A V Rajwade: Private equity

WORLD MONEY/ Why it is so important for modern corporate finance

While foreign institutional investors (FIIs) continue to make headlines and carry the equity index to new highs, private equity investors (PEIs) are also getting increasingly active in the Indian economy.

While FIIs make portfolio investment through stock exchanges or public issues, PEIs do so through negotiated, off-market deals. Hence the name private equity. Reports indicate that as much as $ 1.5 billion was invested in Indian companies by PEIs over the past year.

A couple of other differences between FIIs and PEIs should be noted. The former are pure portfolio investors with little say in management or representation on the board.

On the other hand, PEIs often demand and get board representation and actively influence corporate governance, business strategy and so on.

Again, while FIIs, by definition, invest only in listed companies, PEIs often invest in unlisted companies, sometimes as venture capitalists (about 20 per cent of aggregate private equity investment), and also for takeover of existing companies, including bankrupt ones.

The Indian corporate sector has witnessed many different types of private equity transactions in the past year: in the takeover of Gecis (General Electric's BPO subsidiary in India); in established companies such as Bharati, Moser Baer and Max; in greenfield BPO companies; and so on.

The amount currently committed for investment in India by way of private equity is estimated at $ 4 billion; the actual investments in the current year may well total up to $ 2 billion.

Private equity investments are perhaps nearer to foreign direct investment than to pure portfolio investments, because of their more active role in management/board, and relatively longer time horizons "" typically three to seven years "" for individual investments.

At the end of the period, the exit route could be a public offering, sale to an acquirer (ChrysCapital, a PEI in Spectramind, exited when the latter was purchased by Wipro), or sometimes another private equity firm.

Typically, the process of a private equity funding starts with a fund manager seeking out potential investors interested in a specified country, geographical area or business segment.

The fund manager would then start looking for investment opportunities and draw down the funds only at the time of actual investments.

While most of the major investment banks were active in floating and managing private equity funds, several of them (CSFB, Morgan Stanley, Deutsche Bank and so on) have recently gone out of managing such funds because of possible conflicts of interest.

(They prefer the less risky business of advising investors, providing debt funding, making the investee company public in due course by managing the public issue.)

The private equity fund manager's fees are on the scale of hedge funds "" say, 1 to 2 per cent of the funds under management, and 20 per cent of the profit on the investment.

In the world's most successful private equity deal of all time, the takeover of the bankrupt Long Term Credit Bank of Japan by Ripplewood, the individual who brought together and managed the investor group earned a billion dollars after the new bank's (Shinsie Bank) initial public offering.

Among the private equity funds active in India, the only large Indian managed fund seems to be ICICI Ventures.

Private equity has become so important to modern corporate finance in recent years that, in a recent survey, The Economist described such investors as "Kings of Capitalism".

Interestingly, even countries earlier suspicious of such "finance capitalism" "" China, Germany, Japan and so on "" now seem to be welcoming them.

In Asia's two largest economies, China and Japan, their role has been very important in the purchase of non-performing assets from the banking system, and the takeover of banks in difficulties.

(Recently, Standard Chartered acquired a Korean bank from a PEI, who had bought it when it was having major problems.) Not all private equity investments are as successful as Shinsie by any means.

The biggest boom and bust in the business occurred in 2000 during the dotcom bubble. An estimated $ 160 billion of private equity investments got committed in 2000 alone, and perhaps an equal, if not bigger, amount lost when the bubble burst.

L N Mittal purchased US Steel, to become the world's biggest steel tycoon, from a PEI who had earlier acquired the company from the bankruptcy court.

Another spectacular recent transaction is worth narrating. Earlier, a PEI had acquired a bankrupt retailing company (Kmart) in the US, by purchasing its bonds at a fraction of the face value.

As part of the restructuring, bond creditors became equity holders and the PEI acquired control, as was the objective from the start. Kmart recently took over Sears, as much an icon of traditional US capitalism as, say, Marks and Spencer in the UK, and is already being hailed by media as the new Warren Buffett.

Buffett's own investments have often been through private negotiations but he had become a legend well before the term private equity gained currency.

Tailpiece: Given the 60 per cent turnout in the recent elections in Iraq, M/s Bush and Blair are patting themselves on their back for being instrumental in giving birth to democracy in that country.

Quite apart from the fact that Iraq may well turn out to be a theocracy, if a rape produces a beautiful baby can that justify the rape? More generally, can ends justify unlawful means, with the strong legitimising these by arguments about a "higher morality", answerable not to worldly laws "" but to God?

Email: avrco@vsnl.com