Private Equity Investments in Indian Companies-BejoyDaniel Private equity and venture capital both have been the mainaccelerators for growth of the world economy. The contribution of the privateequity industry to economic development and with timely investment, growth andprofitability trends to be the primary goals. On examining the investmentclimate in India, there is a growing global stature which a far more openeconomy coupled with positive indications of reforms and perception of value thatencourages investments into the country. This has been drivers that poweredIndia’s GDP growth rate to over 9% in 2005. PE investment has had an integralrole with overall foreign investments in India. PE players have contributed atvarious stages in private companies, roles being majorly in funding projects throughseed funding in addition to considered buyouts by entering at mature stage. 1.
Basic understanding of ‘Private Equity’Private equity basically denotes the capitalthat is not noted on a public exchange. Private equity tends to be an equationof funds and investors. Investments are made for private companies and those companiesengaging in buyouts of public listed companies. The buyouts of any public companieswill eventually result in the delisting of the public equity.
Private equitydepicts a medium to long-term finance provided in return for an equity stakemeant for potentially high growth companies. With the case of a few instancessome use the terminology “private equity” to refer only to the buy-out andbuy-in investment sector. However, in Europe but not the USA, the term “venturecapital” is used to cover all stages, i.e. synonymous with “private equity”.
Inthe USA “venture capital” refers only to investments in early stage andexpanding companies. Since the 1970s private equity hasstrengthened with pools of funds created by private equity firms in order toprivatize most extra-large companies. A significant number of private equityfirms carried out leveraged buyouts (LBOs). Through such buyouts, notable sumsof funds are provided in order to help finance large purchases. Efforts by the privateequity firms aim to achieve improvement in prospects, profits and overall financialhealth of the company.
The ultimate motive and goal usually is a resale of thecompany to a different firm or for cashing out through an IPO. A few advantages of private equity can becollated and summarized as below:Ø Availability of capital to under-capitalizedcompaniesØ Where in any company, equity injectionis required which is too small to raise from public marketsØ Easy to obtain fund from anon-conventional routeØ Relief from compliances oftransparency standards applicable to public companies as required for Publiccompanies for raising from IPOØ Adoption of best management practicesØ Brings operational efficiency ininvestee companiesØ Overall growth to economy Institutional and retail investors are usuallythe providers of the capital in private equity. This investment is meant to beutilized to fund new technology, make acquisitions and even expand workingcapital. Investors are inclusive of institutional and accredited investors,especially them who can allocate substantial sums of money for an extended timeperiod.
In quite a number of instances, long holding periods are oftenpreferred for private equity investments so as to ensure a turnaround or toenable liquidity events such as an initial public offering (IPO) or a sale to apublic company. 2. The Market for PrivateEquity (A) Types of Funds / Investors: · Privateequity (PE)PE funds can be considered to be a collationof private equity raised by PE firms from various investors. These pooled fundsare utilized for investing into target companies. They are typically structuredeither as a Limited Liability Partnerships (LLP) or Limited Liability Companies(LLC). Fund Managers usually acts as general partner in these funds andactively involved in investment and management decision of the fund. In additionthese firms may control several similar funds at a given point of time. · VentureCapital (VC)Apart from the described PE funds, there arealso Venture capital funds in market which provides private equity tocompanies.
These funds are very much similar to a PE fund and refer to equityinvestments made for launch, early development or expansion of business. Thesenormally funds Entrepreneur seeking to start or expand business and forcompanies at a high risk early stage and no alternative funding is available.These are specialized in early stage financing of start-up companies and it prioritizeson entrepreneurial undertakings rather than on mature businesses. · Angel investorsThere are wealthy individuals who provideprivate equity in form of seed money to entrepreneurs of companies to startcompanies. These investors usually invest at very early stage in companies evenbefore the Venture capitalists. The contribution by Angel investors is smallerin comparison to the amount from VC. (B) Mechanism and Structuring:The establishment process for a PE is dependedon interaction of two parties. This comprises of a PE fund being the majorinvestor and a PE firm, who acts as the Management Company to the Fund.
