Not a day passes without newspapers screaming their heads off about yet another multimillion dollar private equity investment being made into a virtually unknown Indian company by an even more unknown PE fund. The numbers are mindboggling to say the least.

What do these investments mean? Are they for real, or are they gold at the end of the rainbow? Where do they come from? How can the company you have built get a share? And more important, is there a catch hidden in the proverbial pot of gold? These are the questions we will answer in this piece as we go behind the scenes to unravel the wonder world of private equity.

What is Private Equity?

So, what exactly is private equity? As the words denote, it is equity investment into a privately held company. Typically these are investments by organisations rather than by individuals. While the investor is looking for higher than market returns in quick time, the company is looking for large amounts of capital to fund expansion and growth. The fund requirements would typically be too large and the risks may be high to take the loan route. The company may also not yet be ready to go public. Private equity investments are typically against a minority stake (and a seat on the board).

It is rare for PE to take a majority stake in a company. But there have been instances on the contrary as well as of PE firms taking a public listed company private.

The PE fund can be considered to be a serial investor, who is making a short-term investment in an established company.

Angel, Venture or PE?

Private investment into the equity of a company can come from three routes, Angel investment, venture capital and private equity. Each of these come at different stages of growth of an enterprise and differs in scale of funds, type of investor and involvement and role of the investor.

Angel investment comes first, in the earliest stages of the formation of a company. Angel investments are typically low in value and come from individuals rather than investing organisations. The angel investor also plays the role of the mentor for the budding entrepreneur and his newly formed enterprise.

An Angel typically finances the gap in startup capital; the gap between what an entrepreneur can organise on his own and what is required to start off. Since the Angel comes in at the earliest stages, the investments are the lowest while the risks are the highest.

The next stage in third party equity capital is venture capital. There is a significant convergence between Angel funding and venture capital, with both coming at the early stages of the company. Venture capital typically associated with higher levels of investments in startups, could come from individuals or from funds. More likely they are from venture funds.

Private equity comes once a company has established itself and is looking to fund rapid expansion. This means that PE funds look for companies that are older, may be even ones that have passed through generations and have higher valuations. PE funds pay a higher value for a minority share in the company. In a growth market, the dividing line between venture and PE gets blurred. Now, that raises the question: Should you look for venture funding or should you opt for private equity?

According to Alok Mittal of Canaan Partners, there are various ways to look at it. One way is to look at what kinds of risks are taken by the investor. “When you see a lot of concept and market risks that tends to be more venture. When you see growth or finance risk, it tends to be more towards PE.”

According to him, another way to look at it is the stage of the company. “Early stage investments are more venture. Then there is the time horizon. Venture tends to be more 4-6 years time horizon of investments. PE tends to be more short time. Size of investments could also be an indicator. PE funds tend to do larger investments, because they are investing in late stage companies. Venture tends to make smaller ones”. Like we said before, PE typically is a minority stake. But there are variations.

In the real estate industry, we found that the preferred model is to set up a joint venture or a special purpose vehicle (SPV) for a specific project rather than to invest in the mother company. Om Choudhry, whose FIRE capital deals exclusively in real estate PE, prefers project-specific joint ventures with equal share for FIRE and the promoter, and a more active involvement, particularly in the early stages of the project.

Who can get PE?

The blasé answer is that any established company with a viable plan for major growth can get private equity funding. If you happen to be in one of the growth sectors of the economy, then the going just got better. But in reality it is slightly more complex. Each fund has its preferred sectors, and within the sectors, they would have identified growth areas or areas that they have specific expertise in. Within these segments, they look for companies that can outperform the market in the short term.

Subbu Subramaniam of Baring Private Equity explains the process, “We actually run through a top-down analysis, as we call it. If the economy grows at 8%, which sectors will grow faster than the others? If these sectors are projected to grow at say 10-12%, which companies in that sector will grow faster than that? For instance, if you take automotive over a long term, it grows at about 1.5 times GDP. However, if you take the leader in automobiles, it can grow almost 1.5 times of the sector itself, which means 2.25 times the GDP. We try to identify companies for investment in this manner”

Many promoters prefer the email route of sending in an investment proposal. But this has the lowest scoring rate. According to one fund manager we spoke to, out of the last 600 odd proposals he received by email, two were selected for further processing! Obviously, a lot of home work and investment of management time, energy and money is required to land the best deal. IBS for example, did a global road show and invited bids from prospective investors.

“If you really want to raise private equity, you should follow a process” says Mathews of IBS. He says the process involves developing an investment memorandum or prospectus for presentation to the investor. This should answer questions like: What do you do? What is the state you are at? What is your business plan? Why do you think your business plan is going to deliver?

“You certainly need to have a merchant banker, or an investment banker. In our case, they were really helpful, and they had actually contacted a number of private equity players. We met some of these players, some in the US, some in Singapore, and some in India,” he says, adding “we had five competitive proposals coming down.”

“In the next stage, you look at what are these companies looking at, what is their kind of governance model? We also looked at chances for a close and the time that they will take to close. I met with the Group CEO and partner of General Atlantic; it was very comfortable. The team is exceptionally good. Among all the PE companies that we were considering, GA had maximum footprint in India. They have about five-six people in India, which also was a high degree of comfort,” Mathews says.

