Deal sourcing - the old fashioned way

Throughout my more-than-a-decade long career in Investment Banking, both as an external consultant and in my in-house avatar, I have tried several techniques to source deals. From leveraging close personal relationships, affiliated funds, Investment Bankers and industry grapevine to sourcing deals from other financial intermediaries or even participating in downright auctions through club deals.

What did I leave out ?

It is deal flow emerging from proprietary research, which stands out for its enormous value potential and distinct personality trait. I am far more clued in a deal that I have researched upfront, took time to get upclose with the management and have spent enough time studying their strategies translating into results. Well, to the argument that who has the time, my ready answer is “start scanning early”.

On an average, at any given point in time I’ll be tracking at least three prospective investments very closely. At times, not to lose sight I buy some stock personally so that it figures prominently in my portfolio which I keep a close weekly watch on. As a scrupulous deal maker, I get out of the position immediately before I start peddling the deal to PE funds – to qualify for the full disclosure. My previous post here was one such.

This is significantly better than getting into the rat race for more deals without a care for end result, value unlocking potential - that is. Perhaps even better than hiring star leaders or marquee name rainmakers like an Anil Singhvi or a Mohit Bhatnagar who have an exemplary track record in their respective domains. Here’s why. This very domain expertise could prejudice their vision over the prospects of other businesses, giving rise to missed opportunities or having to build an anti portfolio, like the one Bessemer has. As a PE fund manager, the demand on the individual is of a different kind – a pulse for an early opportunity over a broader spectrum and by extension, scope for an earliest, IRR optimising exit.

Longevity of PE as a long time, credible asset class amongst accredited investors depends largely on building outstanding deal sourcing and investment processes. Especially in times like these when there are several sophisticated HNIs and Institutional investors dotting the field, looking for interesting avenues to apply their wealth, brand building thro track record of consistent performance metrics matters all the more.

.

Some of the interesting http://www.knowledge@wharton.upenn.edu/ articles on related topics be found here, here, here, and here.

.

A tale of two business models

Born less than decade ago, Google Inc. (NASDAQ: GOOG and LSE: GGEA) now reigns as the most profitable—and probably most powerful—force on the Web. As usual, Google's financial firepower flowed from its search engine. That ubiquitous tool has become the hub of the Internet's largest marketing network and appears to be getting even better at identifying the right ads to display with its search results, which in turn helps elicit more revenue-generating clicks

Google 1st Quarter 2007 results snapshot

Revenues - $ 3.66 b
Net Income - $ 1.0 b
EPS - $ 3.18 per share

No. of employees – 12,238 nos.
End quarter cash balance - $ 11.9 b
Quarterly revenue productivity per employee - $ 299,068

Date of Incorporation : Sept. 7, 1998
IPO : August 19, 2004
[19,605,052 shares were offered at a price of $85 per share ]
CMP of stock - $ 482 [ P/E – 35 ]
Market cap - $ 152 b

Did you say scale ?

What stands out or boggles my mind in more ways than one is the amazing power of an ingenuous yet easily scalable business model that Google espoused. Being less manpower intensive (just 12,238 employees now) and more equipment / server capacity centric, it is least affected by the ubiquitous problem afflicting the IT industry – one of employee attrition.

Pitched against the business model of Indian IT bellwether Infosys Technologies Limited (NASDAQ: INFY) which recently celebrated its 25th anniversary, the contrast is glaring. While it can’t be compared strictly because of inherent diversities, the power of robust business models that enable rapid scaling and by that, shaping the very fortunes of businesses is evident here.

Infosys 4th Quarter 2007 results snapshot

Revenues - $ 898 mm
Net Income - $ 272 mm
EPS - $ 0.48 per share

No. of employees – 72,241 nos. (incl. that at subsidiaries)
Quarterly revenue productivity per employee - $ 12,430

Date of Incorporation : July 2, 1981
IPO : February 1993
[1,378,947 shares were offered at a price of $2.26 per share ]
CMP of stock - $ 42 [ P/E – 22 ]
Market cap - $ 30 b

Here’s where the significance of the business model hits home. While it took 23 years for Infosys (with its strength of 72,241 employees) to notch up a billion dollars in revenues, Google’s business model helped it achieve $ 1.46 b in 2003, in just 5 years of its incorporation and one year before its IPO – with just 1/6th of that strength.

Throw in a few other companies like TCS, Wipro, Satyam, HCL Tech and not wanting to be outhired, MNCs like IBM and Accenture too open shop locally and adopt massive ramp up from the limited pool of qualified engineers, you create a mecca for job hoppers. They are all in the same turf just to stay competent. Hiring becomes a non-process as anyone who can spell binary is recruited diluting the quality of the hire. Skill gaps are hurriedly addressed by on-the-job training if not on induction itself. If the hires are not on a project, it hits their bottomlines hard. Billability becomes the watchword instead of quality.

This lacuna is being realized now and precisely the reason why Infosys top brass is tempted to rethink the viability of its business model. Related news item is here and my earlier insights here and here.

What do you make of it ?

.

[PS – I must also place on record the fact that the indian companies mentioned above took birth in the third world aiming to work for the first world. These companies started operations with severe handicaps when Indian businesses were reeling under the yoke of licence raj, a period between 1947-90 when the state policy was riddled with red tape, hostile to businesses, with severe import restrictions even for high end technology. Exports were severely restricted too.

.

Despite the ongoing reforms, India still ranks in the bottom quartile of developing nations in terms of the ease of doing business; and the average time taken to incorporate a company or to invoke bankruptcy is much greater.

Google by contrast took birth in the capitalist mecca - USA, and measured by that yardstick, it took off with an inherent advantage.

My purpose here is to bring out the criticality of business and revenue model in shaping the fortunes of businesses alone and not to denigrate the shining Indian star corporates mentioned above.]

.

Post deal carping

One of my distinct character traits is my ability to go-with-the-flow. But of late the goings-on in the PE industry in India and the way they changed the scale of M&A activity is a bit off putting.

It’s manifesting in the way our companies have the appetite and the financial muscle to make global acquisitions, of companies which are several times their size and value. How many of those transactions make economic sense, to the acquirer as well as its investors? Employee morale downturn is almost a given if the cultural mismatch simmers up too soon and drives the best brains out for a walk. I don’t think the apparatus is ready to calibrate it and M&A firms can’t care less. For them, it’s just another deal.

In the US, there are several examples of multi billion dollar acquisitions that didn’t quite click. Mitchell Madison-Whitman Hart, HP-Compaq, AOL-Time Warner and many more. Learning from all that, Indian companies could do well to undertake extensive post deal planning prior to completion of transaction – perhpas immediately after the due diligence is completed and in principle decision made.

