PE presence whats in it for investors

Written by Rajesh Naidu | Updated: Sep 30 2007, 08:05am hrs
First came the foreign institutional investors and changed the landscape of the Indian equity market and also investing styles. Now that they have settled down, we have a new breed of investors, the private equity funds, who are creating ripples in the global market, have started to make their presence felt in India too.

Recent deals like the Blackstone Group buying out the majority stake in textile company Gokaldas Exports and also taking a stake in Nagarjuna Construction Company and General Atlantic, Warburg Pincus and the Blackstone Group eyeing a larger share in Infomedia India, have started to garner attention.

As an investor, it becomes paramount to understand the dynamics of the funds and be armed with the information. With global experience, PE funds can, to a great extent, determine the future of the company that they have invested in. After all, PE investing is not merely portfolio investing as in the case of FIIs. PE funds go beyond and influence management decisions and in many cases are the management themselves.

On the face of it, the entry of PE funds in a company is a positive move. After all, PE funds carry out a lot of research before committing to invest. And when they invest, they also bring along their expertise in managing the company. Then there is the case of investor activism, as seen in certain cases in the US. PE funds keep close eye on management decisions and see that investor interests are protected. With their sheer size, they wield the clout to reverse decisions that may not be in the best shareholder interest.

Sanjay Mishra, head of a leading portfolio management services provider, says, As an investor if one tracks the movement of private equity one may come across investment opportunities in sectors which are not in vogue. This can enable you to take some critical portfolio decisions yourself. However there are several parameters you must consider while taking cues from PE fund presence in the company. After all, each PE fund is different and has its own reasons for investing and divesting as well.

Factors

A case in point is Citigroup Venture Capitals entry into KS Oils in December 2006. It subscribed to 32,91,656 equity shares at Rs 180 for a share having a face value of Rs 10 each. Currently, the stock is quoting at a price of Rs 80 for each share having a face value of Re 1. If an investor would have tracked this development, he would be sitting on an unrealised profit of Rs 620 per share pre split or 244% on its investment.

A year-on-year 78% growth in the topline and other strong fundamental factors would have attracted the PE fund here. Additionally, when most of the market was after glamourous stocks, the fund identified a core commodity sector player with potential much before others in the market did.

For a PE investor an industry may not be the determining factor when it comes to investing in a stock but it is the companys fundamentals, which matters to it. So, as an investor you need to bear in mind that a PE presence in a stock does not mean it is bullish on the entire sector to which the stock belongs.

Most portfolio funds take a sectoral approach and latch on to specific benchmarks, like the MSCI index and its weightages. We would rather have a bottom-up approach where we identify companies and then validate the case by looking at the sectoral opportunities as well, said Manish Kejriwal, of Temasek India Advisors at a select press meeting.

While there are reasons to be optimistic about a PE fund taking stake in a company, there are no guarantees that these funds will make a difference to the management and the profitability.

A case in point is Hexaware. Private equity major General Atlantic entered the company in early 2006. The companys performance has not improved significantly as many expected the entry of the PE fund. Patni Computers, experts point out, is a similar case.

Exit strategies

So while tracking the entry of a PE fund can be a useful decision making tool, the exit of a PE fund could be critical to your decision making. When questioned about their exit strategy, PE fund representatives commented that given a good price they wouldnt mind exiting the company. They are not there for perpetuity. Hence, as an investor you need to understand the profit-seeking motive of a PE and hence you should book profit as and when opportunity comes.

Now there is no defined rule on exits for PE funds. They exit based on several factors. Their organisational nature, i.e. who are the fund participants, their profit strategy and their investing horizon. All of these count. Most large funds have twin strategies; one is to set aside funds for trading and also keep a substantial amount for strategic long-term investments. The trading portion is utilised when there is a significant opportunity seen, especially when markets are catching the momentum. And strategic funds are invested when a true value proposition is identified.

