Tuesday, January 29, 2008

For PE funds, caution is the word

For long, PE / VC funds have been encouraging and rewarding innovations. But that’s just restricted to the creativity element in the DNA of portfolio companies controlled by them. Innovative business models, processes, productivity improvements and the like. But there are several culture / country specific factors that influence the metrics used to evaluate companies that meet the “investment grade” parameters set by the PE firm. Here I share some attributes that I have noticed for PE firms to consider while evaluating investments –

a) Value unlocking – Normally PE firms unlock value from portfolio companies through interests, dividends and divestitures. But most Indian companies have an umbrella set up, where the finished product of one could be the raw material for another and so on. Since all these companies are owned by the same family or group, by funding one company, the PE firms are doing a favor to those others giving the entrepreneurs more bang for the buck than the PE firm itself. Nothing wrong with that, if transactions between the various links in the chain are at arm’s length that often is not. They don’t surface in the MIS reports placed before the Board Meeting – being the only instance when the PE firm’s nominee gets to interact with the management. So, call for details.

b) Dance with masters of the game – Like most developing economies, Indian bureaucracy is riddled with nepotism, corruption and red tape. Now wait, don’t just head for the door. That way you are shutting down on opportunities that come with it. Local entrepreneurs have grown up in this ecosystem and they know their way around it. Some are deft players in shifting the right gears while others are still learning. See that as a “competitive advantage” and an essential management skill set. Do some fine combing and be with the adroit team.

c) Law is tight, enforcement is weak – So don’t take the functional judiciary and rule of law for granted. You have to do rigorous diligence on your target investments and check everything not just twice. For eg. while doing a real estate deal, don’t just look for the title to the property, see whether title-holder is in possession as well. Go one step ahead and release a public notice seeking other claimants, if are around. As far as possible, do business with entities that honor their contracts and obligations. That said, don’t see this as a weakness. Learn to duck. It also means if you'd crossed some line, don’t hurry to do term or pay up. Look for fixers first :-)

d) Provide for Exchange rate risk – This is playing out now. PE firms that hurried to buy stakes in companies at stretched valuations must be ruing their double whammy. They no longer command the same high valuations thanks to the recent market crash, a weakening dollar is hitting the export realization of these companies as well. The projections no longer hold. Their customers from US and Europe are reeling under heavy losses, especially banks and mortgage firms that make their future prospects even gloomier. Look for companies with a mix of sufficient domestic customers and export customers with wider geographic/currency spread.

e) Acquisition hurdles – Most Indian companies are family owned and controlled. They don’t let go off control easily no matter how sweet the offer is. It takes a lot of persuasion and coordinated effort to get all family members to agree to quit or even dilute stake. And the whole process has to be quick. Otherwise, it will be seen as a murky family squabble where some are for and other are against the deal; such a specter will demoralize the workforce and would force even competent executives to leave instead of dissenting owners. When good people leave, you may have to revisit the deal before it’s too late, especially if it’s a management `buy-in' you had in mind. So, do it quick; structure it uptight. No management, No deal.

Wednesday, January 23, 2008

I am not drunk on that decoupling kool-aid…

When our markets went into a tailspin early this week, everyone including P.Chidambaram came out to comfort the enraged investors. He said India’s fundamentals are strong, our corporate sector is healthy. No cause to worry.

Then I read Wall Street’s reaction to Apple’s stunning results. Apple's holiday profit jumped 58 percent. Its computer sales grew 2 1/2 times the overall market. And despite fears of a recession, the iPod maker expects its revenue to grow 29 percent this quarter. Not bad, huh? Well, not good enough for Wall Street. Focusing on Apple's guidance for the current quarter, a forecast for strong growth that fell short of analysts' expectations, investors hammered the stock taking it down more than 16 percent in early trading.

Would you still have faith in the power of earnings to outwit strong negative sentiment? Clearly I am not sold on that. No, I am not drunk on that decoupling kool-aid either…. So take a cue from wall street and resist that urge to buy in Dalal Street for now...

