A pension fund invests directly in growing companies, eliminating the venture capital middleman.
Soon you may be able to get your capital from the same place that venture capitalists do -- pension funds
You could think of Ed Carlough as a factory outlet store for dollars. The comparison isn't perfect; Carlough, of course, doesn't actually print dollars. But if you go to him for money, you will get what all true bargain hunters yearn for: a chance to eliminate the middleman.
To understand how to do this, you have to understand Ed Carlough. Carlough runs the Sheet Metal Workers' International Association. He got into dollar wholesaling because he also heads the union's $1.35-billion pension fund. For a long time he handled the union's retirement money the way most other pension-fund administrators do: he hired professional money managers to do it. Eventually, though, Carlough saw a problem. "When you go through an existing vehicle, you're locked into someone else's opinion," he explains.
He thought he and the trustees of the pension fund were smart enough to make a few investment choices on their own. So in 1987 they took a radical step: in April they plucked $15 million out of the fund and invested it in a young, struggling technology company. In November they put $20 million into a 40-year-old asbestos-removal company.
In the conformist pension world, this is like eating with your fingers at a White House dinner.
By skipping the middlemen -- the venture capitalists, insurance companies, banks, and others who invest pension-fund monies -- Carlough broke ranks. What makes his defection significant is that it represents an important new source of capital for business owners. So new that although more public and private pension funds are likely to follow Carlough's example, finding one that is ready to make such direct investments today would be tough.
Still, this is a gigantic pool of capital that has already begun to ripple in new directions. Once notoriously sleepy and compliant, pension funds have begun to withdraw from South African investments, ask for board seats, and use their large-shareholder status to influence corporate policy at companies threatened by takeovers. Investing their own cash "is right in line with the pension-fund activism we've been seeing," asserts Lewis Parker, an associate of an investment firm that advised Carlough's pension fund.
For the capital hungry, this bodes well. First, there's the lower cost of pension-fund dollars. At ACMAT Corp., the East Hartford asbestos-removal company that Carlough's pension fund invested in, executive vice-president Henry Nozko Jr. is quick to itemize the cost savings. In 1984 ACMAT raised $6 million through a private placement of debt and equity. To find the money, it went to Prudential Bache Securities. Acting as an intermediary, Prudential placed the debt and equity with Teachers Insurance of New York. The cost: a 5% fee to Prudential, Teachers' legal expenses, and ACMAT's legal expenses. In all, it took about $400,000 to raise $6 million.
By comparison, it cost virtually nothing to raise $20 million in equity from Carlough's pension fund. There were no intermediaries, thus no fees. All of the legal work was done by ACMAT's in-house lawyers, and the pension fund paid for its own legal expenses.
Ah, but how much of the company did the pension fund demand for its $20 million? About 17%. To hear Nozko tell it, establishing the stock price that the pension fund would have to pay for ACMAT's newly issued shares was no big deal. The baseline price was easy enough to come up with. ACMAT is a public company, and in October 1987 its shares were trading at $12. Normally the discount on a large equity placement runs between 10% and 30%.
"There are literally hundreds of deals that substantiate that," Nozko says. "So when it came to that issue, we said, 'The data show this. Why don't we just agree on 20%?' It was a half-hour discussion."
The Sheet Metal Workers' pension fund brought more than cheap capital to ACMAT, however. The union wants ACMAT to succeed not only because it wants a profitable investment, but because the asbestos-removal company is a major employer of sheet-metal workers. The better ACMAT does, the better union members do. With two board seats, the pension fund contributes "super" ideas, says ACMAT chairman and president Henry Nozko Sr. For example, Carlough gave ACMAT a list of the union's contractors, which an ACMAT subsidiary, United Coastal Insurance Cos., can mine for prospective insurance buyers.
Having union members on your board could prove to be uncomfortable at times, of course, but so far ACMAT considers the union's pension fund preferable to other co-owners. Venture capitalists would want a greater piece of the company and often reserve the right to replace management. The thousands of individual stockholders that ACMAT might have gained in a second stock offering wouldn't intrude, but they wouldn't be the resource that the pension fund is, either.
So far, Carlough points out, his pension fund has spent less than $100 million out of a $1.35-billion investment portfolio on direct investments. And like any pioneer, he finds that that has only whetted his appetite. Will he make more such investments? "Without question," Carlough says. "We have not begun to approach the limit."
Pitching your company to a pension fund
If you decide to try to interest a pension fund in your company, be forewarned: it will be difficult. Though many are becoming more adventurous, most pension funds have never made this kind of direct investment before. What's more, there's no precedent for how to do it: funds just aren't equipped to find, investigate, and analyze companies.
That said, the benefits may make it worth the effort of finding one. Just be prepared to do most of the work yourself. Here are some concerns and criteria you'll need to consider:
* Liability. Because a pension fund can exert more influence than it could in a more conventional investment, it is likely to want a board seat. At the same time, though, that exposes the fund to new responsibilities and liabilities it may be unprepared for.
* Liquidity. Pension funds that are willing to make direct investments will eventually want a way to sell them. Experts say that doesn't mean a fund won't invest in a private company, only that the company should have plans to go public or otherwise provide the pension fund with a way to exit its investment -- profitably.
* Rate of return. This is your biggest selling point. As fiduciaries, pension funds must first and foremost deliver good investment performance. The potential rate of return should be between 20% and 30% annually, according to Robert E. Long, a senior vice-president with Potomac Asset Management Inc. That's what the yearly rate should work out to by the time the fund sells its position.
Some of that return can be delivered by structuring part of the capital infusion as a loan. Chronar Corp., another of the Sheet Metal Workers' investments, received $7.5 million as a loan and $7.5 million as equity capital. The 10-year loan carries an average interest rate of 10%, but for the first 5 years Chronar pays only 2.5%. The pension fund also received warrants in Chronar stock as part of the deal.
* Affinity. If your business benefits the workers a pension fund represents, then you have a more compelling case to make. "Before you approach a pension fund, there has to be some synergy," says Henry Nozko Jr., chief financial officer of ACMAT Corp.