Alternative Capital - Rules of Engagement

The Cap Gemini/Merrill Lynch World Wealth Report published in June 2010 revealed that the world's High Net Worth Individual (HNWI) population stood at 10 million, with combined assets $39 trillion. The same report revealed that their appetite for riskier investments grew over the course of the preceding year, during which time their wealth had grown 18.9%, surpassing levels last seen at the end of 2007.

It is this wealth, generated and owned mostly by the world's entrepreneur's powers global wealth creation. Without it, banks would have no liquidity provided through the CD's and other deposits with which HNWI's have traditionally parked their money, in effect, lending their money for the bank to lend to entrepreneurs. But now banks worldwide are rebuilding their capital bases and offering only basic, nominal returns on CD's and other traditional bank deposits. After deluding themselves for decades that they were the liquidity of the global economy, rather than simply the intermediary for it, they are now ineffective as agents of wealth creation.

The only exceptions are banks in emerging economies such as Asia, Eastern Europe and South America. Some of these banks, with rapidly growing capital bases, often struggle to achieve no more than sub-BBB credit agency ratings. Yet they do not have the toxic debt or tax-payer underwritten loans of their AAA western counterparts. Is this because the credit rating agencies are not keeping abreast of the global economic transition? Quite possibly, because it is a transition not even recognized or understood by the majority of the world's media, and most certainly not by politicians and legislators, nor by most bankers.

Wealth creation
A key part of this transition is the gradual withdrawal of HNWI wealth out of the banks into what is becoming recognized as the Alternative Capital market. This is one of the reasons it is getting more difficult for anyone to borrow money from a bank. HNWI's want to see their money creating more wealth because the vast majority of them are successful, risk-inclined entrepreneurs who created their own wealth. It is their money that backs the riskier investments referred to in the Cap Gemini/Merrill Lynch report, and they do it through their own understanding of the risk/reward dynamic.

The sheer volume of money now finding its way into these new businesses has generated what can now clearly be seen to be a rapidly emerging 'Alternative Capital' market. This market is now funding not only private companies, but many public sector infrastructure projects as well. Since 2008, many more of these private investment funds have appeared, with their own unique investment parameters, and they are quite specific and focused about what projects they are interested in.

These interests cover every conceivable market, from bio-tech research and development to wind farms. Currently, solar and bio-mass projects with deal values between $50 million and $3 billion as well as resorts and other hospitality developments were the real sweet spots for these investors. But they will also look at other projects that would normally fall outside interests of traditional investors/lenders. Unlike traditional funders, the HNWI's don't necessarily want a track record for the enterprise itself. They will make their funding available based on their own assessment of the project, and whether their judgment tells them that there is a management team seasoned and proven enough to turn projections into acceptable returns. The funding will be structured according to the requirements of each individual deal. Alternative Capital is increasingly providing finance to major multi-billion dollar public sector infrastructure projects. National and state authorities can now approach these funds and can expect a more positive response than most banks can provide.

This funding is coming from the much maligned hedge funds along with a growing number of HNWI syndicates, asset managers and others constituted in numerous ways to suit their own investment parameters. There are about 1200 private funds worldwide. The share one common characteristic: they don't want you to find them. There is no Google search that will bring the really serious players to your screen. Unlike traditional banks and loan companies and even private equity and venture capital houses, most of them prefer a low profile. For traditional funders it was essential that they had a sustained pipeline of deals so that they could readily process the money they had available to lend or invest. So they advertised and used extensive PR, broker networks and sponsorship to bring prospective clients to their door. They had systems and back offices set up specifically to assess and filter deals until, after an internal process of attrition, just a few made it to an actual funding agreement. Providers of alternative capital are polar opposites of their traditional counterparts. They were never set up as loan or private equity houses. They have always operated in an opaque financial stratum, between the mainstream capital markets and private equity that few can penetrate and is sometimes damagingly misunderstood by regulators around the world. But the changing world funding order, which first manifested itself to any recognizable extent in 2008, has seen them make big inroads into funding territory previously dominated by banks, loan companies, VC and PE houses. Their usual minimum deal range can be $100 million up to tens of billions of dollars, which is what they are structured to comfortably handle, although some are now starting to operate at lower thresholds.

For them, there are three primary concerns:
• Protect their identity: They do not want to be inundated with worthless or irrelevant
funding projects they are not geared to handle.