Tuesday, January 22, 2008

Go, freeze your balls at Davos

And you thought yes, the US has problems, a credit crunch brought on by reckless mortgage lending - and maybe in commercial property and credit cards, too - but we are safe. Not just us, China, Singapore, Korea and the oil rich Arab neibhors are all doing well. In fact, their Sovereign Wealth Funds are so strong that they are busy bailing out failing Wall Street banks. We are convinced. The global prospects could weather an American storm.

Before we could say `decoupled', the Asian stock markets crashed again. The two-day sell-off in Asian markets is a reminder that the world has been dragged along by the insatiable desire of the US consumer for stuff, much of it made in China. If the US really does slow down, so - goes the fear - will all those factories up the Pearl River Delta whose wages are keeping millions of Chinese happy. To meet the margin calls, traders exited their positions at huge losses and even sold gold and commodities. They fell too. Domino effect. Do you still say we are decoupled...?

Meanwhile our economic chieftains are busy freezing their balls at Davos. Few of them are already there, as seen on TV this morning struggling to part their frost bitten lips to talk to the media. Rest of the pack will be off soon. The theme at Davos is interesting this time around – "the power of collaborative innovation". (If Wall Street catches cold all markets should sneeze… that’s collaboration for you. Isn’t that innovative?) For Chidambaram, there’s no better way to escape the political heat than head for the Alpine ski slopes.

Monday, January 21, 2008

The Sound of Crash (is deafening)

RBI Guv Dr.Y.V.Reddy has heard us... Or is it the deafening thud of yesterday's market crash? Here he’s going soft on interest rates as opposed to his earlier tough stance against inflation. Ila Patnaik had argued that lower interest rates would help arrest inflation and the Rupee run since India would become a less attractive destination for foreign funds.

That report quotes RBI view calling for end-use restrictions for investments by foreign VCFs because of concerns on foreign capital inflows it is finding tough to manage. Ila Patnaik’s worst fears have come true - the central bank has been absorbing foreign currency inflows to check the rupee’s appreciation, but has ended up adding to the liquidity in the system.

I quote from that BS article. “Abundant rupee liquidity poses risks of higher inflation as it adds to the already high money supply. The year-on-year increase in money supply (M3) as on January 4, 2008, was 22.4 per cent against 20.8 per cent a year earlier and much higher than the central banks target of 18 per cent.”

With a crash like that, I’d rather the Guv comes up with some good news of lower interest rates, weaker Rupee or anything to perk up the market on 29th Jan, when he reviews the credit policy - and resuscitate the annual non-event that it has become lately.

Sunday, January 20, 2008

Go slap FBT on Taxmen....

Look at Finance Minister P Chidambaram getting carried away! Here he is doling out free laptops, free fuel, free mobile calls and training to taxmen for beating tax collection targets. Have they really?

It'll be fun to watch the scene post A&R (assessment and refunds). What if collections net of refunds fall short of targets? Ah, going by the pace of A&R, our taxmen would’ve totted up a laptop each for all their family members by when the returns are assessed and refunds are due. Life's good, mate…
But then will he slap FBT on those goodies to taxmen too....? If Chidambaram has a sense of fairness, he must.

Saturday, January 19, 2008

"CYA guys.. Now..!"

Ila Patnaik makes her case why RBI should be cutting interest rates right now. (hat tip : Ajay Shah)

Her theory goes so long as there is scope for arbitrage between interest rates in US and India, dollar inflows will continue to drive the inflation and Rupee up. This relationship between Rupee rise and inflation (owing to upsurge in dollar flows) in the Indian economy – where interest rates are higher than that in the US - creates an anomaly in that a cut in interest rates will not only help rein in inflation by slowing down $$ inflows, it will also arrest the surge of the Rupee.