In mostcases the PE fund is structured as Limited Partnership. Limited Partnership istax efficient structure ensuring that the earnings is directly taxable in thehands of investor in PE fund due to its pass through status. The advantage ofchoosing LP structure is that it is inductive of a pass through status,resulting to no tax leakage at the PE fund level. A legal structure of a PE fund consists of aGeneral Partner (GP) and a Limited Partner (LP) A GP is a partner who assumessole responsibility and unlimited liability in the fund. The PE fund is structuredsuch that the firm who handles investment of PE fund is the GP or the ManagementCompany. Characteristic of a GP of theFund is that this partner is established as LLC in order to achieve tax or flowthrough status and to impose an additional layer of legal liability protection.A PE firm, as a GP in Fund, is a management company who makes all investmentdecisions and is compensated with management fees for the management andinvestment decisions of PE Fund (that generally covers the cost of running thefund, including salaries and overhead).
Generally, a common fee ranges between1% to 2%, although, it may vary based on numerous factors. Also the GP ormanagement company is also entitled to a share in profits on the PE Fund’sinvestment (popularly known as ‘carry’ or ‘carried interest’ (CI), a GP normallyis entitled to 20% carried interest in the Fund).All other partners who contributed to PE fundwith a capital contribution, have passive role and limited liability. Suchpartners are LPs in Fund. These LPs are not involved in operation of the Fund andentitled to share in profit after deducting share of GP. (C) Business Methods:Ideally an investment commences with theinvestor seeking out a company requiring investment or being approached by sucha company. Following this, a basic document, such as a memorandum ofunderstanding (MoU), a letter of intent or a term sheet is executed between theinvestor and the company, in order to lay out the framework of the investment.Once the document is prepared, the investor usually conducts, at the minimum, alegal and financial due diligence on the company.
This is often inclusive of abusiness due diligence and background check on the promoters of the company.The due diligence process may include the investor and the company negotiatingone or more investment documents, including share subscription agreements,share purchase agreements and shareholders’ agreements with the company and thepromoters/shareholders. Upon the execution of these documents, and post theclean-up of significant diligence issues, the investor invests in the company.
3. The Process of PE investment and Funding The process of an investment starts with beingcommunicated either by promoters or by any intermediary. Investors may agree topool their money and in some cases even the PE investors / advisors approachesportfolio companies with potential for PE funding. In a PE investment, thefollowing processes are implemented:· Overview of preliminary proposal oftarget companies· Study of background of targetportfolio· Due diligence for the deal· Negotiation of deal· Issue of investment memorandum / termsheet· Preparation and execution of variouslegal documents at PE Fund level for pooling of funds such as shareholders’agreement (SHA). SHA is an agreement between PE Fund and existing shareholdersof the investee company.
The terms in the agreement governs the relationshipbetween existing shareholders, promoters and the Fund making investment. Inaddition the agreement document defines the rights, duties of the PE Fund as ashareholder, any restrictions on issue / sale or transfer of shares / furthercapital by Investee Company, right to appoint directors, veto power,affirmative powers to directors. Exit options are also mentioned like strategicsale, sale to promoters, drag-along / call-put option, sale in IPO etc.
· Investment agreement is executedbetween PE fund and investee companies laying down various terms agreed forinvestment / acquiring stake in investee company, any specific conditionsattached to investment or return of money etc Actual investments completes with the transferof funds by PE Fund to investee company. After actual investment, the PE fundmonitors its investment and various compliances of Investee Company in order tosafeguard its money and interest of its investors. Private equity normally covers financingrequired in private companies at different stages. It not only covers financingrequire to create a business, but also includes financing the subsequentdevelopment stages of the Company’s life cycle. PE Funds invest in Indiancompanies that are in need of long-term equity or risk capital at variousstages of life of the company. There are various stages in funding, mainlyinvolving and being:· Seedfunding stage As the name suggests, seed funding is requiredat entrepreneurial level before actual start-up phase has been reached.
Basically, this financing is for research, assess and develop an idea orinitial concept. At this stage, investors are mostly business angels (eitherentrepreneurs or directors who fund these projects).· Start-upfinancing stageStart-up financing is used for product developmentand initial marketing. At this stage business may be in creation phase butproducts have taken shape but have not yet sold commercially. Mostly Venturecapitalists enter at this stage to fund the business for setting up ofbusiness.· Growth/ Expansion stageOnce the business has taken its full swing,products are sold and business has reached or approaching its breakeven point,the business requires funds or high growth capital to expand its productioncapacity and sales power or to develop new design/products or to finance anyacquisitions and / or increase working capital of business. The mostinteresting part of this stage is that it is here when mostly professionalinvestors fund the expansion opportunities of companies.
