Exit strategy

Written by Shruti Ambavat | Updated: Oct 29 2012, 02:11am hrs
With the current absenteeism of IPOs, private equity firms are having a tough time exiting their expensive and old portfolio firms. Secondary deals offer them a way out, but at what cost

With the current absenteeism of initial public offerings, private equity firms are having a tough time exiting their expensive and old portfolio firms, leaving several firms with no option but to exit through secondary deals. Secondary deals are whereby companies are traded between private equity groups rather than outwardly in the open market.

The private equity industry changed in India and globally post the world economic crises in 2008. With the fall of financial institutions like Lehman Brothers and Bear Stearns, the valuations of companies also began to trickle down. This changed the game for PE investors who had earlier funded companies at valuations over 20 times. The value of some of these companies has reduced considerably, and coupled with the falling rupee, the exit valuations have gone down further.

Some of the large firms that have invested in listed companies in the pre-economic crises period have seen their value diminishing on the stock market. For example, PE firm 3i India Infrastructure had invested R900 crore in Adani Power in 2007. The company went for an IPO in 2009 with a price band of R90-100 but its stock value has halved to close at R47.45 on the Bombay Stock Exchange on Friday. Who will give us the right price now if we exit the company The investment cost us R60 and price is somewhere around R50 now, says an official at private equity firm 3i Group.

However, the industry is divided on the viability of secondary deals. Some promoters say there are certain clauses between the primary investor and the promoters that bind them to follow the first right of refusal clause. The outgoing investor has to offer equal number of shares to existing investors or at least offer a proposal to them, says a senior official of a power firm that has received PE investments.

A few fund managers believe it is the best time for secondary exits but in specific sectors. There is not always a clause between the promoter and the PE investors, says Vishakha Mulye, managing director and chief executive officer of ICICI Venture Funds Management Co Ltd. Sectors like healthcare and education see more secondary deals, she adds. ICICI Venture has done a few secondary deals like stake sale in diagnostics laboratory chain Metropolis Hospitals to Warburg Pincus for R395 crore and Sahyadri Hospitals sale to IDFC Private Equity.

For many PE firms, the most viable option for exit in an unlisted firm is an IPO and a block sale if already listed, says Pramod Kumar, managing director at investment banking firm Barclays Capital. But with the current state of equity markets, PE funds that had invested in small companies find it difficult to exit via that route as the companies have not grown large enough to be listed on the stock exchange. Going forward, the secondary deals route will be much more prevalent because many earlier PE firms have come up with their fund maturity cycle and are forced to show exits to their investors, Kumar adds.

Secondary transactions are an added dimension now just as IPOs were two years ago. Even if the market is doing well, not every company can go for an IPO, says Archana Hingorani, chief executive officer and executive director at IL&FS Investment Managers. Smaller companies usually find few takers on the stock exchanges. But strategic deals are much more easier as compared to secondary ones because new investors expect a larger discount from the previous PE firm, she says.

In PE-to-PE transactions, some haircut is taken because the new investor always asks for discounts, whereas capital markets would give better returns, says Vaibhav Parikh, partner and head of financial investments at law firm Nishith Desai Associates.

Also, experts believe that secondary deal exits will lead to selling at a discount for many investors. Valuations may not be attractive because when the existing fund entered, the company showed a high growth trajectory which may not be the case now, says Kumar of Barclays. Moreover, The new investor will not pay skyrocketing valuations similar to 2007-08 levels today, he adds.

One of the other exit options for PE firms is promoter buybacks. But consultants believe buybacks are not the norm these days since entrepreneurs are happy to sell their company given a good valuation. First generation entrepreneurs do not generally have deep pockets for buybacks and in my experience have been open about selling their businesses/inducting strategic partners, says Mayank Rastogi, partner, private equity and transaction advisory services, at consulting and audit firm Ernst & Young.

For instance, PE firm Actis had sold its 63% stake in Paras Pharma to Reckitt Benckiser for about $726 million in 2011, along with the promoters, Girish Patel and his family. It had acquired the stake for $150 million in 2006.

