Investment Banking & Private Equity

A Project Report On “INVESTMENT BANKING AND PRIVATE EQUITY” AT BIRLA SUN LIFE FINANCIAL SERVICES Under The Guidance Of Mr. Nikesh Ruparel Business Associate Birla Sun Life

Submitted By: MAKARAND ASHOK RANE P.G.D.M. (FINANCE) 2010-12

In Partial Fulfillment Of The Requirements Of Post Graduate Diploma in Management

VIVEKANAND EDUCATION SOCIETY’S INSTITUTE OF MANAGEMENT STUDIES & RESEARCH Chembur, Mumbai.

A Project Report on “Investment Banking and Private Equity” At

Birla Sunlife Financial Services

Submitted By Makarand Ashok Rane M.M.S (FINANCE) Roll No.25 Batch - 2010-12

VIVEKANAND EDUCATION SOCIETY’S INSTITUTE OF MANAGEMENT STUDIES & RESEARCH Chembur, Mumbai.

AUTHORIZATION This report has been prepared under the guidance of Mr. Nikesh Ruparel, Senior Business Mentor, Birla Sunlife Financial Services. This report is submitted as partial fulfillment of the requirement of PGDM Program of Vivekanand Education Society’s Institute of Management studies and Research (VESIMSR).

Date : 05 September 2011

Makarand Ashok Rane

DECLARATION This is to certify that the thesis titled “Investment Banking and Private Equity” is a bonafide work done by Mr. Makarand Ashok Rane, in partial fulfillment of the requirements of PGDM Program and submitted to VESIMSR. I also declare that this project is a result of my own efforts and that has not been copied from anyone and I have taken only citations from the literary resources which are mentioned in the Bibliography section. This work was not submitted earlier at any other university or institute for the award of the degree.

Date : 05 September 2011 Place : Mumbai

Makarand Ashok Rane

ACKNOWLEDEMENT It gives me great pleasure while submitting this report on: “Investment Banking and Private Equity” It was a privilege to work on this project. It has helped me to understand the practical aspects of investment banks concepts and its application in private equity. I feel privileged to be associated with Birla Sunlife Financial Services; I deeply express my gratitude to Mr. Harshad Surve, Business Associates, for giving me an opportunity to work as an intern at Birla Sunlife Wealth Management. I would like to heartily thank Mr. Nikesh Ruparel, Senior Business Mentor, my company guide for his constant guidance and invaluable time and suggestions. I would like to express my deep sense of gratitude to my friend Mr. Akash Kalia, Sr. Analyst – Real Estate, Aviva Global Investors, who devoted his valuable time out of his busy schedule to help me complete this project. I would like to thank him for his suggestions that helped me at all times for the writing of this project. Finally I would like to thank my friends and fellow interns at Birla Sunlife Financial Services who provided valuable inputs throughout my internship, which helped me in formulating a comprehensive report.

Date: 05 September 2011

Makarand Ashok Rane

EXECUTIVE SUMMARY The project deals with the Investment banking and its practical application in Private Equity as well as venture Capital Investment. The objective of the project was to focus on investment banking services for startups and buyout transactions. Indian Economy being one of the fastest developing economies in the world. Rapid changes in the global economy has made India one amongst the more attractive investment destinations globally, driven by a combination of strong economic growth, an improving regulatory environment and favorable demographics. As India continues on its rapid-growth path, several large potential investment sectors such as financial services, infrastructure and domestic consumption offer significant opportunities. Companies in India are growing at farter rate as compared to their growth rate a decade back. Many Indian companies are expanding their business globally with mergers and acquisitions. Lot of foreign companies are attracted to India because of lucrative business opportunities. In order to help companies to take advantage of this scenario, they essentially require advisors to carry on due-diligence and meet regulatory requirements. Investment banking companies pay a very important role here as they provide array of services. They help companies and Private Equities in decision making by helping them on business plan, financial modeling, valuation, deal structuring. The study throws light on the global investment banking and private equity scenario. It helps the reader to understand the functions and products offered by an investment bank and kinds of finance provided by a Private equity. The projects explain in detail several factors taken in to consideration by any private equity in a deal. The projects explain in detail six different stages to be and support provided by investment banker before closing of the deal. The project explains how a fair value of a company is calculated using average of NAV and PECV, and calculation of stake of PE during several funding rounds.

SYNOPSIS Sr. No

1

Topic

Page No.

Introduction to Investment Banking 1.1 1.2 1.3

2

Definition: Investment Banking Evolution of Investment Banking Activities of Investment Banks

1-5 1 3 4

Investment Banking in India 2.1 2.2 2.3

3

Major Players in the Indian Investment Banking Industry Characteristics of Indian Investment Banking Industry Regulatory Framework for Investment Banking

6 - 10 7 8 10

Products and Services Offered by an Investment Bank 3.1 3.2 3.3

4

Underwriting Advisory Services Allied Businesses

11 - 16 11 13 15

Introduction to Private Equity and Venture Capital 4.1 4.2 4.3 4.4 4.5 4.6 4.7

What is a Private Equity? What is a Venture Capital? Private equity Investments and India Top Private Equity Investors in India (2005 – 2010) Top Global Private Equity Firms Map of Private Equity Investments Types of Financing Provided by Private Equity and VC

5.1 5.2 5.3 5.4 5.5 5.6

Overview of Investment Banking Services for Private Equity Business Plan and Financial Model Transaction Structuring Valuation in Private Equity Transactions Deal Structuring Term Sheet Corporate Disclosure

5

17 - 30 17 18 18 20 20 21 22 31 - 59 33 34 38 47 55 57

6

Conclusion

58

7

Bibliography

59

8

Webliography

59

9

Annexures

60

Glossary: Private Equity

60

DIP Guidelines w.r.t. Qualified Institutional Placements

64

Investment Banking and Private Equity

Introduction to Investment Banking

Investment banking is the banking activity not classifiable as commercial banking. Its primary function is of assisting the capital market in its function of capital intermediation, i.e. the movement of financial resources from those who have them (the Investors) to those who need to make use of them for generating GDP (the Issuers). At the macro level, banks and financial institutions on one hand, and the capital market on the other, are the two broad platforms of institutional intermediation for capital flows in the economy. Therefore, it can be inferred that investment banks are the counterparts of banks in the capital market in discharging the critical function of pooling and allocation of capital. Commercial banking in turn can be defined very shortly, but effectively, as “deposits taking and loans making”. In other words, commercial banks simply borrow money mainly in the form of deposits and lend money to families and to firms. Since commercial banks are mostly financed through deposits, they are sometimes called “depository institutions”. Of course commercial banking is a little bit more complicated than this: banks raise money in many ways (other than deposits) and the types of loan they make is limitless. Nonetheless, the core commercial banking activity is still “deposits taking and loans making”.

Definition: Investment Banking 'financial intermediary that performs a variety of services, including aiding in the sale of securities, facilitating mergers and other corporate re-organizations, acting as brokers to both individual and institutional clients and trading for its own account' - Bloomberg 1


'A bank which deals with the underwriting of new issues and advises corporations on their financial affairs’ -The 'Dictionary of Banking and Finance’

'Investment banking is what investment banks do’ -John F. Marshall and M.E. Ellis

There are several definitions of investment banking presented by different organizations and individuals. It has to be understood that the term 'Investment Banking' has different connotations in the US and other markets. In the US market, it is a fund-based activity. In UK and in India, it predominantly connotes intermediation and advisory activity in connection with public floatation’s of securities. However, it is clear that 'investment banking' is a term of wider import describing a range of fund-based and fee-based capital market activities performed by investment banks.

2


Evolution of Investment Banking

Investment banking practices such as extending credit to merchants date back to ancient times. In the 1600s, early investment institutions such as acceptance houses and merchant banks helped finance foreign trade and accumulated funds for long-term investments overseas. The nineteenth century saw the rise of several prominent banking partnerships such as those created by Rothschilds, the Barings and the Browns. These firms had their origins in the Atlantic trade, financing the importation of commodities for European manufacturers and helping them export their finished products around the world. In the United States, investment banking received a boost during the American Civil War. Syndicate banking houses sold millions of dollars worth of government bonds to large numbers of individual investors to help finance the war. This marked the first mass-market securities sales operation, a practice that continued later in the 1800s to finance the expansion of the transcontinental railroads. The 1800s also saw the birth of some of the most famous firms in investment banking, many of which are still with us, in one form or another, 150 years later. In the early twentieth century, investment banking expanded dramatically. One reason was an increase in the number of individuals who owned stock, something that resulted from the prosperous years after the First World War. The stock and bond market boom of the 1920s was an opportunity that banks could not miss. But since they could not underwrite and sell securities directly, they owned security affiliates through holding companies. The affiliates were thinly capitalised and were financed by the parent banks for their underwriting and other business obligations. However, the ensuing run-up in stock prices created an unsustainable bubble that finally collapsed with the Great Depression in 1929. 3

Activities of Investment Banks


Investment banking includes a heterogeneous set of activities, which can be classified into three main areas: I.

Core/Traditional Investment Banking i. Underwriting services - which consist in assisting firms raising capital on financial markets. ii. Advisory services - which consist in assisting firms in transactions

such

as

mergers,

acquisitions,

debt

restructuring, etc. I I.

Trading and Brokerage: It comprised of purchasing and selling securities by using the bank’s money (proprietary trading) or on behalf of clients (brokerage).

II I.

Asset Management: It consists in managing investors’ money. It can be broken down into two main categories: i. traditional asset management (i.e., open end mutual funds) ii. alternative asset management, which includes real estate funds, hedge funds, private equity funds, and any other vehicle investing in alternative asset classes.

Relevant to all the three areas is the research activity, which support investment decisions (trading & brokerage, and asset management), as well as the core investment banking business. However, because of the possible conflicts of interests (e.g., recommending an issuer simply because it is a client), the research activity is normally organizationally separated by the core investment banking.

4


League Table First Half 2011: Global Investment Banks(Based on FeesEarned)

3,196.33

Change in Fees vs. Prev Period* 35%

2,816.24 2,541.27 2,228.22 1,951.99 1,887.63 1,858.05 1,622.75 1,387.56 742.7 44,034.03

40% 51% 20% 39% 33% 38% 35% 30% 9% 23%

Fees ($m)

Top 10 Banks JP Morgan Bank of America Merrill Lynch Morgan Stanley Goldman Sachs Deutsche Bank Credit Suisse C iti Barclays Capital UBS BNP Paribas Total

Source: Mergermarket

% of Fees collected by product in H 1 2011 M&A

Equity

Bonds

Loans

25

23

29

23

19 37 35 20 28 21 21 39 14 36

27 29 33 28 30 24 23 31 11 25

30 23 26 40 30 36 40 25 45 24

24 12 6 12 11 18 17 5 30 15

5


Investment Banking in India

In India, though the existence of this branch of financial services can be traced to over three decades, investment banking was largely confined to merchant banking services. The forerunners of merchant banking in India were the foreign banks. Grindlays Bank (now merged with Standard Chartered Bank in India) began merchant banking operations in 1967 with a licence from the RBI followed by the Citibank in 1970. These two banks were providing services for syndication of loans and raising of equity apart from other advisory services. It was in 1972 that the Banking Commission Report asserted the need for merchant banking services in India by the public sector banks. Based on the American experience, which led to the passage of the Glass-Steagall Act, the Commission recommended a separate structure for merchant banks distinct from commercial banks and financial institutions. Merchant banks were meant to manage investments and provide advisory services. Following the above recommendation, the SBI set up its merchant banking division in 1972. Other banks such as the Bank of India, Central Bank of India, Bank of Baroda, Syndicate Bank, Punjab National Bank, Canara Bank followed suit to set up their merchant banking outfits. ICICI was the first financial institution to set up its merchant banking division in 1973. The later entrants were IFCI and IDBI with the latter setting up its merchant banking division in 1992. However, by the mid eighties and early nineties, most of the merchants banking divisions of public sector banks were spun off as separate subsidiaries. SBI set up SBI Capital Markets Ltd in 1986. Other such as Canara Bank, BOB, PNB, Indian Bank and ICICI created separate merchant banking entities. IDBI created IDBI Capital markets much later since merchant banking was initially formed as a division of IDBI in 1992.

6


Major Players in the Indian Investment Banking Industry

Several big investment banks have set many group entities in which the core and non-core business segments are distributed. SBI, IDBI, ICICI, IL&FS, Kotak Mahindra, Citibank and others offer almost all of the investment banking activities permitted in the country. The long-term financial institutions like ICICI and IDBI have converted themselves into full service commercial banks (called as Universal banks). The Indian investment banks have not gone global so far though some banks do have a presence in the overseas. The middle level constitutes of some niche players and a few subsidiaries of the public sector banks. There are also merchant banks structures as NBFCs such as Alpic Finance, Rabo India Finance ltd and so on. Some of the pure advisory firms that operate in the Indian market are Lazard Capital, Ernst & Young, KPMG, and Price Water Coopers etc.

Major Indian Investment Banks o o o o o o o

SBI Capital Markets Ltd. Kotak Mahindra Capital Company JM Morgan Stanley Ltd DSP Merrill Lynch Ltd. ICICI Securities Ltd IDBI Capital Markets Ltd Enam Financial Consultants Ltd.

7


Characteristics of Indian Investment Banking Industry

Indian investment banking industry has a heterogeneous structure. The bigger investment banks have several group entities in which the core and noncore business segments are distributed. It has its own characteristic structure over the years both due to business realities and the regulatory regime. This is because On the regulatory front: Indian regulatory regime does not allow all investment banking functions to be performed under one legal entity for two reasons x To prevent excessive exposure to business risk under one entity x To prescribe and monitor capital adequacy and risk mitigation mechanisms. In addition, the capital adequacy requirements and leveraging capability for each business line have been prescribed differently under relevant provisions of law. On the same analogy, commercial banks in India have to follow the provisions of the Banking Regulation Act and the RBI regulations, which prohibit them from exposing themselves to stock market investments and lending against stocks beyond specified limits. Indian investment banks follow a conglomerate structure by keeping their business segments in different corporate entities to meet regulatory norms. Merchant banking business has to be in a separate company as it requires a separate merchant banking licence from SEBI. Merchant bankers other than banks and financial institutions are also prohibited from undertaking any business other than that in the securities market. However, since banks are subject to the Banking Regulation Act, they cannot perform investment banking to a large extent on the same balance sheet. Asset management business in the form of a mutual fund requires a three-tier structure under the SEBI regulations. Securities business has to be separated into a different 8


company as it requires a stock exchange membership apart from SEBI registration. Business realities: The financial services industry in India till the early 1980s was driven largely by debt services in the form of term financing from financial institutions and working capital financing by commercial banks and nonbanking financial companies (NBFCs). Capital market services were mostly restricted to stock broking activity which was driven by a non-corporate unorganized industry. Merchant banking and asset management services came up in a big way only with the opening up of the capital markets in the early nineties. Due to the primary market boom during that period, many financial business houses such as financial institutions, banks and NBFCs entered the merchant banking, underwriting and advisory business. While most institutions and commercial banks floated merchant banking divisions and subsidiaries, NBFCs combined their existing business with that of merchant banking. Over the years, two developments have taken place. Firstly, with the downturn in the capital markets in the later phase, the merchant banking industry saw a tremendous shake out and only about 10% of the larger firms remained in serious business. The other development is that due to the gradual regulatory developments in the capital markets, investment banking activities came under regulations which required separate registration, licensing and capital controls.

9


Regulatory Framework for Investment Banking

x All investment banks incorporated under the Companies Act, 1956 are governed by the provisions of that Act. x Those investment banks that are incorporated under a separate statute are regulated by their respective statute. Ex: SBI, IDBI. x Universal banks that function as investment banks are regulated by RBI under the RBI Act, 1934. x All Non-banking Finance Companies that function as investment banks are regulated by RBI under RBI Act, 1934. x SEBI governs the functional aspects of Investment banking under the Securities and Exchange Board of India Act, 1992. x Those investment banks that carry foreign direct investment either through joint ventures or as fully owned subsidiaries are governed by Foreign Exchange Management Act, 1999 with respect to foreign investment.

10


Products and Services Offered by an Investment Bank I.

Underwriting With underwriting services an investment bank helps firms to raise

funds by issuing securities in the financial markets. These securities can include equity, debt, as well as “hybrid” securities like convertible debt or debt with warrants attached. Investment banks structure the transactions by verifying financial data and business claims, performing due diligence and, most importantly, pricing claims. These services are labeled “underwriting” because investment banks actually purchase securities from the issuer and then resale them to the market.

a. Equity Offers In the case of equity, this is done through Initial Public Offerings (IPOs). IPO is a rather generic term, but there are several alternative offering structures depending on the kind of shares being sold, where the company is listed, to whom the offer is addressed, etc. Investment banks also structure seasoned equity offerings (SEOs) and rights offerings, which are transactions through which listed firms can raise equity capital.

b. Debt Offers Debt offering is a debt instrument offered for purchase by private investors - normally with warrants for future stock purchases at fixed prices. This is a way for companies to raise debt financing by selling 11


notes with a set annual return rate and a schedule on when the full payment\ will be made to investors. It must be noted that a bond offering is not really different from an equity offering. The players involved are the same and also the process is pretty similar.

c. Securitization Investment banks also help firms to use their assets to issue debt. This process is labeled “securitization” and the securities issued are called “asset backed securities” (ABS). Many commercial banks securitize their loans. Indeed, in the last years the traditional commercial banking activity has been moving from an “originate-tohold” model (banks make loans and keep these loans on their balance sheets) to an “originate-to-distribute” model (banks make loans and then sell them to the market, through the securitization process). In this respect, although commercial and investment banking are still two very different types of business, the “originate-to-distribute” model of commercial banking somehow resembles the underwriting services provided by investment banks.

d. Loan Syndication It is a loan amount that is too big to be granted by a single bank, and for which it is therefore necessary to assemble a pool of banks (i.e., the syndicate), coordinated by a lead. As a result, each single bank of the syndicate is lending money to the borrower. Investment banks co-originate/structure and distribute loan, mezzanine and other similar private products L/Cs or Guarantee. Transactions can be arranged on an underwritten or Best Efforts Basis.

12


However, a relevant task in the underwriting business is pricing the securities being offered. Indeed, the way the price is set is crucial, being the price the key variable of any offering. The role of the investment bank itself is strictly related to the price-setting mechanism. Generally investment banking fees are much higher in IPOs than in any other security offering. On average bonds are much easier to price relative to equity. One of the reasons explaining why bonds are easier to price relative to stocks is related to credit ratings, which are opinions about the creditworthiness of a firm (or its debt securities) expressed by independent and reputed agencies. The presence of ratings facilitates remarkably the job of the investment banks when pricing bonds. Indeed, when helping firms to raise capital in the financial markets, investment banks do not take a debt or equity position in the issuing firm. In other words, at the end of the transaction the investment bank does not run any risk related to the issuer.

II.

Advisory Services It refers to the activity of advising organisations, including corporations,

institutions and government bodies, on mergers and acquisitions and other transactions that involve a change in ownership of a company or business. In investment banking circles, this activity is commonly known by the general term M&A (Mergers and Acquisitions).

a. Mergers and Acquisitions Merging and acquiring business is a cumbersome task. Any loophole or negligence can lead to huge financial losses and in extreme cases even the closure of business is possible. Investment 13


banks provide advisory services to help their client firms with mergers and acquisitions (M&As) and corporate restructuring in general. Investment banks perform different tasks as advisers. First of all, they take care of many technical aspects related to the transactions. In a M&A deal, for example, they collect and process information about the companies involved in the transaction, provide an opinion about the price payable, suggest the best way to structure the deal, assist their clients in the negotiations, etc. The extant empirical evidence suggests that investment banks play a relevant role in designing, structuring, and executing M&As, as their experience, reputation, and relationship with clients significantly affect the wealth of the shareholders involved in the transaction.

b. Corporate Restructuring A firm can be seen as a combination of contracts. Sometimes these contracts need to be restructured. Restructuring might be triggered by a condition of financial distress. However, sometimes firms re-contract preemptively, to avoid a crisis, or simply to enhance value creation. The main type of restructuring transactions can be roughly classified into two main categories: i. Asset Restructuring: Asset-side transactions either consist in selling a subsidiary (or a given asset) to a third party (divesture) or in creating new stock classes. ii. Debt Restructuring: They are also known as stock breakups, includes equity carve-outs, spin-offs, targeted stocks, etc. Debt restructuring consists in changing the features of outstanding debt contracts (e.g., extending the maturity, reducing the amount, converting into equity, etc.). 14


c. Private Equity Private equity funds are increasingly important clients of investment banks, both in the underwriting and advisory services. Investment banks are increasingly important players of the private equity industry. Virtually all major investment banks manage some private equity funds. Investment banks play a key role advisory role in formulating the transaction for raising equity and intermediates in the whole process till the transaction is closed successfully. More, specifically the role of arranger can be broken down in to following components.

III.

Allied Businesses a. Securities Business: Many universal banks such as SBI, ICICI, IDBI have their broking and distribution firms in both the equity and debt segment of the capital markets. In addition several their investment banks such as IL&FS, JP Morgan have strong presence this area of activity. After the introduction of derivative segment it has provided an additional area of specialization to the investments banks. Derivate trading, risk management, and structured product offerings are the new fast growing segments having future potential for investment banking industry in India. This business enables Investment banks to offer research notes and valuable guidance to its clients, which include institutional as well as non-institutional investors.

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b. Asset Management Business:

Almost all the investment banks have floated separate entity for conduction asset management business in the lucrative market. Mutual Funds provide its investors the service of sophisticated fund management. Most of the Investment banks have entered the Venture capital business, providing essential dosage of finance for startups boosting entrepreneurial skills.

c. Investment Advisory and Wealth management: Investment banks have come up with special services for nurturing investment and portfolios of HNIs, households, trusts, and non-institutional investors. This is a highly regulated activity as it involves public investible funds. Howerver in many cases Investment banks do not offer portfolio services, instead they offer investment advice which includes recommendations from time to time.

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Introduction to Private Equity and Venture Capital What is a Private Equity?

Private equity, in finance, is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange. Private equity investments are primarily made by private equity firms, venture capital firms, or angel investors, each with their own set of goals, preferences, and investment strategies, yet each providing working capital to a target company to nurture expansion, new product development, or restructuring of the company’s operations, management, or ownership. The Private Equity sector is broadly defined as investing in a company through a negotiated process. Investments typically involve a transformational, value-added, active management strategy. Private equity investors seek to obtain a substantial interest in a company in order to have an active role in firms’ strategic decisions. Their goal is to boost the value of a company and walk away with substantially more money at the time of liquidating their investment. Among the most common investment strategies in private equity are: leveraged buyouts, venture capital, growth capital, distressed investments and mezzanine capital. In a typical leveraged buyout transaction, a private equity firm buys majority control of an existing or mature firm. This is distinct from a venture capital or growth capital investment, in which the investors (typically venture capital firms or angel investors) invest in young or emerging companies, and rarely obtain majority control.

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What is a Venture Capital?


Venture capital is a broad subcategory of private equity that refers to equity investments made, typically in less mature companies, for the launch, early development, or expansion of a business. Venture investment is most often found in the application of new technology, new marketing concepts and new products that have yet to be proven. Venture capital is often sub-divided by the stage of development of the company ranging from early stage capital used for the launch of start-up companies to late stage and growth capital that is often used to fund expansion of existing business that are generating revenue but may not yet be profitable or generating cash flow to fund future growth. Entrepreneurs often develop products and ideas that require substantial capital during the formative stages of their companies' life cycles. Many entrepreneurs do not have sufficient funds to finance projects themselves, and they prefer outside financing. To compensate the risk of failure, venture capitalist's seeks higher return from these investments. Venture Capital is often most closely associated with fast growing technology and biotechnology fields.

Private Equity Investments and India India today is among the more attractive investment destinations globally, driven by a combination of strong economic growth, an improving regulatory environment and favorable demographics. As India continues on its rapid-growth path, several large potential investment sectors such as financial services,

infrastructure

and

domestic

consumption

offer

significant

opportunities for PE investor. India is generally considered a ‘must have’ destination for foreign institutional and PE funds, which recognise the potential of Indian Companies to generate high returns leveraging on the country’s economic growth. 18


India’s GDP grew from US$3.76 trillion in 2009 to US$4.05 trillion in 2010 (adjusted for Purchasing Power Parity) while real GDP grew at 8.3% in 2010 which is an increase from 7.4% in 2009. GDP per capita has increased from US$3,200 in 2009 to US$3,400 in 2010. Even though the global economy as a whole experienced several corrections in it’s recovery from the recession, India was able to continue its growth trajectory. PE investors have played a significant role in the development of several sectors in India over the past decade eg Telecom, Healthcare, Technology, Retail, Education etc. PE investments have grown from US$ 2.0 bn in 2005 to US$ 19 bn in 2007. Thereafter, investment value fell to around US$ 6.2 bn in 2010 registering a CAGR of 25% over the last six years. Total PE investments in 2005 - 2010

No. of PE Funds who invested in 2005-2010

19


Top Private Equity Investors in India (2005 – 2010) Investor

Volume

Sequoia Capital India International Finance Corporation Bennett Coleman & Company Ltd Citigroup Venture Capital ICICI Venture IDFC Private Equity Goldman Sachs Investment Partners IL&FS Investment Managers Ltd Intel Capital Reliance Capital

57 53 52 39 32 31 27 23 22 22

Top Global Private Equity Firms x x x x x x x x x x x x

TPG Capital Goldman Sachs Capital Partners The Carlyle Group Kohlberg Kravis Roberts The Blackstone Group Bain Capital Warburg Pincus CVC Capital Partners Providence Equity Partners 3i Group Apax Partners AXA Private Equity

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Map of Private Equity Investments

Different clusters of equity investment have specific features that contribute to investor activity. Every cluster is classified by: x Definition It describes the agreement between entrepreneur and financial institutions. It explains the financing rationale and, indirectly, the firm's needs including why the firm is looking for money and how that money is used. x Risk-return profile: It is related to the four drivers: investment, profitability, cash flow, and sales growth. Every firm stage has risk measured as total or partial loss of invested sources, delays in project implementation, lower profits, etc., and an expected return usually measured as the internal rate of return (IRR). x Critical issues It targets critical issues to manage at every stage in a firm's growth. x Managerial involvement within business venturing Identifies the financial institution’s contribution to the growth of the firm and analyzes the decision process, rather than the percentage of shares owned. Therefore, in private equity finance, very low/high level managerial involvement is not related to the number of held shares.

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Types of Financing Provided by Private Equity and Venture Capitalists I.

Seed Financing (Development Stage) Seed financing is necessary for the development of a new firm.

Development specifies the business idea or the development plan of a product not yet created. During this type of financing, funded firms do not have an actual product to sell and are unable to earn revenue. This is also called first round or initial financing. The purpose of seed financing is to transform R&D projects into successful business companies or start-ups. Therefore, seed financing funded by financial institutions is used to create new ventures. The riskreturn profile is very difficult to define, because risk is very high, while expected returns are impossible to calculate due to the uncertainty of R&D results and the difficulties with transforming R&D into business. Equity-based financing is preferred to alternative debt-based instruments that are more expensive and rely on collateral, which entrepreneurs cannot provide. Entrepreneurs should also realize seed financing might be divided into pre-seed and seed capital finance. Pre-seed or "proof of concept" finance is generally provided from public sources and relates to basic research, while seed capital can be readily applied. Seed financing investors do not ask financiers to be firm managers because the firm has just been created. However, the role played by investors is not passive. They support research activities, translate the business idea into a patent and production process, build the company team, and manage any sudden death risk. The most important elements financiers provide are the business plan preparation, analysis, and validation.

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Seed Financing Financing of a business idea or of a research activity in Definition order to produce a business idea; money is not used to create the new venture. Money is used to finance research. Risk is very high because of the uncertainty of the Risk-return research profile activity and of the development of the business. The calculation of the expected IRR is very difficult. To give strong support to research; To translate the business idea into a patenting process; Critical issues to To build the team; manage To support research; To manage sudden death risk. Managerial Very limited. involvement II.

Start-Up Financing (Start-Up) Seed financing transforms R&D into a business idea, and start-up

financing converts the business idea into a real operating company. For entrepreneurs, start-up financing is used to set up projects and launch production. The funded sources are used to buy equipment, inventory, plants, and anything else useful to move the business idea to operations. Start-up financing is a gamble for the financier. Although the investors think the business idea is worthwhile, they do not know if the market will support the idea transforming it into a profitable business. The risk-return profile of investors assumes high returns, measured as expected IRR, and high risks with possible delays in or the default of the project. During seed financing, financiers are expected to be experienced in technical and engineering fields. In start-up financing, because the R&D stage has already been completed, financiers are expected to support the business plan, have an in-depth understanding of its nature and its

23


assumptions, value the management team, and define the strategy used to implement proposals. For this reason, private equity operators or venture capitalists are very involved in a firm's management and own a large number of shares. Their shares may be the majority of shares issued or make the financial operators the biggest shareholders.

Definition

Risk-return profile

Start-Up Financing Financing of the start up of a new venture that moves from the idea to the operations. Money are used to buy all what is necessary to start (equipment, inventory, building, etc...). Money is used to finance a firm. Risk is very high because of the uncertain of the future development of the business. It is possible to calculate the expected IRR even if the maturity of the investment can be very long.

Critical issues to manage

Managerial involvement

III.

To give strong support to the business plan; To offer capability in deeply understanding the nature and the assumptions of business plan; To realize strong valuation of the team. Very strong and related to all activities which are necessary to produce the business plan. The percentage of shares could be also very high.

Early Stage Financing (Early Growth) Early stage financing is essential when moving from the start-up to the real business life cycle. In this phase, sales and firm growth begin. The objective of early stage financing is to create a stable and permanent organization. During this phase, all problems related to project, design, test, and launch have been resolved. Financial resources are used to fund a little developed company that needs equity to further its growth. For financiers, this is the stage where financing really begins. The risk-return profile at this stage is similar to earlier phases: there is more uncertainty within the market 24


rather than technical items or feasibility questions. Because of this,

financing during this phase is opened to investors new to the sector or the market. The expected IRR and the linked risk are high, because investments are already made and there is no certainty about sales development. In this phase financial institutions are asked to revise and strengthen the business plan. Private equity operators or venture capitalists are very involved in management and own a large numbers of shares. Realized and required activities range from assistance to strategic decisions to business plan certification to marketing and financial advice

Definition

Early Stage Financing Financing of the phase of growth of a venture baked company that moves from the start up to sales. Money is used to buy inventory and to sustain the gap existing between cash flow and money needed.

Risk-return profile

Money is used to finance the first steps of a "baby firm." Risk is very high because of the uncertainty of the future of the development of the business. It is possible to calculate the expected IRR and revised properly the previous business plan.

Critical issues to manage


To give strong support to the first steps of the firm (mentoring, advisory); To offer capability in verifying if the nature and the assumptions of the business plan are realistic; To give strong assistance in strategic decision processes. Very strong and related to all activities which are necessary to avoid mistakes. The percentage of shares could be also very high.

IV.

Expansion Financing (Rapid Growth) Expansion financing is for companies that need or want to expand their business activity. If the market conditions are right, it can be a great move; some businesses find they need expansion financing when fast business growth is possible. 25


Equity or debts are provided to support growing debt and inventories.

The company is growing but may not be showing a profit at this stage. Funds may be provided for the major expansion of a company that has increasing sales volume and is breaking even or has achieved initial profitability. They are utilized for further plant expansion, marketing, and working capital or for development of an improved product, a newer technology, or an expanded product line. The risk in expansion financing is moderate and depends on the sector. Money is used to finance sales growth or to improve projects in known fields so there is no risk due to uncertainty. Returns should be lower at this stage. Although firms are already operating, financial institutions also play a fundamental role during this phase. At this point they are asked to develop effective growth plans. Because of the size of a firm and the financier's need to diversify his portfolio, the percentage of shares held by private equity operators or venture capitalists during this phase is low.

Definition

Expansion Financing Financing of the fast growth phase of a firm that aims to consolidate the position in the market. Money is used only to sustain the gap existing between cash flow and money needed.

Risk-return profile

Money is used to finance sales growth. Risk is moderate (and linked to the business) because the trend of development of the business is well known. It is possible to calculate the expected IRR.

Critical issues to To give strong support; manage To face risks linked to a fast process of growth (i.e., accurate selections of the new markets to enter, inventory choices, etc...). Managerial involvement

Mentoring and advisory activity in defining the right assumptions of strategic decisions. The percentage of share is not very high and it does not represent a specific characteristic in this type of deal.

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V.


Replacement Financing (Maturity Stage)

After the growth (rapid and slow) phase, firms become more stable and enter the mature age. Although profitability and cash flows are stable, private equity finance still plays an important role. During the mature age entrepreneurs modify their needs and, while almost all priorities were driven by sales development and size increasing, in this period the problems come from governance or corporate finance decisions. Replacement financing — the typical support from private equity finance for firms in their mature age — funds companies looking for strategic decisions associated with the governance system and the firm's status, rather than the firm's approach to finance. This kind of investment may be realized in different ways:  Listing on a stock exchange  Substitution of shareholders  A new design for the company governance Replacement financing is never used to boost sales growth or to realize investment in plants. Instead it is used for strategic or acquisition processes. Replacement capital is the proper solution to fund spin-off projects, equity restructuring, shareholder substitution, IPOs, family buy-in or family buyout, etc. For investors the risk profile of these deals is moderate because  The firm business model is successful  The firm governance is settled even though it is in a shifting phase  Entrepreneurs usually remain and work for the company development  The effective risk depends also on the whole sector/market risk and the quality of the process to be put in place. 27


 Financial institutions operating in this environment could be used as just an investor or as an advisor and consultant. The role of the private equity operator is to support managerial strategic decisions and the implementation of the entire deal design.

At this point managerial involvement from the investor is extensive. When the financier acts as more than a financial operator, industrial knowledge and previous expertise become very important. Entrepreneurs need to skillfully manage corporate governance issues and corporate finance deals. In this case, private equity operators buy a large number of shares issued by the firm they are working with. This makes the whole deal easier to implement, and very often the private equity operators turn into prime shareholders. Replacement Financing Financing of a mature firm that wants to face strategic decisions linked to the governance or to the corporate finance decisions.

Definition

Money is used only to sustain the strategic or the acquisition processes. Risk-return profile

Critical issues manage


Money is used to finance sales growth or investment. Risk is moderate and linked to the quality of the strategic process that is necessary to be put in place. Examples are: IPO, turnaround, LBO, restructuring of family governance.

It's possible to deeply calculate the expected IRR. to To give strong support to manage strategic decisions. The role of the private equity moves from a simple financer job to an effective consultant activity. Very high and qualified, in terms of deep industrial knowledge and strong capability to manage corporate governance issues and corporate finance deals.

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VI.


Vulture Financing (Crisis/Decline Stage)

Even when firms are declining or are in crisis, private equity operators are suitable partners. When a firm is financially distressed, private equity operators can offer vulture financing. This is used to restructure firms enabling companies to improve their financial performance, exploit new strategic opportunities, and regain credibility. In extreme situations, restructuring can make the difference between a company surviving or folding. For investors, vulture financing is very risky; there is no assurance the business will be revitalized by the survival plan. The risk is linked to the "nature" of the crisis: a business crisis is different from an audit fraud crisis because it is due to macroeconomic factors and not mismanagement of funds. Vulture investors frequently gain control by purchasing senior securities, and they often become board members or managers of the target company. From this position they can propose a survival plan, implement it, and monitor the growth of the firm. Many skills are required of financial institutions operating in this environment, because their intervention forces them to act as advisor and consultant, or, more often, as entrepreneur. The fundamental role of the private equity operator is to support managerial strategic decisions and the implementation of the entire deal design. This requires deep industrial knowledge or the ability to manage corporate governance issues and corporate finance deals.

29


Definition

Risk-return profile

Vulture Financing Financing of a firm that faces crisis or decline. Money is used to sustain the financial gap generated from the decline of growth. Money is not used to finance sales growth or new perspective but to launch a survival plan.

Risk is very high and linked to the "nature" of the crisis. An example of different typologies of crises is: debt restructuring, turnaround or failure. It is hard to calculate the expected IRR. Critical issues to To give strong support; To manage strategic decisions; manage The role of the private equity moves from a simple financer job to an effective entrepreneur activity. Managerial involvement

Very high and qualified, in terms of deep industrial knowledge and of strong capability to manage corporate governance issues and corporate finance deals.

Diagrammatic Representation of Financing Provided by Private Equity and Venture Capitalists over Different Time-frames

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Overview of Investment Banking Services for Private Equity

The investment banker plays a key advisory role in formulating the transaction for raising equity and intermediates in the whole process till the transaction is closed successfully. More specifically, the role of the arranger can be broken down into the following components: I.

Business Advisory Advise the company on the necessary steps to be taken to fine-tune the business model and make it investor friendly. Perform a study of the industry landscape and competitor analysis, product pricing strategy and SWOT analysis.

II.

Formulation of the Transaction Formulate the business plan incorporating the company's stated business objective along with detailed financial modelling that establishes the financial forecast of the company and the requirement of capital.

III.

Valuation Conduct a valuation of the company for the purpose of assessment of its equity value and develop a deal structure.

IV.

Deal Structuring Formulate the investment offering to be made by the company in line with the requirements of the company and the investment parameters that would find favor with targeted investors. Ensure that the deal structure complies with relevant regulatory framework.

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V.

Offer Literature


Prepare an 'Information Memorandum' that incorporates the business plan, the transaction and the investment offering. The information memorandum should incorporate the necessary corporate disclosures that are mandatory under law. In the case of listed companies it should also comply with the requirements under the DIP Guidelines. VI.

Transaction Advisory Identify suitable investors with related investment appetite, facilitate investor presentations, co-ordinate with agencies that would perform due diligence and valuation on behalf of the investor, negotiate on behalf of the client on the term sheet for the deal, work closely with legal advisers who would draft the documentation for the transaction and co-ordinate the steps to be achieved till the transaction is closed.

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Business Plan and Financial Model

One of the initial tasks in a fund raising program would be to map the business model of the company and based on it, prepare a comprehensive business plan. The business plan preparation helps in understanding the business dynamics that shape the fortunes of the company. This understanding is fundamental to the investment banker as it lays the foundation for the transaction and also gives an insight into the likely perception of investors when the plan is presented to them for investment. The involvement in the business plan preparation helps the investment banker in the following ways: x In understanding the business model so that it stands a test of scrutiny by the investors at a later date. x In providing the key assumptions and inputs required to construct the financial model. x To prepare the company for investor due diligence at a later date. x The most important aspect of a business plan analysis is to make an assessment of the risks that are involved in the business and how well the business plan addresses the mitigation of such risks. The financial model follows the preparation of the business plan as all the key assumptions that go into its preparation directly flow from the business plan. The financial model helps in assessment of the following parameters: x The investment plan envisaged by the company and its relevance and justification from a financial perspective. x The generation capacity for operating cash flow based on the revenue and cost model and the positive and negative cash that the operating statement throws up. x Key financial parameters that define profitability and financial position such as EBITDA, ROCE, RONW, EPS, debt gearing and book value per Share.

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Transaction Structuring


Transaction formulation is another conceptually important aspect of raising private equity since it should meet the requirements of the company and be appropriately compliant with the regulatory framework. Structure of the transaction primarily stems from the following: x The current status of the company in terms of its size, shareholding, listing status etc. x The amount of capital to be raised through the transaction after careful assessment of the company's requirements as per the financial model and finalisation of the financing plan. x The type of instrument to be structured that would meet the requirements of the company and the investors. x The provisions of the Companies Act, Income Tax Act, SEBI Guidelines, FEMA and SCRA. x Target group of investors to be considered. Based on the above parameters, it is possible to discuss the following transaction structures for raising private equity:  Private Equity in Unlisted Companies This transaction structure applies to early stage and later stage unlisted companies wherein there is more flexibility under regulatory provisions. Usually, if the company is in early stage, a debt convertible is structured so that it can be converted into equity as and when the company achieves pre-set milestones. A convertible addresses two important concerns: o For the issuer company it does not unduly depress the EPS when the earnings of the company are still at a nascent stage, o For the promoters, it protects dilution of their stakes to a minority 34


o it protects the investor from high conversion price at the time

of investment and from bankruptcy losses if the business plan does not take off. Other alternatives are preference capital or convertible preference shares and non-voting shares. These are seldom used by well established profit-making companies. As far as regulatory provisions are concerned, private placements in unlisted companies are governed by the Companies Act, the memorandum and articles of association, the Unlisted Public Companies (Preferential Allotment) Rules, 2003 and the FEMA. These regulatory provisions are not very stringent and provide a lot of legroom for transaction structuring to the investment banker. The only important consideration to be kept in mind is the pricing of a convertible instrument shall be disclosed to the shareholders at the time of approving such issue. However, it may be noted that the pricing itself is left open for the company to decide. Private placement under this route is available to all types of investors, whether QIBs or not. Therefore venture capital and private equity funds that are not registered with SEBI (and are therefore not QIBs) are also eligible to invest in these transactions. There are several such unregistered overseas funds operating in the Indian capital market. Therefore, this kind of a placement provides unlimited choice of investors to the issuing company.  Private Investment in Public Equity (PIPE) Placement PIPE placement is identical to that described above except that it is made by a listed company. Listed companies suffer from several constraints including regulatory restrictions on transaction structure. The pricing restrictions on listed companies are discussed in the following 35


paragraphs on valuation. Apart from pricing, the other issues for consideration are the Takeover Code of SEBI and the type of instrument. As per New Takeover code a company can acquire up to 25% in a firm without requiring to make an open offer. The new takeover code also raised the open offer size from a minimum of 20% at present to 26%, providing an exit for more investors.  Qualified Institutional Placement A qualified institutional placement or QIP is exactly similar to a PIPE transaction except that it should be made only to Qualified Institutional Buyers (QIBs). Therefore, all institutional investors who do not qualify as QIBs cannot participate in such private placement. For example, unregistered foreign venture capital or private equity funds are not eligible for a QIP. A QIP is very similar to a Rule 144A private placement that is available in the US capital market. Since QIP is made only to institutional investors, it has some relaxations as compared to a PIPE transaction. The important provisions applicable to a QIP are as follows: o The issue should be only for pure equity or convertible instruments except warrants. o The placement should be to QIBs only. None of the allottees shall have any direct or indirect association with the promoter group. o The company should be listed on a nationwide electronic stock exchange (BSE or NSE). o The company should be compliant with the minimum nonpromoter shareholding norm under the listing agreement. o There should be a reservation of at least 10% of the offer to mutual funds. The unsubscribed portion of this reservation can be allotted to other QIB investors. 36


o The total amount raised under the QIP shall not exceed five times the net worth of the company prior to the placement.

o The shares allotted under QIP can be sold in the secondary market without any lock-in but not in off-market deals upto a period of one year.  Preferential Allotments to Strategic Investors Under this category, a private placement is considered to technical collaborators, joint venture partners or other types of strategic investors. The modalities of this transaction would depend upon whether the issuer company is listed or not. If the company is unlisted, this transaction would amount to a private placement by an unlisted company. If the company were listed, this would amount to a PIPE transaction and would accordingly be governed by the relevant statutory provisions.  Choice of Transaction Structure The transaction methodology has to be worked out carefully after assessment of the facts involved and looking at the different structures available as discussed above. The transaction structure determines the efficiency of the transaction, i.e. cost and time efficiency and the quality of investors attracted to the company. The level of preparedness and growth of the company also determine the transaction structure. The more mature the company, institutional equity becomes preferable. However, institutional equity comes with a lot of responsibility and corporate governance requirements. From a transaction perspective, institutional private equity demands stringent due diligence and more time for execution of the transaction. The investment banker has to assess all these factors and determine the best transaction structure in a given situation.

37


Valuation in Private Equity Transactions

 Valuation for Private Equity in Unlisted Companies While the general approaches to corporate valuation remain the same, the methodologies are fine-tuned while applying them to particular transactions. As far as private equity is concerned, the investment banker determines the benchmark valuation so as to arrive at the deal structure. Such valuation is made using the financial model and other relevant subjective criteria. The methods used to value normal growth closely held companies focus either on the tangible assets or on the stream of future earnings over a time horizon. These methods do not work for valuing entrepreneurial companies with high growth potential because these are idea-based and growth-based rather than asset-based. Valuation methodologies for private equity deals can be broadly divided on two approaches: o The Transaction Multiple Approach which uses certain capitalization factors such as revenue or Profit after tax or Operating profit (EBITDA) or a market multiple such as the Price/Earnings ratio (in case of listed companies) to arrive at the present valuation for the company. This approach is suited for companies that do not have a consistent basis to project future cash flow or there is a considerable element of subjectivity in the valuation using subjective factors such as intangible assets, market potential or human capital. Revenue multipliers are used as a primary valuation method more in the early stages of investment—seed stage, first stage or A round, second stage or B round and third stage or C round. Since companies at these stages have either negative profits or sub-optimal profit margins, it would be 38


appropriate to look at valuation techniques that are oriented towards the top line (revenues) than the bottom line (profits). However, Price/Earnings ratios are used as the company moves towards later stage, it may be possible to get a better picture of the true profit margins in the business and look at bottom line multipliers to value the company. In pure knowledge based companies at the early stage, it is just the idea that is valued based on its market potential. o The Discounted Cash Flow DCF using free cash flow approach tries to arrive at the present value of a company based on estimated future cash flows discounted at the expected rate of return for the private equity investors. This method is appropriate for later stage companies with a stabilised cash flow model and a consistent basis for computing future projections. If this approach is used, the multiplier method may then be used just as a cross check to ensure that the cash flow valuation is not over-optimistic.

Valuation vs. Pricing At this stage it is necessary to appreciate the subtle difference between valuation and pricing a share. For unlisted companies raising capital, what is of relevance is the equity valuation arrived at and not what it translates into as price per share. Price per share is not important till the company reaches the stage of an IPO and is proposing to make an offer to the public. The retail considerations such as minimum application size, minimum investment etc. will become important at that stage. Such considerations do not matter to private equity investors as long as the valuation is in agreement. The following table illustrates the point. 39


Value in Rupees

Company

Company

A

B

Pre- Issue shares with face value Rs 10

10,000

20,000

Current Earnings

25,000

25,000

Current EPS Amount being raised

12.5

25 500,000

500,000

Equity dilution

50%

50%

Number of new shares to be issued

500

1,000

1,000,000

1,000,000

1,000

500

Equity Valuation (Post Issue) Price per share

It may be observed from the above that though the valuation of the two companies is the same, the price per share varies since the issued capital of both the companies at the pre-issue stage is different. Consequently, the fresh shares to be issued would also be different. The price per share is not a correct indicator of value as explained above. However, it becomes a relevant issue at the time of an IPO from a marketing and free float perspective.

The investment banker has to bear it in mind that no two ventures or private equity investors have the same approach to valuing a company and therefore what is required is to arrive at a preliminary valuation that could correspond to a fair valuation. The investment banker has to draw upon experience in similar deals and current market trends and arrive at a valuation that can be marketed to investors. Ultimately, the efficiency of the investment banker is judged by the valuation and terms negotiated for the client.

40


In the case of private placement involving non-resident investors, the valuation guidelines prescribed by the Government of India have to be adhered to as the minimum valuation for the deal. The government guidelines are briefly described below. Government Guidelines Under the Government Guidelines, the share price is calculated under two methods—the Net Asset Value (NAV) method and the Profit Earning Capacity Value (PECV) method and a fair value is determined as follows:

Fair Value

=

NAV + PECV 2

The NAV method: o The computation of NAV should be based on the latest available audited balance sheet with reference to the valuation date. o Under the NAV method, if there is a fresh issue of shares being contemplated either for cash or otherwise, the face value of the fresh issue equity capital is added to the existing 'net worth' in determining the NA V. o Intangible assets such as patents, trade marks, copyrights and goodwill (if capitalized in the books) will not be reckoned as assets for determining the NAV. o Revaluation of fixed assets is not to be taken into account, unless it was made very long time ago, say more than 10 years. o Any reserve that has not been created out of cash profits will not be reckoned.

41

The PECV Method:


o The PECV will be calculated by capitalizing the average of the after-tax profits at the following rates:  15% in the case of manufacturing companies  20% in the case of trading companies  17.5% in the case of intermediate companies, i.e. companies whose turnover from trading activity is more than 40% but less than 60% of their total turnover. o There may be cases wherein the capitalization rate may have to be relaxed to factor in intangible value or other parameters in order to ensure fair and equitable valuation. In such cases, the rate of capitalization can be relaxed up to 12%. o The critical areas in the PECV method are the assessment of future maintainable profits, the provision for taxation and the treatment of profits from fresh issue of capital if any. o Ordinarily the profits are averaged for three years but in cases where there is no perceptible trend or the profits are not optimal, a longer period of five years immediately preceding the valuation date should be used. If profits are showing a declining trend, the profits of the latest year alone shall be used. o If a company is loss making and there is reasonable belief that the company would generate profits in future, the average of the projected profits for five years shall be considered. If there is no certainty of future maintainable profit, the PECV shall be reckoned as zero. o If additional issue of shares is involved, the end use of the funds has to be considered to ascertain the generation of return on such capital. In case the funds are proposed to be used for a new project or for meeting working capital requirements, the return thereon shall be computed as follows:

42


Fresh capital x Existing PAT

Profits from fresh issue =

2 x Existing net worth

The above profits shall be added to the existing profit after tax and the total will be divided by the expanded capital base to arrive at the future maintainable earnings per share. If the fresh capital is not proposed for any revenue generating activity but for general corporate purposes such as research and development or meeting cash burn, no return should be assumed therefrom. However, the expanded capital base shall be considered for determination of the earnings per share. Illustration The following is the brief illustrative valuation data of a company as per the Government Guidelines. Based on Assets Liability Side Existing Equity Capital Share Premium Free Reserves

1131.10 1235.19 3051.44

Networth

5417.73

Less Miscellaneous expenses not w/o Adjusted Networth

10.96 5406.77

From the Asset side Fixed Assets Net Current Assets Capital WIP Investments Total Assets as per Balance Sheet

5701.21 5527.89 1266.25 151.00 12646.35

43

Less Debenture Redemption Reserve Long term liabilities


0

Long term liabilities

7239.58

Adjusted Networth

5406.77

Face value of Proposed Capital

507.00

Proposed Networth Existing Shares No. of new shares Total no. of shares (post-issue)

5913.77 113.11 50.70 163.81

NAV Per Share

Based on Earnings Operating Profit 2003-04 2004-05 2005-06 Tax at 30% Average PAT Contribution from fresh issue Expected Future Profits Total shares (Post Issue) EPS (Post Tax) PECV @ 8% capitalisation (Post tax)

36.10

PBT 212.25 543.78 1397.4 717.81

WTS 1 2 3 6

PBT x WTS 212.25 1087.56 4192.20 915.34 274.60 640.73 30.04 670.77 163.81 4.09 51.26

FAIR VALUE NAV Per Share PECV Total Avearge Less: Proposed Dividend

36.10 51.26 87.36 43.68 2

FAIR VALUE

41.68

In the above illustration, as may be seen, the valuation of the share has been made from both the methods, i.e. the NAV method using the balance 44


sheet values and the PECV method using the past three years profits as

benchmark. The PECV profits have been computed on weighted basis attaching maximum weightage to the immediately preceding year. The weighted average PAT is enhanced with the increase in income expected from the deployment of the fresh funds received from the issue. This would result in the future expected profits, which are capitalised at 8% to arrive at the PECV value of the share. The capitalisation rate was considered aggressively at 8% since the company was well established and its ruling market price was much higher at that time. It is pertinent to note that under both the methods, the benefits that would accrue from the proposed issue were considered in fixing the price. This was a concept that was allowed under the CCI formula, which currently cannot be used as a justification for pricing under the SEBI guidelines.  Valuation for PIPE Transactions In the case of listed companies, the valuation should also be in line with the current trend in market price of the share, the current state of the capital market and the statutory provisions on pricing. The relevant statutory provisions are outlined below: Under the DIP Guidelines, the pricing of the shares shall not be less than the higher of the following: o The average of the weekly high and low of the closing prices of the share during the six months preceding the date which is thirty days prior to the date of the general meeting i.e. EGM or AGM as the case may be approving the placement. Or o The average of the weekly high and low of the closing prices during the two weeks preceding the date of the general meeting i.e. EGM or AGM. In the case of issue of shares to non-resident investors, the price should not be less than the price arrived at as stated above or as arrived at under the 45


government valuation guidelines, whichever is higher. Therefore, if the price as per the government guidelines were more than the price arrived at under the DIP Guidelines, such price would apply. It may be noted that the above provisions regulated the minimum valuation under a PIPE transaction. The investment banker has to consider the actual valuation arrived at for the company in case it is higher than the minimum valuation as stated above.

 Valuation for Preferential Allotments

The essential feature that distinguishes preferential allotments to strategic investors from other types of transactions discussed above is the fact that a strategic investor would be in a position to pay a strategic premium, which is usually negotiated over and above the valuation justified for the company. The amount of such premium depends on the extent of stake being offered and the profile of the investor. Strategic premium is not paid for minority stake unless it happens to be at least 26%. Apart from the aspect of strategic premium, the rest of the valuation methodologies that govern such preferential allotments are identical to those discussed above for either an unlisted or a listed company as may be applicable.

46

Deal Structuring


The deal structure normally evolves as the discussions with investors progress. However, many a time, if it is decided that the Information Memorandum should be presented with the proposed deal structure, it would be necessary for the investment banker to formulate the same. In this context, it would be necessary to discuss certain concepts and terms used in private equity deals.  Pre-money Valuation This is equal to the post-money valuation of a company at a financing round minus the amount raised at that round. For example, a post money valuation of Rs 500 million after raising Rs 200 million implies a pre-money valuation of Rs 300 million.

 Step-up in Value The increase in a company's pre-money valuation between two financing rounds. It is calculated as the pre-money valuation at a round divided by the pre-money valuation at a prior round. For example, a company with a valuation of Rs 100 million in the fourth round and Rs 25 million in the third round has achieved a step up valuation of 4 times between the two rounds.

 Return on Capitalisation The percentage annualised change in the pre-money valuation between two financing rounds. This, to some extent represents the annualised return on investment for the investors if the dilution in his stake from the previous round to the next round is not considered.

