Revisiting Demarcations Between Private Equity And Strategic Investments

Whether an investment is successful depends on understanding the balance between the return and the risk on the investment. Though a high risk investment presents unique arbitrage opportunities for investors with a commensurate risk appetite, most investors seek a steady rather than an exponential rate of return on investment.

Risk appetite is all about judging whether the probability of significant returns justifies the risk of the proposed investment going south. The typical investment model in different markets presents an interesting picture and the model adopted by private equity in developed markets like the U.S.A. or Europe can be distinguished from emerging markets. The primary rationale behind such distinction is the higher level or quantum of risk and uncertainty associated with investing in emerging markets.

However, in reality, riskaverse models may give rise to additional risk rather than offsetting the perceived issues. We believe that the model adopted by private equity in developed markets (where the model is more participative than protective and almost akin to a strategic investment) is more efficient and profitdriving than the model adopted for Indian investments. In developed markets, private equity structures their investments into either

1. minority stakes with protective rights,
2. substantial stakes with management/technical overhauls or
3. complete buy-outs of target companies.

While the portfolio or minority investment is usually in the nature of diversification and hedging against other risk exposures. The primary investments are usually in substantial buy-outs (with management overhauls and inclusion of professional management) or complete buy-outs of target companies (again with inclusion of professional management).

The objective of a buy-out is to acquire an undervalued company, effect a management overhaul and employ appropriate talent, turn the target company around by implementing effective business policies, efficient supply and production chains, and then achieve a return by selling the investment (often through a competitive auction process). In other words, private equity looks at 'creating value', turning an undervalued ailing business into a profitable venture which will fetch a good price.

In the process, the target's business becomes streamlined, efficient and profitable. Untapped opportunities are harnessed and the appropriate expansion opportunities are decisively capitalised upon. Such growth creates employment, develops industry competition, promotes research and product development and paves way for further opportunities. All in all, the buy-out mechanism is a perfect example of how private profit enterprise has a positive social impact through growth, development and the harnessing of opportunities.

However, there are significant downside arguments as well, the most notable being the short-term profit incentive. Private equity can engineer the target company to yield short term returns which will enable it to make good its investment, but may then be harmful to the company in the longer term. For instance, the private equity led target company may decide to invest in a negative net present value opportunity with high volatility.

High volatility will mean higher probabilities of earning a good profit or incurring a bad loss and the investment may yield short-term results because of which the target company's market valuation may spike. The investor could exit the during such a spike to achieve its return on investment. In the long run, the volatility works against the investment and the company suffers a loss thereby harming the subsequent investors and this risk is borne by the subsequent investor, be it strategic or another private equity player.

There is no quantifiable manner in which this risk can be offset - the best risk neutralisation method for a potential purchaser (be it private equity or strategic) will be to conduct proper due diligence, evaluate the net present valuation of each of the target's investments and refrain from investing if the volatility of the target company's investments is estimated to exceed the risk appetite. In other words, appropriate risk analysis is essential.

Emerging markets are termed as such because there are no set precedents on the manner in which the market is predicted to grow, since the market and the economy is growing for the first time. For someone who is not familiar with the Indian market, aspects like the course of economic development, acceptability and saleability of a product and identifying promising opportunities becomes difficult to predict. In such a situation, prudence demands that an alien investor should tread carefully in an otherwise unknown unpredictable market.
It is well established that even information asymmetry gives rise to an exaggerated estimation of risk and volatility, i.e., the ability to assume more risk comes from confidence and confidence comes from familiarity. For instance, familiarity with a market enables an investor to predict its movements and dynamics and this allows it to recognise arbitrage and profit-making opportunities, which is probably why private equity tends to have substantial holdings in their home jurisdiction in terms of value and control holding but, in comparison, their foreign portfolio is lesser in magnitude.

In India, private equity usually has limited control exposures in the target companies and they are still operated by the original management, though equity exposures are substantial in some cases. A substantial equity exposure may be explained from the perspective of returns, i.e., a controlling stake in a profit-making company will fetch a higher price than a minority stake.

However, the fact that the target company is still substantially operated by the old management indicates that the private equity investor is looking at free-riding on the existing management's profit-making abilities and their involvement in the target company's management is purely from the perspective of investment protection and there is little 'value addition' compared to the investment models adopted in developed markets. Often, despite acquiring equity control of the target company, the investor allows the outgoing promoters to continue to manage the day-to-day operations of the target.

In a buy-out model where the substantial share capital is held by the private equity investor and the company is controlled by management essentially cherry-picked for the job and monitored by the investor, the consequent risk on investment and performance is incrementally lower. Logic demands that private equity investors should be looking at reducing as much risk as possible and making their investments safe and assured, but that is not being done in India on the pretext of it being an emerging market.

Foreign investors are probably utilising this time to understand the Indian market and are making small calculated ventures. The hesitation of the foreign private equity investor in creating positive value for Indian entities becomes quite clear when one looks at the aggressive risk-assumption by foreign strategic investors in India. Numerous businesses are entering the Indian market by themselves through wholly-owned subsidiaries or joint venture partnerships.

Their risk exposure in such entry vehicles is direct and not necessarily buffered or hedged. The risks involved in a buy-out investment by a private equity investor are very similar to a strategic investment. The only difference is that the private equity investor will strongly negotiate exits, since the ultimate objective of a private equity investor is to realise a return on its investment. This is distinctly different from a private equity investor's motivation which is returns-oriented. While ascertaining the investment risk, the private equity investor's primary objective is to protect returns.

When the private equity investor does not operate the business or control the company, it is exposed to 'partner risk', i.e., risk associated with possible value-diminishing motivations and incentives of the domestic management running the business. To offset such risks, the private equity investor negotiates for protective covenants at the time of investment, like reserving veto rights over business decisions which may result in a diminution in the value of the business (and consequently, its investment value) and overriding exit options with assured returns if the downside exposure is estimated to exceed the investor's risk appetite.

Strategic investors usually focus on synergising their current business with new business opportunities and are not strictly returns-oriented in their approach but rather growth-oriented. The major difference between the risk offsetting measures taken by a strategic investor and a private equity investor comes down to exit valuation. The private equity investor invests with the objective of achieving returns and will strongly negotiate for an assured baseline investment return at the time of a future exit, while the strategic investor does not invest with a view to exit and the exit mechanism is more of a protection to offset any 'partner risk' in a venture where it cannot acquire the entire stake or where it has partnered with a domestic company to capitalise on such companies local knowledge or supply chain.

It is likely that in the near future, the Indian private equity industry will see more and more private equity buy-out investment models whereby

1. the private equity investors will get more comfortable and confident with the Indian market, and
2. there will be a reduction in 'partner risk' and 'management risk', through either majority controlled acquisitions or 100% buyouts.

The demarcating lines between the risk taken by a strategic investor and a private equity investor will blur and become comparable in absolute terms. In such an era, it is quite possible that the only aspect differentiating a strategic investment and a private equity investment will be in relation to exit valuations.