Stock markets that have fallen for most part of 2008 are delaying private equity, or PE, transactions and also increasing the use of convertible instruments where an investment is converted into equity at a later date at the prevailing price.
The delay is because both the companies and investors are holding out for a better deal. For companies, a better deal means a higher valuation. For private equity firms, it means a lower valuation.
Citigroup Venture Capital International (CVCI), the PE arm of Citibank NA, says it has been exploring potential targets in India for the past nine months, but has closed only two deals, both at the beginning of the year. The snag in most cases was the divergence between what the promoter wanted and what CVCI was willing to pay. By the time promoters adjusted their valuations downwards to reflect market movement, the market had fallen further.
That’s a story that is playing out across India’s PE universe.
“The public markets are not finding their bottom yet. Since private markets adjust with a lag after public markets, in a falling market, the private company looks more expensive than a listed peer. As a result, the term sheet discussions never get over,” said P R Srinivasan, managing director of CVCI in India, which has invested in 70 Indian companies over the past ten years and exited 40 of them.
The CVCI case is just one example of a larger trend ever since the stock market started sliding earlier this year. Since 10 January, when it touched a high of 21,206.77, the Bombay Stock Exchange’s Sensex – India’s most tracked equity index – has lost 38.44%. It closed at 13,055.67 points on 1 October.
Srini Vudayagiri, managing director of Lightspeed Venture Partners, said, “It’s a moving target, and surely we are in uncertain times.” The Menlo Park, California-headquartered firm recently closed Lightspeed VIII, an US$800 million global fund that will also invest in India.
Not everyone, however, buys the logic of markets driving deals. Shujaat Khan, managing director of Blue River Capital, an India-focused PE fund that has US$140 million under management and seven investments to its credit since 2005, said such promoter-investor tugs of war go against the very essence of private equity. “A private equity firm’s job is not to keep a constant watch on the public markets but to find the intrinsic value in companies and invest.”
In July, when the markets were trading at the 13,000 levels, Shankar Sharma, joint managing director of Mumbai-based First Global group, which runs brokerages and an investment bank with subsidiaries in the US and the UK, had told Mint that the Sensex could hit 10,000, adding that he “would not be surprised if it goes even below”.
After recent events in the US and Europe, where several financial institutions have run into trouble and needed rescuing either by governments or other institutions, other stock analysts now seem to agree with Sharma.
Interestingly, the reluctance on both sides – investors and promoters – to accept market-based valuations has given rise to the increasing use of convertible instruments, which gives investors the option of converting them to an equity stake later, depending on whether the promoters meet revenue and cash flow targets at a set future date.
“The use of convertible instruments for private equity transactions is much larger now than it was earlier,” said Vudayagiri of Lightspeed, adding that these instruments give investors the flexibility to invest now but delay the decision to take an equity stake.
Though PE investors traditionally pick up stakes in unlisted firms, in India they have been investing heavily in listed enterprises as well. Such transactions accounted for 30% of the US$14.2 billion PE firms invested in 2007, and 18% of the US$8.1 billion PE investments in the first eight months of this calendar year, according to data from Venture Intelligence, a research firm. The argument in favour of such investments is that Indian companies tend to list much before they have achieved a critical mass and, therefore, have high potential for growth.
But a special pricing formula set by markets regulator Securities and Exchange Board of India, or Sebi, is in place for such preferential allotments in listed entities. The price has to be the higher of either the six-month average price of the stock, or the two-week average. For unlisted companies, the price is derived using valuations of listed peers as a benchmark.
Meanwhile, the operating wisdom remains that investors should invest only when absolutely sure. “We have to make sure we are not blowing up our money by overpaying,” said Shankar Narayanan, managing director of Carlyle India Advisors Pvt Ltd.
Carlyle India, which opened its Mumbai office in August 2005, but has been investing in the country since June 2000, is the Indian arm of The Carlyle Group, one of the world’s largest private equity managers.
It has not closed a single deal in India this year, against five last year.
This article first appeared in http://www.livemint.com on 1 October 2008.