They invest incompanies which already have a strong history or a robust structure in place orwhere significant amount of investment has already been invested. It nowbecomes the aim for a target company to ensure balanced growth while obtainingand utilizing these funds, as financing may be required in various and multiplerounds.· Maturestage / BuyoutIn a buyout either shares in a company held byfamily members may be repurchased or where a large company decides to disposeits business unit or eventually, when investors from previous stages ofdevelopment exit from business. This stage may also be referred as total orpartial retirement of head of company. Buyout allows company to carry ontrading, facilitate generational change at top of a company and enablerestructuring more efficiently by injecting fresh capital. Buyout in a varietyof instances also helps the management of the company by sharing professionalknowledge of PE Firm in that sector, their network contacts and long-termcommitment.
With various PE investment having beenrecorded across various stages, majority of the PE investors are attracted togrowth and expansion stage. This stage gains its importance as it benefits the targetcompanies and PE investors in terms of much needed capital for growth andexpansion plans of target companies as well as higher return on equity to PEplayers. 4. Tracing the Origin and Development of Private Equity The initiations of Private Equity as anorganized form of funding were post World War II. The first firms to enter thisspace are believed to be two US based firms, American Research and DevelopmentCorporation (ARDC) and J.
H. Whitney & Co., both founded in 1946.Despite being called private equity, theinvestments made by these firms assumed different forms at various stages ofits evolution. It started off as venture capital investment which wascharacterizedby relatively small investments into early stage companies.
This followed with leveragedbuyouts which facilitated exits to small business owners. Finally the venture culminatedinto dedicated investments made by institutionalized PE players. In the UnitedKingdom, private equity took off at around the same time as it did in the US, howeverwith setbacks as a result of adverse investment conditions imposed by variousgovernments. Entering into mid 80’s, the State took progressive steps topromote venture capital industry, rationalization of marginal tax rates, etc.The inception of the Unlisted Securities Market (USM) in the early 80’s provedadvantageous for the exit of small firms because of relatively easier listingrequirements.
In India, PE was still relatively new, whileearly stage investment vehicles or venture capital funds were launched as earlyas the mid-1980s, it was only around the mid-1990s that a few firms startedinvesting in Indian companies. 5. PE Investment andFunding Trends in India Until early 2001, the focus was more towardshigh growth sectors such as Information Technology (IT). With the technologyslowdown following the dot-com burst, investors diversified their interest intoother high potential sectors such as manufacturing, infrastructure, e-commerce,pharmaceuticals and biotechnology.
Another effect of the global slowdown in2008-2009 has been the shrinking deal sizes for investors. The PE industry hasfaced substantial correction in valuations of Indian enterprises, and theextraordinary growth bubble has seemingly burst. Investors became much more cautious,and were willing to invest in the traditional economy seeking reasonable andsteady growth. Around 2011 there was a rise of private investments in publicequity deals, with a close to double increase in the number of deals struck.
However, 2012 was another year for smaller deals. The last few years have also tested the legalstrength of many deals, some investors have attempted to enforce their exitrights, though few have succeeded on account of the regulatory restrictionsthat India imposes on foreign exits.Given that liberalization of India’s economichappened in 1991, the sector, it has been heavily dependent on Western-style business practices andentrepreneurialism. It is believed that the investors are seeming to be morediscerning and demanding. In addition there is an enormous maturing in thebusinesses they fund and are turning out to be globally competitive.Quite a number of private equity firms areowned and managed by India.
Although Indian businessmen are trying to learnWestern best practices, cultural and social factors contribute to making this avery different market. Law and property rights are very different. Many things thatare taken for granted simply don’t work the way they would in the United Statesor the UK. Entrepreneurs who made money in the last couple of decades want togive that money back to help create more entrepreneurship, hence accelerating apathway for an angel investor community. 6.
The Indian Market for Private Equity Indiais a growth story, a fact that has remained constant over the ups and downs inPE investments in India over the last couple of years. As of 2005-07, Indiafirmly established itself as one of the top seven PE investment destinations inthe world. It is now quite observant that the focus is shifting from thedeveloping world to the developing economies. A favorable demographics in India,offered a growing GDP. This interested funders along with the rising FDIinvestments coupled with forward looking policy reforms. Such demographicsenabled India in receiving more than approximately USD 15 billion in investmentfrom the PE players. Around 2008 with the fallout of financial marketsthat affected developed economies, the effect rocked India too. This pace andintensity caught many investors unprepared and hence made PE investments inIndian companies to turn cautious.
