The Private Equity sector is broadly defined as investing in a company through a negotiated process. Investments typically involve a transformational, valueadded, active management strategy. Typical forms of private equity include venture capital, growth and mezzanine capital, angel investing and private equity funds. Private equity investors seek to obtain a substantial interest in a company in order to have an active role in firms’ strategic decisions. Their goal is to boost the value of a company and walk away with substantially more money at the time of liquidating their investment.
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What is Private Equity?
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Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies. Capital for private equity is raised from institutional investors and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet. The term "private equity" encompasses a range of techniques used to finance commercial ventures in ways that do not involve the use of publicly tradable assets such as corporate stock or bonds.
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What is Private Equity?
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Private equity investments often demand long holding periods to allow for a turnaround of a distressed company or a liquidity event such as an IPO (Initial Public Offering) or sale to a public company. The seeds of the Indian private equity industry were laid in the mid 80’s. The first generation venture capital funds, which can be looked at as a subset of private equity funds, were launched by financial institutions like ICICI and IFCI.
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PE funds raise money from long term investors and invest them in operating companies
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PE can involve different categories of investors depending on risk profile, stage of funding and investment size
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The strategy and behaviour of PE firms in India is very different from the global scenario
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Evolution of PE investments in India
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India represents an attractive opportunity for global investors
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Private Equity has gained importance in India only in this decade although its origins go back to 1970s
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PE has grown faster in India than other countries in Asia pacific
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Private Equity related investments have started picking up again
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Growth of Private Equity related investments has been in line with stock market sentiments and GDP growth
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VC firms’ share has been increasing as a percentage of total number of deals struck by PE related investments, however their value share is still very low
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Deals below $10 Mn have dominated Indian market over the years
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Financial sector has attracted more investment while IT sector attracted maximum number of deals in last six
years
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Healthcare and consumer staples have been major gainers in 2010
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Average size of deals has picked up in 2010
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Venture capital and Angel investing are concentrated in their top three sectors
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Financial services sector has increased its share of PE investment over last five years
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Venture capital firms have moved beyond predominantly IT to cover more sectors including consumer discretionary and financial in 2010
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Portfolio of angel investors has done an about turn from IT to healthcare
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Exit routes for PE
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PE exits have picked up in 2010 with value of deals already crossing last year’s
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Open market sale has become a prominent exit route over last two years while the share of M & A in total number of exits has gone down
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Buyback and IPO have picked up in terms of deal value
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Roadmap for companies seeking PE
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PE backed firms have posted better results than those not backed by PE
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Private Equity firms bring a number of advantages to investee companies...
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... however, they need to be looked in light of existing
shareholders’ goals and management style
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Companies need to answer key strategic questions before going for PE investment ...
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... and pick the right valuation methodology to arrive
at the value of their business
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What are Private Equity Funds?
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Private equity funds are investment companies that, as a rule, do not trade in publicly-traded securities. Instead, they normally seek equity stakes (that is, partial ownership) in private companies. They may also invest in so-called private placements of securities from public companies. Private equity buyers are extremely focused on cash-flow and have a reputation as cost-cutters.
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TYPES OF PRIVATE EQUITY
1. Leveraged Buyout
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Leveraged buyouts involve a financial sponsor agreeing to an acquisition without itself committing all the capital required for the acquisition. To do this, the financial sponsor will raise acquisition debt which ultimately looks to the cash flows of the acquisition target to make interest and principal payments. Acquisition debt in an LBO is often non-recourse to the financial sponsor and has no claim on other investment managed by the financial sponsor. Therefore, an LBO transaction's financial structure is particularly attractive to a fund's limited partners, allowing them the benefits of leverage but greatly limiting the degree of recourse of that leverage.
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2. Venture capital
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Venture capital is a broad subcategory of private equity that refers to equity investments made, typically in less mature companies, for the launch, early development, or expansion of a business. Venture investment is most often found in the application of new technology, new marketing concepts and new products that have yet to be proven. Venture capital is often sub-divided by the stage of development of the company ranging from early stage capital used for the launch of start-up companies to late stage and growth capital that is often used to fund expansion of existing business that are generating revenue but may not yet be profitable or generating cash flow to fund future growth.
