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PE investing: Look before you leap

By Ramesh Bukka
November 12, 2018 11:15 IST
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Before committing your precious money in PE funds, investors need to get very choosy, advises Ramesh Bukka, co-founder and director, Entrust Family Office Investment Advisors.

Many high net worth individuals (HNIs) looking to diversify their portfolios beyond the listed space consider foraying into private equity.

Many get lured by the promise of extemely high returns.

However, only sophisticated investors, who understand the risks well, should venture into this space.

Besides a minimum investment size of Rs 10 million and above, investing in private equity also requires the patience to stay put for a tenure of 10 years, or sometimes even more.

Experience suggests that returns, adjusted for risk, often turn out to be lower than in the listed space.


Past performance is uninspiring

Private equity investing in India has had a chequered performance history over the past 15 to 20 years.

In the years leading up to the market meltdown in 2008, it was highly sought after by institutional as well as high net worth investors as the economic growth rate in India was strong.

The greed for higher returns coupled with strong push from the distribution community ensured that large pools of capital were raised.

The euphoric times did not last long.

Investments made up to 2008 were at peak valuations and took considerable years to break even.

Most PE funds ended up having marginal stakes in investee companies with inadequate investment rights.

They, therefore, had limited influence with promoters on key decisions.

Most PE funds were raised by first-time managers who did not have enough private equity experience.

Saddled with excess capital, they did not focus adequately on entry valuations and risk assessment.

As a result, investors' returns on most of the funds raised about 10 years ago have been dismal and in low single digits, well below equivalent benchmarks in the listed space.

Most of the capital has also not been returned yet, thereby increasing opportunity costs for investors.

Barring a few exceptions, most PE funds have not made money for their investors.

Part of the blame also lies with the investors as they did not do adequate diligence on the fund or the manager before committing their capital for 10 years or more.

Most existing PE funds are now struggling with exits as liquidity is not easy.

The average holding period for most funds is four-five years.

It is a common feature to see funds writing to investors seeking extension of the original mandate.

With performance being below the hurdle rate, there is no incentive for investors to carry on, and most funds are now struggling to hold on to their investors.

Will 2008 be repeated?

As in 2008, there has been a proliferation of PE funds that have raised money over the past two years, riding on strong sentiment in the equity markets.

Investors have poured billions of rupees, lured by the prospects of high returns, and to diversify their portfolios.

While the landscape has improved, most funds are yet to complete one fund cycle of raising and returning all the capital.

Therefore, it is extremely difficult to assess performance as there is not much to evaluate.

The situation is similar to 2008, when valuations in the public and private markets were rich, thereby increasing the entry valuation risk.

When you look at the promised returns of some of the funds, they target a gross internal rate of return (IRR) of 20 to 25 per cent as anything lower is not in line with investors' expectations.

While certain individual investments may yield very high returns, consistent delivery across the portfolio at current market valuations is akin to asking for the moon. The mistakes of 2008 could be repeated.

High fees will lower investors' returns

While management fees and operating expenses are easy to understand, PE funds levy carry (performance fee) above a certain threshold (hurdle) with provisions of 'with catch up' (profit share on the entire return) and 'without catch up' (profit share on return above the threshold).

For most investors the dice is loaded against them as fees end up taking more than 25 to 30 per cent of invested capital during the life of the fund, irrespective of performance.

Distributors of these products end up getting 5 to 8 per cent upfront.

As the money is locked in for many years, the incentive to sell (or mis-sell) is large.

This is a classic case of 'heads they win, tails you lose'.

Complicated terminology, phantom valuations

PE funds are ideally meant for sophisticated investors.

Investing in these funds is not easy since investors have to contend with several terms like PPM (private placement memorandum), MoIC (multiple of invested capital), TVPI (total value to paid in multiple), tracking multiple, mark ups, mark downs, provisioned investments, waterfalls and clawbacks.

PE funds are mandated to value their investee companies on a yearly basis through an external valuation agency.

Since the investee companies straddle many diverse sectors and industries, valuation is a tricky exercise and is prone to ambiguity.

Since the valuers are appointed by the funds themselves, there always exists an element of conflict.

Unlike the listed space, most of the reporting of performance (or shall we say the lack of it) is done in not-easy-to-understand terminology like MoIC, instead of simple measures like XIRR.

Some underperforming PE funds seem to have found innovative methods of giving fund value as a multiple of the amount invested in the investee companies and not including the fees charged. How convenient!

Ultimately, valuation is discovered only when the investment gets listed or is sold.

Final returns can be computed only when the fund is fully liquidated and paid out, which is usually after more than 10 years. Until then, returns are phantom like, notional and therefore not relevant.

Expensive products

PE funds are expensive products as usually a fourth of the committed capital goes into fees.

If one were to include profit sharing and taxes, net returns are substantially lower than gross returns.

Most investors who have invested in the last peak have ended up with poor returns and any investments committed now will probably see an exit in the next peak.

If you look at recent history, peak to peak returns are poor. Unlike the current period, best returns are made when there is lack of investor interest.

Before committing your precious money in PE funds, investors need to get very choosy and ask themselves:

Are they worth the risk?

Do they fit my overall portfolio?

Am I ready for a long gestation period?

Investors need to look, pause, take a closer look before they take the leap.

Illustration: Dominic Xavier/

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