This article is written by Shreya Kalyan, pursuing a Diploma in Business Laws for In-House Counsels from lawsikho.com. 

Introduction

Private equity investors invest in the private companies to ensure a turnaround for the distressed companies. Private equity investments are larger in size and are targeted at growth of the distressed companies unlike venture capital investment which targets an early staged company. The investment can be utilised by the company for funding new technology, growing working capital and consolidating balance sheets. After buying the company, it will try to increase its value by implementing different strategies and plans. Once the company is out of the struggle, the PE firm may choose to exit either by offering the company for sale to a third party, a strategic buyer or, via initial public offering. 

Private equity has become a popular route for the striving companies to raise funds away from public markets. The boost to private equity was given after the years before the financial crisis and it was burdened with high debt levels. According to a Harvard study, global private equity groups raised $2 trillion in the years between 2006 and 2008 and the companies backed by private equity performed better than their counterparts in the public markets. This was primarily evident in companies with limited capital at their disposal and companies whose investors had access to networks and capital that helped grow their market share. 

Process of Funding

The process of PE investment commences with the companies approaching the PE investors for injecting funds or the PE investors may approach the companies to aid in coming out of a miserable financial position. A private equity investment is for a larger amount as compared to a venture capital investment and in return, the investors prefer either to acquire a substantial stake in the company with active participation rights or go for buyout. 

At the initial stage a document is made called term sheet which will specify about the company, kind of investment, role and responsibility of promoter and intention of investor, before investing. A time period is agreed after which the term sheet will be deemed to be expired if that deal does not go through. But within that time period, there will be due diligence, negotiation regarding other definitive agreements. After the terms are set out in the document, the investors conduct a legal and financial due diligence on the company accompanied by a background check on the promoters of the company. Following this, if the investor agrees to proceed then they negotiate investment documents like share purchase, agreement, shareholder agreement which depend upon the transaction. Once it is finalised, the funds are infused into the company. 

Exit Route

PE firms look for an exit in an average of 5-6 years. The exit strategy is very important for the investors to plan before investing in any organisation. The PE investors never plan for a long term stay or long term mutual relationship with the company unless it is a buyout. So at the time of their entry, they better plan for a profitable exit and set a standard in mind as to how they want to make an exit. Because the better the exit the better are the returns on the investment for the investors. The plan may include sale of stocks through a bid at IPO, selling his holding in the company to a third party, giving the promoters first opportunity to buy back the shares at prevailing market price. They can exercise their exit plan at mainly two events: first being where the company is not bringing profits and the investment has become non- performing and thus, there are very limited returns to the investor. Second being where the objective profit threshold has been met by the business venture for the investor.  

Making the exit profitable is where the value for PE investors lies in. This value is earned by paying back the debt used in funding the company, growing revenue during the holding period, and selling the company at a higher price than what it was acquired for. 

How is PE beneficial to companies?

For a company which is experiencing inefficient management, poor corporate governance and inadequate cash liquidity, equity money is very important to increase quality of commercial assets and long term success of the company. Then the company can rely on the investors to scale up the performance of the business through acquiring stake and providing financial support. Companies prefer PE investment because they get access to liquidity and it is the next best alternative in place of bank’s high interest loans. 

Another possible advantage to a company through PE investment is that it helps a company to prepare for listing in stock market i.e. IPO as the exit route. It becomes advantageous for the companies which cannot raise money from the market, thereby opening enormous opportunities for companies to raise funds. 

Private Equity may be initiated by way of an Alternate Investment Fund. An AIF is a fund which is set up for collecting funds from different investors Indian or Foreign for investing in various projects according to their investment policies. PE may be set up also through a Trust, a Company or an LLP. In most of the cases it is by way of a Trust because of certain registration and taxation benefits, or a firm because of their functioning. Say, there is a Private equity firm, the point arises how it will make the investment. A PE firm will be composed of funds and investors like High net worth individuals, who will directly invest in the private company or take over the ownership of a company through retail or institutional investors. 

