The eighties, in the US saw companies being taken over, financed by risky debt issuances known as junk bonds. Ivan Boesky and Mike Milken, were the leading perpetrators of this mish mash of leveraged buyouts and insider information based arbitrage where a set of investors would profit from prior knowledge of a buyout. What started out as a logical move by companies to acquire rival companies to build scale or other companies to build synergistic advantages, grew into frenzy. Boesky incidentally hosted a party where acquisition activity was the central focus. Curiously, it was called the “Predators' Ball”.
And not curiously enough, there is a similar activity brewing in the global market place. On the one hand there are the hedge funds that have garnered around $14 trillion and are chasing returns around the globe unchecked and adding to the volatility. And on the other hand there are the slightly benign private equity (PE) funds that have been fuelling the acquisition activity. Research agencies report that around $700 billion worth buyouts were made by private equity funds and the figure allocated in the first quarter itself is in excess of $400 billion.
India is also a favoured destination. According to an estimate, PE players have invested about Rs 9,912 crore in India, an increase of 102% than the corresponding period of the previous year (January-March 2006). In the first quarter of 2007 PE funds invested $2.4 billion across 78 deals, up from $1.27 billion a year earlier. At this rate it is expected that total PE investment could touch $10 billion in 2007, from $7.5 billion in 2006. “Clearly, private equity funds are gaining over IPOs,” say directors at Motilal Oswal Venture Advisory Services, a Mumbai-based private equity and venture capital outfit.
Hence, considering such rapid spurt in PE investment, it becomes indispensable to know as to what entails a PE investment, its very nature and flip sides, and primarily what's in store for Indian investors. And global experiences suggest that there are both sides to private equity – one that catalyses growth, enhances valuations and also the seamier side that aims at profit maximisation at the cost of overall interests.
The angel investor
In truth, PE funds raise money from high net worth individuals, financial institutions, and the like for a period of seven to 10 years and then invest in equity or companies, which are not listed and hence not traded on the stock exchanges. This role is now donned by private equity funding agencies known as venture capital funds.
However, with the profit-making objective reigning high in their priorities, of late, PE funds have begun investing in listed entities also. Companies like Bharti, Suzlon and Shoppers Stop have been backed by private equity funds.
PE funds have developed the expertise to analyse deals and unlock value by taking some direct decisions. They are also known to watch the management closely for performance and delivery of promises. “There is a close watch on wasteful expenses. Many companies will find it difficult to attract private equity as the management has elements of unwarranted personal extravagance,” says an analyst.
PE funds also bring in expertise to manage companies and also the ability to stitch synergistic deals. Recently, Kohlberg Kravis Roberts, a leading PE fund bought out 85% in Flextronics Software Systems (FSS) for $900 million, considered the largest leveraged buyout in India. The CEO of FSS Ash Bharadwaj, in an earlier interview mentions, “FSS will benefit from KKR's introductions across the industry. In India, we plan to raise the headcount from 2k-3k people in 2006”
More so, contrary to popular notion, PEs do not trash the business they back, once the opportunity is milked. A research by American academics have found that a company refloated on the stock market after PE ownership performed better than other new issues did. It is also observed that even after they exit a company some funds retain shareholding for years. And this stands in good stead for investors.
Market mechanics
Given this, sophisticated investors are often attracted to companies that have PE participation in them. Anecdotal evidence suggests that companies with PE participation tend to get a higher price to earnings valuations.
“In the short term, it is because the markets trust the PE investor's name and are more comfortable investing in the company where an investor is involved because a PE investor invests only after a thorough due diligence on the past performance and the management of the company,” say directors of MOVCA.
They also believe that in the long-run valuations are impacted as PE funds that support the management get the best of the business opportunities and thereby enhance shareholder value. “A PE investor helps to bring in cash discipline in the company thereby making it more robust,” they add.
“The issuance time for raising funds is also shortened as compared to the IPO route,” says a fund manager. Often promoters wait for the right time to tap the IPO market and in this wait projects have to be kept on hold, sometimes for years together. The option now is to involve a PE fund and get a fair (negotiated) valuation and also shorten the gestation.
Recently, companies like Jas Toll Road Company, Time Technoplast and Vigneshwara Exports took the PE route after IPOs were delayed or deferred for various reasons. Companies, which tap the IPO market and want to meet genuine capex requirements, also have been opting for private equity.
Flip side mechanics
“There is just too much of money chasing too little investment avenues. And this has raised valuation parameters to unhealthy levels,” says a fund manager. PE funds, in the acquisition mode, also have contributed to the increase in valuation metrics. An enterprise value of five to six times of EBITDA was considered a prudent norm earlier.