• Protect their investors: Directly or indirectly, their investors are HNWI individuals,
the vast majority of which are successful entrepreneurs in their own right and fully
understand the risk/reward dynamic. They will not tolerate failure.

• Protect their processes: Syndicates and hedge funds have developed funding
processes and instruments unique to their own requirements.

Alternative capital advisors respond to these three, key criteria in order to establish and maintain relations with the funders. To protect their identity, they use deal-flow providers, who they trust to deliver projects that are relevant to their investment requirements. In this way, they do not need to reveal their identity to anyone prior to actually engaging with them in a transaction. To protect their investors, they invest only in those deals that match specific criteria which they make clear to their deal-flow providers. Integral to this is the format in which the deals are presented, which is nothing like they would be presented to a traditional bank or loan company. It is essential that deal-flow precisely matches their investment and other criteria. To protect their processes, it is almost common practice that the investee or borrower is required to sign an NDA ensuring that the identity of the funder, and the processes they used, are confidential.. In short, they do not want to throw their doors open to the world, in so doing wasting valuable time and resources filtering individual projects. They prefer to leave that to professionals who field individual deals to those funders with the best fit.

For alternative capital advisors, it is absolutely essential to deliver on all the three key demands presented above, as well as ensuring that we or, more specifically, our clients are not going to waste time. Therefore, we need to know from the very start that the client is serious about entering the process and seeing a deal through to a successful conclusion. We will invest time and resources in preparing the client for the process by producing the initial funding submission, in a way that we know the funder will respond to. We will begin this process unless we believe we will find a home for the project. After this initial stage, without exception, the funders want to see that the client has totally engaged in the process through an Engagement Agreement and fee with us. Once we can demonstrate that commitment, the process moves forward to preliminary term sheet. Private funds operate on completely different economics to traditional banking sources, whose systems and back office overhead was absorbed in the cost of loans. This is not the case with alternative funders. Very often the legal, accounting, due diligence and other transaction costs are outsourced, and they have to be paid for. The costs vary, sometimes including an element of the perceived risk or the setting up of a particular financial instrument (as in structured debt deals) but, usually, you can estimate the cost to be 1% or less of the funded amount. It depends on debt type, value, market and, of course, funder. Also, at this early stage of the market's development, some projects came to a halt because applicants, who said they could produce transaction escrow funds, actually could not. Today it is a standard part of our procedure, as demanded by a growing number of alternative funding providers that, where transaction fees will be required, we submit a 'Proof of Escrow Funds' letter from the client's bank, accountant or lawyer. Many funders will not move without sight of it.

Commitment, Costs and Care
Because there fees involved we sometimes find ourselves being associated with the dreaded 'advance fee scam'. We do not waste time arguing about it. It is simply the economics of the new alternative capital market. There is one very simple way to recognize this scam. If the transaction escrow fee is paid to an agent, broker or any other form of intermediary, the chances are that you are about to be scammed. If it is paid direct to the funder's escrow agent, the chances are that you are safe. It is worth mentioning that every commercial bank, investment bank and institutional lender in the U.S. requires some form of deposits or fees for commercial loans. Even the World Bank, Export Import Bank requires such expenses and fees for all transactions. This is the lenders requirement and not in the control of deal flow advisors. The requirement is to ensure that the borrower is committed to the transaction and will act in good faith to conclude it. Keep in mind also that many funders will insist on using their own appointed escrow agent and, if you insist on using your own lawyer or accountant, they will probably decline your funding request. Most funders have developed their own unique instruments and structures and they prefer to work with escrow agents who understand and have experience with their process. The nominal engagement fees not be incurred until we can actually tell you that there is firm interest in your proposition from a investor. These engagement fees are charged to cover basic costs involved in identifying the investor and progressing the deal to hopefully, a successful conclusion. However, in the event that the deal fails for some reason that we were not made aware of at the start, those basic costs have to be covered. If someone sets out to raise $10 million to many billions of dollars and does not want to commit to a nominal engagement fee or the funder's transaction fees as a contribution to the essential work involved, can they really be taken seriously?

No doubt the alternative capital market will evolve further and there will be more changes. It is very likely that within a decade, what is now 'Alternative' will become the traditional capital markets, and hopefully, through this Alternative Capital market, those 10 million HNWI's in the Cap Gemini/Merrill Lynch report will build continue to risk and create wealth in the decades ahead.

erry Inman

Page last updated Sunday, December 4, 2010


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