Ms.Patnaik has this view that since US economy is sliding into recession, Fed has more reasons to cut US interest rates. I see that move could further sex up high interest destinations like India (for not just FII/FDI/ECB flows, but also to NRI remittances) and the deluge will only accelerate. Traditional methods that soak up liquidity viz. OMO by RBI, CRR hike etc., meant to rein in inflation and arrest the rupee rise will only add to inflationary liquidity in the system. In effect, a higher interest rate regime instead of containing inflation will end up exacerbating it.

So here you have a paradox. Normally when you cut interest rates, it could lead to inflation propelled by higher credit off-take. But in our peculiar economic situation driven by excess liquidity and a rising rupee, cutting interest rates can effectively arrest dollar deluge as well as the Rupee rise – the twin goals that RBI is struggling to achieve.

Sound argument. But I say the Indian borrowers of foreign currency (ECB/FCCB) in recent times have large bets on a falling dollar to benefit from the exchange rate arbitrage. I doubt whether our CFOs are equipped with rate sensitive AWACS that scan early symptoms… A sudden reversal in RBI stance could wreck many a business and could rock the stock market sentiment as well. So RBI should give out early warnings.

The least that RBI Guv Dr.Reddy could do is to signal them “CYA guys… Now !”

Thursday, January 17, 2008

Irrational Exuberance -II ?

I find Alan Greenspan has already used up the expression “irrational exuberance” to signify the dot com boom of 2000. Then I read this story on Reliance Power IPO in the BS story today. Excerpts -

"….there are several aspects of the issue that leave many observers feeling distinctly uneasy. Here is a company that has no assets on the ground, and no history of project execution, getting a value on the market that is many times higher than established and successful companies in the same field of business, namely power generation. The many risks associated with investing in such a company have been listed in the issue documents, including the uncertainties surrounding some of its projects — like the lack of assured fuel supply. But investors (including institutional investors who are professionals and who therefore should know what they are doing) have not been deterred…”

And you thought institutional investors and professionals got brass balls...? Come on, get a life pal....! They represent a bunch from where even sheep learnt to herd up. Just this one difference. The poor animals have a better reason in that they feel secure when bunched together. These guys do it so that when their calls go horribly wrong, on a peer to peer comparison all will look alike, deep in shit. No one guy will look or smell better than the other.
Over to Mr.Greenspan. "Now Alan, what would you choose to call this frenzy in this part of the world… IE-II…?"

Performance by default

Sunil Jain in BS –
“Though the country’s tax collections are rising by leaps and bounds, a recent paper in the Economic & Political Weekly suggests this may have more to do with the growth in the economy than with the efficiency of tax administration.”
He quotes some statistics to buttress his pov.

I can’t agree more. I would even draw a parallel. Haven’t you noticed the same thing with performance of our fund managers in Mutual Funds? Don’t they do the same thing? When markets are near their peaks, all of them brag their chests. NAVs of their various funds are high by default than by design – reducing them to just being punters. But then that’s what you and I do. Why pay commissions and entry/exit loads to these pumpkins?

Tuesday, January 15, 2008

Oligopoly in Indian REITs...?

Inox Leisure investing Rs.100 crore in Ajay Piramal’s Indiareit – for a strategic stake as well as “preferred client status” with a ROFR in its future portfolio of RE assets.

The report quotes Industry analysts view that the alliance will help Inox widen access to upcoming real estate projects across primary tire I and tire II cities, thus getting the right customer exposure to multiplexes and branded outlets. Indiareit could ensure preferential access to Inox for these properties. The new alliance would also bring financial support, expertise, presence of leading brands and strong pre lease to developer.

With a handful of REIT/PE funds with mighty financial muscle and just so few parcels of land available, are we not running into an oligopolistic mess? Has Ajay Piramal been inspired by Sam Zell…?

Oh, what a birthday for Mr.Pandit...

Says the Economist.

