A Primer on Indian Private Equity: A Practitioner’s Perspective

Contributed by: Varsha Dhamasia 

Historically asset allocation was focused on only traditional asset classes, i.e., equities and fixed income instruments but over the last few decades, investors have increasingly inclined towards investment in alternative asset classes owing to their wonderfully high and uncorrelated returns. Backed by significant reserves of primarily foreign capital, the private equity industry is fast catching up an alternative source of financing for the up and coming businesses in India. Even when the primary markets weren’t doing well during 2010 – 2014, almost $40 to $50 billion were invested in the Indian private equity markets. India had 253 active private equity funds in 2016.

The CFA Society India – IAIP organized a session on “A Primer on Indian Private Equity: A Practitioner’s Perspective” presented by Mr. Kazi Zaman, CFA and Mr. Abhishek Loonker, CFA in Bangalore on September 9, 2017. An all engrossing and engaging session where everything was discussed from the concept to the real world matters in private investing straight from the seasoned private equity professionals.

What is Private Equity (“PE”) and How the PE Model works:

PE refers to the value added investment approach wherein the fund manager or partner of the PE firm called General Partners (“GPs”) raises fund from investors called as Limited Partners (“LPs”) by getting a significant amount of capital commitments from LPs. When the GPs find an investment opportunity, they issue capital call notices to LPs to draw down the required investment amount from LPs. The LPs undrawn commitments to GPs is called Dry Powder. The return expectations of LPs is generally at an IRR of 25% net of fees and carry.

In PE investing, the GPs are also required to show some skin in the game in order to ensure alignment of interests with LPs, so the GPs put in at the most 5% of the committed capital. The PE manager receives an annual management fee (typically 2%) on the committed capital of the fund. In addition to that, the fund manager receives carried interest or carry, i.e., a share of the profits paid to the GPs (typically 20%) after a minimum rate of return, i.e., hurdle rate or IRR (usually 8%) is realized.

The carry/returns are distributed to LPs and GPs based on the liquidity waterfall: under the deal by deal carry waterfall, at every exit carried interest is returned to the GP if the deal IRR is above the hurdle rate. Whereas under the conventional and more preferred waterfall the returns are first distributed to the LPs and carry is not paid until the entire fund amount and the returns equivalent to hurdle rate is distributed to LPs and beyond such amount 20% of the returns are distributed as carried interest to GPs. Most investment managers prefer this distribution waterfall to prevent LPs to compensate for the early positive deals exit and a bad performance later. For example when Softbank decides to sell its stake in Flipkart then all the Softbank LPs and GPs will exit the investment simultaneously and not the subset of investors within the vehicle; as this would ensure no conflicts of interest between parties within the vehicle.

When the fund is liquidated and LPs receive less than the expected return, there can be a clawback provision in the agreement that allows to make-up for the difference by taking carried interest from GPs and distributing it to the LPs. Furthermore, GPs usually hold back a portion of the cash as a reserve to cover for future contingencies, tax-related or so. An example of such would be the Vodafone Hutchison deal tax dispute.

Since PE is a fairly long and illiquid investment into a non-traded equity, the reasonable estimates of the value of portfolio companies are calculated using market, income, asset or a combination of valuation methodologies. These valuations are also performed as part of the audit or NAV evaluation exercise after each specified period, however, these valuations are merely an opinion and may or may not reflect the true value of a company and will only surely be commented upon post return realizations.

Who are Limited Partners (LPs)?

LPs or the investors are referred to as “GOD” by GPs in the PE industry. LPs can be domestic or foreign; institutional or non-institutional. PE investors generally comprise of pension funds, endowment funds, sovereign wealth funds, insurance companies, fund of funds, families and individuals. In practice, GPs generally prefer institutional investors over individuals/families mainly because of the individuals/families’ misjudged appetite for the long holding period and in turn defaults on capital drawdown call.

Characteristics of Private Equity:

PE asset class not only delivers higher and uncorrelated returns to public equity but also differs from public markets investing such that it is illiquid, requires higher involvement, have longer gestation period and is expensive.

PE funds have a long investment horizon and require at least five years’ time to exit. As PE funds are invested mostly in non-traded companies, the fund manager sort through private companies with the intention to hold a significant stake in the company and assess the companies’ ability to generate expected returns in some time duration. PE managers look for a superior business model, strong and experienced management team, strong promoter track record and good corporate governance and assess whether the investment is a good fit based on the fund’s existing strategy, time horizon, return expectations and mode of exit.

