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

Parameter	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	Low	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.

Lessons learnt from value act capital

“We prefer No. 2 or No. 3 in consolidated industries with stable, predictable cash flows”

-          Jeff Ubben, Value Act capital

Active value investing:

Jeff Ruben sums up in this interview sums up his approach in fairly easy terms:

•  Buy from an uniformed seller at a significant discount in the public markets
• Clean up the business and improve public perception
• Sell the whole or parts of the business with the support and co-operation of management

How his approach is different from others?

Public shareholding, private actions

• Low profile: Unlike other activist investors like Carl Icahn or Bill Ackman, who are in the headlines practically every day, Jeff Ubben has maintained low profile and believes a lot more in silent, behind the scenes dialogue with the board and management. Having been a private market investor, I quite like this approach.
• Co-operation with passive investors: Unlike corporate raiders like Carl Icahn, whose views are typically the diametric opposite of the existing management and the passive shareholders, Jeff Ubben and his team have a unique ability to build rapport with everyone.
• Team orientation: Unlike other hedge funds which are helmed by a public, visible superstar, Value Act has six partners, four of whom have been together since the beginning. This also shows in the rapport they build with the rest of the board members

Investment thesis:

·         

•  Underdogs in consolidated industry: Prefer to focus on mature industries that are consolidated with stable free cash flows.  This allows for even small movements to result in a disproportionate movement in profitability, cash flows and consequently, shareholder value. This was quite a revelation to me - think of pepsi (not coke), think samsung (not apple) - for all you know the No.2 might be better at execution and hence at growing shareholder value - since there is no pressure to keep up market leadership and often this means, the tougher, costly lessons of innovation could be left to the market leader.

•    Focus on IP/brands: Jeff Ubben likes strong franchise businesses that have minimal SG & A costs year after year.  Case in point being, Microsoft (Value Act is bullish on the Microsoft enterprise business that includes servers and tools). This operating leverage ensures that turnaround is quick and adds to disproportionate increases in profitability and cash flows - FCF, especially.

•  Patient accumulation of stake:  It takes more than a year for them to accumulate a 4-5% stake (which necessitates filing a 13-D).

• Focus on getting “welcomed” into the board room:  This allows them to focus on getting information only privy to the board which helps make informed, evolutionary decisions that carry the stakeholders along.  

Post investment Action:

Separation/restructuring leads to value creation:

Often a lot of companies are bucketed into different categories – For eg., in Value Act’s own words, Microsoft has been branded as a “PC growth led” business. The market completely ignores the value attached to its Enterprise division – Servers, sharepoint, software which is an incredibly sticky, high margin, recurring revenue business.

Value Act, in my opinion, simple provides for better visibility into the crown jewel  - this could be done through spin-offs, selling the loss leaders (that drag down the profitability of the overall company) or restructuring the management (grapevine has it that Value Act pressured the board to find a replacement for the legendary Steve Balmer).

Sample portfolio companies:

Name of company	Thesis	Value Act’s action to unlock value
Mentor	Leader in breast implants	Professionalize management Sell urology business
Catalina marketing	Monopoly in gather Point of Sale promotions – coupons, mobile apps. Undervalued because of accounting issues related to revenue recognition	Created strategic interest for the company and resulted in company getting bought by Hellman & Friedman – a digital marketing firm
Allison transmission	Market leader in the automatic transmission space for large CV’s, mining, fracking and buses	Non activist thus far- play on the revival in heavy commercial vehicle markets in North America

Lessons to learn from Value Act:

The interview and the consequent research I did on Value Act was quite an eye opener to me. It made my universe that much smaller - a No. 2 or No.3 in a consolidated industry has everything to gain and much less to lose,making the risk-reward equation asymmetric. Also, hopefully, given the learnings from the leader, the No.2 or No.3 should have an easier job of execution resulting in superior capital efficiency. The lessons I learnt are:

•  Focus on the No. 2 or No.3 in  consolidated industries – such companies trade a significant discount to the leader  and often, offer better value
• Look for strong franchise businesses that can grow with very little incremental capital

The big short – the need for an externality in a short

“In the short run, the market is a voting machine. In the long run, it is a weighing machine”

Said Warren Buffet.  

However, what he did not say was not quite how long the short run would last.

Given the froth in today’s market and how “concept stocks” like Tesla, Netflix continue to scale new highs.  In an artificially created world of euphoria , (The Truman show as Seth Klarman calls it), it is easy to get burnt by short positions.