In a recent survey by KPMG, 80% of the companies surveyed were not well prepared to handle the smooth transition and integration of two businesses post deal. Yet we only get to hear more about *culture conflicts* which only rank second biggest challenge in it. Another interesting finding was that it took on an average, nine months for companies to get a grip over post-deal issues. Nearly two thirds of the acquirers failed to realize the synergy target, even as 43% of the synergy target was built into the purchase price. Well, competitive pressures can explain why premiums are justified as there could be many bidders to a deal. But astute deal makers will have to apprise the management and make them see more value in the transaction than the asking price and convince themselves why the price is right.

Acquisitive ego can never be allowed to out-compete valuation math, and that sets a great deal maker apart from a good one. I will always argue that a good deal maker should be quick on the uptake where it comes to understanding the client’s business in under an hour. He can learn as he diligences, but should be making early calls on the expediency of the transaction to the acquirer’s business and compare it with their goal. Private Equity houses are found to be adept handlers of post deal issues than corporations. As per the report, 95% of PE houses surveyed have started post deal planning prior to signing as compared to Corporations with 59% score.

It is important for Indian Companies scouting for acquisitions globally to do their homework on post deal issues well in advance. In default, they will be choking on the buy without being able to run with it, especially if it is funded by high cost debt. When managed well, acquisition of global corporations by Indian companies would be seen as a normal business decision.

.

What price relationship ?

Ever since I had turned a freelancer 15 months back, I’ve been approached by partners from several Investment Banks each with different intentions. Some wanted to hire me, others wanted business to be channeled their way. It did not surprise me since most of them had read my blogs and had found something common, interesting and worthy of mutual exploration. I had always been open so long as it excited me, be it a position on offer or a strategic partnership on fair terms.

But one thing common in all these tete-a-tete has been the question on *relationships*. They invariably ask “what relationships you have or can bring to us ?”. It made a lot of sense since in I-Banking industry, ready relationships meant not having to waste time on introductions or cold calling investors or PE / VC fund managers, when you have a worthy client. Eventually we rattle out our acquaintances and the conversation goes on.

Some of them act up. They come up with some nondescript client having some hollow business plan with little fundamental strength and ask whether we can get them some investors. Without sounding judgmental, I ask for more information, a web site to search in and anything like an executive summary or some information memorandum or at least a business plan, on the basis of which I can form my thoughts. Some will have that ready, others will say they’ll send it across (mostly don’t come back).

There’s a third group which is more adventurous. They say, “we are putting together that information, but we need your help here”. Probe a little deeper what *help* they need, it would be something like a company in a deep mess, founder having a history of siphoning off funds, out to leverage the buoyant sentiment in the stock market by merely changing the name of the company and its objects clause. Anything goes here, a financial services company could be renamed into a clean energy company or a textile mill resurrected as an Infotech venture. Surprisingly they quote examples of many that have gotten away and they’d be right since I knew of some myself.

The relationship they seek is for palming off such deals. I had often wondered - how can these people be so naïve that just because you have a prior relationship with a PE fund, they’ll be ready to invest in a doubtful venture ? Every PE fund does a scrupulous due diligence on each deal that comes before it that it wants to invest in. I am yet to come across a PE firm that would invest in a business just because it was brought along by a reputed investment bank. All of them have their own internal well laid investment processes and every deal will have to go thro that filter. When that being the case, relationships don’t get you investments – it’s the fundamental strength of a business and how well it resonates with the PE firm’s objectives, in the way it stacks up as a sound investment destination.

If I were to look for a potential candidate or partner, I would look for independent research capabilities, ability to draw insights, the instant relationship building ability and sound knowledge of the PE industry in India, which firm likes what industry, domain expertise, latest rounds of funds raised etc. Asking for ready made relationships can only be of use if you have a superb client needing no introduction. For the rest, you need people who can look straight in the eye of the managements and tell them to get their things organized before seeking investor participation.

Wouldn’t you agree ?

The QIP deep dive

As early as January, 2006 a report by the SEBI-committee raised concern over the growing number of Indian listed companies tapping funds through the GDR/FCCB routes, on account of its time and cost effectiveness adversely impacting the depth of the domestic markets. While the number of follow-on public issues in domestic markets during 2001-02 to 2004-05 period rose from zero to six, the number of GDRs/FCCBs from listed Indian companies grew by three-fold from three to 42, the report had said.

On the basis of this report, SEBI came out with a solution in May, 2006 in the form of Qualified Institutional Placements or QIPs, which were significantly less cumbersome than IPO filings. As per the guidelines, issuers will have to allocate a minimum of 10 per cent of such placements to mutual funds. For each QIPs, there shall be at least two allottees for an issue size of up to Rs 250 crore and at least five allottees for an issue size in excess of Rs 250 crore. "Further, no single allottee shall be allotted in excess of 50 per cent of the issue size," the guidelines stipulated. The securities issued through QIPs will be equity shares or any securities other than warrants that could be converted into (or exchangeable) with equity shares, SEBI said in a circular.

The placements of these specified securities could be made only to Qualified Institutional Buyers (QIBs), while a minimum of 10 per cent in each such offer should be allotted to mutual funds, the regulator said. Promoters or those related to the issuers are barred from participating in such issues. Owing to these advantages, companies took to it happily.

But now since the market has been in a bearish mode for the past few weeks, the floor price stipulation (being the higher of the six-month weekly average or 15-day weekly average of the quoted prices) in the QIP guidelines have begun to adversely affect the issuances. The floor prices based on the SEBI formula are now higher than their current market prices. The floor price is again applicable from the date of the enabling resolution by the board. Of late, prospective issuers are finding their floor prices higher than their current prices. While SEBI doesn’t allow the QIP issuer the flexibility to revise the price downwards, investors wouldn’t be willing to come in at a price higher than the prevailing market price. Catch 22 of sorts.

.

Will SEBI relax its floor price norms for QIPs or let it lose flavor ? Keep watching this space.

.

Time for ICICI Venture to mull an IPO…?

I keep reading about the phenomenal success of Fortress IPO and related reports and had also chronicled it in one of my earlier blog posts. Going by this Fortune article, it seems the world’s still awestruck and clearly has not had enough. It as well reminds Blackstone is next in line to hit the road.

Excerpts -

“On the night before Fortress Investment Group became the first hedge fund to trade on the New York Stock Exchange, Wesley Edens and the other four principals celebrated in a manner that befits the firm's intentionally low-key profile. They gathered at a bar on the Upper West Side of Manhattan.