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2. Venture capital
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Entrepreneurs often develop products and ideas that require substantial capital during the formative stages of their companies' life cycles. Many entrepreneurs do not have sufficient funds to finance projects themselves, and they prefer outside financing. To compensate the risk of failure, venture capitalist's seeks higher return from these investments. Venture Capital is often most closely associated with fast growing technology and biotechnology fields.
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3 .Growth capital
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Growth capital refers to equity investments, most often significant minority investments, in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business. Companies that seek growth capital will often do so in order to finance a transformational event in their life cycle. These companies are likely to be more mature than venture capital funded companies, able to generate revenue and operating profits but unable to generate sufficient cash to fund major expansions, acquisitions or other investments. The primary owner of the company may not be willing to take the financial risk alone. By selling part of the company to private equity, the owner can take out some value and share the risk of growth with partners.
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4 .Distressed and Special Situations
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Distressed or Special Situations are a broad category referring to investments in equity or debt securities of financially stressed companies. The "distressed" category encompasses two broad substrategies including: "Distressed-to-Control" or "Loanto-Own" strategies where the investor acquires debt securities in the hopes of emerging from a corporate restructuring in control of the company's equity; "Special Situations" or "Turnaround" strategies where an investor will provide debt and equity investments, often "rescue financing" to companies undergoing operational or financial challenges.
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5 .Mezzanine capital
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Mezzanine capital refers to subordinated debt or preferred equity securities that often represent the most junior portion of a company's capital structure that is senior to the company's common equity. This form of financing is often used by private equity investors to reduce the amount of equity capital required to finance a leveraged buyout or major expansion. Mezzanine capital, which is often used by smaller companies that are unable to access the high yield market, allows such companies to borrow additional capital beyond the levels that traditional lenders are willing to provide through bank loans. In compensation for the increased risk, mezzanine debt holders require a higher return for their investment than secured or other more senior lenders.
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6. Secondaries
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Secondary investments refer to investments made in existing private equity assets. These transactions can involve the sale of private equity fund interests or portfolios of direct investments in privately held companies through the purchase of these investments from existing institutional investors. By its nature, the private equity asset class is illiquid, intended to be a long-term investment for buy-and-hold investors. Secondary investments provide institutional investors with the ability to improve vintage diversification, particularly for investors that are new to the asset class. Secondaries also typically experience a different cash flow profile, diminishing the effect of investing in new private equity funds. Often investments in secondaries are made through third party fund vehicle, structured similar to a fund of funds although many large institutional investors have purchased private equity fund interests through secondary transactions. Sellers of private equity fund investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds.
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7. Buy-Outs/Buy-Ins
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Refers to transactions where private equity managers provide funds to enable current operating management to acquire an existing business (a management buy-out) or to enable an external manager or group of managers to buy into a company (a management buy-in).
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8. Pre-IPO
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In a Pre-IPO investment the private equity manager acquires a stake in the business prior to its initial public offer (“IPO”) and then assists the company to prepare for its IPO and stock exchange listing.
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9. PIPE (“Private Investment in a Public Entity”)
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Is a private equity investment in a company that is listed but possesses similar characteristics to that of a private company. In most cases its shares are seldom traded on the stock market, and the company is not widely followed by financial investors or analysts. As a result, the company does not have ready access to the capital markets to raise new funds. Some private equity funds are focused on investing in one or two of the above categories, while other funds invest across the spectrum of private equity. These funds are commonly referred to as “generalists”.
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10. Private Placements
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In a private placement the private equity manager provides liquidity to existing shareholders through the purchase of existing shares.
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The Stages of Private Equity
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Process of Private Equity Investment
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1. Deal Origination (Deal Sourcing)
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Deal Origination or as some call it ‘Deal Sourcing’ is how Deal Makers get their deals, a potential deal can either come through a company owner approaching them or from an intermediary who will try to bring both parties (Company and Deal Maker) to make the deal. In some cases, they may just approach companies who are expanding fast and wish to grow further. In a year, Deal Makers come across hundreds of potential deals - but only a few are selected.