Take the case of Sintex Industries. The companys core business is to manufacture water storage tank, plastics and textiles. Over a period of time the company has introduced more related products. Warburg Pincus had picked up stake in the company in 2005. And herein the PE has made a killing.

The PE picked up 17% stake in Sintex Industries at Rs 280 per share of face value of Rs 10. Gradually, the PE increased its stake in the company to more than 26%. Subsequently, the PE sold off around half of its holdings at Rs 345 per share of face value of Rs 2. To put it simply, the stock has delivered return of 416%.

Experts attribute this sale to a normal profit booking by the private equity fund. So the core portion of the holding remains, and the fund also managed to get some trading profit.

The partial stake sale in Deccan Aviation, the owner of the low cost airline leader Air Deccan, by ICICI Venture, is another case. On the one hand when the Kingfisher is raising the stake in the company, ICICI Venture partially exited from the company. The company has made more than double on the investments it made in the company after being for over three years with it.

Analysts reckon that the partial exit comes at a point when the crude oil prices have crossed the $80 per barrel mark, increasing aviation turbine fuel (ATF) prices, which is a major part of the expenditure, along with increasing employee costs, and the not-so-encouraging trend seen in the infrastructure development in aviation. Not to mention about the negative impact of these hurdles seen in the earnings, which may be one of the strong reasons for the partial exit of ICICI venture.

Overall, PE funds bring in value to the companys management and improve its prospects and their presence can be seen as positive from the investors side. While this has largely been the case, there are instances when funds presence has been detrimental. A senior PE fund executive mentions that there are increasing instances of smaller funds coming in and taking positions in companies.

These funds do not have the staying power and would take quick and hasty decisions that could be detrimental to the share price. Moreover, fears that PE funds could coerce managements to take short-term decisions to prop up the share price at the expense of long-term shareholder interests.

Just imagine if a PE fund was a prominent shareholder in Tata Steel, and had a three-year view on the companys earnings.

There could have been chances that Tata Steels acquisition of Corus, which has a longish gestation, would be stalled in the garb of investor activism. As the market expands and more PE funds come searching in India, things would get more exciting. From a portfolio perspective, investors would definitely be well off by getting more information about these funds and their intentions.

The next big thing

The PE overseas is experiencing its Generation Next in the form of Search Funds, which may sooner or later find its way into Indian markets. Hence it is important to understand the difference between a PE and Search Funds. These funds are an alternative investment vehicle. It is considered to be the most direct way for someone with limited capital or financial resources to run a company that they partially own.

It involves a four-step process, which goes like this:

* To start with, search fund entrepreneurs raise funds to constitute the search fund. This money is used to identify a company that operates in a highly fragmented industry with strong growth potentials.

* Here the prime candidates are companies where the promoters are either intending to sell off to pursue their different interests or they want to distance themselves from day-to-day operations of the company due to issues like succession planning.

* In the second stage, the search fund identifies and makes an acquisition. Here the search funds make a second-time capital raising, to get the complete amount, to all the participating investors and close the deal.

* In stage three, the fund takes charge of the business. Here the search funds operate the business, restructure the business if need be and grow it to reap dividends.

*In the last stage the search fund may choose to exit the company by selling it off.

The prime difference between the private equity funds and search funds in developed markets is in the investor profile. Private equity funds typically comprise pension funds and other institutional investors having stricter investment horizon. On the other hand the search funds involve both individuals and institutional investors.

The private equity fund looks at a company more as an investment option. However, search funds consider a business to acquire and operate, as owners do. This leads to replacement of senior management, which typically private equity funds dont prefer.

May be the time is ripe for you as investor coming across such a fund that comes shopping here in India, floated by a professional who has worked with a company which is acquired by an Indian corporate.

And above all, you may get to invest in it. But what you need to keep in mind as an investor is the profit point in a company. This is the point, which will always benefit you as an investor. And this point makes the difference.