How to get LBOs in...?

Remember how we buy homes taking the mortgage route? We spot a good house, negotiate with the seller, lock the deal down by paying some token advance and finance the deal by mortgaging that property. Simple enough? But ever tried buying a company that way? No, you can't in India. After all, companies have a steady cashflow, substantial assets and if sellers are willing, why should regulators say No? Perplexed?

The regulations bar you from mortgaging the assets of the target company to buy it. Their interpretation - the company can’t raise debt pledging assets that it *wants to* buy. Ok, fair enough. It's like seeking to use your credit card to pay its past dues. What if a foreign company floats a specific SPV to do this acquisition? Can that SPV raise debt to buy the assets of this Indian company? The answer is NO again. Here the reason is foreign companies should bring in fresh capital from abroad to pay Indian sellers. I think this rules were drafted at a time when the country badly needed foreign exchange. Today, we are in a surplus situation. Should this law stand? Indian companies are permitted to borrow from domestic banks for purchasing equity in foreign JVs, wholly-owned subsidiaries and other companies as strategic investments. Indian companies also have the option of funding overseas acquisitions through ECBs. Recently they’ve been allowed to invest up to 4 times their networth abroad.

So what are the typical buyout structures that are allowed? Gaurav Taneja of E&Y says -

a) Foreign holding company – raises the debt overseas for acquiring the Indian company. The hurdle is the assets are in India and may not be allowed to be collateralized against the foreign debt. Another area is exchange rate. The loan is in foreign currency but the earnings are in Indian Rupees. Adverse movements in exchange rates can kill.

b) Asset buyout structure – Foreign buyer floats an Indian arm and injects equity and debt, sufficient enough to finance the asset by asset buyout of Indian companies. There could be issues of stamp duty and VAT but the major hurdle here is it works best only in a 100% buyout situation. Not in a partial acquisition of majority controlling stake.

But I suggest it is a far better alternative than using own equity by companies to buy other companies. At a time when costs of borrowing overseas are going up, we must put our vast forex resources to good use by allowing LBOs in India. Imagine some of the world’s best companies operating from Indian soil! I think that would be wonderful. Exxon, Shell, GM, Chysler, Harvard, Stanford – what if these companies/Institutions were subs of Indian companies/Institutions? In fact, their assets are a much more valuable than that of the borrower. A safe bet for the banks to lend.

So, SEBI – you’ve pretty little time left to get your act right. Play it wise. Anyway you are not extremely bothered about Food Stock or inflation. At lease work with the government and be a flexible, understanding and practical regulator.

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Nothing stops the deal frenzy

And you thought the liquidity squeeze following subprime fiasco has affected the PE appetite for leveraged buyouts… Hardly.

Bain Capital, a private equity firm, decided the 28-year-old Network equipment maker 3Com Corp. still has enough potential to justify a buyout carrying a hefty 44 percent premium to the stock's Thursday closing price of $3.68 per share. At one point in 2000, its shares briefly rose above $100 apiece. For 3Com the $2.2 billion buyout by Bain would mean giving up its independence, but it's gaining freedom from the whims of the market and a chance to expand in China. The cash deal announced on Friday also gives Huawei Technologies, China's largest manufacturer of telecommunications equipment, a minority stake in the technology pioneer - something that could improve its prospects in Asia and raise eyebrows in Washington. 3Com, which faces brutal competition from Cisco Systems Inc. and others, is now a shadow of the high-flying star it became in the late 1990s technology boom. 3Com now counts more than 6,000 employees in over 40 countries, and annual revenue of $1.3 billion.

Here’s yet another and bigger deal. Shareholders of communications and software company Avaya Inc. voted to take the company private Friday, selling it for $8.2 billion to two private equity groups - Silver Lake and TPG that valued its shares at $17.50 apiece. The deal is expected to close by end October. Avaya, based in Basking Ridge, N.J was spun off from the former Lucent Technologies Inc. in September 2000. Shares have jumped more than 25 percent since word of the deal leaked in late May. The deal comes with its set of strings too. The agreement also provides a 50-day "go-shop" provision for Avaya to solicit proposals from third parties. If it ends the merger agreement after receiving a superior proposal from a third party, Avaya must pay Silver Lake and TPG Capital an $80 million termination fee. Also, Silver Lake and TPG Capital must pay a $250 million fee to Avaya if the merger agreement is ended under certain circumstances.

So, la, la, la time for PE firms has not fizzled out. The party is on in the buyout street… Will it have an impact on Avaya Global connect, the Indian company…? Jury is still out.

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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 ?

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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.

Barbarians at the ( India ) Gate...?

If the bidding frenzy for Hutch Essar made interesting read, it was much more intriguing to read about Ranbaxy and Cipla being wooed by bigtime PE funds like KKR, Blackstone and other usual suspects for the generics business of Merck at a perceived valuation close to $ 5.1 billion – as a consortium. While the PE funds bring in the money in a mix of equity & leveraged debt, the Indian companies are expected to provide management expertise.

We’ve heard about the biggest buyout deals by PE funds in healthcare and real estate in the US, though. KKR and others bought hospital company HCA (NYSE: HCA - news) for $33 billion, breaking the $30.6 billion LBO record that KKR established in 1988 with its takeover of RJR Nabisco. The record was broken again when Blackstone and other investors bought Equity Office Properties Trust for $36 billion.

