both the A and B Peconic share classes by Gatz Properties and the Gatz family.

Gatz made and approved such a “major decision” when he chose to perform a sale of Peconic, which ultimately led to a dispute with Auriga and other minority owners of Peconic Bay. In 2010, after the underperforming golf course operator with a sublease on the property chose to exercise its early termination option, Gatz turned away a serious bidder for Peconic Bay and orchestrated a sham auction. Gatz was the only bidder for the company, and purchased Peconic Bay at an unfairly low price. The minority members, whose invested capital amounted to $725,000, received a paltry $20,985 distribution from the sale. This led them to file suit and claim Gatz breached his fiduciary duties.

At trial, Gatz raised various defenses. However, of particular interest was his assertion that the LLC Agreement of Peconic Bay “displaced any role for the use of equitable principles in constraining the LLC’s manager,” and thus removed his actions from any fiduciary duty analysis. The Court rejected this argument, however, and affirmatively determined the existence of default restrictions on the actions of a managing member of an LLC beyond the requirements of good faith and fair dealing.

Existence of Default Duties

Like the Delaware General Corporation Law (“DGCL”), the LLC Act (the “Act”) does not plainly state the fiduciary duties of care and loyalty apply by default to managers and members of an LLC. However, unlike the DGCL, 6 Del. C. § 18-1104 of the Act provides an explicit default application of the “rules of law and equity.” Do those rules of law and equity include the duties of care and loyalty? Footnote 34 of Auriga explains they do.

That § 18-1101(c) provides for the contracting out or modification of fiduciary duties implies these duties exist by default. The Court goes on to explain that when §§ 1101(c) and 1104 are read together, these sections establish that when a manager or member would traditionally owe fiduciary duties, they are a fiduciary and are subject to the express right of the parties to contract out of those duties. So far as a manager or member would not owe fiduciary duties under traditional equitable principles, they do not owe any in the LLC context. This is not by operation of the Act, but by those same traditional equitable principles. The Act does not create a broader range of duties.

The Court also pointed to the 2004 amendment of the Act (in addition to the amendment of Delaware Revised Uniform Limited Partnership Act (“DRULPA”)) by the Delaware Legislature. The amendments were instigated by a Delaware Supreme Court holding in Gotham Partners L.P. v. Hallwood Realty Partners L.P, which questioned the extent to which default duties could be completely eliminated in the partnership context. (3) Both the Act and DRULPA were reworded to permit the complete elimination of fiduciary duties, as well as full contractual exculpation for breaches (through the introduction of §18-1101(e) for LLCs).

The Court in Auriga reasoned if the “equity backdrop” did not apply to LLCs then: 1) the amendment would have provided that members and managers owed no duties to the LLC other than those set forth by agreement or in the statute; 2) the General Assembly would have eliminated or modified the default application of the rules of law and equity in §18-1104; and 3) the General Assembly would not have provided for the elimination and exculpation of something if that something did not exist. These factors combined with the case law establishing the existence of default duties in the LLC setting and the policy concerns surrounding displacement of a widespread investor belief in the same, firmly established, in the Court’s mind, the alignment of those holdings and the legislature’s intent.

Outcome of Auriga

The Court determined, and Gatz conceded, as an LLC manager without clear and unambiguous elimination or modification in the LLC Agreement, Gatz owed the other members of Peconic Bay the fiduciary duties of care and loyalty. The Court then determined that:

“Gatz breached his fiduciary duty of loyalty and his fiduciary duty of care by: (1) his bad faith and grossly negligent refusal to explore any strategic alternatives for Peconic Bay from the period 2004-2005 forward when he knew that American Golf would terminate its lease; (2) his bad faith refusal to consider RDC’s interest in a purchase of Peconic Bay or a forward lease; (3) his bad faith conduct in presenting the Minority Members with misleading information about RDC‟s interest and his own conduct in connection with his buyout offers in 2008; and (4) his bad faith and grossly negligent conduct in running a sham Auction process that delivered Peconic Bay to himself for $50,000. The results of this conduct left the Gatz family with fee simple ownership of the Property again, a Property that had been improved by millions of dollars of investments and now contained a clubhouse and first-class golf course. The Minority Members got $20,985.” (4)

Chancellor Strine awarded the minority members what they should have received in a fair auction: their initial investment of $725,000 and a 10% return. He deemed this “a modest remedy and the record could support a higher one.” Additionally, because the “record is regrettably replete with behavior by Gatz and his counsel that made this case unduly expensive for the Minority Members to pursue,” Strine required Gatz to pay one half of the minority’s attorneys’ fees and costs. If the manager or a member of an LLC wants a lesson on what not to do, this case is a very instructive read.

Key Takeaways for Private Equity and Venture Capital

In reflecting on Auriga, drafters and parties to LLC Agreements should find some comfort in the relative certainty the holding provides. In drafting their LLC Agreements for Management Company, General Partner, and Portfolio LLCs, parties should ensure their Agreements clearly and unambiguously reflect their intentions as to the types and extent of duties they intend to apply between members and management. Some key takeaways include:
• The traditional duties of loyalty and care apply by default to Delaware LLCs.
• A manager of a Delaware LLC is a fiduciary and subject to those default duties.
• Such duties may be altered or eliminated and liability exculpated by clear and explicit agreement under the LLC Agreement.
• Evaluation of fiduciary duty claims “cannot occur without a close examination of the LLC agreement itself.”
• The duties of good faith and fair dealing, as they exist independently from the duty of loyalty, apply to all LLCs and cannot be contracted around.
• LLC agreements in existing Private Equity and Venture Capital investments should be evaluated for clarity in any desired modification of fiduciary duties, with necessary amendments made to bring them in line with the intentions of the parties to the agreement in light of the Court’s clarifications.

1- Auriga Capital Corp. et al v. Gatz Properties, LLC et al, C.A. 4390-CS (Del. Ch. Jan. 27, 2012).
2- See Kelly v. Blum, 2010 WL 629850 (2010), Bay Ctr. Apartments, 2009 WL 1124451 (2009).
3- Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160 (Del. 2002).
4- Auriga, C.A. 4390-CS at 62.