PE firms tread cautiously after 2008 crisis – ET

Posted on March 18, 2011 by

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Private equity firms, it seems, do not want to leave anything to chance. The financial crisis in 2008 and turbulent stock markets, for the next three years, have forced them to play safe while structuring deals. A great majority of transactions, as high as 90% according to industry officials and lawyers, are fashioned in such a manner that the capital invested is protected against any downside. This is contrary to the popular perception that private equity players are high risk takers.

A typical PE investment in an unlisted company is in the form of convertible instruments – compulsorily convertible preference shares (CCPS) and convertible bonds are the most popular – which can be either redeemed at a pre-agreed price after a period of time or converted into equity at a price linked to future profits of the company.

The essence of such structures is that the downside risk is limited. The usual exit from an unlisted company is through an initial public offer (IPO). If the IPO is higher than the pre-agreed exit price then there is no problem. But the problem arises when the market is unwilling to bear a high IPO price. So, agreements are structured in such a manner that the owner, or the promoter, of the unlisted company will provide a minimum return to the investor. In such a case, the owner or another investor could buy out the ‘original’ PE fund.

“How an actual deal happens depends on what the promoter wants versus what the investor is willing to pay. Sometimes, promoters push a transaction into a complicated structure because they believe that they can get a better conversion price. If a promoter is more bullish about the capital market and thinks he can launch the IPO at a much higher price, or about the company’s financial performance, then they seek such structures,” says PR Srinivasan, managing partner of Exponentia Capital and former-MD of Citigroup Venture Capital International.

Industry observers say that structured deals are most visible in the infrastructure and real estate sector.

While IPOs are clearly the most preferred exit route, the sponsor sometimes has to step in to fulfil the internal rate of return promised to the investor. Choppy market conditions have also forced funds to structure their exits through put, or buyback, options if an IPO fails to happen.

In a put, or buyback, option, promoters purchase the shares back from the investors at a pre-agreed price.

Such transactions have to go through an authorised dealer, which is usually a bank. A bank would require a fair-valuation certificate from a chartered accountant. Obtaining such certificates is not particularly onerous, say industry observers.

“For that extra comfort, private equity investors incorporate a put option in the agreement apart from an exit through an IPO or a sale to other private equity investors,” says Abhay Pandey , managing director of Sequoia Capital .

Between 2008 and 2010 there have been 20 buybacks, with the largest deal being that of L&T Infrastructure Development Projects (L&T-IDPL) buying out JP Morgan and IDFC Private Equity (see table).

PE arms of multinational banks as well as pure-play private equity funds are increasingly seeking such deals. “Convertible instruments provide flexibility vis-A -vis pure equity in structuring the transaction and hence are preferred,” says Bhavesh Shah , executive director of investment bank JM Financial .

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