By the next day's closing bell, though, Edens could afford more than just beer and pretzels: His shares from the IPO were worth approximately $2.3 billion. Six weeks later, on March 22, Blackstone Group followed suit when the private-equity shop revealed plans to raise $4 billion in an upcoming IPO.

Since that news broke, Wall Street has been buzzing about who will be the next firm to announce plans for an IPO and invite the public into a world once reserved for high-net-worth individuals and institutional investors.”

I took time off to think what if our local Private Equity firms decided to go public ? Would they fetch similar buoyant response ? The existing listed PE firms like IDFC an Infrastructure focused financial powerhouse ( P/E 18.6, Market Cap $ 2.13 billion) and ILFS Investment Managers a pureplay PE firm (P/E 24, Market Cap $ 76 Million) have been doing well for themselves in comparison with the broader market. But the big fish of them all is ICICI Venture, which is the Private Equity / buyout arm of largest new generation Bank ICICI Bank, with funds under management in excess of $ 2 billion. It would be interesting to watch if ICICI Venture decides to go public and the likely valuation that it might secure – given the dynamism demonstrated by its CEO Mrs.Renuka Ramnath, it is not totally out of whack to speculate.

.

And if it chooses to hit the road, here’s what Mrs.Ramnath and her team can aspire for - more or less.

Being comfortable in the limelight may be what finally determines who does and doesn't go public. Given that affairs of ICICI Venture are pretty much transparent, and its very much in the limelight already for Mrs.Ramnath’s stellar fundraising capabilities, if at all there’s anything to hold back, it could only be its investors privacy concerns than one of its likely valuation.

.

I'd like a slice of the action....What do you think ?

.

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.

Shall we hatch this ?

What could be the next move for a PE firm in India ? It got me thinking…! Without having to storm my brain too much, it just occured to me. A buyout…there are quite a few candidates that come to my mind.

.

What would it look like if a PE firm takes Wockhardt Ltd. private, add significant strategic value, impute explosive growth and then take it back public to make a killing in the process for all stakeholders ?

With that, lets take a look at this company that could sustain an interest payment and debt load required to take it private. I think it is ripe for a buyout by a mid-sized PE firm, and therefore, ripe for the purchase by value oriented equity investors.

Wockhardt [ source : Annual Report 2005 ]

.

[ Full disclosure - Neither I nor my close relatives and to the best of my knowledge any of my business associates have any shareholding or other interest in this company as of now. ]

It's amazing how Wockhardt, the Indian pharma player has created an integrated global business model with state of art R&D, manufacturing facilities and differentiated marketing strategy during this most difficult year for Pharmaceutical industry which terribly underperformed every stock index. The company is banking on billions of US $ worth critical drugs especially in US and Europe coming off patent in the near future. During the year, its consolidated revenue grew 12.82% to $ 321 MM and PAT at $ 58.43 MM grew by 20.42%.

While writing this now, I have also read the company has acquired Pinewood, the largest generic Company in Ireland helping it achieve a wider wingspan in Europe spread over Germany, UK and Ireland which geography accounts for more than 40% of its revenue growth.

Wockhardt generated $ 39.61 MM in cash from operations in 2005 and is likely to improve that number this year. The company's equity market cap ( as of 03/27/06) is $ 928 MM, with a net cash balance (as of Dec.05) of about $147 MM.

About 73.73% of the stock is held by the founders and the rest of 26.27% is held between Foreign and domestic institutional investors (15.72% ) and public investors ( 10.55%). Currently the stock is quoting at $ 8.48 ( Rs.373.30) at a P/E of 19.8 times. Let’s assume a PE firm offers to buyout the company at a 30% premium to market price ( allowing for bidding frenzy) at $ 11.02 (Rs.485.29) at a P/E of 25.74 times on current earnings. The total acquisition bill would be about $ 1.2 billion.

At a 7% interest rate, the interest payments on $ 1.205 billion ( assuming total buyout ) would be $ 84.35 MM, that is just 57% of $147 MM, which is what the company has consistently generated over the last few years. Since Wockhardt has significant net current asset cushion in its Balance Sheet and only needs about $ 125 MM in maintenance capital expenditures, it's a perfect buyout candidate. With some cost cuts and knocked down expenses, the company could easily generate enough cash to continue operating smoothly.

In fact, it presents an ideal case for a leveraged management buyout with Mr.Habil Khorakiwala and his team in tact, retained for its enormous savvy and experience over the industry besides the international expertise available from its European acquisitions in the recent past. If we can infuse a significant load of external strategic muscle as would help fuel the global ambitions of the company, we've got a multibagger in as much as 3 -5 years as could be relisted anywhere in the world. If the PE firm has a good pharma portfolio in sync with Wockhardt credentials, ah...!

Asking for orders now. [ One of the biggest secrets to dating hot women is having the guts to ask them out in the first place. That’s right. You’ve got to be a man of action, because all of the plotting and planning and dreaming in the world is going to get you nowhere if you don't dare to ask her out :-) ].

.

Alright Mr.Private Equity, shall we call this a mandate ?

.

Latest trends in Indian PE

A recent report indicates that the share of private equity (PE) investments in listed companies in India, which accounted for as much as a third of all investments in 2005, fell to 22 per cent in 2006. Some of the companies from which PE funds have exited partially or fully in recent times include Punjab Tractors, Simplex Infrastructures, IVRCL and Gammon India. A similar trend of PE exits from publicly-listed companies in the US has also been seen, though the reasons may be different.

In India, this development comes at a time when private equity is gaining currency. With an estimated 100 private equity funds swarming around for deals, India is now one of the fastest- growing private equity markets in the region. And although the stock markets have scaled record highs (despite the current volatility), the preference by private equity for listed companies seems to be changing. How is this to be explained?

Some of the obvious reasons include –

a) Indian market has been one of the best performing markets. It’s time they book some profits now that it’s late in the day.

b) India growth story is continuing and a little churn in portfolio will give every PE that extra % comfort in terms of RoI and enable fresh round of investments.

c) Average deal size in India is still small barring a few. As such it doesn’t justify longer holdings aiming at large scale returns.

d) Natural Indian scepticism wouldn’t let owners dilute substantial stakes in favor of PE firms as they are not sure of the value PE firms bring to its businesses.

e) Looming threat of Government scrutiny over buyout deals – Few examples are of Vodafone acquisition of Hutch Essar, Punjab Tractors exit by PE firm Actis (formerly CDC ) and Burmans, acquired by Mahindra & Mahindra. In the US, it’s the rigor of SOX Act compliance which eases PE firms out of Public listed companies.

