Friday, August 15, 2014

Indian Private Equity - Control deals - watering the weeds

Shareholder value

It is a well-accepted fact that shareholder value gets created ONLY by two parameters :

  • -          Return on Equity- the efficiency with which capital is deployed – viz., the spread above the risk-free rate of 10% in India
  • -          Growth in earnings – the rate at which earnings and hence the absolute return on invested equity grow

Every single long term trend corroborates this fact and this is the underlying thesis of fundamentals driven investing. For example, TCS is a great business because it has a RoE of 33%% (excluding surplus cash) and grows its earnings consistently in the 15-20%.

Indian PE  - Strong correlation to high PE owned stakes and a decline in RoE  - A serious concern- decreasing capital efficiency

A quick run through of PE funded companies with revenue range of $ 5-$ 30 mn range (at the time of funding) over the last five years (viz., funded since Jan 2007) shows an RoE fall of at least 400-500 bps from before the time of funding (viz., comparison of the highest RoE achieved post funding to the RoE of the company in the full FY prior to the funding).

This problem is especially acute in the mid-market buy-in (not “buy-out” or secondary capital) universe with RoEs. Too understand this better I did a quick analysis of the earnings growth and RoE’s  and also ROCE of all “buy-in” investments owned by PE funds in the mid-market space (Atria Cable, Meru,  etc).  To allow for the watering down of the above because of the “J-Curve effect”, I looked at the highest RoE/ROCE recorded in the first 5 years/take a realistic projection of where the RoE would likely to be at.

 The result was  particularly intriguing given that buy-out funds are usually famous for investing into profitable, stable and rising cash flow assets (eg., Warren Buffet’s buy-out of Heinz, Burlington Rail Road etc.) – In India, it squarely seems to be the other way round (low profitability, Return on Equity lower than Cost of capital, Negative Free Cash Flows etc.)

Significant differences between Western buy-out funds and Indian buy-in funds

Buy-out funds
Buy-in funds
Business models
Steady, high Free cash flow generating assets (eg., FMCG, tobacco). DO NOT need any equity infusion
Low EBITDA margins; Still significant concept risk;
Deal logic
Going private to make long-term investments
Building scale & profitability
Cash flow
Extremely high Free cash flow yields
Negative free cash flows – often require substantial amounts of capital to grow.
Intrinsic value
High- usually buy-out targets have most or all of the following :
-          High cash balance on books
-          Strong Free cash flows
-          Dividend payment history
-          Strong tangible/intangible assets ( brands, distribution etc.) at historical values
-          Strong governance (history of returning cash to shareholders)
Low – very risky.  Often have :

-          Low sustainability
-          Negative free cash flows
-          Unproven concept (negative operating cash flow)
-          Typical early stage governance issues

Execution risk
Extremely high
Financial risk to shareholders
Low – since the company is typically profitable, already has sufficient cash in books and has a stable growth ahead

Extremely high – potential threat of bankruptcy/stalling high since there is a combination of business model risk (basic profitability), execution risk (scalability) & organizational risk (governance)

The few trends that can be gleaned from here are:

  • -          These companies had profitable business models/were close to profitability at the time of investment. The underlying RoEs could at best be described as modest (ranging from negative to 15%)
  • -          These companies are trying to consolidate a large, fragmented market but have extremely low market share (ranging from 0.5% to 3%)
  • -          The money that was invested into was often 6-10 times the book value – much higher than what one would have been able to raise from capital markets – quite surprising, that this much capital has been committed
  • -          RoEs fell massively fairly soon after the infusion. In a good number of cases, even  4-5 years after the infusion they continue to remain negative with no visible clear uptrend. This is very surprising given that all of these are services/product businesses that require no significant IP/R & D/capital expenditure upfront.  What should have been a normal J-curve looks like a L-curve. It is worthwhile to note that even highest RoE’s recorded even 4-5 years post investment are significantly less than 10% - the minimum cost of capital.

I am now, not surprised that a lot of these companies are staring down the barrel  with no capital market exit in sight- with such low RoCE's and RoE's it seems to be a case of capital mis-allocation - pumping dollops of capital into cash hungry, unprofitable business models. 

In the next post, I will look at reasons why M & A exits would look like by comparing these business models to western business models.

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