Private Equity

PRIVATE EQUITY

Here?s a business problem. You want to buy a store in Delhi that makes Rs10K of profit per year. The owner says ? You can have it for Rs200K or 20X the Price to Earnings ratio. Now if you gave him Rs200K from your personal savings, the 5% annual return on your investment may not seem very attractive, especially when India?s stock markets are headed for the stratosphere. So here?s the private equity spin on it. You pay Rs200K for the store, using Rs80K from your personal savings, and borrowing the remaining Rs120K from the bank. To secure the loan, you place the store as collateral. Then you incentivize the store management by giving them some piece of the upside, or you bring in a new management team that has retail expertise to make the store more profitable and efficient. By the end of the first year, you are finished fixing it, and it is generating Rs20K per year in profit. In six years, you have paid off Rs120K the loan, and now almost own the store.

You put it back on the market and sell it for 20X earnings or Rs400K. You pocket the entire sum ? a handsome profit of Rs320K on your original investment, a return of 41% over five years. This is a simplistic example, but this is essentially how it works. If you are able to leverage up the store even further by using only Rs40K of equity and $160 of debt, you would have generated a 73% return on your investment. The wider definition of Private equity includes venture capital (early stage), growth capital, and Leveraged Buyouts (LBOs). LBOs typically focus on more established companies with stable cash flow characteristics that can support a high level of debt (or leverage) Private Equity Street Stress A career on The Street is exciting and rewarding. But, it is not for everyone. The Street is infamous for big egos that go with the enormous pay checks. It is also a cyclical industry with a hire & fire mentality. Investment Banks are notorious for over-hiring and then over-firing every five years.

The last sizeable round of layoffs took place between 2000 and 2004, where entire divisions were decimated. It affected Indians in unusually large numbers. Some were out of work for up to three years, eventually getting back in when the market turned. Most people who on the Street are driven, ambitious, intelligent and talented. They are survivors. Careers are made or broken on the backs of single trades or deals. The pressures are enormous. Higher risks bring higher returns. But you have to be tough. Investors typically take full control of a company, sit on the Board of Directors, and act as partners to the management team to help them grow the business.

Private Equity in its current form was spearheaded by Jerome Kohlberg, Jr., and cousins Henry Kravis and George R. Roberts, all of whom had previously worked together at Bear Stearns, a large Wall Street firm. The three partners created Kohlberg Kravis Roberts, or KKR, in 1976, which has become the worlds? most storied private equity firm. This firm became famous in the book, Barbarians at the Gates, which details the takeover of RJR Nabisco. The $25 billion deal remains the largest of all time. Private equity firms put in anywhere between 20-50% equity, and use leverage to make up the rest of the purchase price. They seek to create value in three ways: (i) paying down debt, (ii) improving the underlying cash flow characteristics through growth and operational improvement initiatives, and (iii) exiting the business at a higher cash flow multiple than the acquisition multiple. As the industry has matured, private equity firms have identified specific focus areas ? either by size of transaction (large: >$1 billion, mid- market: $100 million to $1 billion, lower middle market: $25 million – $100 million) by industry vertical (eg: healthcare, consumer, media and telecom, etc.), or most recently, but functional specialization (eg: turnarounds, sourcing expertise, etc.)

The past few years have seen a huge interest in private equity in India, with many Greenfield and global private equity firms opening shop. Examples of Greenfield funds include ChrysCap and Westbridge, and examples of global private equity firms in India include Temasek, Warburg Pincus, The Blackstone Group and The Carlyle Group. Private Equity firms have historically generated attractive returns for their investors. A recent example of a highly successful investment is Warburg Pincus? $300 million investment in Bharti Televentures which generated $1.3 billion in returns in a short span of time. In mature markets such as the US and western Europe, IRRs of 15- 20% are typically the benchmarks set by high performing funds. Professionals in Private Equity firms make their money based on performance over the life of a fund (typically 5-8 years) ? making it a long term game (unlike investment banking or hedge funds, where annual compensation is based upon the previous year?s performance).

The capital for funds are primarily raised from institutional investors such as pension funds and large financial institutions. Fund professionals earn 1-2% annually as a management fee to fund the ongoing operations. The upside comes from the ?carry? ? which represents 20% of the fund?s profits over its life. Thus, for a $300 million fund, with a 15% IRR over a 5 year period, the fund gains are $300 million, resulting in a $60 million payout to the partners of the fund. The industry is highly relationship driven, with with strong connections to the banking community as well as senior corporate professionals. John Major, the former UK Prime Minister is Chairman of Carlyle Group Europe.

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