What is Private Equity?
Private Equity Firms are a type of an Alternative Investment Fund managed by the General Partners. The primary contributions to these funds are made by Limited Partners such as HNI’s, Institutional Investors and Sovereign Wealth Funds. PE Firms majorly invest in private companies, or in some cases take public companies private after investing in them. Their approach often involves acquiring a majority stake within the company with a drive to generate substantial profit growth.
Unlike Venture Capital, which focuses on early-stage companies, PE Firms tend to invest in companies which are more mature and preferably debt free. They enter with a strategic plan, generally laid down for the next five years and have a defined exit strategy. Over the years, with aggressive strategies and the hunger to generate return on investments, General Partners have created value for investors and have improved the working of the target company.
Rise of Private Equity in India
In recent years, the importance of PE Firms has significantly increased. In 2022, Private Equity deals in India reached its all-time high with a mark of USD 70 billion across 2000 deals. Several factors, including better practices, more access to data, enhanced due diligence and technological advancements have been the prominent reasons for the rise of PE in India. Private Equity has been a major factor in contributing to the GDP, generating wealth for its investors and driving up the target company’s value.
What do PE Investors Look For
Private Equity investors seek specific characteristics in the companies they choose to invest in. Below are the major factors that attract PE funding:
1. Model of the Business
Private Equity investors invest in a business with the sole motive to earn high returns over a definite period, that is why they want to invest in solid business models. They look for businesses who can eventually expand their operations or develop new products and enter new markets. The business model should be flexible enough to adapt to changes in the dynamic market.
2. Historical Success
A solid track record demonstrates that the business knows how to succeed. PE Firms prefer the companies who have shown strong performance over time by reflecting steady growth in revenue, profitability or customer base. A strong historical performance should be reflected in a clear pattern of growth and effective management. Historical success not only highlights the potential for continued success but also reduces the potential of risk.
3. Strategies
Investors look for companies with a focused strategy outlining specific goals, growth plans and steps required to achieve them. When we talk about the strategies to be made, it is not just a simple list of what needs to be done in future but rather a detailed plan or strategy like a launch of products or diversification into some new sector or entering any new market. It is also not smart to have too many strategies making the investor think that the company is not focused rather the investor prefers companies with a sharp vision that understands the company’s objectives and the way to achieve them.
4. Experienced Management Team
Having a strong management team is essential for attracting investment from Private Equity. Developing clear plans and strategies is just not enough, a management team with a past record of success, can successfully execute these plans ensuring the longevity of the business. A strong experienced team with a clear vision can make all the difference in turning a company around or scaling it for growth. PE Investors will try to find the team that can drive innovation and execute the strategy effectively while ensuring that profits are achieved in the long run.
5. Sector Agnostic
PE Funds are specialized alternative investments fund having their industry expertise. It is important for target companies to conduct thorough research and reach out to those funds where there is a possibility of working together, eventually having a higher chance of receiving the funding. Investors will want to see synergies between their portfolio and the target company, which can unlock additional value post investment.
6. Future Financial Performance & Stability
A company with strong financial performance, having increasing revenue with healthy profit margins catches the eye of PE Investors. Being profitable is not enough, to fund their deals PE Investors generally take on huge amounts of leverage and to ensure that necessary payments are being made, they prefer the companies to be cash flow positive. They use the cash flow to make the payments on debt and reinvest them to the company to achieve hyper growth.
7. Knowing Your Customer
As the PE Investors are revenue and profit driven, it is important for the target company to have the data and insights ready such as which customer drives the maximum revenue, what is the cost to acquire new customers and what could be the potential of selling new products to these customers. Having data and insights of customers readily available can significantly provide a competitive advantage over the competitors.
8. USP
A company should have a USP whether it be in the form of product, technology, IP, branding etc. A clear USP helps the company to distinguish its brand from its competitors and provides a foundation for long term success. PE Investors are looking for companies that can leverage their USP to gain market share, build customer loyalty and outperform their competitors in the long run.
9. Risk Management
Every business face risk- whether it is competition, regulatory challenges or market volatility. Private equity firms are focused on whether these companies can manage these risks effectively. Risk management is necessary for the longevity of the business. Investors look for companies who have strategies like contingency plans for economic downturns, regulatory challenges etc. effectively placed.
10. Scalability
Private equity firms want to see that a company is operating in a stable market with significant growth potential. This means operating in a stable market with opportunities to capture more market share, expand into new markets, or launching new products. PE Firms wants to see that the company has plans for scaling up and growing rapidly.
Actions like expanding products or services, diversifying the customer base, building strategic partnerships, and improving customer experiences will all help attract private equity investment capital.
11. Significant Ownership Stake
Private Equity firms typically seek a substantial ownership stake in the companies they invest in, allowing them to influence key business decisions. The Ultimate Goal for a PE Investor is to sell the company for a profit. To achieve this goal, they want a seat at the table to take the influential decisions. This is the major reason why PE Investor wants a significant stake in their holding companies.
12. Full Transparency
PE Investor conducts a detailed due diligence report on the target company. This is one of the most crucial steps of the deal. The company should prepare clear financial statements, accurate reports and ensure that complete transparency has been followed, which can help the investors make better decisions. Any lack of transparency or hidden risks can make investors change their decisions.
