A V Rajwade: Other investments & private equity

The equity investor today has a very wide choice of investment vehicles with a menu of alternatives.

Internationally, it is estimated that the aggregate size of the funds invested in so-called "alternative", i.e. non-traditional, avenues is around $3 trillion""a huge sum by any standards. These include an estimated $1,200 bn in hedge funds and perhaps a thousand billion each in private equity and real estate. Traditionally, investors in such alternative assets used to comprise wealthy individuals; lately more and more institutional investors like pension funds, university endowments, etc. are also placing a part of their portfolios in such investments. The recent rise in interest rates, globally, is unlikely to dull the appetite for the higher risk, higher reward asset classes; nor would the huge loss sustained by the Amaranth hedge fund (see "World Money," October 9, 2006). In short, the alternative investment pool will probably keep growing and is already too large to be ignored by any analyst or student of financial markets. "Finance capital" has become a very powerful force in 21st century corporate finance.

The term private equity is generally used to refer to large pools of funds managed by the likes of KKR, Warburg Pincus, Blackstone, etc. available by way of risk capital to new or established businesses through private, negotiated deals. In this, they are somewhere between direct and portfolio investors, not generally providing technology or executive management, but involved in governance and providing contacts and perspectives. A large segment of PE funds is active in highly leveraged buyouts (LBOs) or takeovers, friendly or hostile, and purchase of stressed assets.

Some of the government-owned and -sponsored funds also, in effect, act as private equity funds, but are not included in the numbers quoted at the beginning. They are managed by paid executives, not fund managers sharing in the profits, but otherwise their investment strategies are similar to PEs. While Singapore's Temasek is well-known as a powerful and shrewd investor (it has made large investments in India as well and clearly has appetite for more), South Korea has also reportedly earmarked a part of its burgeoning reserves for deployment in private equity. As has Norway. Many oil-rich Middle East governments like Dubai, Kuwait, Abu Dhabi and Qatar also have professionally managed investment funds which, in many ways, act as private equity. (Temasek was recently in the news as, reportedly, the proximate cause of the recent military coup in Thailand was the huge tax-free gain made by the erstwhile Thai Prime Minister's family by selling his business empire to Temasek at a huge profit.) The International Fina nce Corporation, Washington, an affiliate of the World Bank, is also a private equity investor. If most of those quasi-state funds keep away from LBOs and stressed assets, the huge hedge fund industry is active in these segments. The distinction between hedge funds and private equity is getting blurred in these areas also because major investment banks like Goldman Sachs and Morgan Stanley manage both types of vehicles.

It is the area of LBOs that seems to be causing regulatory concerns. Gearing in leveraged debt and junk bond markets keeps going up as the lender/investor is more focused on rewards, ignoring the risks. The latest gambit is "recapitalisation"""the clever name for what is, in effect, adding to debt post-LBO, to take out as much of the equity as possible through dividends""and that too a short time after the LBO! (In one recent case, "recapitalisation" was 1.8 times the original equity investment""one salutes the brave lenders, some of them hedge funds!) "Leveraged" loans/bonds amounted to almost a quarter of all global corporate fund raising over January-September 2006.

In an earlier era, say a decade back, when the private equity pool was small and competition not strong, the skill lay in buying companies cheaply and selling them at a higher price, using financial engineering, and exploiting fiscal efficiencies. As competition has grown, this is no longer enough. PE funds are being forced to take a greater, more hands-on approach to managing the business they own, and creating value. This requires the engagement of experienced professionals and focusing on specific industries""in other words, what was pure finance capital is now coming nearer the direct investment strategies.

The equity investor today has a very wide choice of investment vehicles with a menu of alternatives in terms of management cost, liquidity, and risk and rewards: starting with low-cost index funds and traditional equity mutual funds, where the management cost would typically be 1-1.5 per cent. Such funds take limited bets away from the index they use as a benchmark, and their higher fees in comparison with the index funds are justified only if the net return is, on average, higher than in index funds. Investments in such funds are liquid, and the funds are tightly regulated.

As one moves to the alternative asset classes (hedge funds and private equity), the management cost, risks and rewards go up sharply, and the liquidity comes down""there is also hardly any regulatory oversight. Typical cost would comprise a 1/2/3 per cent management fee, and 20, 30 or even 50 per cent of the profits by way of remuneration to the fund manager. Apart from cost, the investor also has to reckon with low liquidity. Typically, hedge funds would allow withdrawals perhaps once a quarter, and that too with several weeks' notice. Investors in private equity funds have to commit to several years of lockup of the investment""i.e. until the fund manager can divest the investments made through sale to another private equity investor, in the market through a public issue, or to a mutual fund""but the rewards can be huge. Early investors in Skype, the IP telephony service, had a return of 350 times the original investment in just three years! The value attached to the skills of the fund manager is exemplified by a recent transaction: Wilbur Ross sold his fund management firm for $375 mn, though the profits on existing investments remain with the erstwhile owners. Clearly, his own ability to create value in the future is worth $375 mn! Incidentally, Mr Ross has several India connections. Indeed, India has become a honey pot attracting large private equity funds""but more on this in a later article.

avrco@vsnl.com