Recently I finished a book on Private Equity: "Private Equity as an Asset Class" [Author- Guy Fraser-Sampson; ISBN - 978-0-470-06645-4, Publisher- John Wiley & Sons]. The book is helpful to those who are still outsiders for PE business but are keen to learn it. Not only one gets a practical view of the concept, but also the reader-friendly writing makes it easier to grasp.
Some of the things I learnt, from this book and others and from discussions with people, shall be topic of my coming posts. Starting with this one, I am sharing what from an eagle's view PE business looks like. Any comments on the post are warmly welcomed.
Introduction: In its most typical form, private equity (PE) is provision of medium to long term funds to potentially high growth unquoted companies mainly in the form of equity.
Other kinds of PE investment can be:
- Taking over a division of a large company which has been neglected and needs severe reconstruction.
- Making a public company private [PIPE or Private Investment in Public Companies], in order to make changes in its management, business plan and capital structure. Such changes can be done even when the company is listed but it may be difficult to do so because of market's short-term view which weighs current earnings much more than long-term wealth creation.
Venture Capital (VC) / Angel Investing – These are investments done in start-ups or during seed-capital stage. The riskiness in these investments is more as there are no or negligible cash flows (during the early stages). So the investment done by VCs is more in the nature of debt as against PEs which have more equity component in their investments.
Features of PE investment:-
- Funds are provided by PE firm for medium to long term (5-12);
- Target of PE firms are companies which have either huge potential to grow fastest among the industry; or have an edge over the peers which if nurtured will lead to huge wealth creation;
- PE firms usually revamp the top management of the investee company. This is very common in family run businesses. Experienced and talented manpower is provided to the company. Often PE firms place their own people, who are experienced in that sector, on company's board. All the strategic decisions of the company are taken after confirmation or recommendation by firm's executives.
- Investments in the company are made in several rounds. Successive investments are made only if previous funds have shown expected results.
PE and Debt: -
Companies have two sources of funds – debt and equity. Debt has more rigidity in terms of interest and principal payments and equity has more cost. Now equity can be raised from public or PE firms. There are several reasons why companies go for PE instead of debt. First, no debt service burden. Secondly, PE firms bring with them lot of experience and expertise. These firms understand the industry structures very well and have exceptional domain knowledge. Thirdly, companies benefit from PE investments as latter bring lot of contacts and linkages which enable companies to spread their wings in domestic and in international markets. This enhanced networking can be used for inputs or for marketing. Another value-adding feature of PE investment is that PE firms are comfortable with negligible or no returns during initial periods of investment. This is because they have a long-term view for wealth creation and can sacrifice preliminary returns. This is not the case with debt-holders who command a timely return irrespective of stage and nature of operations. Last but not the least, PE firms come to rescue even if company is not able to turn-around even after the investment is made. But lenders are the first to file for liquidation in the event of company failing to honor its contracted payments.
Investor in PE firms:-
- Institutional investors like pension funds, Mutual Funds, Hedge Funds, governments, etc.
- Banks
- High net-worth individuals (HNIs)
- Parent organization (ICICI Bank holding stake in ICICI Venture Capital)
- Other private equity firms
PE investment exit routes:
- Sale to strategic investor- One of the most common ways PE firms realize their investment is by sale to another investor. For instance, a PE firm which had stake in a textile company sells it to a retail company which can take advantage by integrating its operations.
- Initial Public Offer (IPO) - By timing the gestation period of investment with sale of stake to public through an IPO, many PE firms make considerable gain. This is because in IPO not only Investee Company's valuation is taken into consideration but also if the market is bullish the gains are huge.
- Trade Sale- another mode by which firms exit from their investment is through sale to another investor. It can be another PE firm or any company in the same industry or in diversified industry.
- Sale to management- There has been instances where the management of companies have bought stake from PE firms - MBO (Management Buy Outs, as these are commonly known).
Principles of PE investments:
The most distinct feature about PE investments is their strategies to restructure companies' management, turning them around and exiting their stake. No two PE investments will be exactly same in all respects. However there are some principles which can be associated with PE investments.
