Our Purpose and Private Equity Focus.
Luna Capital Fund is a non-bank alternative lending source for private equity buyout opportunities. The regulated banks have been forced to over-compensate for the excesses of the early 2000’s. However, this has left a gap in the market for raising capital to acquire small and medium sized companies via buyouts. Luna Capital is a non-bank private equity fund that raises and places capital via preferred shares. We focus on supporting buyouts of established, profitable companies that ordinarily will not meet bank underwriting standards because they are asset-light or do not have sufficient US-based employees to qualify for Small Business Administration funding.
Our Private Equity Deal Criteria.
Our target raise is $7.5M per fund via Regulation D, Rule 506(c). Our minimum fund-raise is $350k. We deploy this capital in exchange for a 12% preferred dividend and a 10% carried interest. The private equity investment opportunities we focus on are in high growth (e.g., e-commerce, software-as-a-service, SaaS) or high margin (e.g., insurance, industrial services) sectors. Our capital helps private equity companies and buyout firms complete their mergers and acquisitions. Our criteria for investment are: a) profitable target companies, b) trailing 12-month revenue growth, c) 3x-5x EBITDA multiples, d) deal size less than $6M. The other short-term alternative we provide lending for is inventory financing for established businesses.
Our Private Equity Deal Rationale.
Asset and wealth managers have developed a diversification strategy that is now used by the most sophisticated and larges institutional investors, including foundations and endowments. It includes domestic equities, international equities, real estate, venture capital, total return hedge funds, and private equity. Price to earnings multiples are at an average of 22x. Real estate is at 33x.
Private equity portfolios have companies at lower multiples. As Bain Consulting outlined in its 2019 Private Equity Report the multiples that private equity firms pay over the EBITDA of the acquired company ranges from 10x to 20x.
The Bain report yielded two other interesting insights. First, there has been significant investment in private equity since 2003. The amount of “dry powder” or funds available to private equity firms to buy companies or assets has grown from $400B (2003) to $2T (2018). The growth in dry powder also reflects the fact that private equity is crowded at the top end of the sector. The largest funds need larger deals and they are competing with each other for them. (Recall the 20x multiples in the chart above for companies with $1B EBITDA.
The second interesting finding in Bain’s report are the qualitative interpretations of the challenges facing the sector. The figure below shows how participants in a survey felt that the competition for a smaller number of large deals was driving up acquisition price multiples. Not only is it affecting the $1B EBITDA businesses, but also the $25M EBITDA business acquisition multiples have shifted from 5x to 10x (Figure 2.4 above).
Our strategy is akin to fracking. The United States has energy independence in oil and natural gas because small operators with low costs of capital and low barriers to entry fracked the global energy sector. The same thing is happening in other sectors but in different ways.
Uber is fracking the taxi sector. The wholesale and retail sectors are being fracked by individual brands (e.g., harrys.com, purple.com, nike.com/nike-by-you, bollandbranch.com) and ecommerce platforms (e.g., shopify.com, etsy.com, overstock.com, ebay.com, walmart.com, alibaba.com, and amazon.com) providing direct-to-consumer deliveries. Local labor markets are being fracked by new freelance sites (e.g., fivrr.com, upwork.com, freeeup.com) that provide access to a global workforce. The information and news sectors are being fracked by bloggers, tweets, podcasts, streaming services, apps, chat, and innumerable variations.
We have found a segment of companies that are profitable and are trading at an average of 3-4x multiples. These businesses are for sale, but they are not attractive to established private equity firms because they are much smaller ($500k to $50M sales price), i.e., we are offering small business private equity.
Our strategy is what Felix Barber and Michael Goold called the “strategic secret of private equity”: buying to sell. By this, we mean we intend to purchase these businesses, operate them for two to five years to continue their growth and optimize their earnings, combine them with other acquisitions to create a portfolio, and then sell them either to another private equity firm or to a public company.
The best performing private equity funds (which are not always the largest PE funds) employ diversification through portfolio management. Their approach to capital raising, asset management is rooted in their logic for generating returns. In the sections below, we explain our logic further.
The Future of Crowdfunded Private Equity.
2012 was a watershed year for investing, as the Jumpstart our Business Startups (JOBS) Act ushered in new regulations and investment opportunities for accredited and unaccredited investors. Since then, many have jumped into building crowdfunding platforms, invested in startups, or been lured by the even more esoteric (and higher risk) initial coin offerings (ICO), which blended crowdfunding and blockchain technology.
Starting a private equity fund comes with its own regulatory requirements, some of which are redefined by the JOBS Act. New private equity firms are are focused on taking private equity online (i.e., retail private equity), but this does not change the need to:
- have a private equity investment strategy
- define a private equity investment period
- have a focus (e.g., small cap private equity funds, consumer private equity, direct lending private equity, micro private equity).
Without a digital strategy, the private equity firm resembles what it might have in the 19th or 20th centuries — accredited investors writing or wiring funds to a private equity partnership. Leveraging digital payments technology, direct-to-consumer advertising technology, and software-as-a-service platforms help drive down the costs of operating a private equity fund. It also enables the fund to comply with regulations for understanding if they are working with an accredited investor, and the additional disclosures and tracking needed to serve unaccredited investors (what we like to think of as “accrediting” investors.)