Commercial Intent of the Investors before Making Investment

The commercial intention behind the investment is of sound returns. Other scenarios might be that while injecting capital into the business through equity or convertible debentures, the PE firms may acquire control over the company and completely buyout the company making it private or getting it delisted. Another scenario might be where a PE firm may acquire partial control and still leave the major stake with the founders to stay involved in the running of the company and involve in future upward returns. 

Impact of COVID-19

Previous year showed a tremendous indication of the country’s growth potential through PE investment. According to the data, the credit flow through regular channels had slowed down and the country was expected to show a 15-20% rise in Private Equity investment by 2020. The event that attracted a new class of investors was the growing number of businesses which in turn was facilitated by various initiatives of the Government such as improvement in ease of doing business, Infrastructure Investment Trusts, Real Estate Investment Trusts. The experts opined that because of the immense growth of PE investment, the economic slowdown would be a short term factor. Also the growth in PE investment was aided by deal size becoming larger owing to an increased number of buyouts. 

However, now Covid-19 is driving the market fluctuations and including other sectors it is also affecting the way investment operations are handled by investment managers. This pandemic is causing hardship for businesses and communities all over the world and is raising a number of distinctive challenges.  

For the PE firms who have already injected the funds and have entered into the management of a company following effects can ensue: 

1. PE firm’s ownership in all the underlying companies is not intended to be long term so they are usually not prepared for a crisis like this. They would not have even planned for such an emergency at the time of effecting acquisition. In a normal stance what a company expects is a crisis of natural disaster or any cyber affair. 
2. PE firms may also be experiencing a situation where they have multiple underlying companies with thousands of employees looking for guidance and direction.
3. All the companies burdened with debt, would ultimately impact the PE firms who may face increased liquidity risks and unexpected challenges concerning their ability to make interest payments and avoid defaults.
4. In this outbreak, customer behaviour has changed exponentially. The underlying companies operations have reduced and the revenue from those operations have become limited. The companies have ramped down their production and have slowed down their purchases. All the companies dealing in products that are underneath the degree of basic consumption needs are not being preferred. Customers are sitting at home and have shifted their consumption habits towards those products needed to survive the crisis. 
5. For PE firms, this means a radical shift in ongoing business strategy. This becomes a threat to survival for the companies who cannot adapt. This kind of interference diminishes the business and in the worst case, ends a company prospects for growth and further survival. Innovating and investing in dominant sale options like online, may help get them out of the complication. 
6. The investors who are investing through the PE firms may demand transparency regarding the firm’s actions in the crisis. While dealing with the crisis, PE firms could overlook basic investment company issues, such as commitment call deadlines, financial statement filings and shareholder updates. The firms must focus on reviewing valuation models for deterioration of any assets affected by the crisis.

The crisis if looked at from another perspective can also be proved to be an opportunity for the industry to excel and transform. For the past many years all the PE firms who have been successful in building up and accumulating large funds which are still unused can be used at this time to make tough business decisions that could help the underlying companies move beyond the crisis. PE firms may deploy this capital commonly called as the ‘dry powder’ to meet the social expectations of the larger market.

The disturbance caused by this pandemic accompanied with economic slowdown in India can lead to creating opportunities for the investors who are viewing the crisis as a bigger picture. According to some experts, investors may see a maximum demand slowdown for investment for two quarters and it would not be impacted in the long term. 

Several companies are going to need to raise fresh equity capital if they wish fresh credit which in turn implies that PE investments are going to be inevitable. Only the fit companies would be able to survive around this disruptive crisis.

Conclusion

The situation of the crisis from what it was a decade ago is quite different because of factors like a stronger economy, the financial system is far more volatile and the damage is likely to be contained. The crisis demands an improvement in the expertise in strategic sourcing for underlying companies. Covid-19 has taught the PE players to pay heed to crisis management like this, business continuity plans and downside protections.

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