Some of these principles are listed below:-
- Aim of management of a business is to maximize investors' wealth by consistently increasing after-tax cash inflows and reducing after-tax cash outflows. How to achieve this goal depends on industry in which company is operating. For a FMCG (Fast Moving Consumer Goods) company, a robust sales and distribution network is prime requirement. For a manufacturing firm, keeping margins intact by reducing input costs becomes the surviving factor. And companies in the telecommunication sector (marketing corporations like Airtel, Vodafone) are always busy building their brand value and providing value-added services to consumers.
- Greater the degree of competition, lesser the chance of entity making supernormal returns. This is because if there exists any opportunity where huge returns can be made, then many players will jump into the arena to be a share the meal. With more players coming in, entity will not be able to charge wishful prices from consumers (as now latter have choices) nor the cost of resources will remain low (due to increased demand). It is mainly due to this reason that PE firms target companies which are in emerging industries. For example in a country like India where pollution has become a big problem for environmentalists, companies manufacturing pollution-control equipments are good investment opportunities for PE firms. By investing in research and development, a company can come up with innovative products and services which will open up one more profit avenue. Also tapping new markets will enable companies increase their top-lines.
- When a division or business becomes more valuable for outsiders than internally, then it's wise to sell that division/business and deploy the funds in another investment avenue where owner believes can add value. This may happen because of poor strategic management of division or wasteful allocation of resources. This is the main area where PE firms show their magic.
- An acquisition is successful only when the price paid for it is less than the incremental value which acquisition is expected to add. The incremental value should not be merely in terms of future cash flows but also include embedded value in assets acquired. This incremental value is commonly known as Synergy. In simple terms, it means that when an acquisition is made, the combined results of the two entities should be more than the individual results.
Synergies can be related manufacturing/provision of services (economies of scale), taxes (losses of one entity being used to reduce tax burden of a profit-making entity), market (clubbing of brands, customers, etc), sales and distribution (stores, franchises, agents, etc) or capital structure (lower cost of capital, increased capacity to raise funds, etc) and so on.
Acquisition, mergers and takeovers usually are common in fragmented market where there are many small players. For example, in India we saw lot of integration in banking sector in last ten years. Next was the airlines industry.
- Out of two companies in same industry, one public and other being private, former will pay more than latter for Target Company. This is because of higher liquidity of shares of public company. As the acquisition/merger/takeover takes place, the value of purchasing company will increase with the incremental value added by the integration. Whereas this is not the case with private companies.
Difference between Private Equity firms and Hedge Funds:-
Many a times a comparison is between PE firms and hedge funds is made. Though both don't have any particular structure and both invest in companies but their investment objective and horizon are poles apart. Hedge funds, in most simple terms, are pools of money which invest in stocks, bonds, real-estate and almost everything, for short-term, to earn high gains while keeping the capital intact. These funds make use of short-selling and some of the most complicated derivative structures to reap profits. Hedge funds are not concerned with the financial results of Investment Company. Whereas PE firms are businessmen who want to make profits by taking performance of investment companies to new heights, allow their investment to grow and then exit.
Difference between Mutual Funds:
Mutual funds (MFs) are registered trusts which pool investors' money and invest in stock, bullion, real estate, etc.
Following are some distinctions between PE firms and MFs:
- MFs are registered under SEBI in India, PEs not.
- MFs have to report their daily performance to investors. There are two implications of this aspect. One, this actually prevents MFs from investing in potentially high growth companies which reap great gains. Secondly, the investment horizon of MFs can't be as long as PE firms. This is because low gains during initial period of investment, MFs will make no or negligible return which will make them unattractive in the market.
- MFs issue units to investors, retail and institutional. PE firms have, as discussed above, only HNIs, FIs, Institutional investors, etc as their investors. As a result, MFs have small investments also (retail portion).
- One of the most important feature of PE firms that is lacking in MFs is that latter are not bothered about the management of the company. They concentrate only on the returns from trading stocks. So to the investee company no value is added by MFs.