Standard Chartered Private Equity is looking to sell its investment in generator manufacturer Powerica Ltd via the secondary sale route. PE firm General Atlantic is also looking to offload its stake in technology services firm Hexaware Technologies through a similar strategy. ICICI Venture is looking to exit from Updater Services Pvt Ltd and may rope in other PE firms for the same. PE firms like Kotak Private Equity and 3i Group are also looking to sell stake via secondary route in Siro ClinPharm Pvt Ltd.

PE firm Olympus Capital Asia Investments invested $100 million into DM Healthcare, which provided a partial exit for existing investor India Value Fund. General Atlantic bought stake in logistics firm Fourcee Infrastructure Equipments for $104 million, which led to the exit of Mayfield Fund from the company. In July this year, IndoUS Venture Partners invested in online retailer of baby products HushBabies. Through this investment, Nexus Venture Partners sold their existing stake.

Some of the large PE firms like Blacktstone, Baring Private Equity and Warburg Pincus, among others, have at least six-nine portfolio firms that they have invested in since 2006-07 and yet not exited. In most cases usually the exit is IPO, but we are looking at secondary deals as well, says Akhil Gupta, senior managing director and chairman of Blackstone India.

Secondary deals are primarily getting stuck on entry valuations paid by investors in earlier funding rounds. Many PE firms that had invested in 2007-08 may have to book unattractive margins or even losses as currently investors are far more discerning on valuations, says Rastogi. Also, in deals which have both primary and secondary components, the incoming investors typically get all the PE investor type rights but in pure secondary deals (PE-to-PE transaction), there could be issues around rights of the new incoming investor as the investee company may not be required to be a part of a transaction. In such cases, the secondary PE investor asks for a reduction in valuation from the earlier levels, he adds.

A number of fund charters also restrict too many PE-to-PE transactions. The new investor sees growth in a company and is ready to pay the valuation keeping in mind those growth levels. But, they will not pay the same valuation to the existing investor who is looking to exit because the money will not be going into the company. One of the leading investment banks is working on a secondary transaction in the industrial space, where a large existing PE investor holds 30% and is stuck on the valuations with the new one since marginal money will be going into the company.

PE firms are also wary of secondary deals because their investors or limited partners do not prefer such deals. LPs do not prefer secondary deals because they have exposure to multiple PE firms which may overlap. Most of the deals are then structured with a mix of primary and secondary deals, says a PE fund manager on condition of anonymity.

Many funds are anyway shying away from deals, be it primary or secondary, and for the latter an investor needs a very good justification to enter the company, says Chintan Bhayani, manager, investment banking & corporate advisory, at stock broking and boutique investment banking firm Asit C. Mehta Investment Intermediates Ltd. LPs commit a certain amount to PE firms, which is on an as-and-when required basis. In the meantime, this amount is invested in other instruments like real estate or capital markets. If those markets fall, then the LP's investment value falls as well and they will not cash it out when the PE firm asks for its commitment amount, he says.

But consultants and fund managers are also very positive about the secondary deals space in India and only see it growing every year. People have realised that a single company can have multiple rounds of investments from different types of funds with each investor entering at a different stage in the lifecycle of the companyat the venture stage, growth stage and the late stagewith each of the investors having different value proposition for the company, says Rastogi of E&Y. The firm is currently working on at least 12 deals in the secondary space in the range of $10-$200 million. In the last one year, the firm has seen maximum secondary driven deals.

For instance, recently, IDFC Private Equity invested R155 crore in dairy company Parag Milk Foods, giving a partial exit to Motilal Oswal Private Equity. Trivitron Healthcares promoter also received R122 crore for a 10% equity exit from Norwest Venture Partners.

From a venture capital perspective, it is a good space to be in because you find it as a nice exit mechanism, says Abhay Pandey, managing director at Sequoia Capital India Advisors Pvt Ltd. From a large buyout fund perspective, it is a way of finding good companies, which are already being tested by other PE firms, he adds. He is not worried about reduction in valuations for primary investors because the sellers are not always desperate to exit a good company. The seller usually waits for the right time to exit and I see many exiting partially in their portfolio firms, Pandey adds.