As such, now PE investors appear to be more comfortable with a fund of funds model – invest as LPs in other PE firms who are already in the fray. One of my earlier posts explaining the advantages of FOF model is here.

Isle of Man-based Evolvence India Holdings is planning to raise $65 million (Rs 290 crore) through placement of shares on London Stock Exchange. EIH, a private equity fund company which principally targets investments in the Indian subcontinent would place up to 65 million ordinary shares of one dollar per share, a statement to the London Stock Exchange said. The public listing of EIH on LSE's Alternative Investment Market (AIM) will give investors access to a diversified Indian private equity portfolio, while mitigating issues usually associated with private equity investments, such as a lack of liquidity and relatively large minimum investment size.

Evolvence has already invested in Indian PE funds such as IDFC PE, Barings India PE, etc.

US-based Investment bank Thomas Weisel International is planning a $200 million private equity fund of funds for India. The company is also keen on rolling out its asset management business in India, focusing only on institutional investors. The fund of funds, which is yet to close, has already made two investments worth $25 million in IDFC and ilabs.

Sounds cool ?

.

PE funds – way to go in India II

Just after I’d finished writing my previous post on the subject, there still was this lurk. Have I said it all ? I owe it to the PE fund managers in India to drive home my point - by contrasting it with the US scene, where PE funds had their origin, the mistakes they made and the way they matured. We may still have to tailor it a bit to suit our businesses, the ownership fetish to be addressed, high quality CEO material will have to be nurtured and newer methods of value creation to be learnt.

Let's visit it then and look at the situation there. This will help us avoid the pitfalls if we are intelligent enough to recognize.

To give you a glimpse of the PE canvas, of the record $1.56 trillion spent on mergers and acquisitions in the U.S. last year, PE buyouts accounted for 25% of the action, up from 10% in 2005. PE's firepower has never been greater. Last year firms in the U.S. raised a record $156 billion in new capital. It is believed that the global buyout industry currently has $400 billion available to be invested. With leverage, that $400 billion represents as much as $2 trillion in potential buying power. (To put this in perspective, U.S. mutual funds have more than $10 trillion in assets.)

Private Equity funds, like hedge funds, are classified as "alternative investments," the two are often lumped together. And they do share common ground. Investing in both is limited to those with deep pockets, who can presumably handle the greater risk. Both feature lavish fee structures - variations on the "2 and 20" formula, in which general partners take a 2% fee for simply managing the assets they control and a 20% slice out of any incremental profits they deliver. Both soared in the wake of the 2000-01 market meltdown, which persuaded well-heeled investors that riding the market indexes (Dow 36,000! Nasdaq 10,000!) wasn't automatically going to make them richer.

But here's where they differ. While hedge funds mostly have individuals as investors, PE firms get the bulk of their money from institutions (roughly half from pension funds, another big chunk from banks, insurers, endowments, and foundations, and only 7% or so from individuals). Though so-called activist investors running hedge funds at times noisily pressure public companies into making changes to boost stock prices - think Nelson Peltz or Carl Icahn - most rarely end up owning companies; nor do they want to.

So what does this mean for those of us who don't wear pinstripes or dine where the elephants bump? Are we moving into an era when we have both a public and a private economy in the same way we have a public and a private educational system? Do Blackstone and its peers really take broken companies, mend their wings, and set them free in the public markets? And how big can PE get, anyway?

Cheap debt is the rocket fuel for this, but it's not the only driver. In terms of governance, management focus and strategic decision-making, the PE model is usually superior to that of publicly held companies. Otherwise they’ll end up holding the hot potato. There are only two ways for a PE liquidity event. Flipping the portfolio company to another PE or to take it back Public. On both options, the invariable question they face is “what were you doing with it so far ?”.

They had better show value. Unlike the quick-hit artists at hedge funds, PE is a long-term investor who succeeds only when its companies succeed. That's typically followed by the it's-all-about-the-talent chorus. “Today anyone can raise equity and borrow money," says the Carlyle Group's co-founder David Rubenstein. "What's rare are two things: a deal everyone isn't clamoring to get into, and people who know how to operate the companies we buy. Given a choice between hiring an experienced investor for our firm and landing a guy who's run a leveraged buyout, I'd take the latter."

Amen, adds Michael Milken, whose nearly single-handed creation of the junk-bond market in the 1970s gave rise to the first great LBO wave of the 1980s. "The concepts and financial structures that we introduced back then - and that were rejected as too radical and poorly understood - are now in every introductory textbook," says Milken. "But success then and now mostly depends on finding great people. The difference is, where I only backed strong individuals who wanted to start or buy a business - Steve Wynn in gaming, Len Riggio in books, Craig McCaw in cellular, and Bill McGowan in telecom - the PE industry today has the scale to first buy up assets and then match them up with the right managers."

Another difference between Milken's era and today is that instead of merely bankrolling entrepreneurs, private-equity firms are co-opting CEOs. There are the elder statesmen - Lou Gerstner, Jack Welch, Larry Bossidy, Jim Kilts, John Browne, and many more - who have joined PE firms rather than retire to the golf-and-board-of-directors circuit.

They have learnt it the hard way in US. We have a better template now that needs to be customized to suit local businesses. We must do better since they’ve committed a lot of mistakes before us which we must avoid. We may commit new mistakes, learning newer lessons while on the run. That learning capability should differentiate us. Are our PE fund managers listening ?

If not, watch out for the train wreck ahead. What do you think ?

.

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 !

.

Ad budget for Law firms ?

Why not ? Market they will, if that’s what it takes to float their boat.

With the increasing number of M&A transactions, the number of law firms have also grown. It is looking more like any commodity business. Soon you’ll be surprised to find a wal-martish, “hire us for an acquisition, we’ll do your eventual Chapter 11 filing free” or worse, a “balance transfer facility” incentive to switch your existing lawyer and sign up with another. “We are not a Bank, so no processing charges or penal interest” could be thrown in for good measure !

Well, for now it seems the marketing strategies of other businesses are fast catching up with legal profession. Accounting firms have already been doing it for quite some time now in the guise of advertising their transactions and not the firm.

Zusha Elinson of The Recorder quotes John Hodder, CMO at Orrick, Herrington & Sutcliffe, "All firms are spending more on marketing. The market is increasingly competitive and there are a lot of firms out there and it's about finding what differentiates your firm from the others." [ Note : The CMO stands for Chief Marketing Officer and we are talking law firms here ! ]

Am Law 100 firms budgeted an average of $9 million -- or 2.2 percent of their gross revenue -- for marketing last year, according to a new survey by Boston-based BTI Consulting Group that polled about 60 percent of Am Law firms.

Read the full report here.