Again, as someone who is endlessly interested in the intersection of philosophy, physics and finance (read that as behavioural economics), I find it extraordinary as to how the market for a long time continues to “vote” for “talk” rather than the “walk” – viz., valuations increase with announcements and introduction of concepts/prototypes, no matter what the impact on cash flows)

• The market is ultra focussed on one metric that it tracks – all else, is irrelevant. For Amazon, it is revenue growth (no matter what the cost of the growth), for Netflix (it is the number of subscribers), for Tesla (the number of new cars)
• The CEO is a visionary and has had past success – there is a “halo” bias. Infact, a study that was run earlier showed that CEO’s who look good, talk glibly and can talk the language analysts want tend to push up stock prices higher (now, isn’t that obvious ?)
•  The business model has operating leverage because :
•  Network effect
• Creation of  a strong brand
• Marginal costs of servicing are ostensibly low no matter how high the cost of acquisition  (how many SaaS companies that burn money to acquire customers are eventually believed to become “cash flow” fountains once operating leverage kicks in)
• At one point, there is a serious threat of the company taking over the world. Think of all the "high fliers" at one time - Web van at one time threatened to wipe out all retailers, AOL was touted as the dark knight that would wipe out all media houses.

One of the bitter lessons that I learnt from my experience of shorting “high momentum, high growth stocks“ is that they enter into what George Soros calls the “zone of reflexivity”.  Where new actions reinforce the earlier actions resulting in the stock price climbing higher and higher.  

This results in one of the greatest paradoxes that you will see in stock market history – fundamentals driven investors get burnt, get out only to see the stock coming down finally.

Why does it happen?

While in the long run, a stock price is determined by fundamentals, on a day to day basis it is determined by the transient demand and supply. As long as there is someone (“the bigger fool’s theory”) to pay higher for the same piece of paper, the price would climb and vice versa.

The wisdom of crowds - "Crowds do not listen"

The trouble with that is that investors have a huge herd mentality (much like the Great Beest migration) and it is easy for a lion or a tiger to get crushed by the sheer momentum of the beest. Modern day philosophy too espouses the same thing  (Charles Mackay’s  book – Extraordinary popular delusions and madness of crowds)

It's warmer and safer inside the herd !

         "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

So what’s the solution ?

Is the momentum broken ?

No matter, how tempting it is, I have learnt never to short a stock unless I am sure that momentum is broken.  Ironically, the answer might lie with technical analysis and a little bit of common sense.

External validation & discountinuities

Look at what happened with the recent Herbalife tug-of-war. Each point of discontinuity comes whenever there has been a material event that has led to a loss of momentum. If FTC is investigating herbalife, the stock falls 3-4%. If its has been cleared, it goes up 3-4 %. Have the fundamentals changed ? Not in the least.As a corollary, I have found that it is easier to short a stock which has far more externalities than one that operates in a free market.

Cases in point :

• Regulatory interference : Herbalife – which operates in a regulated industry and comes under the purview of FTC and the business model comes under the laws of the land
• 
  
• Quantitative externality: Allied capital/Lehman – financial services companies intrinsically have a lot many linkages that makes it easier for the market to sense triggers that can break momentum. For eg., increase in cost of funds (which happened when markets froze in Sep ’08),  ability to validate the value of an investment from external sources (like David Einhorn did with the portfolio of allied capital).
•  
• Fraud/misconduct:  Even in case of shorts, often the most profitable ones have been fraud/misconduct. In most cases, frauds/misconducts are the lids that keep the “blackbox” of secrets closed (because frauds by their very nature are ones easy to establish). These often are the key points for reversal of momentum that allows for gravity to take over and allow a falling knife.

This gets compounded by the fact that shorts are typically for a year and have to be rolled over frequently. In a summary, it might actually be worth it to follow:

·         An activist investor (who can expose the flaw – Einhorn in Allied/Lehman, Ackman in MBIA/Herbalife)

·         Wait for break of momentum (material event that is bound to cause irreversible damage to the fundamentals – eg., adverse preliminary findings from a FTC probe, margin calls/cost of funds going up for a financial institution)

And then jump in to the short.

If ever there were reasons to follow a "falling knife" (unlike the conventional worry about "catchign a falling knife"), a big short would be on.

In summary,

"Never ever short a stock just based on valuation. The market can stay irrational for longer than you can stay solvent. Remember to use the wisdom of crowds to your advantage."

Capital raising & law of diminishing returns

An article that I had published on my one of my passions - Capital efficiency got published in :

http://www.beyondproxy.com/law-diminishing-returns/

I feel humbled to be recognized by Beyond proxy - "The manual of ideas" is a valuable website for all fundamental driven investors.

I hope you enjoy the article and my thoughts. It intrigues  me how little emphasis is paid to if the company can continue to deploy capital at rates of return above the cost of capital. This is often a key factor while companies that continue to grow topline/revenues eventually get strapped for liquidity/bankruptcy.

