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This article is written by Nikunj Arora, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.

Introduction

After setting records in two consecutive years, Indian Private Equity (“PE”) / Venture Capital (“VC“) investments had notched an all-time high in 2019 and crossed US$48 billion. After the global financial crisis in 2008, India received PE/VC investments worth $198 billion between 2009-2019, out of which, PE investments accounted for 56% from 2017 to 2019. Private-Equity generally means investing in privately-owned companies or in public companies with the intent to take them private. PEs are usually categorized according to their investment strategy which may include leverage-buyouts, venture capital, distressed investing, etc. In 2018, investments in the Infrastructure sector accounted for 30% of all PE/VC investments as compared to the value of 12% in 2018. In 2019, there are bigger deals in the Infrastructure sector such as Brookfield’s buy-out of Reliance Jio’s tower and investment in Reliance Industries Limited’s East-West Pipeline for $3.7 billion and $1.9 billion, respectively. Talking about PE/VC deals, the largest deal in the traditional PE/VC asset category was Alibaba and Softbank’s investment in Paytm for $1 billion. 

PE firms’ ability to increase the value of their investments and achieve higher returns has helped fuel their growth in recent times. The ability to achieve higher returns is attributed to several factors, such as, high-powered incentives for private equity portfolio managers, aggressive use of debt, focus on cash flow and margin improvement, etc. At the beginning of the Covid-19 pandemic, the immediate focus of PE firms was to stabilize existing portfolios and now PE investors are heading back to sourcing and executing new investment opportunities. PE firms/investors have dramatically amended their investment strategies and have also adopted some new strategies for their current future investments. 

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Understanding private equity

What is private equity (pe)?

PE means providing private financing for companies, and in terms of its definition, ‘Google‘ provide us with the following definition:

‘PE is an alternative investment class and consists of capital that is not listed on a public exchange. PE is composed of funds and investors that directly invest in private companies, or that engage in buy-outs of public companies, resulting in the delisting of public equity.’

In a layman’s language, it means raising money and investing in companies to make them perform better and then gaining a return off of that improvement in productivity or performance. 

Partnership structure

Limited Partnership is the type of partnership that is relatively more popular in the US. In this case, there are two types of partners, i.e, limited and general. 

  • Limited partners are the individuals, companies, and institutions that are investing in PE firms. These are usually high-net-worth individuals who invest in the firm.
  • General partners are involved with the management of the fund, target company portfolio selection, and post-investment advisory. GP charges the partnership management fee and has the right to receive carried interest. This is known as the ‘2-20% Compensation structure’ where 2% is paid as the management fee even if the fund isn’t successful, and then 20% of all proceeds are received by GP.

How to classify private equity firms?

The main classification criteria to classify PE firms are the following:

  • Size: The biggest PE firms are known as mega-funds and have over $50 billion in assets under management (“AUM”). Then are middle-market funds and boutique funds.
  • Stages of investment: There are 4 main investment stages for equity strategies. In the ‘early-stage investment is done for pre-revenue companies such as tech startups. The ‘Growth stage’ is for later-stage companies which have good and proven business models but need capital to grow. The ‘Mature stage’ is for the companies that are not growing quickly but have substantial cash flows. At the ‘declining stage’ when companies run into trouble or any other reason whatsoever, the PE firm that does distressed investing as their investment strategy may play an important role.
  • Geography & industry: A PE firm may focus on a single country, a few countries, or an entire area, or developed or emerging markets. On the other hand, a firm can diversify and invest in all industries, or it could specialize in a specific industry. 
  • Investment strategy: PE firms focus on several investment strategies such as leveraged buy-outs, distressed/turnaround, growth equity, etc. 

Examples of PE firms

The following are the world’s top 10 PE firms:

  • KKR & Co. Inc.                                   (AUM: $252 billion)
  • TPG Capital.                                           (AUM: $85 billion)
  • EQT                                                (AUM: 52 billion euros)

Private equity investment strategies 

The process of understanding PE is simple, but the execution of it in the physical world is a much difficult task for an investor. There are several PE investment strategies, but the most commonly used is the ‘leverage buy-out’ by the firms. However, the following are the major PE investment strategies that every investor should know about:

Equity strategies

  • Venture capital (early stage)

In 1946, the two Venture Capital (“VC“) firms, American Research and Development Corporation (ARDC) and J.H. Whitney & Company were established in the US, thereby planting the seeds of the US PE industry.

