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Capital: State of the Union

Searching for growth capital? Don't be intimidated by this unexpected -- but nevertheless burgeoning -- source of private-equity financing.
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Capital

As a successful serial entrepreneur in a rational universe, Charlie Schoenhoeft should have had an easy time raising capital for his latest business venture, San Francisco-based UFO Communications, a broadband-services provider. But his timing was poor. He was searching for $12.5 million last year, when the economy was weak, the private-equity market had largely dried up, and investor enthusiasm for broadband had simply evaporated.

Enter unions, a new type of private-equity investor, one with fairly deep pockets and an investment agenda that suits some types of fast-growth businesses -- such as Schoenhoeft's. Without much fanfare, unions are just starting to get involved in the private-equity market. Though the trend is still at an early stage, it is worth paying attention to for two reasons: unions may represent a new source of capital for your company, and unions want to invest in worker-friendly businesses and therefore may one day have the same kind of impact on private-equity deals that socially responsible investors have already had on the stock market.

Organized labor has always invested in the private-equity arena, typically with money from state-employee and corporate pension funds. And the behavior of union investors has been virtually indistinguishable from that of other large institutional investors: they all seek the highest possible return at an acceptable level of risk.

What's different today is that so-called Taft-Hartley pension plans are starting to get into the act. These collectively bargained retirement plans (which typically cover the union employees of more than one company) have assets of more than $400 billion. But in most cases the money has been invested in conservative, blue-chip stocks and high-quality bonds.

Private equity's illiquidity makes it riskier than publicly traded stock. But the stellar returns earned by private-equity investments in the roaring 1990s have enticed trustees of Taft-Hartley plans to start placing some bets. In the world of institutional money, Taft-Hartley holdings aren't sizable, but the plans' new involvement in private equity is welcome at a time when many traditional investors are holding back.

Michael Steed, a managing director at Paladin Capital Group, a private-equity firm based in Washington, D.C., whose investors include Taft-Hartley pension plans, predicts that within the next few years 3% to 6% of Taft-Hartley assets will go into private-equity deals. (The reason that unions may keep the percentage relatively low -- at least for now -- is that they can limit their risk exposure by restricting private-equity holdings to a small fraction of their large, diversified investment portfolio.) "The labor movement has increasingly come to realize that small to midsize companies are creating most of the new jobs in America," Steed says. "By using its funds to help those companies grow, labor can have an impact on the quality and conditions of those jobs."

Company owners who might seek capital from union investors may respect such reasoning, but the overarching question surrounding it is critical: If we accept union funding, are we talking about a dance with the devil? Charlie Schoenhoeft certainly worried about that when Steed first approached him with an offer. If UFO Communications were to meet Paladin Capital's standards on both the financial and workplace fronts, then Steed might be interested in a piece of Schoenhoeft's deal. "It's pretty common for business owners like Charlie to ask me something along the lines of 'Are you going to try to organize us?' I always stress that the answer is no," Steed says. "We are investors first and foremost. We're not union organizers. But I do want to know what owners believe and how they will behave when it comes to a number of issues that relate to the workforce, because these things matter to us and our investors."

In an environment in which union investing is still fairly new, will union investors eventually start acting more like traditional investors? Or will they attract a wide range of copycats from other sectors who will apply a separate agenda and a different set of criteria to private-equity deals? After all, some investors might focus on workplace concerns and others on environmental matters or global economic issues. Indeed, in their search for alternative sources of capital, entrepreneurs may find themselves grappling with term sheets that include demands for all kinds of social responsibility.

Most observers doubt that anything fundamental will change. "People who do private-equity investments right are very shrewd and very driven to focus on key issues like investment return and exit strategies," says Gary Simon, a partner at the New York City-based law firm Jenkens & Gilchrist Parker Chapin. "I've been in the trenches with these guys, and I've seen the way these deals happen, which is with a hard-boiled, take-no-prisoners approach that is strictly focused on financial issues. There are battles on numbers, battles on returns, battles on all the usual terms. I'm pretty skeptical about how workplace issues would fit into all that."

When it comes to financial terms, plan to be held to the same rigorous standards that any private-equity investor would hold you to: a clear investor exit strategy (probably within three to five years) and projected annual returns of 20% to 30%. On the nonfinancial front, it's highly unlikely that a requirement to unionize will ever be put on the table, because most companies on the receiving end of union investments aren't large enough to be worth an organizer's time and effort.

But if a union considers investing in your company (either directly or through a private-equity fund), you may experience a due-diligence investigation, as Schoenhoeft did, in which an investment manager reviews your company's benefits package (or intentions to set one up), employee-training programs, and handling of layoffs (if you've ever experienced any). Having an employee-stock-option plan or a profit-sharing plan will certainly be a plus. A salary structure in which you (the owner) and maybe a few top executives monopolize most of the goodies will count as a serious negative, as will a history of workplace-safety violations, employee-discrimination lawsuits, or a disgruntled-employee Web site that details significant worker discontent among your ranks.

You also can expect that a union's investment manager will negotiate some deal covenants related to fair-workplace practices, though you needn't fear that they'll be onerous. They might include such common conventions as paying severance in the event of a layoff, establishing a retirement or profit-sharing plan by a certain date, or using union-organized suppliers for key purchases. For Schoenhoeft, who thinks of his employees as one of his biggest assets, the terms weren't a big deal. But the $5 million-plus that Steed was willing to invest certainly was.

So if you're strapped for growth capital, it might pay to listen if a union investor comes calling.


Jill Andresky Fraser is Inc's finance editor.


Looking to Become a 'Unionized' Company?

If you think that your company (and your management style) would make a good fit with a union investor, prepare to do some legwork to track down candidates.

Forget the Internet. For such a recent development, there's not yet a good source of comprehensive statistics or leads.

Hit the phones. Call the trustees of all the big-union pension plans to find out if they are currently making any private-equity investments and, if so, how they're handling the deals (either by direct investment or through a private-equity fund).

Hone your approach. The good news is, unions will be making their investments through an investment firm. Once you develop a list of firms that handle union investments, approach them in the same way that you would any other investor: with a short, focused letter that whets their interest.

One size doesn't fit all. To spark union interest, include with your business description and financial prospects a section emphasizing your company's job-creation potential, fair-workplace practices, and other issues that might be of interest to the union that you're approaching.


For more on pension funds, see Jill Andresky Fraser's review of the book Working Capital: The Power of Labor's Pensions at www.inc.com/keyword/union.


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Please E-mail your comments to editors@inc.com.

Related content:
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