Before investing the PE investor also conducts due diligence on the target company and its promoters. It makes deal-making a lengthy process. Further, the fund manager helps the portfolio companies’ strengthen internal capabilities by providing value-added services to the firms by helping in with their cost-cutting and revenue-boosting measures, improving capital efficiency, bettering corporate governance and much more. To better understand it using a sports analogy – if cricket, a non-contact sport, is like public equity investing then rugby, a close contact sport, is like PE investing where PE managers get actively involved in the business operations which is not the case with public market investing. Another characteristic of PE is blind pool investing which means that the investors (or LPs) invest in the fund without knowing where the fund manager will invest and rely on the fund managers’ expertise for the entire duration of the investment.

Although through our studies we have learned that alternative investments provide portfolio diversification to investors, the public and private markets’ fund flows have indicated higher correlation and the returns in both the markets also seems to be correlated at all times.

Structure of Private Equity Funds:

The PE funds in India are structured as either Unified or Parallel. Under the Unified structure, the investment manager floats the Alternative Investment Funds (which is registered with SEBI under the AIF Regulations) with investments from both domestic and offshore investors. The domestic investors would directly contribute to the AIFs whereas the overseas investors pool their investments in an offshore vehicle and this offshore vehicle enters into a subscription agreement as Foreign Venture Capital Investors-registered with SEBI. Under the Parallel Structure funds from the domestic and foreign investors are pooled separately and investments are made directly into the Indian portfolio companies.

Type of Private Equity deals:

1. Minority Growth Capital wherein GPs invests series B-C onwards or in the mid-market companies when the money is needed for working capital, expansion or restructuring to increase the growth rate. One such example of minority growth capital PE is Ascent Capital.

2. PIPE (private investment in public equity) Deals – Many PE funds invest in public companies through preferential route or in secondary markets. Typically long-only funds invest in public companies with the gestation period of about 5 to 7 years. Risk Capital Partners and WestBridge Capital Partners have done many PIPE deals lately.

3. Passive/Active control – PE funds sometimes take passive and occasionally active control in the portfolio company. In their active control, GPs play a prominent role in the company’s operations For Example India Value fund – wherein they own 100% in few and 50-90% in most portfolio companies. It hires management team or engages people from their fund for monitoring (e.g. – Meru Cabs, Act Fibernet). While taking passive control, funds may have majority investment in the firm but promoters or the existing management team continue to run the show. GPs just maintains checks and balances but do not actively control or take part in the operations.

4. Platform Plays in which the portfolio company develops the platform and the GP invests and owns that platform. Few examples of Platform Plays are the investment into iNurture and Big Basket platform by Ascent Capital and investment in Burger King by Everstone Capital. Platform Play differs from a control transaction because GPs collaborates with the promoters to create a platform from scratch, and differs from venture capital investment such that the size of the opportunity in platform play is very large, i.e., investors are not looking at the incremental growth but a rapid growth rate.

How Private Equity (“PE”) differs from Venture Capital (“VC”):

The PE and VC investing are used interchangeably due to the much similar investment features. PE and VC are both illiquid, long-term investments in private companies and follows similar funds structure and fees structure. VCs invests in startups, pre-revenue stage, and small- and medium-size private companies and takes concept risk and bets on the promoter’s idea/business model whereas PEs provides working capital for expansion, new-product development, or restructuring of the company. Using Cricket jargons, VC is similar to T20 form of cricket where more boundaries are required to win the match and PE is like test cricket where regular singles with occasional boundaries are sufficient to perform well in the overall match.

Term sheet Jargons:

• Pre and Post Money – It is the value of the company before and after the new investment comes in. The pre and post money values are calculated using the post money fully diluted count.

• Anti-Dilution (full ratchet) – If the new money comes in at a lower price than the previous funding, the already existing investor’s shares are adjusted based on the price of the latest funding round.

• Tag along – When there is a change in control, the promoter provides an exit to the PE investor before transferring its majority stake, or when there is no change in control and the promoter wants to dilute its stake in the firm then PE investor also dilutes its pro-rata stake in the firm.

• Earn-outs are a clause in the investment agreement which states that if the company earns returns beyond a specified limit, say 3x or 4x, then they would share part of that return with the promoter.

Recommended reads:-
• Barbarians at the Gate: The Fall of RJR Nabisco by Bryan Burrough and John Helyar
• The Second Bounce of the Ball: Turning Risk into Opportunity by Ronald Mourad Cohen

-VD