In India, Venture Capitalism began in 1986 with the start of economic liberalization, however, initially was limited to only subsidiaries set up by banks. Then, foreign investors got attracted to well-established start-ups by Indians in the Silicon Valley. 

In the early stage, VCs were investing more in manufacturing sectors, however, with new developments and trends, VCs are now investing in early-stage activities targeting youth and less mature companies who have high growth potential, especially in the technology sector. VC invests in target startups before their true revenue potential has been validated. 

Thus, VC is a form of PE financing that is provided by VC funds/firms usually to start-ups, early-stage, emerging companies which has high growth potential or had high growth potential in terms of the scale of operations, number of employees, etc. VC firms/funds generally do investment in early-stage companies/startups, in exchange for an ownership stake, because startups are risky and uncertain and VC investments are also based on high rates of failure.

Apart from angel investing, equity crowdfunding, VC also focuses on the companies which have limited operations, too small to raise capital, cannot obtain a bank loan or complete a debt offering. There are several examples of startups where VCs contribute to their early-stage, such as Uber, Airbnb, Flipkart, Xiaomi, and other high valued startups.

PE firms/investors choose this investment strategy to diversify their private equity portfolio and pursue larger returns. However, as compared to leverage buy-outs VC funds have generated lower returns for the investors over recent years. 

PROS:

CONS:

  • There is usually a higher potential for above-average returns.

  • There is a commercial uncertainty because VC funds are investing in risky and uncertain startups. 

  • A small amount of initial capital required (i.e. seed and startup). However, some tech developments may require large amounts. 

  • Unreliability of cash flow because sometimes the business is not at all profitable and may generate losses in near future.

  • High growth promotes economic development and job creation in the industry. 

  • May tend to be small size investments, thus, accounting for a relatively small amount of the equity (10-20-30%).
  • Growth equity (growth or expansion stage):

Growth Capital, also known as expansion capital or growth equity, is another type of PE investment, typically a minority investment, in mature companies which have a high growth model. Under the expansion or growth stage, investments by Growth Equity are usually done for the following:

  • High valued transactions/deals. 
  • Mature and developed companies who are looking for capital to expand their operations, or restructure their operations, or looking for entry into emerging markets or planning to finance an acquisition without a change of control of the business. 
  • Companies that are likely to be more mature than VC-funded companies and can generate enough revenue or operating profits, but are unable to arrange or generate a reasonable amount of funds to finance their operations.
  • Where the company is a well-run firm, with proven business models and a solid management team looking to continue driving the business. 
  • Where the primary owner of the company may not be able to take the financial risks alone, and thus, by selling a company or a part of the company to private equity, the said owner can take out some value and share the risk of growth with other partners. 
  • Where the capital will be used for the company’s needs or shareholder liquidity and additional financing rounds are not usually expected until exit. 

The following are the financing vehicles used for Growth Capital:

  • PIPEs: Private investment in public equity (“PIPEs”) is a form of growth capital or Growth Equity investment that is typically made into a publicly traded company. These investments are made in the form of convertible or preferred securities that are unregistered for a particular period. 
  • RD: The Registered Direct (“RD”) is also a form of growth capital and is similar to PIPEs but is sold as a registered security. 

PROS:

CONS:

  • Growth Equity is relatively ‘safer’ (considered with moderate risk) than VCs because the companies have already demonstrated their ‘pull’ and are mature enough.

  • Requires extensive work in system development, heavy recruitment of management team, investment in production, build-up of advertising, etc.

  • These deals usually require less amount of money than the buy-out deals. 
  

  • This type of PE investment is considered popular in emerging markets where businesses do not have access to capital from banks or capital markets. 
  
  • Growth capital v. venture capital

Growth Capital 

Venture Capital

  • These types of investments come with a lower holding period (average 3-7 years).

  • VC investments come with a longer holding period (average 5-10 years) because early-stage companies require more time to realize their potential as against mature companies.

  • The source of return for these investments shall be the company’s ability to scale its operations, resulting in significant revenue and profitable growth.

  • The primary source of returns for these investments shall be the profitable introduction of the company’s product or services.

  • These investments come with a moderate type of risk. However, the execution and management risk is still high. 

  • VC deals come with a high level of risk and this high-risk nature is determined by the number of risk characteristics such as product and market risks. These risks are associated with the operations in the new market and the absence of commercially viable products of the companies. 
  • Leveraged buy-outs (maturity stage): 

A leveraged buy-out (“LBO”) is a strategy used by PE funds/firms where a company/unit/company’s assets shall be acquired from the shareholders of the company with the use of financial leverage (borrowed fund). In layman’s language, it is a transaction where a company is acquired by a PE firm using debt as the main source of consideration. 

