August 2008 - Legal Notes

Today’s Economy:
Dispelling the Myths

By Jeffrey D. Knowles and Charles J. Morton Jr.

Companies seeking to raise money to fund expansion can be forgiven for thinking the outlook is bleak these days. The stock market is deep in bear territory, the credit crunch has made credit difficult or impossible to secure and the IPO market is all but dead. Despite all

of these negatives, companies-especially Internet-based enterprises with a solid business model-are dead wrong if they believe investors and cash to fund expansion are not readily available. Although money might be tough to raise on Wall Street, private equity firms are actively on the hunt for strong companies to fund.

Three factors are driving private equity’s continued strength as other funding sources suffer: foreign investment, a shift in the investment strategies of major private equity firms and the re-emergence of mezzanine finance.

Today, American companies have become attractive targets for international investors looking to leverage the strength of their currency over the weakened dollar. The strength of the Euro, which has stayed about $1.50 to the Euro since February of this year, as well as other strong foreign currencies have made investing in American companies a bargain. Because of this, international investors have injected tremendous amounts of capital into American private equity funds. This influx of capital has enabled private equity funds to become less dependent on the traditional debt markets as a method of raising capital. This alternate source of capital provides private equity groups the funds to do more deals and finance more companies.

In addition to the influx of foreign money into American private equity and venture capital funds, there has been a noticeable shift in the way those funds are investing these monies, especially in the Internet sector. Only a couple of years ago, the large brand-name private equity groups would only consider investing in established companies. Today, more private equity firms are entertaining investment in early stage technology and e-tail companies, which is good news for early stage companies in need of funding.

Another recent change in the funding landscape for small- and medium-sized Internet companies is the rapid growth in mezzanine financing opportunities. As the credit crunch has crimped the amount of conventional funding available to companies, mezzanine-funding groups have stepped into the breach to provide funding that closes the gap between what is available and what is needed. The tightening of conventional credit markets has reduced the funds senior secured creditors, such as banks, are willing to offer companies. Meanwhile, mezzanine funds are able to realize great rates of return by filling the void left by senior secured creditors. Although mezzanine funding is subordinate debt, meaning that those holding it are the last to be paid out in the event of a bankruptcy, savvy investment decisions have enabled many firms to realize good rates of return, while ensuring a low risk of default by taking an active role in the companies they fund.

While each of these three trends is good news to companies in need of capital to fuel expansion, none of them are “one size fits all” solutions. Companies must objectively weigh the market advantages their organization holds, as well as the challenges it faces before deciding that private equity investment is the right path for their organization.

Jeffrey Knowles manages Venable LLP’s Government Division and heads its Advertising and Marketing Practice Group. He can be reached at (202) 344-4860. Charles J. Morton Jr. is a partner in the Business Transactions Group. He can be reached at (410) 244-7716.


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