14. Exit Strategy
PE Firms don’t plan to hold onto their investments forever. Before investing in any company, PE Investors lay down a detailed future plan outlining their exit strategy and predicted return on investment. Whether it be an IPO, sale of the business or a merger with a larger group. For the target company, it is important to be aligned with the investor’s exit strategy and understand how it fits into the broader business plan.
Strategies and stages at which Private Equity Invests
Private Equity (PE) Investments have become widely popular because of the high returns generated compared to the other investments. The major reason for the success of PE Investments has been their unique, tailored strategies designed for different businesses. While the specific approach may vary from company to company, PE firms share a common goal to generate significant returns over a fixed investment period.
Below are some key strategies executed by PE Firms:
1. Growth Capital:
PE Firms having a growth capital fund tends to invest in businesses which are mature enough to expand their business with plans to expand either with a new market entry, product diversification, or restructuring them to significantly reduce the costs and improve profitability. The ultimate goal for the PE firms is to achieve maximum return for its investors by ensuring the company achieves its maximum potential.
2. Venture Capital:
Where the growth capital funds prefer to invest in mature businesses, venture capital firms invest in early-stage startups which have high potential to outperform the market in the future. The most important factor while investing in early-stage startup companies is due diligence. It helps the investor understand the company operates, potential sources of revenue, assets and liabilities. Having all this information, VC firms develop strategies on how to nurture and groom these young companies and take the exit through acquisition or an IPO.
3. Leveraged Buyout:
A leveraged buyout is when an investor acquires a controlling stake in a company using significant debt. In this strategy, PE Funds looks for companies with less or no debt as the debt taken by them to acquire the business is secured against the assets of the company, with the aim to be paid with future higher profits.
4. Distressed Investing
With this strategy the PE Funds look for companies which need liquidity as they have defaulted on their financial obligations. The aim is to purchase these debt instruments at a discount and gain control over the company’s operations. The plan is to restructure the company, turn it back to profitability and take an exit while maximizing the return for the investors.
Importance of PE Exits and different Exit Strategies
A private equity fund consists of General Partners (GPs), who manages the fund and its investments, and Limited Partners (LPs), who are the investors providing in the fund. General Partners work on management fees and incentive fees (also called carry) depending on the return generated for LP. The limited Partners earns the returns generated by the GP’s.
Usually, the life for a PE Fund is 5 to 7 years, in some cases a maximum of 10 years and after that they must liquidate their investments. Throughout the life of the fund, LPs generally cannot withdraw their capital but at the end of the Fund’s life, they are entitled to receive their share of returns on investments. If the GPs fail to liquidate the investments within the specified timeframe, penalties may be imposed. This makes it extremely important for the GPs to plan an exit strategy before making an investment.
Let’s discuss some of the most popular exit strategies:
- Strategic sale:The GPs exit the venture by selling the company to a buyer who has a strategic interest in the business and wants to build the offering in its ow business.
- IPO:Initial Public Offer is considered as one of the best exit strategies. It requires Private Equity to float the company on the stock market and liquidate their investment from the proceeds.
- Liquidation: If the company doesn’t perform as per the fund manager’s expectations, the last resort is to file for bankruptcy and liquidate the company to pay its stakeholders.
- Secondary Buyout: It is the route where the company continues to stay within the PE circle, but some other PE Firm acquires the company.
- Secondary Market Transaction: Another contemporary route is to sell the company to other financial institutions or buyers in PE secondary market.
- General Partner - led Secondaries: Another exit strategy which has been in existence for quite some time but gained maximum attraction during the covid period when liquidating the companies became difficult. To avoid paying penalties, the strategy became popular, where the general partners used to form another fund and raise proceeds on it. Those proceeds were used to purchase the venture from their previous fund. This strategy was also called ‘Selling to Yourself’. The strategy helped:
- To avoid the penalty fees because of delayed exit
- Giving the investors the opportunity to take an exit or continue to be the investor eyeing the future potential of the company.
- Also helped the general partners to maintain their management fee.
Private Equity Firms in India
Few International Players with presence in India are:
- KKR
- Bain Capital
- CVC Group
- Blackstone
- Everstone Capital
Few Domestic Players are:
- Kotak Private Equity
- Chrys Capital
- ICICI Ventures Fund
- CX Partners
- IDFC Private Equity Fund
Additional Considerations While Selling to PE Funds
- While selling the company, the target company should not expect to maintain a majority stake as it is a pre-requisite for PE Investors to take the controlling stake within the company.
- There might be PE investors who might look to change the compensation structure by awarding more equity to the management, emphasizing their value and contributions to the firm’s growth.
- While some Investors might be growth driven, there can be the ones who are for other purposes like selling out assets, leveraging the business, restructuring to reduce costs significantly etc. It is important to identify the reasons for Investor’s motivation.
Conclusion
Private Equity firms are very specific when they are looking to invest and not every business aligns with their criteria. The considerations mentioned above do provide a solid foundation of what needs to be done but the list is not exhaustive as the process involves many additional factors unique to each deal. Our team of advisors can guide you through the complexities of private equity funding. If you are considering PE Investment, reach out to us to explore whether this path is the best fit for your growth strategy.
