The importance of de-risking PE buyouts

PrivateEquity funds ought to consider forming consortiums. This will not only allow such investors to overcome capacity issues but also help distribute their risks

It’s certainly boom time in the private equity (PE) buyout space. In the year just gone by, India witnessed the value of PE buyouts rise to $5.5 billion -- the highest since the turn of the decade, and more than double the value of 2017. What’s more, the last quarter of 2018-19 is set to push that value up even further, surpassing the $6 billion mark.

Buyout opportunities have come and continue to come from large and small businesses alike. While large businesses are looking to sell their non-core specialisation segments — such as the buyout of Unilever’s spreads division by KKR in December of 2017 and more recently, Kodak’s sale of its flexographic packaging business to a private equity firm in November of 2018 — small businesses are trying to benefit from the premium that PE funds are willing to pay to avoid the challenges that come with seeing a business through its seed stage. 

We have seen particular interest in the infrastructure, technology and financial services space for buyout deals. Notably, the overhaul of the insolvency framework has led to the distressed assets sector in India attracting a lot of interest from investors. 

In our opinion, the success of a buyout opportunity — apart from being contingent on financial considerations — is intrinsically linked to the sector-specific knowledge and experience that the management of the PE fund possesses, especially in the distressed space. It is only with this know-how that the PE fund will be able to drive the target entity based on sector-specific needs and considerations. 

Here are a few key commercial factors that PE funds look at before considering a buyout. 

The most important consideration for a PE fund is the future exit opportunity and the potential return the exit will generate, even though value creation remains an important factor. In the Indian context, an initial public offering (IPO) presents investors with the best exit opportunity in terms of the return on capital. However, for certain PE funds, especially those seeking short-term exit opportunities, the key consideration would be the potential to secure a secondary buyout or sale to a strategic investor. 

The second factor considered by PE funds is leveraged buyouts; such buyouts are attractive to PE funds as they provide the potential for increased returns — considering their cost of debt is lower than both the return on equity in target entities, and the opportunity cost of capital. Taking advantage of this potential for return is a major incentive for PE funds to adopt the buyout route. However, the opportunities available for leveraged buyouts in India is very limited due to the large number of regulatory restrictions, such as stringent exposure norms for financial institutions, restrictions on foreign and domestic lending by companies, corporate governance restrictions, foreign exchange regulations, and tax considerations. 

Valuation and growth is the third issue that PE funds look at, prior to signing a buyout deal. PE funds tend to focus on the qualitative aspects of a transaction like the strength of the management of the buyout entity, the network created by the target etc. However, quantitative aspects remain equally important. Free cash flow, debt servicing capacity, profit ratios, and most importantly, the effect of the investment on the potential year-on-year growth of the target are important determinants for arriving at the valuation of the target. 

This brings us to the subject of managing interests. Corporate entities are well regulated, with certain legal protections in place for minority shareholders. Thus, it is essential for PE funds to ensure that their own management and governance obligations — primarily contractual — are harmonised with those of the target entity. While managing the buyout entity may increase complications for PE investors, the maximisation of returns is ultimately in the best interest of all investors in the target entity.

The last consideration pertains to regulatory challenges. While acquiring controlling stakes in large corporates is a challenge by itself, regulatory restrictions — including limitations placed on domestic funds  alternative investment funds regulations and the lack of leverage opportunities for large acquisitions — make this only tougher! Moreover, with the recent requirements introduced by Indian regulators in relation to ultimate beneficial ownership, individuals who ultimately own/control substantial interests in an entity are identified on a look through basis, bringing them under the scrutiny of the regulator. 

In our view, PE funds ought to consider forming consortiums. This is especially important given the increasing number of distressed deal opportunities in India, and for the acquisition of larger businesses. Strategic consortiums, such as the ones formed by the Blackstone Group LP, Carlyle Group LP, Onex Corp, and Canada Pension Plan Investment Board to invest in Arconic, and closer to home, the consortium of Temasek and Advent for the buyout of Crompton Greaves Consumer Electricals Ltd, will not only allow such PE investors to overcome capacity issues but also distribute their risks. 

This, we feel, is the definitive way forward for 2019 and beyond. 

Views are personal