The transactions happen when PE firms borrow a large amount of money from several lenders (approximately 70-80% of the purchased price) and the remaining balance shall get funded by their equity.

In this investment strategy, the capital is being provided to mature companies with a stable rate of revenues and some further growth or efficiency potential. The buy-out funds generally hold the majority of the company’s AUM.

The following are the reasons why PE firms use so much leverage:

  • When PE firms use any leverage (debt), the said leverage amount helps to enhance the expected returns to the PE firms. 
  • PE firms put a very small ratio of their equity against the leverage amount. Through this, PE firms can achieve a larger return on equity (“ROI”) and internal rate of return (“IRR”).
  • Based on their financial returns, the PE firms are compensated, and since the compensation is based on their financial returns, the use of leverage in an LBO becomes relatively important to achieve their IRRs, which can be typically 20-30% or higher. 

The LBOs usually involve a financial sponsor which will raise the acquisition debt. The amount of which is used to finance a transaction varies according to several factors such as financial & conditions, history of the target, the willingness of the lenders to provide debt to the LBOs financial sponsors and the company to be acquired, interests costs and ability to cover that cost, etc.  

PROS:

CONS:

  • The LBOs involve debt which is usually non-recourse to financial sponsors and has no claim on other investments managed by the fund.

  • LBOs are beneficial as long as it is limited to the committed capital, but, if buy-out and exit go wrong, then the losses shall be amplified by the leverage. 

  • During this investment strategy, the investors themselves only need to provide a fraction of capital for the acquisition.

  • The large scale of operations involving large firms that can take on a big amount of debt, preferably at cheaper interest. 

  • The returns to the investor shall be enhanced as long as the return on assets exceeds the cost of debt.
  

  • Lenders can insure themselves against default by syndicating the loan by buying CDS and CDOs.
  

Note:

CDS: Credit Default Swap means a contract that allows an investor to swap or offset his credit risk with that of any other investor or investor.

CDOs: Collateralized debt obligation which is usually backed by a pool of loans and other assets, and are sold to institutional investors.

  • Distressed/turnaround (declining stage): 

The distressed or turnaround is a category of investment which is also referred to as ‘special situations’. It is a broad category where the investments are made into equity or debt securities of financially stressed companies.

This is a type of investment where finance is being provided to companies that are experiencing financial stress which may range from declining revenues to an unsound capital structure or an industrial threat.

Distressed PE firms invest in companies’ debt or equity that are in trouble, to take control of the company during the time of any bankruptcy or restructuring processes. The PE firms turn these companies around (hence, the name, turnaround) and either sell them or take them public. The other name given to this type of strategy is ‘credit strategy’ because in most cases distressed PE firms will end up investing in troubled companies’ debt. 

The term ‘distressed’ is categorized into the following sub-categories:

  • ‘Distressed-to-Control’ or ‘Loan-to-own’ strategies (control-oriented): Here, the investors are acquiring debt securities of the financially stressed companies in the hope of emerging from corporate restructuring in control of the company’s equity.
  • ‘Special Situations’ or ‘Turnaround’ strategies (turnaround approach): Here, the investors are providing debt and equity investments, which is termed as ‘rescue financing’, to the companies who are undergoing any operational or financial challenges. 

Pros:

  • The biggest advantage of this type of investment strategy is that the distressed financial situation may favor the PE fund, and during this financial situation, it can acquire very low multiples of cheap equity. Assuming it can exit afterward, this will create a good investment opportunity for PE firms.

Cons:

  • The only disadvantage is that there is a risk associated with this type of turnaround approach. There is a risk of not being able to reverse the financial distress situation. 
  • Mezzanine capital:

Mezzanine Capital is referred to any preferred equity investment which usually represents the most junior portion of a company’s structure that is senior to the company’s common equity. It is a credit strategy.

This type of investment strategy is often used by PE investors when there is a requirement to reduce the amount of equity capital that shall be required to finance a leveraged buy-out or any major expansion projects. 

Smaller companies that are not able to access the high-yielding markets often use Mezzanine Capital because this will allow such companies to borrow additional capital which the traditional lenders are not willing to provide through bank loans. 