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2. Due Diligence
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Due Diligence is what you could call ‘doing your homework’. Before starting detailed negotiations, investor try to make sure everything is fair and secure. Although Auditors and Consultants are appointed to conduct the Financial, Tax, Legal and Technical Due Diligence - they also work side by side to understand the target company and its industry better. All the information collected at this time, is then used during negotiation.
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3. Deal Negotiation
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At the Deal Negotiation phase, investor set out the terms and conditions (covenants, representations and warranties) and other deal terms that defines (or makes the deal). Contracts such as Investment Agreement, Share Purchase Agreement, Management Agreement, Advisory Agreement etc are drafted to include all items that put the deal together.
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4. Deal Closing (Acquisition)
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Deal Closing is probably the easiest part but also contains an element of risk. It’s the conclusion of the deal, the signing of all Agreements and transferring funds from the buyer to seller, conducting other administrative functions (usually done by a separate entity) like updating any articles of association etc.
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5. Post Acquisition Monitoring
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Post Acquisition Monitoring requires the Deal Team (those who have worked on putting the deal together) to closely monitor the company, both from an operational and financial point of view against the expansion plan and budgets that were setup earlier by the company. Improvements to business, from Corporate Governance, Financial Reporting, and Information Flow to Strategy are made at each level through either the company’s management or its board.
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6. Exit (IPO, Trade Sale or Buy back)
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As the company matures (usually after 2 - 4 years) with the presence of the Deal Team, investor prepare it for an Exit - either an IPO or a Trade Sale (sale to a larger party, multi-national or conglomerate) or in rare cases a Buy Back by the owners. By this time, the company will have grown quite a bit with still plenty of room to grow further. (There’s a saying, in a deal - always leave something extra for the person buying – it makes everyone happy.) And once investor have exited the company, they return their money with the profit they gained for company after taking their fees for all the effort put in the above process. Although this may seem like a linear process - it isn’t exactly so, primarily because investors deal with a number of companies and each one is at a different stage in the private equity process.
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Ways of Investment
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Ways of Exit
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A. Trade sale
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A trade sale, also referred to as M&A (Mergers & Acquisitions), of privately held company equity is the most popular type of exit strategy and refers to the sale of company shares to industrial investors. The trade sale is agreed in private and makes both the buyer and the seller less vulnerable to the external pressures of a stock market flotation. It is often advisable to keep the transaction a closely guarded secret because clients, suppliers and employees may interpret a trade sale negatively. These negative signals become even stronger if the negotiations fail.
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B. Entrepreneur or Management BuyOut
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The Buy-Out of the funds stake by its management team is becoming more and more successful as an exit strategy. It is a very attractive exit for both the investment manager and the company’s management team if the company can guarantee regular cash flows and can mobilize sufficient loans. The accounting and financial aspects of this exit need to be studied very carefully.
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C. Sale of the investment to another financial purchaser (called a secondary market investor)
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One financial investor may sell his equity stake to another one when the company has reached the stage of development or when the current development of the company no longer corresponds to the investment criteria of the original fund. This can also occur if the financial support required maintaining the company’s development has exceeded the capacity of the fund. This strategy has the advantage of enabling an exit when the team does not want a trade sale or a stock market flotation.
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D. IPO (Initial Public Offering): flotation on a public stock mark
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A stock market flotation may be the most spectacular exit, but it is far from being the most widely used, even in stock market booms. A stock market flotation should correspond with a genuine wish to make the company more dynamic over the long term and to profit from the growth possibilities offered by a stock market. Therefore, the equity share placed on the market (the float) must be sufficiently large to ensure liquidity – the reward for appealing to the market. A flotation is not an end in itself but the beginning of a long process of development. A stock market flotation always leaves company open to the risk of an unwanted bid whereas equity held by an investor that company has chosen can be better managed. If company decides to opt for this route, it must be minutely prepared over a long period.
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E. Liquidation
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This is obviously the least favorable option and occurs when the efforts of the head of the company and the investors to save the company have not succeeded.
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IPOs and public market sales will remain an increasingly important route to exit
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