Would we get to see Crawford Bailey & Co or Nishith Desai & Associates hoarding around the world cup 2007 cricket grounds at the Carribean ?

No bets.

.

The story of Chrysler Goodwill

What it has produced isn't so much a case of two rights making a wrong, as three rights making a left.

I am referring to the troubled automaker DaimlerChrysler which lost $1.475 billion in 2006 and is put up for sale.

Daimler-Benz AG paid $36 billion for the company in 1998, but industry analysts now place its value at anywhere from nothing to $13.7 billion. Estimates vary with the value placed on assets such as brand names, factories and materials, all weighed against Chrysler's estimated $19 billion long-term liability to pay health care benefits for unionized retirees.

Some analysts say the liability exceeds the value of the assets, meaning that German parent DaimlerChrysler AG would have to pay someone to take Chrysler. Others say the company is worth more to the right buyer.

As two private equity firms examine Chrysler's books and consider making offers to buy the company this week, they'll be grappling with a question whose answer is uncertain: How much is the automaker worth ?

"It's a hard thing to really figure out, and the uncertainty is what the health care liability really means," said David Cole, chairman of the Center for Automotive Research in Ann Arbor. "If that were removed, then it's a wholly different game."

Chrysler was once bailed out with the support of Federal Loan guarantees in the 70’s. Now the Automaker is back in trouble.

The fun is that it’s value varies with the type of buyer. A private equity firm could take the company into bankruptcy, shed its union contracts and then break it into pieces for sale at a handsome profit, he said.

GM could sweep its estimated $50 billion retiree health care liability into Chrysler's and negotiate a deal with the United Auto Workers union to take on the cost at a discounted rate. GM, Cole said, could save billions of dollars on its health care liability by buying Chrysler. If that were done, it could make a pretty good case that GM would be the ideal suitor.

Read the full story here.

This is what I call as going down in style. Even as you go broke, there are so many suitors with higher and higher bids. They call it Goodwill - what you pay more than the firm’s intrinsic worth, that is.

Welcome to Corporate derring do !

.

Some JV puzzles solved – by Pat Love, marriage therapist

I was particularly fixated by this interview with Pat Love, marriage therapist. Much as it would clear up the doubts of many a young men and women on the choice of their dates, it answered a lot of my queries why a great company often walked into a JV relationship with a mediocre or downright bad company. I just switched the `boy’ and `girl’ metaphor in this interview for corporate partners in a JV.

Some excerpts :

Q: Why are bad boys so irresistible?

Pat Love: Bad boys are handsome and elusive, and that triggers attraction. But it's largely a societal issue. We are programmed by our culture to think that chemistry is love. We are constantly stimulated-by work, television, shopping-and we tend to move on if we're not excited. Also, some women's brains are wired to interpret anger and petulance as love because of their early negative experiences with men.


Q : What about bad girls ? Do you think that’s as much a phenomenon ?

Pat Love: Oh yes, there are bad girls. They're usually very attractive women who feel entitled. They're used to getting everything, and they know how to work a crowd.

Q : Why is it dangerous to be with a bad boy?

Pat Love: Well, they're unreliable. They don't feel an obligation to have a relationship. It's important to understand that when a woman has sex, she releases oxytocin and bonds with her partner. Oxytocin is called the "snuggle chemical." It triggers orgasm, but it's also released when a mother breast-feeds. It makes you feel close and connected and vulnerable. The effects of oxytocin are offset by testosterone, so a high-testosterone person doesn't bond from having sex. And there you have it: Bad boys don't get attached! They say all these wonderful things, and you get this chemical rush that lowers your defenses. But he could be gone the next day. He could lose interest.

Q : Do bad boys ever change, or is that just what we want to believe?

Pat Love: Most don't change. When they get old, then they're with somebody who has clout because of youth and beauty. Look at Michael Douglas and Catherine Zeta-Jones. She has youth and beauty; he has power and status.

Q : What about bad boys who give inconsistent signals? Bad boys who snuggle?

Pat Love: If you want a rat to push a bar forever, don't give him a pellet every time he pushes-then he'll only push when he's hungry. If you take away the pellet, he won't push the bar at all. But if every now and then you give a rat a pellet, he will push the bar forever. It's called intermittent reinforcement. That's the way to get a woman forever; throw her a little tidbit every now and then.

Now I know whom to consult before finalizing a JV partner. Seriously, this is much better than many a Big Four feasibility report.

Man Up ! for social values and integrity

Clean tech sure is catching up. I am all glad for that.

Serial entrepreneur Sunil Paul has this brilliant post in Venturebeat on why he’s veered into clean tech – for social values he upholds or for the profit that it might entail. Excerpts.

“We investors and entrepreneurs in the cleantech world have a guilty conscience. People often ask us, “Are you motivated by the money or by the mission?” It’s become unfashionable and a little shameful to say you’re driven by anything but profit, but I’m not afraid to say I’m a clean energy investor because of my values.

The money vs. mission question comes from fear. Environmentalists and energy security hawks fear capitalists will sell out their social goals in favor of profit. Investors fear a venture investor or entrepreneur will subvert their financial return for a social agenda.

Venture capitalists are beholden to their limited partners who are weighing whether to put money into venture capital versus, say, currency arbitrage. Those investors don’t want to hear that the venture capitalist has any motivation other than giving them a great return. That mentality rubs off on venture capitalists, and trickles down to entrepreneurs and management teams.

But it doesn’t have to be a choice between social and economic goals. Clean energy is like the love child of John Muir and Adam Smith. It joins environmentalism with capitalism. Cleantech companies have great value not captured by the price of the good or service. Their entire business model generates excess social return. In addition, the energy market is huge, and is ripe for change – and so the opportunity for profits is tremendous”.

This reminds me of a paper on leadership posted by Jason Drohn on Howard Schultz vision of Starbucks [ you may have to download a 4 page PDF file, but it’s good stuff – it has some exclusive finds ; like the lawyer who organized capital for Starbucks acquisition was Bill Gates’ Father !]. I think all these people are where they are today because of the level of genuine social commitment they carry.

Jason opines – “Schultz has a wonderful degree of integrity. As he was growing up, his father worked mid level jobs to pay the bills, without health coverage or worker’s compensation. So if he got laid off, his employment was simply terminated. If he got hurt on the job, he didn’t have anything to go back to.

In a 60 Minutes interview, Schultz commented on remembering what it was like to walk into his house, with his dad on the couch, cast on his leg. No job, nowhere to go to work, just a stack of bills and nothing to pay them with.