Why Investors Need Private Equity in their Portfolio.
Investing in PE is not new. Queen Isabella of Spain invested at least $1M to fund Christopher Columbus’ trans-Atlantic search for the West Indies. Today though, modern portfolio managers, e.g., Yale University endowment, include private equity as a critical component. Pension funds, family offices, endowments, high net worth individuals, and sovereign wealth funds have grown rely on private equity historical returns. Private equity risk is different than emerging market or international equities, and depending on the type of private equity (e.g., distressed), it may be less risky than a venture capital firm working with the newest start-up.
Like most of life, the key is moderation and diversification. A study by Cambridge Associates demonstrates that private equity delivered better annualized returns over 10-, 15-, and 20-year investment periods than stocks and bonds. The figure below summarizes their findings.
In the same study, Cambridge Associates also examined how private equity contributed to investors with diversified portfolios that also included private equity. The risk and reward of private equity helped deliver higher returns to the diversified portfolio, and it also reduced the volatility of the portfolio. This is likely because private equity and domestic stocks are not completely correlated.
Private equity opportunities represent another alternative investment. Private equity risk is less correlated with domestic securities and its lower priced multiples leave room for higher returns as private equity funds exit via other buyouts or by taking an acquired company public. Wealth managers from pension funds recognize this, which is why private equity is approximately 15% of these professional investment portfolios. These wealth managers value private equity.
How our Private Equity Deals Compare to Venture Capital.
To compare and contract venture capital and private equity, we first must examine private equity basics (private equity 101). In its most simplest form, private equity is an investment in exchange for equity in a private company. In other words, you are buying an ownership stake in a company’s permanent capital — its equity. Who the investor is, how they do it, and what stage of growth the target firm is in leads to great variety among private equity investors.
Private equity firms tend to be more associated with the buyout stage of a firm, which is one form of exit. The target firm has grown out of an early stage of development. It might even be at the end of its owner’s tenure, a 40- or 50-year old company in search of a new owner to replace a retiring CEO with no heir apparent. Private equity firms can also provide lending in exchange for financial instruments that enable an equity ownership stake (e.g., warrants, convertible note, preferred shares).
Private equity funds can also focus on distressed assets, or they can be part of taking a struggling public company private. Private equity investors can can acquire the corporate assets of a company going in a new strategic direction. As you can see, PE funds, PE companies, private equity merchant banks, are all the same and at the same time, they are not the same.
In contrast, venture capital partnerships, venture capital funds, venture capital companies, etc. tend to focus on early stage “ventures” — entrepreneurs or inventors with an idea, but not a company or a business. They exist in a formulaic process of capital raising. An entrepreneur has enough of an idea and a story that they are able to gather up a seed stage investment, probably from family and friends or from angel investors.
After that milestone, if a VC takes an interest in them (either through networking, pitch presentations, accelerators/incubators), then the entrepreneur is entering a “round” of venture investing. These “series” of rounds go by letters, such as Series A, Series B, etc. In each round, one or more VC funds will come together to raise and establish a valuation for the company’s idea.
Like private equity, VCs invest in exchange for permanent capital, most frequently in the form of preferred shares. This provides them with protective provisions and more control. Rather than taking out debt against the purchase price of an acquired company, a VC tends to use the funds of its limited partners, and it tends to not take complete control of the company. They want the CEO, guided by a new board, to operate and deliver on their idea, but without the distracting requirement of paying back principal and interest on a loan.
In exchange for this risk, they eventually get much higher returns. Not every investment works out. Some companies do not grow, or their competitor beats them. Some VCs backed Facebook, and some were hoping Friendster and MySpace would be the new VHS to win out over BetaMax.
Like private equity, VCs get paid when they receive dividends or sell their stake in the company. VCs prepare a company to go public and the IPO is a natural exit point. Sometimes they sell their stake to private equity.
Early stage private equity can be a form of venture capital. It all depends on the stage of the target firm and whether there are likely to be other rounds of equity financing. Like VCs, private equity needs funds to invest. They can do it by taking out debt or by accepting funds from other investors who are willing to leave their investment with the PE or VC fund during their commitment period and can patiently live with the illiquidity risk premium of private equity.
Where We Fit in the Private Equity Sector.
If you were trying to make a list of private equity funds you would eventually put them into categories. We belong squarely in the buyout category. Like venture capital firms, we prefer companies in a very large and growing segment of the economy. We also prefer companies with high barriers to entry or high margins that can weather competitive pressures or business interruptions.
We are not likely to be considered a boutique private equity firm, but we do have focus: e-commerce, software-as-a-service, industrial services, and regulated sectors . We view ourselves as a potential feeder fund to middle market PE firms, but with our experience in public companies, we have the potential to merge our target company into public firms as an exit strategy. We are prepared to operate a conglomerate of companies for a long time and sell them when we can achieve an attractive multiple.