Investments worth approximately around USD 4.5billion were made around 2008. This showed a drop of more than 70% compared to the2007 peak. However there were changes observed and analyzed in investmentchoices. This was measured and experienced across the boom and decline periodswhich led to investor confidence in India’s growth.
The growth and confidence continuedand the deal activity increased to about USD 9.7 million in 2011. The current investment environment in Indiacomprises of several new and previously unforeseen challenges for the PEinvestors. In the never ending search for growth, typically investors aim tosatisfy two preconditions, namely:7. Care for capital 8. Realization of expected returns. A deficit in the above preconditions has beenthe main restraints in the Indian market. This has created a scenario for the investorscontinuing to go slow in deploying capital, and in remaining optimisticallycautious when investing in India.
Trends show a distinct adaptation ofinvestment preferences seen in proportion to economical climate of the country.Distinct trends were being noticeable for sector wise investment preferences,entry stage and size of investments, promoter expectations and with holdingperiod and exit mode. A trend with the prominence of open market andsecondary sale along with strategic sale also began. This was in connect withPE funds seeking returns with a stable stock market, hence paving a pathway fora preferred mode for exit in 2010. The year 2010 experienced a record number ofexits with total value being approximately around USD 5 billion and a volume ofas high as 174 exits. There were strong records of exits in 2010 which boostedinvestor confidence.
PE exits in 2011 were minimally promising due tounpredictability in Indian capital markets and other economic challenges. Othernoticeable trends were seen with IPOs being nearly dried up, while open marketand strategic sale transactions continued. The total value of exits fell byabout 50% to USD 2.5 billion in 2011 compared to a an encouraging peak of 2010. Assumed forecasts for early stage investmentsdepicted an increase with the equity attraction to the minority shareholding.The emergence of a new breed of first time entrepreneurs, would promoteinvestments in technology across the mobile, retail, and the internet space. 7.
Conclusion India’s strength in the IT sector was firstwitnessed in the late 1990s and early 2000s. The Y2K risk mitigation servicesin addition, gave global investors confidence in India’s IT capabilities.Following this 60% of PE investments in the early part of the decade attributedto the IT sector. The year 2007 was at its peak, with a shift in the focustowards various other investment opportunities. These opportunities comprisedmore than 50% of the total PE investments during the year. This included realestate, construction and infrastructure segments and telecom, media andentertainment.
The technology sector continued to find uniform attractivenessamongst investors. While the combination of adoption or smart phones andtablets combined with mobile internet is viewed as a winning combination,medical devices and innovation in healthcare delivery models also caughtinvestor attention. Another emerging trend was the increasing flexibilityprovided by the investors to their investees regarding usage of invested funds.Recent transactions were indicative of funds being provided to companies forscaling up through inorganic route especially in the ecommerce space.
Investorsare focused, with an eye to invest in companies which in some cases alsoincluded portfolio companies. Thesecompanies are of interest to investors primarily due to having provided goodreturns in the past. This scope of returns drives scale up by mergers andacquisition. With the continuing trends, investmentscontinued in the real estate and construction sector during 2010 with a totalinvestment approximating around USD 2 billion. The power and energy sectortopped in terms of value during the same period. In 2011 private equitywitnessed a shift in trends with investments within real estate andinfrastructure sector from commercial and residential moving towards largeinfrastructure projects such as airports, ports and roads. Investment attractiveness increases withclarity in respect to the regulatory framework with the role of the Governmentto include favorable policy development aimed at welcoming investments into thecountry.
According to International Monetary Fund’s (IMF) World EconomicOutlook Update as released in January 2017, India was estimated to have grownby approximately 7.6 % as in 2015 and claimed the status for the fastestgrowing developing economy. However there experienced a downward revision in2016 to an approx 6.6 % mainly attributing to the demonetization announced bythe government around November 2016. Despite the demonetization’s negative effect, therewitnessed positive influences such as industrial productions rising and exportspeaking to the highest ever around December 2016.
Further with the Government’sendeavor to increase investment in core infrastructure, PEs support in theareas of infrastructure, healthcare, education and renewable energy stands abright scope. This was with the expectation to further expand the participationof private equity in Indian core infrastructure companies. The role of PE and Government led initiativeswould be a solution to the limitations on alternative sources of funds such asdebt against assets, equity investment remain a sought after option.
Hopefullyrole of the Government would be to evolve from merely a standalone policy makerto a facilitator of these investments. Hence it seems very likely that India’sgrowth story is likely to stay with investor confidence with the correction ofeconomic downturns and refinement of policies in line with the economic shifts.