For this reason, Starbucks offers health insurance to anyone who works more than 20 hours a week, even in unmarried, spousal situations. They offer stock options to their employees throughout the whole company. And Schultz said that those benefits were something that would never be reconsidered.

This is the primary reason that coffee is as expensive as it is. Starbucks pays more in health care than they do the coffee beans to make the coffee !

So if you spend $4.10 on coffee, the majority of the cost goes to the health care being consumed by the person across the counter from you (the barista, in Schultzian terms..).

Adding to the integrity of Schultz and his company, he pays the coffee bean growers above market value for their crops. He feels that if he overpays a farmer, more passion and consistency will be given to their coffee beans. His social responsibility also plays a role in the decision as well.”

When you are asked, “are you in this to make money or change the world?” bring yourself to reply like Sunil bravely does. “Of course we wanted to change the world! Making money was just validation that it worked. Virtually every early internet entrepreneur I knew recognized the opportunity to change the world for the better by growing the Net. It wasn’t until many years later that the hordes of profit-only entrepreneurs came to the scene. Indeed, if you want a sign of over-investment in cleantech, look for an invasion of founders and CEOs who are in it only for the money.”

Would you not like to leave a green planet behind for your grandchildren ? This way, you will. You can convince your limited partners – for they too will have grandchildren !

Why buy when smart guys are selling ?

I was reading Roger Ehrenberg’s review of the valuation and rationality of Fortress IPO which was a blockbuster success on Wall Street.

For the uninitiated, Fortress Investment Group LLC, which manages $30 billion, became the first private-equity and hedge-fund manager to sell shares on U.S. markets and promptly emerged as one of the hottest initial public offerings in years. Its shares, issued at $18.50 apiece, opened for trading at $35 amid frenzied demand and closed at $31 -- 68% higher than its IPO price.

With its stock offering, Fortress is essentially inviting the public to share in the fees it earns managing private-equity and hedge-fund assets. At the end of 2005, the company's then-$7.6 billion in hedge fund assets (a hoard that has since grown) ranked it the 36th-largest fund globally.

What took me by surprise was Ehrenberg’s shock (“ Investors, are you stoned ?“ asks the Wall Street veteran) when the public market offered 40x valuation to Fortress’ shares.

I’ve commented my views to the blog post but then I couldn’t elaborate since I am a strict observer of blog ethics ( always be brief with comments ). But then I came across this wonderful piece in LA Times which squarely settles Ehrenberg’s misgivings.

To sum up, Fortress despite being a Hedge Fund manager went public because :-

a) a presence in Public Market gives it a perceived longevity, besides credibility ;

b) having a publicly traded stock allows its employees to turn their stakes in the company into income. In a partnership as Fortress had been, it was difficult to cash out. In a public company, it's a simple matter of selling shares. ;

c) it is a well timed move since hedge funds returned fantastic results in the year that had gone by ( 2006 ) and Fortress in particular enjoyed a great year itself ( earned $88 mm in the first half of 2006 ). Further, If Goldman was letting the public into its business after 130 years as a highly profitable — and secretive — private partnership, the insiders must have known that was as good as it would get.

d) Fortress is essentially inviting the public to share in the fees it earns managing private-equity and hedge-fund assets ; conversely if the following years turn out to be not as good as those gone by, it’s risk gets evenly distributed across a larger investor base.

e) Being publicly traded will increase the odds of gaining "permanence" as an investment manager. It will also attract high quality accredited investors and Board managed Pension and University funds which by their charter are barred from investing directly in lowly regulated vehicles like hedge funds which are not transparent.

f) The hedge fund and private-equity businesses are becoming ever more competitive as the number of players mushrooms. A serious shakeout is inevitable. When it happens, the firms with the deepest pockets will have the best chance of surviving.


But the question remains. Would you buy when these smart guys are selling ?

The Retail kettle rattled ; now it’s Multiplex’s turn to quake.

Even as the Indian retail industry is geared up to meet the impending arrival of global retail chains like Wal-Mart, Carrefour and Tesco, their knee-jerks do betray their internal jitters however best they try to conceal.

And now this. Wal-Mart, the no. 1 retailer in the US, known as the 800-pound gorilla, unveiled a movie and TV download service yesterday and all the major studios have joined the party. Wal-Mart Stores said the download movie service offers more than 3,000 titles from Twentieth Century Fox, The Walt Disney Co., Lions Gate, Metro-Goldwyn-Mayer, MTV Networks, Paramount Pictures, Sony Pictures Entertainment, Universal Studios Home Entertainment, and Warner Bros. It also includes content from television networks Comedy Central, Fox, and Nickelodeon

The entry of foreign retailers has been a contentious issue for many years, with the government unable to convince the political establishment to support the move, given the stiff resistance from the powerful trader lobby who argues foreign players would wipe out the mom-and-pop stores ( called “Kirana stores” in local parlance). Under existing foreign investment norms, international players can own up to 51% stake in companies that sell only one brand through a chain of stores. The commerce & industry ministry is, however, planning to expand the scope of foreign participation to select sectors like electronics and sports goods, where global chains can open retail outlets.

But the truth is that with the emergence of the Indian retail formats like Big Bazaar, Subiksha and others have already begun to impact the fortunes of these kirana stores. Their customers have been deserting kirana stores en masse because of the better shopping experience and apparent discount offers at the neibhorhood mall. In fact, the real threat for Kirana stores are from retail supermarket format itself regardless of the nationality of its owners.

So it is in fact the Indian branded retail lobby which is running scared of the foreign retail chains.

The ruling Indian Congress party President Sonia Gandhi, had written to Prime Minister Dr.Manmohan Singh asking the government to take into account the implications that these transnational giants could have on neighbourhood kirana stores.

Lately the big Indian retailers including Big Bazaar, Ebony, Shoppers' Stop, Landmark, Westside or even Subhiksha are looking to source merchandise at the lowest rates globally. Future Group's Pantaloon Retail India has just set up global sourcing offices in Hong Kong and Mainland China - the first overseas sourcing operation by any domestic retail chain.

“For retail chains across the globe, the world is becoming a single market. We are looking at markets across the world from where one can source merchandise at the lowest price. We have opened our global sourcing offices in Hong Kong and China a few days back,” Future Group's CEO Kishore Biyani reportedly told a correspondent.

Now it’s the 800 pound gorilla’s turn to shake up the Indian Film industry and the budding online DVD rental outfits funded by Venture Capital firms in India. Huge PE investments ( $ 7.46 billion in 2006 across industries, bulk in infrastructure and real estate including multiplexes ) have been made in India anticipating blockbuster performances of these businesses.

The fun has just begun. With Indian VC investors quaking in their boots, it sure has all the trappings of an edge-of-the-seat thriller. Watch the space.

