Thursday, March 15, 2007

Private Equity - Way to Go in India

As the markets continue their dance of death, I snuck a wistful glance at the PE funds which up until now were cutting deals by the dozen. Almost all investments now have declined by over 50%, construction / brokerage stocks in particular.

The deals still continue, but on a very selective basis strictly playing by the rules.

I’ve been watching global markets over the last decade with particular interest to Indian equity and its investor psyche. I don't claim any phenomenal ascension of knowledge over a space as dynamic as equity markets, where emergence of a credible pattern ever is highly improbable. I believe in open systems, randomness of life events ( would gladly throw darts on bulletin board any day ) and that markets are no exception.

“Why bother, then ?” - you might ask. Well, when has absence of definition or randomness of events stopped a blogger ?

I base my theories neither on historical movements nor on future trends. I use none. I neither get turned on nor off by the J-curves or sinking slopes. I’d rather use a more predictable element – that of management psyche. Almost 85% of Indian businesses are owned and controlled by business families, handed down over generations. There are occasional family feuds that erupt, but the fallout has seldom been a sellout to professionals or to Private Equity. The division has been among families themselves, ably assisted by professionals though.

The psyche of the family management has more or less been consistent over fairly long periods of time. Most of them are conservative and traditionalists. Even the younger generations that inherited the business, despite their Harvard and MIT degrees acquiesced as they slowly settled down in their business. They used the modern technology and other tools in their business, but never tried hard enough to dismantle the ancestral philosophies that stood translated as corporate culture. Amongst others, it gave absolute dominance over the Board, having the last word in everything - well, who wants to upset such a setting !

When something ain’t broken, why fix it ?

The downside is that capable professional managers felt stifled, came in and went after short stints. The ones who stuck around, willingly putting up with the drudgery, became deadwood, felt unwanted here and anywhere else. With no strategic inputs from the resigned-to-their-fate executives who ran the business, the owner often had to rely on external consultants for ideas, who served up ad hoc quick-fixes the owner `liked' than what the business `needed'. Besides being easy, it streamed them steady revenues. Did you say corporate governance ? You must be nuts !

So that’s it. Absence of strategic direction puts them at a clear disadvantage. I had done a little analysis and had quite a few insights. I found most of the family businesses characterized by –

a) low operational and working capital leverage that became a drag on their performance. Can be easily restructured and put on a high growth path.

b) fully depreciated equipments and other operational assets indicating the need for modernization of equipments. Besides affecting productivity, it is limiting the scope for tax savings offered by higher depreciation.

c) The adverse effect of owner and CEO being one. Decisions lacked the boldness expected of a non-owner CEO upon being influenced by the risk-averse nature of the owner.

d) Little or no focus on sales promotion, brand building or market expansion. While shipment volumes are higher, realization and margin pressures are glaring.

e) A claustrophobic mindset which does not allow for exploration of opportunities for inorganic growth thro strategic alliances / M&A with others having state of art technology and market access.

f) Adoption of sub-optimal capital budgeting techniques leading to accumulation of more debt for both short and long term resource requirements. Results : skewed debt equity ratio leading to bad credit rating and higher interest outgo. Dilution of equity being a strict No No even for capex.

This is not all. I have built my deal scouting and origination strategy around those deficiencies as I am thinking of associating myself with a PE fund shortly.

PE funds normally wait for I-Bankers to bring deals to them. I-Bankers depend on their *connections* to get deals. I’ve never seen a banker undertake proprietory research, identify a needy client, make that cold call to present a winning strategy which could culminate in a deal. Instead, I see them persistently knocking the doors of corporates which never needed them since already they were doing well. Recently in an interview, Subhash Menon, Owner/CEO of Subex Azure ( NSE-SUBEX-Quote ) was saying how I-Bankers never entertained him when he needed them most during his initial days and now when he built everything up himself, they are all over the place with deals and more deals.

In India, because of this situation of predominance of family business, PE funds should hire shrewd ones that think its cool to do proprietory research and having the capacity to identify those who need them badly. It’s time they stop hiring wet-behind-the-ear greenhorns with *connections*. It’s cool to say “I know Mr.X, CEO of XYZ Inc personally” having sucked up to him at some party where (s)he gate-crashed, rather than admitting her friendship with a startup founder who needed support.
It could be that Mr.X doesn’t need support because his personal portfolio resembles that of a leading mutual fund, or worse, he could be a limited partner in a PE fund himself !

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