Understanding the strategy and execution capabilities of PEs is very important

Updated: Sep 30 2007, 08:30am hrs
Though the markets have been gaining newer peaks, creating a bit of cautiousness among investors, it has not deterred private equity players in getting into newer companies unabatedly. Sri Rajan, head of private equity practice in India, Bain & Co, gives a perspective on the parameters private equities follow while entering into a stock. He interacted with Rajesh Naidu of The Financial Express. Excerpts:

What are the parameters private equity funds take into account while committing funds to a business

The first is to develop a perspective on the overall industry and the underlying dynamics. How big is the market, how fast has it grown in the past, what are the underlying drivers of growth and what does that mean for likely growth in the future Is the industry consolidated or fragmented, what are the underlying profit drivers and how might they change over the coming years Do suppliers of customers present a choke point and do they have a disproportional advantage over you How are customers segmented; what is the difference in customer buying behaviour across segments Is there a difference in terms of profitability in serving these different customer segments

The second broad area is in developing a point of view on the revenue and profit trajectory of the specific company you are evaluating for investment. Many of the questions raised above are relevant to this section as well but with a more pointed focus. What is the value proposition of this company and is it differentiated in the marketplace What do their customers think about this value proposition and what do they think about this company What is the level of customer stickiness Is this value proposition sustainable or not based on what competitors are doing

The third area is an assessment of the management team of the company. This is far more important in India than in markets like the US since the private equity firm may not have the ability to change management teams. Understanding their strategic and execution capabilities becomes very important.

Finally, there are other elements that need to be undertaken - an accounting and legal diligence; where necessary, an understanding of other exposures that the company might have - e.g. pension liabilities, environmental clearances, etc.

What is the most important factor for a private equity fund to buy stake in a company Is it market dynamics or the standalone company fundamentals

Both are important. You need to get a very good understanding of both these factors to understand the underlying value creation potential of the company. This combined with the financing structure will determine what you are willing to pay.

Does the presence of a private equity investor in a company make a stock a lucrative investment option What are the factors an investor must consider while investing in such stocks

The presence of a private equity investor indicates their belief in a value creation opportunity. That does not necessarily mean that it is the right investment choice for you. A PE investor may have a different time horizon that you do and may be more willing to ride out a possible down cycle that you might be. They may be driven by their need to have exposure to a certain sector. At the end of the day, you have to make your investment decision based on your own criteria just as the PE firms are making the decision based on theirs.

It has been observed that as PE funds pick up stake in companies, the stocks run up immediately, overlooking the long-term nature of PE investments. Your comments.

One should note that no PE investment carries a guarantee of success. Academic studies of PE investments in the US seem to indicate that over the long-term, average PE returns may only equal those of public markets. However, it should be noted that the best funds did earn far in excess of the index which would explain why there exists a halo effect.

It is seen that many public companies go private and herein PEs seem to be acting as a catalyst, contributing to this trend. Do you think that PE funds, in a way, may rob public of investment opportunities

This is referring more to what is happening in western markets. In India, there are very few public to private transactions. In these public to private transactions or buyouts, the PE funds are looking at a short- to medium-term horizon for their investments. At the appropriate point in time, these companies will get sold to a strategic buyer but more likely than not will be brought back into the market through an IPO, thus creating an investment opportunity. You also need to remember that when the company was taken private, the PE fund most likely paid a premium over existing prices (sometimes quite a significant one) which would have nicely benefited the shareholders at that time.