Private equity funding for minority media ownership.

• Author: Fried, Vance H.

1. INTRODUCTION

   The private equity market is a major source of capital in the United States. In 1998, organized private equity firms raised over $85.3 billion.(1) These firms are very interested in media investing. For example, one private equity firm, Hicks, Muse, Tare & Furst, recently financed the $2.1 billion purchase of SFX Broadcasting and the $1.7 billion purchase of LIN Television.(2) Private equity financing is important to all sizes and types of media companies. Much of the rapid growth of the Internet has been financed by private equity.

   The two defining characteristics of the private equity market are in its name. First, it is structured as equity or near equity (e.g., subordinated debt with warrants) investment, not debt. The investor is at significant risk and is looking for long-term capital appreciation. Second, it is an investment in an unregistered (private) security that cannot be purchased or sold in the public market.

   Private equity is one of the most expensive forms of finance. Thus, companies that raise private equity tend to be those that are unable to raise funds in other markets such as the bank loan, private debt placement, or public equity markets. Many of these companies are simply too risky to be able to issue debt or need funds beyond prudent debt levels. Investment in these companies may also require a large amount of investigation on the part of potential investors because little public information is available, and there are unique risks involved. The companies may also need investor guidance and expertise in developing their business. The private equity market, where a large investor can take the time and effort to understand such risks and may exert some influence over management in return for its investment,(3) may be the only viable alternative.

   From the perspective of an entrepreneur or top manager, being part of a company financed by private equity is often far more attractive than being part of a subsidiary of a large company. The private equity investor allows them to have a significant economic stake in the business. They are co-owners, not just employees. In addition, private equity investors give them much more control over their company. Private equity investors generally try to stay removed from day-to-day operations. Private equity investors function like active board members, not like a chief executive officer and headquarters' staff.(4) While private equity investors :may have investments in several different companies, these companies are usually allowed to operate totally independent of each other.

2. OVERVIEW OF THE PRIVATE EQUITY MARKET(5)

   Sometimes a private equity investment is made directly by an investor in a company issuing the stock. However the bulk of private equity comes through the organized private equity market. In this market, an intermediary organizes investors and makes investments on their behalf in the issuing company. Figure 1 presents an overview of the organized private equity market.

   [Figure 1 ILLUSTRATION OMITTED]

   1. Issuers

      Issuers in the private equity market vary widely in size and their reasons for raising capital, as well as in other ways. Issuers of traditional venture capital are young companies, often developing innovative technologies, projected to show very high growth rates. They may be early-stage companies still in the research and development stage or the earliest stages of commercialization, or later-stage companies that have several years of sales but are still trying to grow rapidly.

      Since the mid-1980s, nonventure private equity investment has outpaced venture investment. Middle-market companies, roughly defined as companies with annual sales of $25 million to $500 million, have become increasingly attractive to private equity investors.

      Public companies also are issuers in the private equity market. Public companies that go private issue a combination of debt and private equity to finance their buyout. Public companies also issue private equity to help them through periods of financial distress and to avoid the disclosures associated with public offerings.

   2. Intermediaries

      Intermediaries--mainly limited partnerships(6)--manage an estimated 80 percent of private equity investments. Investors are the limited partners. Professional private equity managers, working through a partnership management firm, are the general partners. Limited partnerships have a ten-year life, during which investors give virtually all control over the management of the partnership to the general partners. The general partners are paid an annual management fee but receive a significant amount of their compensation in the form of shares in the partnership's profits.

      Slightly different from traditional partnerships are Small Business Investment Companies (SBICs). Small Business Investment Companies can leverage investor capital with federal government capital through the Small Business Administration (SBA). Today, SBICs play a small role in the overall private equity market, accounting for less than 1 percent of total industry capital. However, one type of SBIC, the Specialized Small Business Investment Company (SSBIC), may be a very important source of financing for minority media. By their charter, SSBICs are required to invest in businesses owned by the socially or economically disadvantaged.

   3. Investors

      A variety of groups invest in the private equity market. Public and corporate pension funds are the largest investor group, providing about 50 percent of the capital. Pension funds are followed by endowments and foundations, bank holding companies, and wealthy families and individuals, each of which holds about 10 percent of total private equity. Insurance companies, investment banks, non financial corporations, and foreign investors are the remaining major investor groups. The federal government is also a supplier of capital through the SBIC program.

      Most institutional investors invest in private equity for strictly financial reasons. They expect the risk-adjusted returns on private equity to be higher than the risk-adjusted returns on other investments, and they want to diversify their portfolio by asset class.(7) While SSBICs receive funding through the federal government and are required to invest in minority-owned businesses, the program is designed so that the private investors in the SSBIC are financially driven.

   4. Industry Segments

      Private equity firms have largely segmented the market based upon characteristics of the companies in which they are investing. The primary characteristics are age, size, and reason for seeking equity. Although the boundaries between segments are not precise, most private equity firms will specialize in one, or sometimes two, of these segments.

      1. Early-Stage New Ventures

         Early-stage venture capital goes to small companies wishing to grow rapidly. Examples of media companies at an early stage are a new Web site, a start-up cable channel, or a developer of new broadcasting equipment. Early-stage new ventures vary somewhat in size, age, and reasons for seeking external capital. The smallest type of venture in this category is the entrepreneur who needs financing to conduct research and development to determine whether a business concept deserves further financing. The concept may involve a new technology or merely a new marketing approach. Financing may be needed to build a prototype, conduct a market survey, or bring together a formal business plan and recruit management.

         A somewhat more mature type of company in the early-stage category already has some evidence that production on a commercial scale is feasible and that there is a market for the product. Such companies need financing primarily to set up initial manufacturing and distribution capabilities so they can sell their product on a commercial scale. Slightly more mature companies may already have basic manufacturing and distribution capabilities but need to expand them and to finance inventories or receivables. The most mature of the early-stage companies are starting to turn profits, but their need for working and expansion capital is rising faster than their cash flow.

         Early-stage venture investments are by their nature small and illiquid. A typical...