Private equity (PE) investments in small-ticket deals are on the rise. Experts say funds prefer deals below $15 million (Rs 80 crore), especially in smaller towns, as the risk factor is low and it provides better exit options. Early-stage companies are not affected by markets and certain trends are working in their favour, they add.
Some PE companies increasing their investments in non-metro areas include Motilal Oswal PE, Baring PE Partners and IDFC PE, according to reports. A decade ago, PE investments were limited to the top five cities. Now, they are spread over 40, including tier-II and tier-III cities.
According to Ernst and Young (E&Y)’s second quarter report on the PE investment trend, the average deal size in the second quarter this year did not experience any significant change from the previous quarter. However, a year-on-year comparison indicates a sharp decline (30 per cent) from the same period last year.
While the number of small-size deals (below $10 million in value) have been consistent over the last five quarters, large-size transactions (greater than $50 million in value) have dipped substantially.
The number of mid-market deals ($20-50 million) have also been reduced by more than half from the level seen in the second quarter of 2011, says the E&Y report.
The median deal size declined significantly in the second quarter of 2012 (59 per cent fall from $15 million in the second quarter last year and 45 per cent from $11.2 million in first quarter of 2012). The decline reflects decreased big-deal activity but sustained venture capital (VC) activity.
Also Read
The research firm’s global PE watch quoted Philip Bass, E&Y PE global markets leader, as saying: “PE is demonstrating that it doesn’t need to do mega deals to be successful. Many firms are moving to smaller deals, putting in more equity and aligning themselves with entrepreneurs to drive growth.”
Varun Batra, partner, Baring PE Partners India, said interest in small companies had increased after successful listing of a few VC investments like Info Edge and MakeMyTrip. This has drawn the attention of PE funds. Some VC investments naturally progress to a stage where it makes sense for PE funds to provide the next round of capital.
Unlike larger companies, capital required by small companies is relatively low at each stage — $5-15 million. While the risks in this segment are high, potential return on investment is much higher.
According to Venture Intelligence data between January and September, deals between $100 million and $200 million reported a 27 per cent drop with 11 deals, compared with 15 in 2011.
Deals in the $200 million-plus category dropped 78 per cent. Only two deals were reported in January to September against nine a year ago. It is not that deals less than $15 million grew, but compared with other segments, the fall was lower in this segment. Data shows $5-15 million deals during January-September was 40, compared with 54 in the year-ago period.
The early stage market is not impacted much by equity markets. Certain trends such as Internet, SaaS, healthcare have been attracting significant VC in the past two years and driving the growth of the venture market. Part of the growth of the early stage market is also directly impacted by the enhanced start-up ecosystem, said Niren Shah, managing director at Norwest Venture Partners.
Norwest, which manages assets of $3.7 billion, has made about 25 early-stage investments in India from its $1.2-billion global fund that was raised in 2010.
He added, initially most private equity and buy out funds were seeking to deploy more than $100 million in each deal.
A new trend which has been emerging in the past six-nine months has been that PE funds are also considering much smaller transaction sizes. This is typically possible for fast-growing companies which need less than $50 million in immediate capital, but which will probably require an additional follow-on financing within 18-24 months.
What works for the PE fund is that the overall deal size (after considering the next follow-on financing), is still likely to be $50 million plus, but the fund is able to use this structure to target earlier stage companies and potentially get proprietary deals compared to the typical banker-led $100 million deals.
Additionally, PE funds which choose to invest in the follow-on financing have also had the benefit of knowing and understanding the company more deeply (by virtue of their first round of financing) which definitely reduces their risk. This also works well for entrepreneurs who are able to attract deep-pocketed investors who can potentially finance the follow-on round as well.
Kunal Bhakta, partner and head of research, Lastaki Advisors Pvt Ltd, added that while big-ticket deals have slowed down, deals in the sub $25 million bracket continue to flourish. He added PE investors in the mid-market space are looking for targets which offer something unique and scalable that can address an unmet need from a consumer perspective or offer innovative ways to address pain points facing their customers.
Similar trend is also seen in terms of merger and acquisition deals (M&A) and so far this year, the advisory firm concluded two cross-border inbound M&A deals in the digital marketing space. First, the sale of Indigo Consulting to Publicis Groupe and then the sale of Communicate 2 to Aegis Media.
A recent report by Protiviti Consultants and the Asian Venture Capital Journal, based on a survey of PE fund executives, said 48 per cent of respondents felt small and medium enterprises (SMEs) presented a better value opportunity than other categories of companies, while 40 per cent said it would depend on the sector, and only 12 per cent cited large enterprises.
In terms of investment size, India will continue to be a small- to medium-sized deal market, the report said. Asked what they thought would be the most common size of investments in SMEs, given the current economic scenario, 48 per cent said $5- 10 million; 36 per cent said $10-15 million; eight per cent said greater than $15 million; and another eight per cent said $2.5-5 million.
On challenges, intermediary networks and legal and due diligence capabilities are in their early stages of development, lack of governance, clarity in the rule of business law, foreign currency and talent identification represent complex hurdles to being a successful investor. Achieving success will require a heavy dose of pioneering spirit, backed up by local talent and sophisticated management processes to ensure that risks are appropriately managed.