Though many believe private equity infusions help make a firm more competitive, the evidence seems to suggest just a one-time hike in returns.
The private placement market in India has witnessed a very rapid growth in the recent past with companies increasingly adopting the private route for funds mobilisation, and choosing to make private offerings to sophisticated and qualified institutional investors rather than issuing securities publicly. This is borne out by the fact that in the financial year 2006-07 alone, around 1,300 companies raised Rs 126,790 crore (Rs 1267.9 billion) through private placements (debt only).
The accelerated growth of private placements in spite of the presence of a well-developed public stock market warrants an investigation into the possible effects it could have on the performance of the companies concerned.
Some analysts state that private placements can be effective in resolving several agency issues, while spurring a firm to higher performance by increasing the efficiency in the operations and management system through direct and concentrated control.
Another school of thought argues that private placement investors' interest in a firm is limited to the short haul with the sole aim of maximising their returns for a limited period of time. This gives them an incentive to under-invest to the detriment of the long-term growth capacity and sustainability of firms.
Private placements generally involve a few investors who, as opposed to public investors, are more proactive, have higher control and might have a higher risk appetite. This could both act in favour of or against the interests of a firm. The importance of examining the effect of the choice of financing decision in terms of private versus public offerings on the performance of firms cannot be overemphasised.
We examined the performance of a sample of publicly listed firms that placed equity through private placements in the period 1999-2003. This was done on a few market parameters and accounting-based measures. The companies were grouped by the type of investor that bought the private issues, viz, financial investors, strategic investors and promoters to examine whether the investor type had a significant role in affecting the firm performance.
Financial investors are organisations like mutual funds, which invest in companies with the main objective of earning high returns on their free cash and generally do not have a strategic advantage or expertise with respect to the core competency of the firms they invest in.
Strategic investors, on the other hand, are in the same or related areas of business as the firm and invest to perhaps gain from synergies and use their expertise in the same area as the firm whose shares they purchase. Some of the private equity placements are also purchases by the promoters of the same firm looking to increase their share in the ownership and control of the firm.
The returns in excess of the markets return earned by the shares of these firms showed a significant positive announcement effect, causing an immediate, sharp and uncharacteristic rise in the share prices of these companies (50-100 per cent more than the Sensex): a reaction different from the negative return generally reported for a seasoned public issue.
The abnormal positive performance was, however, found to be unsustainable and the share prices closely mimicked the general market pattern, once the initial announcement effect had been accounted for. This effect was found to be uniform across firms irrespective of the nature of investor and the level of dilution (as measured by the percentage of stake acquired). When measured by McKinsey's MVA method scaled for the size of these firms, the pattern is similar with positive announcement effect and normal returns later.
The post-announcement increase in the market value of equity can be attributed to a positive signaling effect. The purchase of a company's stake by well-informed and qualified financial investor suggests the potential of the company to offer higher financial returns in the future. Strategic investments hint at a hitherto unrealised core potential in firm and investments by promoters strongly signal their optimism about the firms' future return to shareholders. This signaling effect is reflected in the market prices.
Our examination of accounting measures like Residual Earnings and Economic Profits, adjusted for size and type of industry revealed that the performance of firms with private issues to financial and strategic is similar to that of those with public issues. However, firms in which promoters increased their stake seemed to be under-performing in accounting terms in the year following the issue (10-15 per cent lower Residual Earnings than average).
This could be consistent with the tendency to save on taxes by underreporting earnings (promoters, being the major shareholders are less answerable to shareholders). This result may also have another implication. It suggests that the lower than average accounting performance of the firm did not affect the market sentiment, with these firms having normal returns in the market. Thus, the market attaches a lesser weight than expected to the accounting measures derived from a firm's financial statements.
A cluster analysis (a multivariate hierarchical clustering method) of the firms resulted in clusters that could not be characterised by any single parameter like dilution levels, size, type of industry or investor type. This suggests that there is no particular type of firm characterised by a single parameter, which benefits more from private placement.
On the basis of the above findings, it is suggested that a retail investor invest in firms that have announced a private issue of equity to institutions and promoters. These investments, if made immediately following such announcements or in anticipation of them, can capitalise on the announcement effect but there is no extraordinary return on longer-term holding.
Moreover, with respect to investments in a firm with large promoter holdings, more importance should be given to market data and related parameters rather than accounting measures while assessing its performance.
(The authors are second-year students at the Indian Institute of Management, Bangalore. This article is based on an intensive three-month research carried out by them. They can be reached at email@example.com and firstname.lastname@example.org, respectively.)