VIKRAM PANDIT has just celebrated his 51st birthday, but this will not be the best week of his year. His first set of quarterly results as boss of Citigroup was one for the history books, for all the wrong reasons: a record net loss of $9.8 billion, driven by a whopping $18.1 billion in pre-tax write-downs and credit costs on exposure to subprime mortgages. This was more than even the most pessimistic analyst had forecast—although gossip had pointed to $20 billion or more. But that doesn’t bar the off-shoring vendors including the SWITCH from extracting their pound of flesh.
It’s their opportunity, stupid…

Saturday, January 12, 2008

Our taxmen will soon get this scent

In an increasingly flattening world, no new taxing strategy could slink under the taxman’s radar for long. They are always on the prowl picking up new excuses to tax the citizen. India’s Finance Minister P.Chidambaram borrowed the concept of Fringe Benefit Tax and Securities Transaction Tax not from US or Europe, but went all the way down under and picked it up from Australia. I am sure he will be closely watching the debate on “carried interest tax” on VCs that is raging in the US.

We had a similar row last year when the Government sought to restrict the “pass through” status for income streaming to VC firms around February 2007.

Steve Brotman of SAVP, a VC firm in New York has a detailed post here. I liked the interesting illustration Brotman has inserted in there.

Suppose a entrepreneur starts a corporation, and invests $50,000 in it. Then they raise $100,000,000 by selling 80% of it in preferred stock; preferred stock means the investors get paid first, and is quite typical structure with startups. Then the entrepreneur sells the corporation for $300,000,000 after 5 years. Should the entrepreneur who continues to own the 20% piece that he owns, pay capital gains tax of 15% or ordinary income tax of 35%?

Today the law is 15%, as these are long term capital gains.

Now change the word "entrepreneur" to "VC".

Is that OK in your book if a VC creates such a company, and generates capital gains this way?”

I haven’t read US tax law. But in the Indian context, VC firms registered with SEBI enjoy a conditional “pass thro” tax status so that the income is not taxed at the firm level. It is taxed in the hands of the investor when it gets distributed. So if the investor stations himself in a tax haven like Mauritius or Cyprus, they escape with nil taxes. But it is biased against India based VC firms like ICICI Venture since the Indian investors in the fund would be liable to pay tax on their income either by way of LTCG or income tax depending upon the nature of its receipt.

Friday, January 04, 2008

Debunking two chinese myths

Well, the media is chockfull of reports that China’s economy may not be as robust as it has been made out to be. But should anyone be smug about that? The facts seem to the contrary. The global growth have slowed down.

As is the other popular wisdom, Chinese economy is way too much dependent on its exports and is certain to suffer a dent because rich world’s finances are in trouble. Here again it’s a myth waiting to explode. It seems it’s got to do with the investment led growth and increased domestic consumption, two healthy indicators that drive the Chinese economy.

My fuel hedge - can I mail my car?

The military situation in Iraq is arguably improving, and Iraqi oil exports are beginning to flow again. Tensions between US and Iran have eased a bit. There are forecasts for a mild late winter in the United States, which should help bolster oil and gasoline inventories going into the spring and summer driving season.

So, why are oil prices going up now…?

Experts say the answer lies in the investment decisions of traders and hedge funds. With the markets in equities, housing, credit and currency shaky in the United States, traders are betting on oil and other commodities as a perceived safe haven. Recent interest rate cuts by the U.S Federal Reserve had underscored for traders the depths of the country's economic risks and led them to buy oil futures.

Vinod Khosla must be a sad man. He has been spearheading the new energy initiatives together with his friends from PE ecosystem and has been making some significant investments in solar and other non-conventional energy sector like wind and biofuel development, but so far they are making only a slight contribution to energy supplies.

To those holding euros or yen, the weakening dollar makes oil and gold look cheaper; they can bid up prices in dollar terms without spending any more of their own currency. Moreover, gold, and nowadays oil too, is seen as a haven when the dollar is weak—so the latter’s drop may be accelerating the former’s rise.

Is there a way to mail my car with me inside? I am a poor guy. I don’t want to be poorer. So what do I do? I bought MRPL stock so that I can offset my fat fuel bill with gains from stock price. That’s my inflation hedge. What say you?

