What new capital options are on the rise as markets change

By Steven Shultz, Global EY Private Tax Leader

    As the world addresses the economic consequences of COVID-19, private businesses — particularly resilient and leading businesses — are thinking creatively about their potential sources of outside capital. Some of the more common capital sources may be less available or less attractive measured against the long-term ambitions and purposeful ownership of many private businesses.

    In this environment, we are continuing to see the strong rise of alternative, “direct” capital sources, both debt and equity, with less emphasis on short-term market dynamics and hurdles, and in some cases favorable terms. For many private businesses and owners navigating capital and liquidity scenarios, today’s direct capital alternatives may be very appealing.

    The global economic response to the pandemic has tightened some traditional equity and debt markets, with investors and lenders facing uncertainties of their own. In addition, we realize some investors will be seeking distressed businesses at pricing levels that reflect a shorter-term focus and may not match up with the longer-term focus of many private business owners.

    Here the availability or strategic fit of institutional private capital, public offerings and traditional debt options (e.g., short-term loans with balloons, working capital revolving credit lines) may be more limited. For private business owners, the key questions often center around how the various capital alternatives support their strategic intentions particularly as it relates to longer-term growth, ownership control and shareholder liquidity.

    It is important to note that the crisis has also amplified and accelerated several trends in the market as it relates to purposeful ownership, sustainability and governance and the ambition to create societal and human value in addition to financial value through the business. These trends were already at play.

    Still, today’s heightened awareness on sustainability and economic disparity has many business owners and investors expanding their definition of value. As they do so, they are actively considering innovative private capital sources that align fully in terms of patience and purpose. For some, the alternatives around direct and family capital may have a special appeal and certainly warrant careful consideration.

    What distinguishes direct capital providers is they are generally investing their own capital rather than raising and redeploying capital from other investors. Many direct capital providers will consider strategic, patient capital investments in other businesses.

    Often the direct capital is controlled by family offices, family strategic investors, business-owning families or a syndicate of strategic investors ready to invest in other businesses. These investors have the ability and desire to provide capital with a long-term horizon and a broad concept of value that can be very appealing for private businesses and purposeful owners.

    Advantages of these direct, family capital sources can include strategic fit on definition of value, lower costs of capital when compared to institutional funds and/or less regulatory burdens when compared to raising capital via the public markets. Importantly, the absolute amount of capital that is potentially available for direct investment exceeds what is available from institutional sources.

    Moreover, direct capital often comes with a complimentary, entrepreneurial mindset from the investors that may prove beneficial to the private business.

    Direct capital can have drawbacks as well. The pool of potential investors is more concentrated in a way that can make access, fit requirements and readiness expectations challenging. We know that leading direct capital investors have quite rigorous expectations when screening the companies that they choose to fund.

    Private businesses wanting to access the benefits of direct capital will want to ensure they take a comprehensive approach to preparation and readiness in order to ensure they are “direct capital ready.”

    Direct capital investors, like many strategic investors, often expect board representation or a vote in strategic decision-making. Where the strategic fit is right, this provides added value for private businesses as they tap into the experience and insights of direct capital investors.

    Private businesses seeking direct capital will want to carefully consider their readiness for business and family governance models that optimize the influence and control of direct capital investors.

    To attract direct capital sources, a business must demonstrate a well thought out and carefully articulated investment thesis, a fit for purpose business infrastructure, capable financial mechanisms and the right rigorous process for planning and implementation to ensure continued value creation and protection even amidst disruption.

    Good governance and organization are the backbones of every business and the building blocks for future success. Your organizational structure and operational plans must support your business model and strategy. Further, you must have the executive management and employee support to carry out those plans.

    Your company must have the financial mechanisms in place to not only safeguard the investment, but to deliver a return through a prosperous business. This includes a well-managed treasury function as well as sufficient financial, accounting, tax and IT processes, systems and controls.

    Your business should be forward thinking with advanced forecasting and planning that rely on institutional quality reporting, and capital providers want to understand how plans will be implemented. You should have in place sound risk-management processes, policies and procedures that provide insight into potential problems and offer transparency on pending issues, including environmental and legal.

    Conducting a succinct and focused readiness review to determine if your business is ready and equipped in critical areas — and prepared to demonstrate the same for potential direct investors — is a great preparation step if direct capital may be right for you and your business. A key component is having a strong network and the right advisors to support assessment and preparation for all capital options.

Questions? Reach out to EY Private Cincinnati: Todd Immell, Principal, 513-384-7979 or Todd.Immell@ey.com, or Stephanie Silver, Senior Manager, 513-612-1497 or Stephanie.Silver@ey.com. Website: ey.com/familyenterprise

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