How does the system work?

The PE ritual is much like a courtship and takes time to reach communion. Do not expect results overnight. While the general expectation was that it takes around six months to finalise a deal, the sense we got was that regulatory and compliance issues along with the time spent by the company preparing to go out and woo the prospective PE investor put together, it could be anywhere from six months to up to a year or even more.

Industry sources point out to deals that went bad in the final stages because of changing promoter expectations (read escalation in price demanded), or simply because the promoters were not able to present their case well in the last stages. Sign off on a deal has two stages. The first is the term sheet, which the investor issues, outlining their interest in investing in the company and then there is the final contract. So, a PE deal can be clearly divided into the pre-term sheet and the post–term sheet phases.

For Mittal, “pre-term sheet is essentially our business evaluation – all the informal diligence that we do around the business, talk to customers… this would typically be a 4-6 weeks exercise. At the end of it, if we are still interested, we would issue a term sheet, which is basically our broad intent to invest, under a given set of terms. After that, we do a lot of confirmatory diligence,”

Mittal makes sure that all the financials that were reported are true and all the legal aspects of the company are accurately represented. The legal documentation of the agreement (which elaborates on the term sheet) is also done. “The whole cycle, at the lower end, would be about three months and at the upper end, it could be 4-5 months. It might take slightly lesser on the initial diligence part because there is data. But it might take longer on the tail, because we have to verify more stuff,” he says.

Very clearly, the PE route is the option when you have a well established company, particularly in a niche but growing market and you want capital for aggressive growth. Now, the question is, should you opt for PE or should you take the IPO route?

Most of the companies that take the PE route are too small for listing, and the inherent risks of the expansion plan are too high for the rigors of daily trading in the stock exchanges. Exponential growth does not happen overnight and the share market is not a very forgiving mistress when it comes to perceived slack in returns. The PE investor also helps you in leveraging his portfolio and his contacts to help reach the right markets; something that the stock exchange cannot do.

For Mathews, the choice was clearly not IPO. “In both IPO as well as PE, you are raising capital. When you go IPO, the public is more interested in how his share value is increasing, and is not interested in what you do. The valuation of the company, in the eyes of the market, depends purely on how materially you are performing. Now that is best when quarter by quarter, you are able to bring in very predictable results. In the case of private equity, they understand that they are involved in the business. They know the business more than the public”

He says private equity players are looking at a slightly longer term, because they are looking at a three to five years timeframe to see the results. IBS has come to a stage where “we still need to invest in many of our lines of business. We really need to build up the business, before we can say that we will deliver the quarter by quarter results.”

anuman Tripathi of Infrasofttech also chose the PE route with investment from Baring because “we have grown on a very small initial capital of $1.4 million and internal accruals over the last 12 years. For growing rapidly, we needed investments in three areas — international sales organisation & branding, infrastructure & training and inorganic growth.”

Once the deal is done…

In the euphoria surrounding the mega deals, not much has been talked about what happens after the deal is signed and the paper work is over. One needs to remember that the PE fund is a short term investor, but with a board seat!

In order to get it right, it is important that both sides have a clear understanding of expectations as well as capabilities of the other party. Some PE funds like to be more involved while some others take a hands-off approach unless asked for help. It is very important for the promoters to understand and more importantly is comfortable with the investors approach.

According to Subramaniam, each fund will have its own investment philosophy. “We have our own philosophy. We are more involved than others. It is completely on a need to basis. The promoters respect our ability to help them, and they will ask us for help. It is completely driven by the need, and by the level of equation, communication and openness that is set in the first six months of the relationship,” he says.

Baring as a team is more involved than the others, which means “we have more than board meeting interactions. We request for monthly reports to track sales activities, operations, recruitment, attrition, etc,” he says. “In each company, it is different – sometimes it is production, sometimes it is raw material cost. We create a format the companies send us every month, and then we discuss it with them. We think it is no fun to wait for the quarter to end and then find out something that we could have corrected two months ago. So, we have monthly interactions at the least. And yes sometimes we do recommend significant changes in the strategies of companies we have invested in,” adds Subramaniam.

The PE investor also plays an interventionist role, getting senior people to join in or even getting portfolio companies to merge, particularly when things don’t work out as planned. Mittal has this to say: “The fact that we take risks means that we are accepting that some of the companies will go out of the system. We would then like to look at something that would give a soft landing to the business, the customers, and the employees of the company.”

The role that Baring played in Mphasis is a case in point.

Says Subramaniam, “the Mphasis engagement was very deep. We were the VC who did the first round of investment along with the founders. Then when it was growing at a rate at which they could not fund, we gave it additional financing. To leverage and sustain their model, we actually merged it with BFL, which is another portfolio company. BFL had off shoring capabilities, Mphasis had sales capabilities. So we drove the merger as the single largest common share holder.”

The exit

One of the features of the PE business is that the investor will exit. And the promoters have to be ready and willing to create this exit so that the investor realises the value of the investment. Typically, for PE, this is in the form of an IPO or a buyout. Selling back to the original promoters is not something that the PE funds think is the best option, since it does not often get them the best valuations.

Article earlier appeared in the Investment World.