Ask Mint | How do private equity funds raise money for mammoth buyouts?

Ask Mint | How do private equity funds raise money for mammoth buyouts?
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First Published: Mon, Sep 10 2007. 12 11 AM IST
Admirers call private equity (PE) funds “the new kings of capitalism”, whereas those who hate them call them “barbarians at the gate”. Our friend Johnny is not sure why PE funds arouse so much interest. Are they really kings? Or are they some sort of mischief-makers working behind closed doors? As usual, Johnny has no answers. He starts a discussion with Jinny to find out.
Johnny: Hi Jinny! I hope I am not disturbing you, but I wanted to ask you something. I want to know what kinds of businesses PE funds are into. Of late, I am seeing a lot many regulators taking interest in their private affairs.
Jinny: Regulators are always busy sniffing around something or the other. That is part of their job. But I will tell you a few basic things about PE funds. PE funds, true to their name, like to do their business privately. This is not because they have some sinister design, but mainly because private businesses provide them better flexibility. PE funds, as a part of their strategy, invest in unlisted companies. In case the company is already listed, they get the company delisted after the acquisition.
There are many advantages of investing in an unlisted company. First, an unlisted company is not required to make many disclosures. For instance, an unlisted company is not required to publish its quarterly results. It is also not subject to any listing rules. So, you do not have to worry about a regulator poking his nose in to see how many independent directors you have on board.
Further, the value of investment in an unlisted company is not subject to day-to-day fluctuations in the stock market. The value of investment depends on the long-term performance of the company. So, PE funds can conveniently focus on long-term goals. For these reasons, PE funds opt to invest in unlisted companies. They not only bring in capital, but also management and technical inputs for improving the performance of the company.
Johnny: Well, there seems to be nothing wrong in what PE funds have been doing. But, tell me, how are they able to raise funds for mammoth buyouts of companies?
Jinny: PE funds do not raise funds publicly like mutual funds. Their entire investment corpus is collected privately, and is used for making investments in unlisted companies. Other than their own funds, PE funds are also famous for using the technique of leveraged buyouts (LBOs) for making big-ticket acquisitions.
LBO is a complicated term for something very simple. I will give one example to explain it. Suppose I want to purchase a company having assets worth Rs100 crore by paying a price of Rs125 crore. In a leveraged buyout, I mortgage the assets of the company with some financier or bank and take a loan of Rs100 crore. In this way, I have to spend only Rs25 crore from my pocket for purchasing the company and the rest of the cost is taken care of by the loan. The repayment of the loan and interest is taken care of by the cash flows generated from the business. This whole technique of acquisition through loans is called LBOs in business jargon.
This kind of leveraged funding has become very famous—not only among PE funds, but also among acquirers of different colours and sizes.
Johnny: I have a silly question in mind. Why would anyone pay Rs125 crore if the assets of the company are worth Rs100 crore only?
Jinny: The price at which you purchase a company depends not only on the value of its lands and buildings, but also on many other factors. There are many intangible things, such as the value of the goodwill enjoyed by the company in the market, the future earning prospects of the company, and so on.
You should not be surprised if somebody buys a company at a price that seems higher than the price of its bricksand mortar.
Johnny: Thank god I don’t have to think about intangibles while purchasing my rations, otherwise I would never be able to arrive at the correct price! Anyway, tell me, what do PE funds finally do with the companies they acquire?
Jinny: Well, PE funds try to turn the fortunes of the company around by providing better management and technical inputs. They are famous—or should I say infamous?— for stripping costs and streamlining operations through hard decisions such as retrenchment of the workforce. Once the company is successful, they float the shares to other investors, mostly through initial public offerings (IPOs). In this manner, they earn handsome returns on their investments.
Johnny: Wait a minute, you have never talked about IPOs before. What’s that?
Jinny: Well, it’s now time for me to actually attend to my private business. We will talk about IPOs some other time.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at realsimple@livemint.com
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First Published: Mon, Sep 10 2007. 12 11 AM IST