This multiple roughly indicated that the operating profits could pay back the investment in five to six years, a broad payback period indicator. However, the race for acquisitions has seen this number reach the double figure mark. In other words, PE companies have increased the number of years to achieve payback from current operations. Here is where concerns start emerging. With valuation parameters climbing, the need to generate profits, that too in a shorter time frame, increases. And this leads to the PE funds taking drastic actions to build in profitabilty.
Labour unions and managements in Europe and the US are running scared of PE funded buyouts because they expect large scale retrenchment. Experts reckon that this fear has nothing to do with PE based buyouts, these fears exist in any buyout where the new owner would want to rationalise operations and generate profits.
There are also fears that the PE backed companies often indulge in asset stripping, where assets are systematically sold off to generate returns. Asset stripping is a valid business activity where unremunerative assets are stripped off and sold piece by piece to generate returns.
“I am not a destroyer of companies. I am a liberator of them,” declared Gordon Gekko in the film Wall Street 20 years ago. PE funds can be heard making similar claims today; however, given the background of a high valuation and the need to generate returns and garner those exorbitant fees, it does not seem as convincing.
The seamier side
The need for profits are also driven by the fact that PE fund managers need to generate around 30% returns on an annual basis to justify high management fees charged by them. Industry observers reckon that PE funds charge around 1-1.5% of the asset size as management fee and an extra 20% on investment gains. A study points out that on deducting huge management fees, PE fund returns are actually lower than that of the benchmark S&P 500 index.
So what we have here is the mad rush to acquire more funds to get those buyout numbers in. Much of this is through the debt route. Then there is the need to service debt taken in by the PE players. Increasingly, PE funds have been sourcing a lot of funds, especially in buyout deals, through the debt route. International rating agency, Standard & Poor also pointed out that the quality of debt sourced for private equity deals was falling significantly.
The report mentions that 75% of loan-backed deals for European PE deals were rated in the junk bond category. A grim reminder of the Predator's Ball days. The scary interpretation of the junk bond rating is that one out of five companies using loans, as was private equity financing, could land into default.
But then PE funds have been known to add to the concerns by holding back information and being extremely secretive about their dealings. This has led to the increasing suspicion on their operations. A case in point is the incident of US-based Dow Chemical. PE investors had reportedly approached certain top level executives and joined hands with them in a move to stage a coup on the company management. The company's CEO came to know about the conspiracy and they were sacked.
The Indian side
Albeit this, in India, PE funds have an increasing reach right across the sectors. Not only has the PE activity increased this year in terms of number of deals, but also the average size of the deals has gone up significantly. During January-March period, 90 deals were struck, of which seven were $100 million-plus investments. In Q1 last year, 75 private equity investors pumped in funds, with a lone mega deal ($100 million plus) of Temasek's investment in Tata Tele Services.
The IT and ITES sectors attracted the maximum number of PE and VC investors, followed by manufacturing, financial services, media and engineering and construction. A similar trend was reflected in PE deals last year, with IT leading the pack.
Increasingly, managements and promoters are moving towards the PE route to fund their plans. It is time for them to get aware as well. “PE can have high risks associated with it. It is not a place to bet your house on. Do it only as a part of an overall portfolio strategy,” says Sri Rajan, head, Bain's Private Equity Practice in India.
For investors, high net worth individuals and institutions, wanting to be a part of the PE fund circus there is a caveat as well. Sri Rajan adds, “Remember that PE is a cyclical industry. We haven't seen the occurrence of this in India since it is a relatively new industry but in the US, this is a well established fact. In PE downturns (which may not always match with downturns in the economy), returns can crater.”
Like any other investing avenue, there are caveats to be followed. In India, the wise men at the Securities and Exchange Board of India (Sebi) and Reserve Bank of India have formed study groups to analyse the structure and impact of such funds on the investors, the companies in which they invest in and their effect on corporate governance.
The purpose of the study, say media reports, is to ascertain if investors in private equity funds are losing out during leveraged buyouts, and in the de-listing and re-listing process. Based on the study's findings, regulators may issue guidelines for listing and registration of such funds to ensure better monitoring.
Internationally too, the US and the UK governments are working out modalities to better regulate the PE fund sector and rid it of the dubious elements. An interesting development has been the listing of private equity funds on exchanges. This, some believe, will bring in increased transparency for fund operations.
And as developments take place in this part, investors need to understand the dynamics of PE funds before basing their decisions. There have been cases where a set of sophisticated investors tracked PE funds and invested in a financial services company. Both the PE fund and these so-called sophisticated investors are now saddled with shares that barely amount to a rupee. PE funds, then, cut both ways.
Source : Financial Express