Tuesday, April 03, 2007

Leveraging NIFTY 50...

Just finished blogging a management buyout op, I am dreaming up something else. When you keep getting wild ideas, why wake up ?
Often when PE activity is very high in any market, the first signal that emerges is that the stocks are underpriced and valuations are attractive. Scratch beneath the surface we stumble upon factors like low cost of funds, low gearing of companies, higher scope for dividends, better yields etc.

Currently if you look at the downturn in Indian equity market, a confluence of all these factors can be seen across the spectrum.

Let me start out by saying that I don't think that stocks are necessarily overpriced at this level, but I don't think the private equity deals necessarily signal massive underpricing anymore. Compared to the past, there is much more money out there in the hands of these investors, and it's all money that they have to get invested or they don't get paid.

Even with stocks fairly valued, with high yield and leveraged loan markets pricing risk so low in recent years, PE firms can still pay a fair price and make killer returns. The point is really seeing if the returns are that great on a risk adjusted basis. Leon Cooperman , previously strategist of Omega Advisors Hedge Fund did his own study back in the 80s which showed if you levered the S&P500 to the same capital structure of typical LBOs, it would beat average PE fund returns. I also believe Prof Kaplan at U Chicago has done some research questioning how strong PE returns really are.

PE funds just take the "market" aspect out of the companies they buy, add some leverage and wait for the returns to be generated. I think the biggest reason it's so easy for PE funds to take these cos private is because investors are so myopic and will take a 20% premium rather than allow management/company to continue doing what they are doing and ultimately wait for the market to assess a higher valuation.

Back a decade or so, with a couple hundred million dollars, they could sit back and wait for a fat pitch that they could knock out of the park. Now, with billions to invest and many more competitors out there bidding up all the really nice deals, it's tough to wait for the same types of situations. So what I think a lot of the larger firms will end up doing is taking private firms with a target return lower than in the past. They will likely end up looking a lot more like mutual funds that can take much more concentrated positions, and benefit from being the controlling shareholder. Also similar to mutual funds, in order to put their money to work they'll have to be more consistent buyers through various market conditions.

Don't get me wrong, returns aren't going to look like public market returns, they'll still bring in returns that pass that, but by less than in the past. It just can't be expected that with all of the money out there and the increased competition that the buyers can be as discriminating as they once were on the deals they choose or the price they pay.

So as these big buyout deals continue, I'm keeping in mind that “take-privates” might not be as solid a market signal as they once were. May be, a few months down the line, we can think of lowly geared companies in the NIFTY 50 to lever up a bit and be eligible candidates in the take-private orbit. Will they ?

Presently in India as the market unwinds, a few smart PE funds are even exiting quietly. ICICI Venture Capital has sold a 3.25% stake in Deccan Aviation for about Rs.32 crore to UBS securities Asia, thro an open market deal for around Rs.94 a share, bringing down its stake in low cost carrier to about 10-11%. As early as 2005, ICICI Venture had acquired around 19% in a pre-IPO deal, valued at Rs.65-70 per share. The Deccan aviation scrip closed at Rs.88 on Tuesday, while the 52 week high was Rs.162. It appears the sale has translated into a 40-45% RoI over a two year period for ICICI Ventures. Considering the volatility in the market and accentuated bad times for aviation sector as a whole, by not waiting for the tide to turn in its favor to higher levels, ICICI Ventures did make a smart move indeed.

Watch this space, just watch ( no noise, or else I'll wake up) for more fun.

No comments: