Parabellum Investments: Beware the private equity trap

For the latest generation of Australian business owners, recession has been little more than economic theory they will have read or heard about. In all likelihood, many will not know what it feels like to be in a shrinking economy. And it could get worse because of the long-term ramifications of Covid-19. Consumer confidence is waning – and this will have a detrimental impact on many businesses.

A loss of revenue creates a multitude of problems such as finding new sources of capital and servicing existing debt. As head of a privately-owned investment firm, specialising in the mid-market, I regularly speak to the management teams of such companies. Right now, not only in Australia but around the world, many are feeling the heat and looking for new sources of funding to weather the economic storms ahead. 

Equity investment, if available, is the best option for many because it will improve treasury and working capital. It sounds glib but not all forms of equity investment are equal. One particular example is an instrument portrayed as equity but behaving as a mixture of debt and equity – preference shares.  

Preference shares, used by many private equity firms for funding, rank ahead of ordinary equity in the sense that the first money that will be paid out of a sale will go to the preference shares holder, ahead of the ordinary equity holders. 

The ranking of distributions upon a sale is not a concern if things have gone well and there are sufficient funds for debt providers to get their money back and all equity holders to make a return. However, in cases where returns are less than 1x investment (excluding any interest), it is always the debt providers who are paid out first and the balance of proceeds then split among the equity holders. 

In addition, preference shares also attract an interest rate, which the company is often required to service on a regular basis, typically monthly. This means it is debt, which could well be in addition to any bank debt – and priority of debt servicing will usually always go to the bank first.

Debt is a valuable instrument when used judiciously and when everyone understands the rules of the game. In good times, when trading is buoyant, many businesses may cope perfectly well with the cost of servicing their debt, including that carried in the preference shares. But in tougher trading environments – like now – many businesses will struggle to generate free cash flow given profits are siphoned off by onerous debt obligations.  

Other than the obvious, the practical implications of this is that the company can be deprived of sufficient working capital, particularly in cases when it is intending to reinvest. What results is an unhealthy environment where management feels trapped and views their effort as simply serving obligations to the bank and the private equity firm. 

The debt and financial structuring of an investment in the business can, without proper scrutiny and controls, leave management in a worse state than before – not making enough money to re-invest in the business and unable to raise more, or sell. At Parabellum, we do not – and never will – inject equity in the form of preference shares, preferring to invest in businesses where we believe our operational experience will help the management team turn a company around or take it to the next level, allowing profits from the company to be reinvested and deliver growth. 

We are all living through difficult times and I understand one does not always have the benefit of being selective with new funding – but it is always worth a closer look. We are a new class of investors that have genuine operational knowledge and the mettle to use our own funds rather than those raised from third parties by bankers and private equity houses. In our own experience, this can make a huge difference in the performance of a company.

Rami Cassis is CEO and founder of international investment firm Parabellum Investments, which backs mid-sized companies looking to grow in global markets.

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