Vultures can't give India a miss, cagey just yet.

Private Equity funds which feed on distressed debt - buying them at a steep discount, turn them around and sell off at a fabulous premium later are an asset class by themselves - known as “vulture funds” got a shot in the arm in Nov 2005, when Reserve Bank of India ( “RBI”) allowed Foreign Direct Investments up to 49% in the equity of Asset Reconstruction Companies (ARC). The RBI circular no.16 dated Nov.11, 2005 also allowed Foreign portfolio investments in security receipts issued by ARCs upto 49% of each tranche of such issue. There has been several legislations in this direction for quicker unlocking of value from stressed assets.

A cursory glance at the nature and size of distressed debt available is quite mind boggling. The total distressed asset market in India is estimated at about $ 35 billion at last count.

But dealers in distressed assets, like the Asset Reconstruction Company of India Limited ( ARCIL ) are far from happy.

WITH the upturn in the economy raising the prospect of windfall gains from bad loans, banks are demanding a share of the upside from potential buyers of bad debt. This has come in response to the normal stance of private equity (PE) investors asking exiting debt-holders to exit the distressed company by taking a haircut of nearly 20% of the debt. In the recent past, some PE players such as Spinnaker had invested in IG Petrochemicals, Clearwater in Gayatri Waters and WL Ross in OCM.

There is also a long pending need for rationalisation of stamp duties by different state governments. In the case of a financial weak company, the government should allow conversion of debt into equity without triggering the Takeover Code of Securities & Exchange Board of India ( SEBI). – which imposes the obligation on the acquirer to make an open offer to buyout public investors.

India is becoming a hot destination for ‘scavenging’ despite all these pain points. Cash-rich private equity distress funds are hovering atop the $35-billion distressed asset market in the country sighting enormous wealth-creation opportunities. According to experts, 2006 has been an eventful year for distress funds as estimated investments in non-performing assets have grown from around $1 billion in 2005 to over $1.7 billion. It has been a safer bet for private equity (PE) players investing in distressed assets as many have fair potentials of recovery and are largely secured against tangible assets including high value real estate.

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.

.

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...?

.

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. “

More concerns on optimal deployment of mega PE funds

I have aired my concerns ( “No Way Out”) relating to the prospect of PE investors funds getting locked up for lack of exit opportunities. At that time, I was fresh from the report of Sevin Rosen Funds having retuned funds to investors citing lack of investible opportunities and laggard IPO markets.

I was also not pretty much sure about the potential for optimal deployment and returns generating capabilities of PE firms engaged in a bidding war in most emerging markets ( “Flipside of PE buyouts” ), where the acquisitive ego often side-stepped valuation math. I had flagged caveat emptor for the winning bidders in Hutch Essar.

I recently found support in a Red Herring article, where there’s an added interesting perspective on such record PE fundraising in 2006 ( 322 firms raising $215.4 billion ) and its impact across industries, Venture Capital and the relative risk and suspicion. Very insightful.

Flipside of PE buyouts

Private equity has been a turbocharger for the market. Every time private equity takes a company private, they pay a big premium and investors mark up the rest of group in the hope that another PE firm will come along. This has forced private equity to pay ever higher prices for the deals they do. As long as rates remain low and the economy is strong, private equity can pay up.

What if tables turn…?

Our capitalist system has a habit of swinging between fear and greed and right now we’re seeing it lean toward greed – at least in private equity. Wealth has accrued, and investors — many of them public pension plans — are searching for places to put their excess capital. So they’re parking it with the huge private equity firms and hedge funds promising to put large dollars to work profitably. As per reports, PE firms firms raised a whopping $198 billion in 2006 ( a record ) and almost five times the amount raised in 2004. They pumped $ 725 billion to take public companies private, and buying divisions from public companies that are trying to restructure. That’s another record, more than twice the level in 2004. The trend is expected to continue this year. One firm, Apollo Management, alone participated in $37 billion of transactions in just three days.

Looks like things are getting out of control. With PE firms buying up all these companies, they will need to sell or take those companies public again, in order to cash out of them. But no one knows how they will do that. If you try to sell these companies on the public market at the same time, the resulting downward pressure will kill the stock market. ( Firms will have to hold their stakes, thus lowering returns, and causing a shakeout). Meantime, the excess cash is pushing up stock values artificially, because if a company doesn’t like its stock price, it knows it can get a premium price by selling to a private equity investor. Alternatively, if a company’s stock price dips too low, it becomes an acquisition target. So, of course the market has gone up! The Dow is at record highs.

That’s the problem. Most economists would like 2007 to herald an economic slowdown. If it slows too much, we could be in for a choppy ride. It takes a long time to unload stock, even in the best of markets. I recall Roger McNamee helped buy disk drive maker Seagate in 2000 while he was at Silver Lake Partners. Though Seagate’s value rose within a year or two, and is now near an all-time high — creating handsome profits for Silver Lake on paper — the firm has been unable to sell Seagate shares very quickly. It still owns a large portion of Seagate shares — six years later. And that’s a near-ideal case.

For the past couple of years, private equity has been a safety net under the public market. Stocks go down less than you would expect on bad news because private equity is there….So many companies went private in such a short period of time, that you have to wonder what happens in three years when they all want to go public again. What happens if the market says no ?

Another example is the purchase of Warner Music Group for $1.25 billion in 2003, by a group of investors led by Thomas H. Lee Partners. Within two years, Warner Music made dividend and other payments to those investors of $1.43 billion, in other words paying off the Thomas Lee and other investors the entire cost of the acquisition. Like Seagate, the investment represents a fortuitous case. However, even in these best of conditions, Thomas Lee has been unable to knock it all home with a sale. It is stuck holding to the company, with a declining stock price. Warner can’t merge with EMI, as originally envisioned, because European anti-trust regulators have said no.

The bubble might continue to grow for a while, because there’s so much cash still looking for a place to go. But its time for investors — and here we mean state employees and others whose pension fund money is being pumped into these PE funds — to start asking questions. It’d be too bad if joe public investor is left holding the bag again, just like in 2000. I’d rather hope not.

No Way Out

Private Equity firms buy and sell companies using money raised from Limited Partners who are savvy Institutional or accredited Individual investors. PE buyout firms used to take four to five years to spend their funds, allowing investors to receive returns gained from the sale of assets over that time. These LPs include mainly Pension and Endowment Funds, University funds and other large institutions with huge annual revenues looking for a temporary parking lot before the incidence of predictable future outflows. So they invest these funds in PE funds and try to gain max return on their investments before it is paid out. Right now the money is not flowing back in and is mainly going out.

