In the context of the very unfortunate demise of V.G. Siddhartha, some unfounded aspersions have been cast on the construct and functioning of the private equity (PE) industry. Given the preponderance of institutional investors and the intense diligence and regulatory scrutiny under which this industry operates, the reality is that it is one of the cleanest financial services businesses which operate globally.
Private equity is a phrase, which encompasses a wide array of financial activities, and is as broad a term as manufacturing. Different PE companies adopt different strategies customized to their investor risk and duration tolerance profiles, the underlying opportunity set, the regulatory framework prevalent and the teams’ DNA and strengths. Venture debt, venture capital, minority growth investments in private companies, PIPEs (private investment in public equity), control transactions, buyouts, leveraged buyouts, high-yield illiquid debt, debt with warrant structures, listed investing with growth acceleration or governance intervention, etc., are multiple engagement models, which are all collectively labelled as “private equity".
In an Indian context, over 90% of the cumulative capital deployed is venture growth (and bedrock of the startup ecosystem) or private growth and the PE player will typically make their return because of accelerated and disproportionate pace of growth of the partnered company.
This usually involves the facilitation of and catalyzing creation of meritocracies, incorporating best global governance and sustainability practices, adoption of the latest technologies and managerial intervention to drive best-in-class productivity. This results in significant job creation and concomitant societal benefits.
In the West, the main driver of return typically stems from the disproportionate leverage on the partnering companies’ balance sheets and relatively lower societal benefits. All models of PE, other than control buyouts, typically involve dealing with illiquid situations.
Since investors into PE companies invest for a fixed duration, the PE fund manager has to necessarily negotiate a path to liquidity with the entrepreneur with whom they partner. As a rule, the wider the pool of accessible buyers, the fairer the price realization that the PE player can hope to realize.
Usually, a path to increasing the potential pool of buyers is negotiated with an entrepreneur and some safeguards are built into the agreements in case the entrepreneur does not deliver upon the agreed actions. Buyback arrangements, where they exist, are usually the last recourse in a PE agreement, when the entrepreneur hasn’t fulfilled his commitments to enable the PE fund to achieve liquidity. Sadly, in an Indian context, where courts take forever, such constructs are essential for a PE player to assure its investors that it will be able to return their capital within the time frame that they have been given.
Sometimes, entrepreneurs need equity capital, but want to capture a significant part of the upside for themselves and in exchange offer higher downside protection in what amounts to a structure, where they buy calls and sell puts. This taken to the extreme can end up with a pay-off profile akin to a high-cost borrowing. Very risky, especially when it’s premised upon expectation of rising valuations, and not on cash flow. Works brilliantly for an entrepreneur when all goes right, but can have devastating consequences when things don’t turn out as anticipated.
The high reputation risks that PE firms expose themselves to, by operating in an environment with a poor culture of governance and the typically high-entry valuations driven up by an over-banked market and the increased effective taxation burden, have already diminished access to this value-added capital in the local ecosystem.
It’s worth reflecting upon the extent to which the social stigma attached to business failure and the tendency to criminalize the same, can exert serious stress on an entrepreneur dealing with an already stressful circumstance. Add to that a predisposed hostile tax administration, less-than-transparent dealings with the political ecosystem, underreported and underdiagnosed mental health issues, and you have the making of a human tragedy.
Rahul Bhasin is founder and managing partner of Baring Private Equity Partners India.