Private equity ("PE") Investment being amongst the most significant options for raising liquid capital lately, is surely and inevitably an industry to be affected by the unfortunate pandemic crisis of COVID 19. This untimely and uncertain health crisis is a thorn on one's side and has caused the word to stop. The present situation has not only brought down people to believe into surviving first and planning later but has also caused a ripple effect on economy, making the overall move towards the great depression. However, the structure of the PE Investment is capable of providing the much-required fuel to the economy by catalysing the jolted transactions and putting back the market in motion. All the more, a depressed economy has presented an opportunity for investors to take the leading role in pulling up the economy from the edge of cliff by investing in the distressed assets and businesses. The objective of the present article is to explain the working of PE in simplest terms and to edify the investors on the watershed importance of such investment in the distressed economy.
HOW DOES IT WORK
PE funding is an alternative private source of debt financing which allows the capital seeking businesses to raise funds without diluting the ownership of the business among huge quantity of stakeholders or increasing the value of the business, without tunnelling through the complex and lengthy process of raising funds from public. PE source of funding allows the investor with dry powder (surplus funds) to invest in businesses having potential to provide return on investment within a period of time. A PE investor being an accredited investor or an institutional investor holds the capacity to block their funds for a long period of time which helps in providing a flexibility of gustation period to the investee. Also, the structure of PE investment provides for a profit-sharing strategy which not only provides a transparency in usage of funds but it also ensures the involvement of experienced PE investors into the operation and management of businesses.
The working of PE investment in simplest terms, can be described as a retail business, wherein the PE Investor invests in a company in exchange of equity, increases the value of the company over the span of its ownership by funding the new projects, paying off the existing private debt or raising capital for mergers and acquisitions for the company and later selling their stake or equity through their exit routes to redeem the profits.
Over the years the investment strategies in PE Funds have enlarged the scope to include venture capital, real estate investments etc under its garb. However, in every investment strategy, the most important factor or the status quo is "Valuation". The financial mechanism of the PE investment revolves arounds the basic principle of increasing the value of the business for further resale. The valuations are calculated through different mechanisms such as the asset approach, market approach or income approach, whichever suits the investment strategy and provides the fair value for all the stakeholders.
LAWS AND REGULATIONS IN INDIA GOVERNING PRIVATE EQUITY:
PE transaction being a private investment, has to be set up as Alternative Investment Funds (AIFs) under SEBI (Alternative Investment Funds) Regulation, 2012 however the funds established before the enforcement of SEBI AIF Regulation can be registered under SEBI (Venture Capital Funds) Regulation, 1996 and are not needed to register themselves again under the SEBI AIF Regulation until the end of their term.
Under the SEBI AIF Regulation the funds have been divided into 3 categories where in Category 1 are the close ended funds having a minimum 3 years tenure and the funds are invested in early stage ventures that are ideally considered economically desirable by the government and regulators, mainly including Venture Capital, SME Funds etc. Category II funds are the ones that do not fall under either Category I or Category III and that does not borrow other than to meet the day to day operational needs, this is the category which includes most of the investments such as Private Equity, Real Estate etc. Category III are the ones using complex investment strategies with an objective of gaining quick short-term returns such as hedge funds etc.
The regulation embodies various compliances on the AIFs, some of them are as follow:
Moreover, rcently by way of SEBI circular dated 5th February, 2020, SEBI introduced the Performance Benchmarking and Standardization of Private Placement Memorandum (PPM) enhancing the disclosure standards of AIFs and bringing transparency in their working. After this amendment the AIFs will have to issue PPM for potential investors, similar to the objective of issuance of prospectus by companies. The PPM will give an opportunity to the investors to assess the risk in investment and also to have a fair idea of the usage of their funds by AIFs. Moreover, AIFs will be subjected to mandatory bench marking of their performances within the timeline provided under the regulation.
PANDEMIC, CRISIS AND MARKET REACTION: WILL THE HISTORY REPEAT
In the last two decades, India has witnessed a surge in PE Investments and it has also been alluring destination of investment by foreign PE investors. However, with the advent of the pandemic COVID 19 and downturn of the economies across the world there has been graphically lower transactions and PE investments have gone into tailspin. The impact of Pandemic on overall PE Investment will however be difficult to deduce owing to the fact that the investments are made in various sectors and every sector has been hit differently. Sectors such as real estate, transportation, retail, tourism have seen new lows whereas sectors like technology, pharmaceuticals etc have seen an up rise. The question is "should PE investors continue to invest during this economic crisis or should there be an abeyance on any further investment?".
During the last economic crisis of 2008, the world witnessed the great recession wherein many company's defaulted and were declared bankrupt. Amidst the crisis, there were few companies that survived and most of them were the ones backed by PE investment. Nevertheless, PE investors were experiencing such downturn for the first time then and the uncertainty of times made them hesitant is assuming the risk from the market, which is often referred to as the missed opportunity. It is said because, it was later observed that not only did the companies that were backed by PE investment not default, but those were also among the better performing businesses that rewarded the initial investments.
Therefore, the history of missed opportunity must not be repeated. The investors must make most of the opportunity presented to them. PE investment is the potential wildcard for better economy.
HOW BENEFICIAL AND BENEFITTED
The grand outcome of the PE Investment at the time of economic crisis can be simply explained by the most basic market practice of trading, i.e. one should buy when the market is down, as less investment can yield more profits. The investment strategy of PE funds is based on valuation as explained above, therefore, during the crisis the valuations of businesses and assets are undervalued and medium and small business are surviving on minimal capital. At such point of time, pumping of capital by PE Investors can save the drowning companies. The studies have shown that companies backed by PE investment are more likely to survive the economic shock and also are capable of providing a good investment on return over the years.
At the other hand, the PE investment is a great choice for revival of the economy as a whole. Economic crisis or economic depression means when the normal business cycle of the market is put at abeyance due to downturn of economy, where the supply is more than the demand, the trade and commerce is reduced, where people hold on to their investment or purchase which leads to dry economy, where there is unemployment and bankruptcies. However, there is a ray of hope down the tunnel in the form of Private Equity investment.
As per the trend over the years, it can be easily concluded that PE Investors mostly invest in middle sized businesses with the immense potential to generate more revenues when provided correct resources. While the reputation of PE may suggest that acquisition by PE firms leads to pay cuts and employment termination but over the years it has been observed that of PE investment fuels the economy and generates employment as an overall outcome.
In such a scenario when a PE investors assume the risk of investment and pumps the money in a middle sized companies, in turn the activities of these middle sized companies pushes the jammed wheels of business cycle in market which resultantly will generate employment, increase the purchasing power of the people thereby increasing the demand and balancing the demand supply equilibrium. Therefore, it will not be an exaggeration to conclude that PE investment is a successful non-governmental and efficient way out from this economic crisis. The Government, Central Bank and Institutional Investors must understand the role of Private Equity and shall take steps to promote such investments as it will be beneficial both for the individual businesses and economy as a whole.
Views are personal only.