So many PE firms who have accepted large sums of money from LPs have used up most of their commitments and are hungry for more. If $ 36 billion RJR Nabisco buyout was a one-off large deal for KKR a few years back, now these kind of deals are put together even in emerging markets. This ravenous hunger for large ticket deals is sudden and directly corresponds to the large number of PE firms active in the markets across geographies. The LPs are naturally getting jittery.

What is the reason behind this sudden one way trend…? Reasons are not hard to find.

Almost all equity markets have run up quite high and the average PE is close to 25. This is normally considered overheated in those far eastern markets and the local investors have already pulled back. The PE firms and hedge funds with their financial muscle force their way in not because they find them attractive, but due to absence of investible stories elsewhere. This is extremely risky for the investors as well as those local economies, since the borderline between fundamentals and exuberance is being redrawn and the local investors and fund managers are equally confused. Result, they end up entering at the peaking end of the curve only to have a hard landing. These markets after a fall from such heights rarely get back up for another three or four years since it takes such a long time for the painful memories to fade and for local liquidity to build-up. Restoration of faith in markets will still take some time more. The cycle has to reverse for the foreign PE players to take to these markets again ( they have to run out of options elsewhere ) which is just about one in as much as a decade.

Eventually this rubs off on those developed markets where PE fundraising gets harder by the day. With fewer exit options available, the LP investors are increasingly reluctant to commit more funds until they see returns from their earlier investments winding its way in. After all, they are just custodians of `faith money’ entrusted by employees and universities and someday they have to pay it all back. There is a limit to the interim risk that they can assume – no matter how enticing the returns be.

What drives Private Equity today...?

We have surely missed some reasons underlying the private equity wave, but it should be clear that there are a number of important reasons behind this powerful trend. For individual investors who do not have the ability to access private equity directly, what does it all mean for their investments ?

Most would agree that the stock market has been reacting in part to the continuing wave of buyouts. Buyouts and share buybacks, net of share issuance from IPOs, have been draining market capitalization from the U.S. stock market. This “de-equitization” may be leading investors to bid up stocks in anticipation of further deals.

The presence of deep-pocketed corporate and private equity buyers standing at the ready creates what Citigroup strategist Tobias Levkovich calls “an underlying bid,” which tends to dampen volatility and stop prices from falling too far. And it tends to scare away short-sellers.
So, what drives PE deals today…?

Capital / Liquidity

Could it simply be the case that private equity firms now feel the need to put to work their vast war-chests? The easiest way to do this in a hurry is to ratchet up one’s target size. In the last few years private equity firms have been flooded with an unprecedented amount of capital. Growing liquidity is fueling the private buyout boom for one. There is tremendous liquidity in the market. Deals are being done because they can be.

More than any other factor, the ascendance of private equity buyers over the last few years reflects the willingness of well-heeled investors to pony up mountains of cash in search of better returns than they can earn in stocks or bonds. Unfortunately this makes it all the more difficult for individual investors to find attractively priced asset classes. There’s lots of money, and it’s being put to work. Never mind that finding bargain-priced deals is getting harder by the day. The money will keep flowing until Mr. Market (or Ben Bernanke) yells stop. For the moment, however, there are only celebrations. Looking for historically healthy risk premiums, as a result, remains a thankless task.

The buyout boom is more than just an abundance of private equity capital. Deals can only be made when there is abundant debt available to finance these leveraged transactions.

Credit

A major reason behind the number and size of buyout deals is that ample high yield financing, with reasonable covenants, remains available. Many of those issuances offer surprisingly low yields, suggesting that despite the glut of new debt, demand is still outpacing supply and investors are betting companies won’t default on their new, risky loans. A further sign that borrowers, rather than investors, are calling the shots is the growth of pay-in-kind notes, which allow a company to pay a bond’s interest with more debt rather than with cash. Both Freescale and HCA used pay-in-kind notes to finance their buyouts. There’s a huge amount of money out there looking for a place to go. So private equity groups are buying companies and debt investors are pouring money into risky bonds to chase returns.

Complexity

Another observation is how markets are hooked on “complexity.” Given, of late, the muted returns on plain vanilla stocks and bonds, investors have sought out more complex structures that have the potential to provide incremental returns. Alternatives like hedge funds and private equity clearly fit the bill. They both in turn create demand for more additional financial instruments that can provide additional return leverage.

The private equity-led buyout boom leads to a self-reinforcing cycle of high yield debt issuance, credit derivatives and unnaturally tight credit spreads. These credit spreads therefore allow for even bigger deals. Where this all ends is up for debate, but one must realize that the desire for complexity on the part of investors has created an new industry infrastructure that has yet to be truly tested in light of a significant market (and/or economic) downturn.

Control

Of late, a trend is also emerging out of how the changing pressures on the CEOs of public companies has provided them with an incentive to align themselves with private equity shops to take control of their current employers. The financial incentives of a buyout are clearly an attractive factor for an incumbent CEO to take part in an MBO type-deal. However the chance to control their own destiny absent the many distractions inherent in running a public company must also play a role.

Clearly the lack of constraints on private equity managers to run their companies as they see fit can be an important catalyst for strong performance. Freedom to pay is just one example of an advantage that many PE veterans consider critical: general freedom from the pressures of the stock market, media and Wall Street analysts. Remember, these companies have strong incentives to act quickly - but acting quickly often produces volatile quarterly earnings, which Wall Street doesn’t like.

In a perfect world it should be possible to run a large corporation just as well as a private or public company. At the moment it seems that the playing field has tilted towards private ownership. However a changing political landscape may shift it once again.

Congress

Given the increased pace of deals it begs the question: is there some exogenous event accelerating deal making? It has been speculated that the looming change in control of Congress may be forcing the hand of some deal-makers. While Congress has limited power to regulate deals, it could very well be the case that the anti-trust crowd at the Justice Department may feel a new wind blowing.

The past six years has seen a lax attitude toward deals making. More important may be a socio-political shift that may be against big deals. If this really were a binding constraint on private equity then we may very well be seeing the last gasp of this boom. While possible, we would discount this possibility. So long as the economics of large buyout deals remains attractive, deals will continue to be announced and closed.

The pointers….

At some point this buyout trend will dissipate. Any, or all, of the five C’s mentioned above could reverse in whole, or in part. Fears that the public market for equities will become marginalized are undoubtedly premature. The fact of the matter is that to reverse a private equity-led buyout of any magnitude usually requires a public offering. We have already seen some of those, often in the form of a LIPO, or leveraged IPO. The question is not if we will see some of these very same companies re-list on the various stock markets, the only question is when.