Combined with the analogy to Heisenberg's uncertainty principle, a lot of investors pay a lot of attention to growth (of EPS, topline) but seldom to capital efficiency. Remember that if you are making a 1000 mile trip, it is not just the speed of the car that matters, but also its fuel efficiency and consequently the time and effort spent on pit stops.

Heisenberg's uncertainty principle - applied to capital allocation

I was fortunate to have read Howard Marks's The most Important Thing and I was impressed by the graph he had sketched out was how well it ties into some of the basic principles of physics that we are all aware of.

It's no secret that one of the issues that investors deal with is the ability of a company to take on capital and continue to deploy them at high rates of return. Taking out the market risk and focussing only on business risk, risk could be defined as the uncertainty of the business to deploy capital at the expected rate of return.

So, this risk depends on the following ?:

- the capital at work
- the ability of the business to soak up the capital


However, things get complicated in an IPO/private placement (we're talking primary here) because of the dollop of capital that comes in, that adds to the liquidity. Think of it as a pit stop in  a Formula 1 race - discerning viewers of Formula 1 would know that there is a distinctive change in pace post a fuel stop and change of tyres.

Remember that a slackening of pace immediately after a fuel stop does not mean that there is a loss of advantage - quite the contrary, cars/teams that have the ability to time pit stops well and decide upon the right frequency for them, have an ability to pull ahead when it finally matters.

Oh wait - is'nt that what Heisenberg's uncertainty principle is all about - that the mass and the position cannot be determined at the same time (as the video shows below). Translated in a financial context, it means that balance sheet and P & L cannot be projected accurately at the same time Or, more importantly, RoE and growth rate of RoE which are the two levers that generate shareholder value cannot be measured in tandem accurately.


http://www.youtube.com/watch?v=a8FTr2qMutA


No wonder, that IPO's and private investments have a much higher risk attached to them. All else being equal, the investor has to understand the company's incremental RoE even as capital (fuel ?!) is pumped in.

Sort of like measuring the velocity of a car even as the car is being refuelled. Too fast, you loose fuel efficiecy and too slow, you loose momentum/speed.

There you go , another risk unravelled, at the intersection of strategy and risk allocation.

The myth of industry size and growth in strategy/capital allocation

One of the most pressing questions that I come across is the importance of industry size and growth in making a capital allocation decision.

For eg., would you invest into a company that is making healthcare IT in the US (in the light of the healthcare reforms) or  into an ebay challenger in an emerging market like India ?


In each of these cases, the novice investor in me would gravitate towards how big the industry was, how competitive the field was and how fast it was growing etc. That was, until I saw the TED lecture by Daniel Kahneman and understood the power of patient, deliberate, second degree thinking.

I realized that looking at the market size and growth, while being important, is akin to an aspiring sportsperson looking the size and the spoils of the established athletes in the sport before plunging into it full time. So, would you choose cricket in India, because it is a much bigger sport than kabaddi ? By the same logic, Tendulkar should'nt have chosen cricket. After all, did'nt he take up tennis watching John McEnroe win Wimbledon in the early 1980's.

Myth : The larger a market, the more shareholder value it creates

What matters a lot, lot more is your own skill sets, capabilities and passion for the sport. Some of the greatest businesses happened from "inside out" entrepreneurs - Bill Gates of Microsoft wrote something that gave him joy, Warren Buffet tap dances to work because he loves investing and Google was created because Larry Page/Sergey Brin felt they could organize information in a way hitherto never done.

What matters a lot more is how " consolidated"' the market is - viz., how differentiable the various competitors are within that segment.

This reminds of the famous quote by Warren Buffet, at the peak of the 1999 dot com bubble, ostensibly justifying his decision not to invest into unprofitable, dot com stocks:

"The physical growth prospects of an industry do not necessarily have any correlation to shareholder returns. If that was the case, the US automotive industry would have generated more than the ZERO return it generated over the last century as it grew a million-fold. "

This is especially true of industries which exhibit one or many of the following characteristics :

- Low switching costs (eg., small box retail)
- Commoditized production (unbranded textiles, non-rare commodities)
- Low degree of differentiation ( eg., e-commerce retailers)

What, it seems, then matters is skill sets and competence, MORE than the market and the size and the growth of it.

This was, more than ever, the case with several buy-outs/acquisitions - a fact I was quite late to recognize. As this excellent article, points out, this is a fact that can be overlooked by even the best minds - including the world's greatest management consultants and thinkers.

So, there it is, the moat around the castle is far, far more important than the size of the castle itself - a lesson that will stick with me always.