How long would it take for the PE attention to turn towards lowly geared Indian Public companies…? What will it portend for Indian retail investor…?

Imagine a Reliance Industries, Infosys, Wipro, Telco, Tisco going private…? Then to go into PE hibernation for about 3-5 years, dole out large dividends with leveraged debt before re-emerging with more vigour and higher valuation in the public markets again…? Not farfetched. Rather it’s a snap job given their relatively low market cap vis-à-vis that of the US corporate majors which have been gobbled up already.

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It flashed across my mind as I read the news “Essar Group to exit from Indian bourses”. The cost of the acquisition of shares will be in excess of $ 435 million, a back-of-the-envelope calculation showed. This is small change for the Ruias ( majority holders of Essar ), who are expected to get around $ 1.3 billion if and when Hutch Essar, in which they own 33%, is sold to the highest bidder.

Going by the trend, I wonder is it not being signalled by the string of PE buyouts in Indian Companies big and small, the latest one being Blackstone investment of $ 275 million in Ushodaya Enterprises Ltd (UEL), a large media and film production company owned by Ramoji Rao,

P.V.Shahad’s VC Circle reports this is probably the largest deal in the Indian media and entertainment business. UEL is also raising bank financing of $190 million, which takes the total fund infusion to $465 million.

In the US, Managers of companies bought out by private equity funds are seen resorting to savage cuts to pay the interest on huge debts taken on to finance the deals and give pay-back to the private equity owners, meanwhile allegations of collusion to force down buyout prices are being made against private equity companies KKR and Blackstone.

2007 could be the year when private equity chickens may come home to roost. But should you buy when Private Equity sells ?

While Regulators on both sides of the Atlantic are investigating the sector, class action law-suits against private equity firms for collusion in the US are being initiated, and some deals are beginning to unravel messily. SEBI had better keep a close watch.

As the year closed, private equity firms took perhaps the ultimate step toward joining the business mainstream. On Dec. 26, 11 firms formed a Washington lobby group, The Private Equity Council. Private equity firms have begun to come under closer scrutiny, as the size of deals they pull off has soared and the amount of money they wield has grown. Success always comes with a price. In this case, it's attention.

Did you hear the doorbell...?

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Wait - it could well be Barbarians at the (India ) Gate !

PE and LBO - where are they headed...?

Some excerpts from an insightful interview by Justin B Wender, president of Castle Harlan, a Private Equity firm in New York as appeared in New York Times. Covers a lot of contemporary questions on club deals in private equity, their sustenance and how fair it is to Public investors when PE funds take public companies private etc. It gives some wonderful insights

( may need a simple process of registration to read. Worth it. Just check out ).

Few snippets :

“ Q. Will the wave of private equity deals increase, or is it nearing the end of the cycle?

A. Given the dollars raised in private equity, it’s likely we’re going to continue to see significant-size leveraged buyouts. But it’s important to remember that this represents a relatively small percentage of all the securities traded in the United States. I don’t believe this is a huge cycle that’s cresting. It’s just a function of the money that’s been raised.

Q. Why are public companies going private to fix themselves, instead of restructuring while they are still publicly traded?

A. As to why some companies are going private, there is increasing scrutiny and regulation, namely the Sarbanes-Oxley Act, and that has had an impact. Chief executive officers are spending much more of their time on compliance issues and dealing with shareholders and analysts and the outside world. They have less time for their business than they might like. And when they’re private, they can dedicate time to the business itself.

Q. Are you suggesting that a climate has been created in which public companies can’t really take tough steps to correct their business model?

A. I don’t think that’s true. But there are challenges in making changes in public companies. There is constant scrutiny. The research analysts and others are constantly digging into the business and putting out research. You have a lot of public documentation that has to be filed. You can’t spend 100 percent of your time fixing the business.

Q. Who are some of the C.E.O.’s who’ve been lured into the private sector?

A. One good example is David Calhoun, leaving General Electric for an opportunity to join an LBO of the Dutch firm VNU. The public speculation was that he got a $100 million package to lure him. So here’s a guy who was a vice chairman at G.E., where he ran $60 billion in revenues, and he left.

Q. Isn’t it bad for the average investor that people are taking companies private and reaping big gains that public shareholders might otherwise have shared in?

A. The only way that a private equity firm is going to buy a business is as a result of a process in which the board looks for other buyers. Nobody is buying a business without paying a market-clearing price. Now, are private equity guys taking upside profit that shareholders would have gotten? The complication with that analysis is that doing a buyout creates a different risk profile. If you take a business and double its debt, you’re taking different kinds of risks than when public shareholders were involved. The other point to add is that most of these buyouts probably will end up being taken public as an exit vehicle for these private equity firms.

Q. Isn’t it bad for the average shareholder, at least in the short term?

A. Isn’t that an apples-to-oranges analysis? Return and risk are correlated. When these buyouts happen and more debt is put on the company, it’s a different level of risk. It’s not exactly comparable to say that the same amount of equity value would have been created. There may be situations where the public market doesn’t appreciate aspects of a business that a thoughtful private equity investor might see. “