Mezzanine Capital is an expensive source of financing for a company as against any secured or senior debt. They also involve additional risk because it is usually private placements used by smaller companies and may involve a greater level of leverage. 

The following are the uses of Mezzanine Capital:

  • LBOs: In most of the LBOs, mezzanine capital is used along with other securities to fund the purchase price of the company being acquired. The financial sponsors use mezzanine capital in an LBO so that there is a reduction in the amount of capital invested by PE firms because mezzanine capital lenders have a lower target cost of capital.
  • Real estate finance: Mezzanine capital is used by the developers in real estate finance to secure supplementary financing for several projects in which mortgage or construction loan equity requirements are larger than 10%.
  • Real estate:

The PE real estate funds tend to invest capital in the ownership of various real estate properties. This is an industry-specific and level strategy. These real estate funds have the following strategies:

  • The ‘Core Strategy’, where the investments are made in low-risk or low-return strategies which usually come along with predictable cash flows.
  • The ‘Core Plus Strategy‘, where the investments are made into moderate risk or moderate-return strategies in core properties that require some form of the value-added element.
  • The ‘Value-Added Strategy‘, involves a medium-to-high risk or medium-to-high return investment strategy which shall include purchasing of property and sell it again.
  • The ‘Opportunistic Strategy’, where high-risk or high-return investment strategy is used in properties requiring large amounts of enhancement. 

Unlike the traditional PE firms, the real estate private equity investors/firms (“REPE“) are now investing in properties to operate them, or improve them, or develop new properties to gain value.

Some REPE firms are focusing on commercial real estate, while others are the geographical focus, and the others are investing in the real estate debt. The targeted IRR on such real estate deals is quite lower than the traditional LBOs. 

  • Activist investing:

This type of investment strategy comes into play when the PE firm is going to buy a large block of publicly traded equity and slowly buy up their stake. The reason why PE firms initially buy a large block and then slowly acquire their stake is that they can get influence and control over the board of that particular company. After getting some control over the board PE firms can influence them to make more profit-driven activities. This is another way for a PE firm to take control of a business to add more value.

The activist investors in the form of PE firms offer various innovative strategies but usually acquire significant control over a public company to take them private. The activist investors believe that the public companies can run profitably if taken private and that they can fix various problems in these companies if they acquire control, such as mismanagement in companies, excessive cost, or other similar issues. 

Companies targeted by the activist investors over the years:

YEAR:

NUMBER OF COMPANIES TARGETED:

2014

172

2015

188

2016

168

2017

188

2018

226

 

Activist shareholders targeted the largest number of companies ever in 2018, a record of 226 companies-based activist campaigns. 

  • Buying spin-offs & carve-outs:

Spin-offs: it refers to a situation where a company creates a new independent company by either selling or distributing new shares of its existing business. 

Carve-outs: a carve-out is a partial sale of a business unit where the parent company sells its minority interest of a subsidiary to outside investors.  To understand how buying the spin-offs and carve-outs act as an investment strategy of a PE firm, the following example shall be considered:

Suppose there are large conglomerates similar to that of ‘Microsoft Corporation’ or ‘Apple’. These large conglomerates get bigger and tend to buy out smaller companies and smaller subsidiaries. Now, sometimes these smaller companies or smaller groups have a small operation structure; as a result of this, these companies get neglected and do not grow in the current times. This comes as an opportunity for PE firms to come along and buy out these small neglected entities/groups from these large conglomerates. The said conglomerates agree to sell these small entities to the PE firms because of the following reasons:

  • These bigger companies do not have much time or resources to maintain or grow the small groups/entities; hence, it is reasonable for them to sell these small divisions to PE firms.
  • When these conglomerates run into financial stress or trouble and find it difficult to repay their debt, then the easiest way to generate cash or fund is to sell these non-core assets off.
  • Seed funding/series funding:

There are some sets of investment strategies that are predominantly known to be part of VC investment strategies, but the PE world has now started to step in and take over some of these strategies. One of the most common VC investment strategies is Seed funding or Series A funding where the PE investors are now stepping in.

Seed Capital or Seed funding is the type of financing which is essentially used for the formation of a startup. It is the money raised to begin developing an idea for a business or a new viable product. There are several potential investors in seed funding, such as the founders, friends, family, VC firms, and incubators. 

Suppose an entrepreneur wants to test an idea and want to develop a Minimum Viable Product (MVP), then he will initially go to VC firms for the entire funding requirement, but now a lot of PE firms have started to provide this type of funding. It is a way for these firms to diversify their exposure and can provide this capital much faster than what the VC firms could do. 