Tuesday, January 01, 2008

Yet another swing against insider trading

In a move to curb insider trading, the Securities and Exchange Board of India (Sebi) today proposed that an `insider’ in a company should surrender profits made in any equity-based securities transactions of the company, if both the buy and sell side of the transaction are entered into within six months of the other.

This is the latest in a series of doomed legislations as I would call it. Insider trading regulations have failed to be effective because they seek to achieve the theoretical “level playing field” or “information democracy”. Is it not just human nature to take advantage of knowledge? Does it not happen in other walks of life? Imagine Californian gold rush. Did the first prospectors scream from top of the roof that they’ve struck gold? Should ONGC and Reliance alert other explorers to oil finds? Should we ban scientists from filing patents of their inventions? All these could be construed as insider information, in a way. We all take advantage of the information that we come to possess (with absolutely no sense of guilt) and why shouldn't we?

I feel so long as there are insiders, they will take advantage of knowledge they have access to. That is enterprise. In a way, by default, it automatically places all confidential, price sensitive information in public domain because when insiders buy, it reflects in a sudden spike in share price and volume of trading in that stock. If others are watchful enough, that acts as the best gauge of something brewing. Advanced corporations are now using internal betting markets to tell them what the official chain of command will not. They are inviting their employees to anonymously bet on when projects will really be completed. The results are more accurate.

Legislation have never been known to prevent white collar crimes, it has only stimulated creativity in criminals. Trying to ban it by legislation does not automatically mean plugging that hole and creating a level playing field. It would just tempt the shrewd insiders to devise ways to take a proxy route to exploit the opportunity.

Why don’t we look at it as one of those equity-efficiency tradeoffs? Sure, if we allowed insider trading, then prices would better reflect the firm's true value. But it would be a wealth transfer from price-sensitive traders to corporate insiders. What say you?

New year, New avenues

I flipped the calendar... It's love all...
SEBI presents us with a new investment avenue this new year... Real Estate Investment Trusts (REIT) – specialized mutual funds that invest only in real estate - are here. How well they suit the Indian market? How appealing will they be to our investors?

The way it is structured by SEBI, I think it will appeal to those who prefer bank fixed deposits than equity investors. Let’s look at the up and downsides –

a) Compulsory distribution of 90% of its income to investors. That means higher dividend yield and low scope for capital appreciation. This suits fixed deposit mindsets better;

b) An opportunity for small investors to capture the fortunes of commercial real estate market – something they can never dream of owning;

c) A new diversified avenue for investment in times of recession in equity markets; Right time to buy REIT units will be when the economy is slowly coming out of recession when its NAV will be low. That’s when businesses choose to expand and new businesses sprout up in new locations driving RE demand up; Ride the wave and capture the upside.

d) When interest rates are down, dividend yields from REIT units will be higher. Businesses shall borrow more and expand at new locations. Move your FD investments to REIT units.

e) Benefits of professional RE management.

f) Liquidity is assured since REIT units shall be listed at stock exchanges.

Now let’s look at its downsides –

a) Cyclical nature of its income stream. The investors ROI is dependent on the performance of RE market. That makes it risky especially if investors buy REIT units when RE sector is at its peak and will be victims of a bubble burst.

b) Being a close ended fund, REIT units cannot be safely held till maturity. It could be possible that the fund is closed out and units compulsorily redeemed when RE market it not exactly on an uptrend. Does not suit passive “buy and hold” type investors.

c) REIT funds provide a safe exit for early stage PE investors in a RE project. PE funds normally value their projects after discounting their earning on a forward basis. Therefore the investors in a REIT fund will not be left with much on the table when they bite in. That will expose them to the vagaries of RE market.

d) Bloated valuations commanded by early investors (including PE firms, developers) would drive up RE market to unsustainable levels. REIT investors will have to put up with poor dividend yield since they would be buying units at a high NAV.

I have not touched upon the tax issue since CBDT notification on tax treatments has not yet been finalized. I shall revert when it gets done.