If it’s successful, Pearl Street Group (PSG), could make the world of private equity a much more public place. PSG plans to create an American bond-based venture capital investment fund. “We will have established a new asset class for private equity,” says Bill Glynn, vice chairman and managing director of PSG, based in Boulder, Colorado.
The new asset class would allow a broader group of investors-mutual funds, pension funds and individual investors-the opportunity to employ a low-risk strategy for entry into the high-return private equity market. Granted, these bonds will never realize the kind of investment return a pure investment in a venture fund can, but there is little risk because the bonds would be insured against failure by re-insurers.
“If they are insured [and a bond rating agency] rates their bonds, it’s a slam-dunk,” says Bud Byrnes, CEO of Los Angeles-based RH Investment Corp. With 20 years of experience in California’s wholesale municipal bond market, Byrnes should know. He points to the success of pop icon David Bowie in issuing bonds that monetized the royalty stream of his recordings, noting that those were intangible assets. In this case, says Byrnes, “It’s up to the insurers to verify [PSG’s] assets [VC-backed portfolio companies], and if they do that, then there is an even greater value to the issue.”
There is a credible precedent outside of the United States for what PSG plans. The Partners Group, a Swiss private equity and hedge fund investor founded in 1996, has grown to a $4 billion investment fund that places capital in evergreen funds alongside firms like Deutsche Bank, ABN AMRO, Credit Suisse, Liechtenstein Global Trust and Dresdner Bank. Partners Group invests through funds like Castle Private Equity, Princess Private Equity and Pearl Holdings across a broad set of investment stages, from venture capital to buyouts to mature and distressed companies.
Partners Group’s great achievement is its combination of high-risk private equity investing with that of low-risk bond investing. It accomplished this through the development of bond-based investment vehicles that insulate investors like insurers, pension funds and individual investors from the vicissitudes of private equity while providing the stability (funds are fully insured) and fixed income returns of bonds.
Through Partners Group, the most conservative investors in the world are able to participate in the high-risk, high-return world of private equity while minimizing their downside risk. And Partners Group, based in Zug, Switzerland, has been able to get into top funds. Its Pearl Holding Ltd. fund, for example, has investments in NEA X, Morgenthaler Venture Partners VII, Summit Ventures VI-B and Oxford Bioscience Partners.
It was only a matter of time, really, before someone tried to recreate Partners Group’s vision in the United States. Enter PSG, which is not related to Partners Group. PSG came out of an Internet incubator called iBelay. The incubator raised $77 million and acquired 11 startups in the financial arena just as the Internet bubble burst in March of 2000. Glynn, a founder of SouthEast Interactive, an early-stage investment company, was promptly brought in to clean up iBelay’s portfolio. Glynn quickly shot all the portfolio companies except VentureDebt.
For Glynn, VentureDebt was an epiphany and became the basis for PSG. Several execs from iBelay (including Glynn) became PSG employees. The data developed by VentureDebt was sufficient to convince PSG to bring to the world its own bond-based funding model for private equity investments, which it refers to as collateralized private equity obligations (CPOs). In early March it outlined its plans to 100 of the world’s most powerful institutional investors at the World Private Equity Forum.
PSG will lend up to $100 million to VC portfolio companies, after which it will securitize the assets by selling investment bonds to gain liquidity and provide funds for its next round of investments. Glynn points to private equity trusts of Partners Group as proof that Pearl Street is onto something big and something doable.
And where does the first $100 million come from? Glynn says that Pearl Street already has “visibility” into the first $50 million of that money. He says the real work begins after raising the first $100 million, obtaining a matching credit line and making the loans. The next step will be securitization of the loans through the issuance of bonds.
PSG compares itself to real estate investment trusts (REITs) because “the attraction of REITs is twofold,” Glynn says. “First, they are traded, or in other words they are liquid, while the asset upon which they are based (real-estate) is largely illiquid. Second these real-estate-based trusts pay high dividends to their investors.”
Like REITs, PSG wants CPOs to trade through financial intermediaries like investment banks until CPOs develop their own market makers. Glynn says the CPOs will pay dividends interest like Partners Group’s bonds, and that the rate will depend upon the rating level PSG hopes will come from firms like Moody’s. Most importantly, Glynn says that PSG’s approach to CPOs will provide additional incentives for investors: warrants held by PSG, which his firm will realize as appropriate and then share with investors. It is that upside potential from the warrant realization that Glynn says will pull in the institutional investors-not the mere 2% to 7% interest rates on insured bonds.
He projects warrant yields of 7% to 12%. It’s not the high two digits of traditional venture capital, but given the investors that PSG seeks, the potential for earning is a much safer haven for such investors.
In the end, you have to return to the question of whether there is money to be made by monetizing assets, something well known outside of the venture industry, but less known within the industry. At Paul Capital Partners (PCP), a San Francisco-based global private equity firm specializing in secondary markets, there is yet another precedent for private equity firms monetizing assets. PCP created a business portfolio in private equity, based around the monetization of royalties, within the medical technology, diagnostics, and pharmaceutical space, where it now employs a full-time team of eight to manage its work in the field.
As to whether PSG will be successful in expanding the concept already employed by the likes of the Partners Group, only time will tell. Michael Milken gave un-rated bonds (also known as junk bonds) a bad rap in the 1980s, but today they are a credible, perhaps indispensable, source of billions of dollars of corporate funding in times of tight capital.
Can PSG accomplish the same for a new class of investment based upon the assets of venture capital firms?
“The key for [PSG] is going to be whether the rating agencies-and investors-can get comfortable with this asset class,” says Michael Penner, a partner at Baker & McKenzie in the firm’s San Francisco banking and finance practice. “People in this market are familiar with standard debt obligations [in the securitization process]-credit cards, equipment leases, loans-that have predictable payment streams and more easily quantifiable risks,” says Penner. “But private equity is not as well known or understood in this context. Ultimately [PSG] can do this, but it will depend upon the reaction of the rating agencies and, more importantly, investors, since the private equity market doesn’t have any significant history of deals in this area.”
If PSG is successful, if Glynn is right, money may flow into CPOs like it used to into mutual funds.