  • Secondary investments:

Secondary investments are the type of investment strategy where the investments are made in already existing PE assets.

These secondary investment transactions may involve the sale of PE fund interests or the selling of portfolios of direct investments in privately held companies by purchasing these investments from existing institutional investors. 

In 2010, the following transactions occurred as ‘secondary investments’:

  • Lexington Partners, the largest independent manager of secondary acquisition and co-Investment funds in the world, purchased a PE fund portfolio worth $650.17 million from Lloyds Banking Group.
  • Ardian, France-based PE Investment Company (formerly known as AXA PE) acquired a $1.9 billion portfolio of PE funds from the Bank of America. 

Other strategies

  • Infrastructure
  • Energy and Power
  • Merchant Banking
  • Fund of funds
  • Search fund
  • Royalty fund

Investment strategies of major pe firms

The following are the major PE firms worldwide with their investment strategies:

  1. The Blackstone Group (aum: $619b): 

The Blackstone Group Inc. is situated in New York, US. It is an alternative investment management company. The investment strategy of this firm focuses on the real estate fund.

  • ‘Opportunistic Strategy’: The firm’s entrepreneurial/opportunistic business tries to gain under-managed, all around found resources across the world. Regarding these acquisitions, they assemble organizations that are set up to deal with the hidden properties and eventually augment their worth by founding top-tier executives. In the post-acquisition scenario, the firm likewise put resources into the properties to improve them before offering the resources and restoring money to our restricted accomplices. 
  • ‘Core Plus Strategy’: This strategy highlights balanced out land with a long venture skyline and moderate influence, where the firm can open extra worth through centered asset management. The Firm’s BPP supports a center around the modern, private, office, and retail resources in worldwide passage urban communities.
  • ‘Debt’: The real estate debt business gives innovative and extensive financing arrangements across the capital design and hazard range. The firm begins credits and puts resources into obligation protections supported by high-quality real estate. The group manages Blackstone Mortgage Trust (NYSE: BXMT), a leading real estate finance company that originates senior loans collateralized by commercial real estate.

2. The Carlyle Group (aum: $58 b):

The Carlyle Group is an American multinational private equity, alternative asset management, and financial services corporation. 

  • Corporate Private Equity: This involves investing in LBOs and growth capital transactions through a range of geographically focused investment funds;
  • Real assets: Where, investments are made in real estate, infrastructure and energy, and renewable resources;
  • Global credit: Under this, investments are made in distressed & special situations, direct lending, energy credit, loans & structured credit and opportunistic credit; and
  • Investment solutions: This involves investments in PE and real estate fund of funds, co-investment, and secondaries.

3. KKR & Co. INC. (AUM: $78 B):

KKR & Co. Inc. is an American global investment company that manages multiple alternative asset classes, including private equity, energy, infrastructure, real estate, credit, and, through its strategic partners, hedge funds. The association’s methodology is to look for foundation speculations with restricted drawback hazards. They look to drive esteem creation through unmistakable sourcing, profound operational commitment, and dynamic stakeholder management. The firm accepts that this methodology prompts esteem added returns for their financial investors. 

Conclusion

As per Business Standard, PE/VC investments have declined in January 2021 amounting to a 35% drop from $2.5 million to $1.6 million. In January 2019, there were five (05) larger deals worth approximately $1.4 billion and twelve (12) larger deals worth $6 billion in December 2020, however, this ratio declined in  January 2021, where the deals were recorded worth approximately $680 million. The biggest deal in 2021 was in January when a group of investors such as Tencent, Lightspeed, Altimeter Capital invested around $280 million in Udaan.com, which is India’s largest B2B platform for business and shop owners. This was followed by Tiger Global, Steadview, and Fidelity, etc. investment in Zomato worth $250 million. According to Vivek Soni, who is a partner and national leader of PE services at EY, the e-commerce platform has been emerging as the top priority investment sector with $689 million, thereby, amounting to 43% of all investments of January 2021. 

The PE firms are booming and they are improving their investment strategies for some high-quality transactions. It is fascinating to see that the investment strategies followed by some renewable PE firms can lead to big impacts in every sector worldwide. Therefore, the PE investors need to know the above-mentioned strategies in-depth.

The above PE investment strategies provided by the researcher do not in any way provide any legal advice. The strategies are purely based on the research work done by the researcher. 

References

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