Story Highlights:
- Hedge funds / Investors specifically looking for a quick flip have exited their investments
-The portfolio company’s management’s digression from agreed plans remains a concern
-Regulation too remains a key concern but there remains potential for investment
I previously covered how the private equity model differs in India and the growing amount of hedge fund money in the country over the past few years. This week, I'll go into further detail about the degree of competition and the effect of corporate governance.
Degree of Competition and Current Challenges
What has happened in the markets in these last two years has created a market with greatly reduced competition since hedge funds/other institutional investors who were looking for a quick flip (i.e. getting out of their investments in less than a year) are not present in the market anymore. Their funds are 90% exhausted and they are now in the market raising new funds. The challenge for PE houses today is to come up with a strategy to differentiate themselves and be more sector focused, as opposed to sector agnostic, in order to sustain and improve returns. The challenge for portfolio companies, on the other hand, is that PE funds may not be invested long enough in the business and, consequently, the implications of their exit. Portfolio companies naturally are concerned with exit implications, especially where there may be “drag along” rights. PE houses could do better in educating prospective portfolio companies and developing strategies early to align their exit interests with those of the owners of the portfolio companies.
Corporate Governance
Taking a seat on the board is a condition that will be required in the Indian PE market in the future. This requirement by PE houses is driven by the fact that corporate governance standards need to improve in portfolio companies.
The single largest post-investment issue is management’s digression from agreed plans. Expansion into unrelated businesses, non-compliance with shareholders’ agreements and deviations from financial performance are some of the examples provided by fund managers as issues of concern post-investment. With increasing competition for deals, there is some urgency to complete the deal and not adequately challenge owners on their business plans. Further, deal teams in India tend to be small and may not have the breadth and depth of sector specialization to adequately challenge future plans. Therefore, to minimize the risk of overpaying for the deal, funds need to conduct robust due diligence on management’s future plans. An absolute priority for PE firms is to ascertain that the accounting books of potential portfolio companies are clean. Post the collapse of Satyam, the scrutiny should be even more.
There is a general market perception that PE portfolio companies should adopt better corporate governance practices, which would help command a better stock market price at the time of the IPO. Some PE houses act as a catalyst in bringing about a change in auditor to a Big Four firm. Others help educate management regarding the benefits of implementing IT systems, etc. Yet some are reluctant to press management on these changes as the PE holding is a minority investment. The survey findings suggest that PE houses could increase their involvement in acting as a catalyst of change for improving corporate governance
Conclusion
Regulations appear to be a key concern for PE, as are restrictions in investments in certain sectors such as retail, insurance, banking and finance, and others. Although tax is seen as a key regulatory concern, India’s current tax regime for PE investment is actually more favorable than several other emerging economies' regimes.
In times like these, finding companies with lower valuations should not be difficult. The overarching theme for Indian PE today is finding the right, reliable partner. Also, there should be flexibility in exit mechanisms so that if Plan A fails there is a Plan B, there is a Plan C. Since ultimately all PE investors need to exit, they need to make sure that they have the right structure where they can exit and also earn a premium. There should be no pressure to exit if the desired premium is not being achieved. Investing into companies with strong corporate governance is critical, if you wish to have a more stable sustainable private equity model for India.
