Private equity (PE) could soon be rechristened ‘change capital’ or ‘value-added equity’. Expressing these views at a recent conference, David Rubenstein, co-founder of Carlyle Group, believes that going forward, “investments will be smaller and less frequent, equity levels put into deals will rise, debt will be more expensive than before and holding periods will also rise.
Ultimately, however, the industry will grow larger than before.” Thus, while PE has been one of the main drivers of recent corporate transactions, it is evident that the industry is undergoing transformation. Some argue that the transformation may actually be a gift of fate.
Historically, PE investors made tangible value additions in investee companies, accompanied by active management.
This approach shifted during the boom period earlier this decade when PE players altered their buy and hold approach and started pursuing more short-term gains. With deals backed by large amounts of debt, PE funds became financial speculators.
The global financial crisis, with its squeeze on credit, affected PE businesses. Thus, PE funds now more than ever need to restructure themselves and consider the effects which the geo-political and macroeconomic trends may have on their business.
In the Indian context, the years immediately preceding the financial meltdown saw extensive PE activity. However, the nascent PE industry in India was not immune to the global crisis. But, fortunately and in contrast to the west, a large number of the deals in India were equity based, although this may largely have been for regulatory reasons.
Also, a bulk of these equity investments were made in unlisted family-owned and -controlled entities. And while the investments in private enterprises present their own challenges on matters like corporate governance, going forward, one can expect changes in the way Indian investee companies will perceive PE investors.
With increased competition for deals, one hopes that domestic businesses will begin to recognise the value these investors bring in helping them become effective global enterprises.
Amongst some of the more sweeping changes that one should expect is an alteration in the relationship between limited partners (fund investors) (LPs) and the general partners (fund managers) (GPs).
Basis a research jointly undertaken in India by KPMG and Stanford University, LPs believe that GPs need to develop greater competencies required to become effective post-investment managers. GPs for their part desire a greater say in the sectors of investment and the timing of fund deployment.
Additionally, according to a large investor, LPs no longer want to pay the GPs a flat management fee, especially when their money hasn’t even been invested. The industry appears to be moving closer to a performance fee model and GPs will be expected to provide strategic support to investee companies.
Another major change to be expected is the increase in the number of secondary sales. “Secondaries”, as they are termed in PE lingo, refers to a LP selling its stake to another partner or a third party. With increased scrutiny of existing portfolios, coupled with LPs not wanting to make any further capital contributions and with quality portfolios available at attractive prices, LPs will now more actively pursue this route to exit.
Additionally, going forward, it may not be uncommon for PE investors to increase their levels of transactional scrutiny. The due diligence process, which includes a review of the legal contracts, the financial position and the core business and operational issues of the target may be enhanced.
This would result in the transactional documents becoming more detailed which would have a direct effect in increasing the transactional timing and costs. But, with investors becoming more risk averse they may be willing to undertake such enhanced scrutiny.
Specific to India, one major transformation would be the search for a domestic pool of LPs. The reliance on domestic investors helps avoid the uncertainties of the international market. This finds support from the fact that ICICI Ventures, IL&FS Investment Managers, and Tata Capital all raised money domestically.
In conclusion, as Ben Jenkins, co-head of Blackstone’s PE business in Asia states: “We (PE) may be smaller than in 2007 but our fundamental position as an allocator of capital and patron of business is still a valuable role”.
India, with its capital markets of international standards, developed banking system and a well established legal network, seems well placed to handle the transformation being witnessed by the PE industry.
Eventually, it is reassuring that the above referenced KPMG joint research concludes that, “India offers immense opportunities for PE investments and India will likely be at the forefront of a global PE recovery. The next 12 months should be viewed as an opportunity to build values in portfolio firms and show that PE is an integral part of India’s future.”
First Published in the Economic Times on November 26, 2009