At a time when deal flows in private equity remains muted, structured deals are being seen as the most prominent form of deal making, going forward.
Market players believe, with valuations firming up, structured deals will be the way to go for PE funds, rather than basic equity transactions. A structured deal is one where the investor gets a minimum assured return and any downside risk from a fall in earnings is protected.
Satish Deshpande, head of private equity at NV Advisory Services said, “The valuation gap between promoters and PE funds has widened. In such a scenario, it makes sense to do a structured deal because, first, one can link valuations to the performance. Two, funds get over the stalemate of not doing a deal. It is not insurance against a bad deal but an incentive for promoters to work hard.”
How do structured deals work? If the promoter and the PE investor are unable to decide on an upfront valuation, the deal is structured based on the performance. A PE company typically evaluates a company’s potential based on its earnings growth forecast and pays a multiple of this when it invests. However, in case the earnings growth forecast differ, valuation and the number of shares to be sold is determined at a later date, based on the performance. The downside for a PE fund gets protected, as the valuation becomes lower if the company does not deliver. Sometimes, there are built-in clauses which mandate that the stake goes up if the company does not perform as promised.
Also, there are structures such as ratchets, put options and convertible instruments. The ratchet is an anti-dilution clause in the agreement that protects an investor from a reduction in percentage ownership in a company even if additional shares are issued by it to other investors.
A put option allows investors to sell the stock back to the company at a pre-set price (or range) within a given period of time. And, convertible instruments allow investors to convert these into equity at a later date and at a pre-set price, once the investor feels more comfortable about the company meeting its growth projections.
“Structured deals come into play when valuations run up sharply. It is done to essentially bridge the valuation gap. There are structures where the fund’s stake goes up as profitability decreases and some structures wherein minimum returns are guaranteed to the investor till the IPO. In such cases, a minimum of 20-25 per cent is guaranteed, which protects from the downside. However, we would like to do straight equity deals rather than structured ones, as incentives get aligned,” says Shujaat Khan, Managing Director, Blue River Capital, a private equity fund.
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The convertible structure is the most popular route, where a PE fund keeps getting the coupon for two-three years and then converts it into equity at a pre-decided price. There are exit structures wherein the PE fund’s stake is bought out by the promoters.
A recent instance is Blackstone’s investment into Allcargo Global Logistics. In March last year, Allcargo had issued warrants to Blackstone, equally convertible at a price, linked to the consolidated Ebitda (earnings before interest, taxes, depreciation and amortisation) during 2008, ranging between Rs 934 and Rs 1,284 a warrant. According to the terms, if Allcargo’s Ebitda during the year to December 2008, was above Rs 210 crore, then the conversion price was Rs 1,284 a share.
Similarly, Shriram City Union had allotted warrants to a clutch of PE funds, including ChrysCapital, Bessemer and India Advanatge Fund. The investors recently hiked their holding through conversion of warrants, resulting in fresh fund infusion.
There are some structures wherein the fund invests in a global holding company which is not constrained by exchange control laws. There are also earn-out structures, where a PE investor agrees to share the upside of any return the company earns, over and above a minimum targeted IRR (internal rate of return).
However, experts say there are also risks attached to structured deals. Vijay Sambamurthy, Partner, Lexygen, a legal consultancy, says: “The biggest risks for structured deals centre around regulatory and tax changes or changes in judicial interpretation. While a lot of effort may go into devising a complex structure that is fully compliant, the whole effort could come to nought if any important piece of the regulatory or tax regime changes in future.”
Adds Srinivas Chidambaram, Managing Director, Jacob Ballas Capital Fund, “The nature of structure should not be an impediment in the way business is done, going forward. Having said that structured deals tend to create aberrations in the short term.”