47


To arrive at an appropriate deal structure, it is important to determine the following parameters. o The pre-money valuation for the current round of financing. This could be based on the valuation approaches discussed above. o The approximate returns to the investors in that round based on the period of holding from the date of investment till the proposed date of a liquidity event such as an IPO or a buy out. o The amount of funds being raised in the current round. o The present value of the company's valuation at the date of liquidity event. This would be based on any of the valuation approaches discussed above. o The amount of further funds that may have to be infused through the equity route through subsequent rounds till the liquidity event happens. o The stake that has to be offered to the investors in the current round so as to meet their return expectations. The investment banker while structuring the deal has to keep ready a projected investor return model based on the criteria discussed above with suitable assumptions to back the model. The stake that an investor needs to hold is always calculated with reference to the post-money valuation by the following formula:

% Stake

=

Investment proposed Pre-money valuation + Investment proposed

Therefore, % Stake

=

Investment proposed Post-money valuation 48


The post-money valuation has to be calculated in present value terms if the investment is proposed to yield returns to the investor over a given holding period. Therefore % Stake

=

Investment proposed Present value of the company's future valuation

Which is: % Stake

=

Investment proposed Future valuation/Present value factor

Which is:

% Stake

=

Investment proposed Future valuation/(I + Discount rate)^No. of years

The discount rate to be considered in this case would be the expected rate of return that an investor would look for in the given circumstances. This method of arriving at the deal structure is known as the 'Conventional Venture Capitalist Method.

49

Example:


From the following details, the stake to be offered to a VC under the Conventional VC method is shown below. a. The current level of earnings (R) = Rs 2 million b. The expected annual growth rate of revenue (r) = 50% c. The required capital at present round - Rs 2.5 million d. Expected holding period = 5 years e. Expected Profit after tax margin at liquidity event = 11% f. Expected P/E ratio = 15 g. Expected rate of return (d) for the VC = 40%

Solution to Problem Step 1: Extrapolate the revenues at the end of five years at a CAGR of 50%. This comes to Rs 15.19 million which forms the top line at the end of year 5. Year

Earnings (In INR Million)

2011 2012 2013 2014 2015 2016

2.00 3.00 4.50 6.75 10.13 15.19

Step 2: Calculate PAT thereon @ 11% works out to Rs 1.67 million. Step 3: The PAT capitalised at a P/E ratio of 15 yields a valuation of Rs 25.06 million Step 4: The required present value factor = (1 + 0.40)5 = 5.378 50


Step 5: The present value of the company = 25.06/5.378 = Rs 4.66 million. Step 6: The stake to be offered to the PE = 2.5/4.66 = 53.7%

A variation of the above method is the 'First Chicago Method' wherein three scenarios, the best, the worst and the survival scenarios are plotted to get three different valuations. These are assigned appropriate weights to arrive at a weighted average valuation. This weighted valuation is discounted to arrive at the present value and the stake to be offered. The computations under the above method get complicated if there are proposed future rounds of financing wherein the investor in the current round may or may not participate. If the current investor does not participate in future rounds, to that extent, based on the valuations adopted in such future rounds, there would be a dilution of such investor's stake. Therefore, when a future valuation is being made under this method, it is difficult to estimate what would be the extent of future equity financing that may be required to achieve such valuation and the consequent dilution. The following illustration explains the point.

Example The promoters float the business with a capital of Rs 5 Cr and support from a VC to the extent of a further amount of Rs 5 crore. Thereafter, the company goes for two more rounds of financing and an IPO. The changing profile of investor returns is explained by the following table and the discussion thereafter.

51


Jan-11

Jan-12

Jan-13

Jan-14

Round 1

Round 2

Round 3

Offer for Sale

Pre-money Value Rs 5 crore

Rs 20 crore

Rs 60 crore

Rs 100 crore

New Capital Invested Rs 5 crore

Rs 10 crore

Rs 20 crore

Post-money Value Rs 10 crore Investor VC Stake offered = 50% of post money valuation

Rs 30 crore Investor VC2 Stake offered = 33.3% of post-money valuation

Rs 80 crore Investor VC3 Stake offered = 25% of post money valuation

Rs 100 crore

Post-money Shareholding Pattern Promoters — 50% VC1-50%

Promoters— 33.33% VC1- 33.33% VC2 — 33.33%

Promoters—25%

Promoters—25%

VC1 —25%

Public — 75%

VC2 — 25% VC3 — 25%

Annualised Return for VC1-133.33%

VC2= 75%

VC3= 25%

The annualised return above has been computed on the basis of the period of holding. For example, VC 1 holds the investment of Rs 5 crore for a period of 3 years before selling it off in the IPO for Rs 25 crore. Therefore, VC 1 makes a return of Rs 20 crore which works out to 400% in 3 years or an annualised return of 133% and so on. It may be observed from the above example that the holding of VC l has diluted from 50% at Round 1 to 25% at the liquidity event. If this holding had 52


remained at 50%, VC1 would have earned an annualised return of 333%. However, this hypothesis may not be correct since the valuation of Rs 100 crore after 3 years would not have been possible without the capital infusion of Rs 40 crore in all. Therefore, the company has achieved a non-monetary value enhancement (step-up in value) of Rs 60 crore (100-40) at the IPO stage. VC1 actually gets a share on the step up value of Rs 60 crore. If one were to take a weighted average approach, the return profile can be worked out as shown in the Table below:

Rs Crore

Investment

No. of Share of step-up Product years value 3 15 15/70*60 = 12.86

Annualised Return % 85.7

Promoters

5

VC 1

5

3

15

15/70*60 =

12.86

85.7

VC 2

10

2

20

20/70*60 =

17.14

85.7

VC 3

20

1

20

20/70*60 =

17.14

85.7

Total

40

70

60.00

The above calculation shows that the weighted average return for all the investors is the same at 85.7%. However, in reality, they do not get this return. They get returns that are either superior or inferior to the mean returns. For example, in the above case, the promoters and VC1 end up getting superior returns by 47.6% each (133.33—85.73) while VC2 gets a return that is inferior by 10.73% (85.73—75.00) and VC3 gets an inferior return by 60.73% (85.7325.00).

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Apart from valuation and the stake proposed to be offered, the deal structure should importantly take into account the following as well:  The company in which the stake is being offered, in case of a group of companies represented by the same promoters. It may be noted that investors normally attach a 'holding company' discount if stakes are offered in holding companies rather than in the operative companies.  The proposed exit route and the feasibility thereof. This is mainly relevant for unlisted companies. The usual routes that are available are o I P O, o repurchase by promoters and their group o sale to another investor and o strategic divestiture of the company by the promoters and the investors. o Type of instrument and staggered conversions if any. The conversion options and the basis of arriving at the conversion price keeping in mind the statutory regulations should be provided. o Sweeteners such as equity warrants or convertible preference shares if any, should be included in the deal structure.

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Term Sheet


A 'term sheet' is a broad statement of the deal structure that the investor proposes to make with the company for a given offering in response to the offer made by the company. It is not a binding offer on either side and both parties are free to terminate it if the deal is not proposed to be carried through at any stage during its validity. The term sheet outlines the details of the investment together with the deal specific conditions. In a nutshell, the term sheet describes the basic structure of a transaction and provides a set of protections against expropriation. The following are the typical contents of a term sheet. x Number of shares or other instrument proposed such as a convertible preference share and the issue price x Conversion price and conversion ratio in case of a convertible x Anti-dilution formulas (known as 'ratchet clauses') such as 'equity clawbacks' and 'liquidity preferences' for the investors. These are contractual clauses that safeguard the investors against future dilution of investor's stake. For example, if the company does not achieve the stated financial performance, it could affect future valuation. Therefore, investors put in milestone conversion price mechanisms and if the milestones are not reached, they are entitled to additional equity so as to neutralise the reduction in valuation. Similarly, if in a subsequent round, new investors have to be allotted equity at a price lower than in the current round, the current investors have to compensate through issue of fresh equity to neutralise the dilution effect. Anti-dilution clauses also include suitable adjustment for stock splits, conversion of outstanding options, warrants, mergers and other such events that may lead to dilution.

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The investment banker has a crucial role to play in term sheet negotiations

with the investors. While the investors usually try and peg down the valuation to their advantage, investment bankers start off with aggressive pricing to ensure that even if it is watered down during negotiations, they achieve an attractive pricing for their client. However, valuation is not the only negotiation point. The term sheet has to be read and understood completely in all its implications. Generally, term sheets tend to become restrictive as the investor looks for a strangle hold on the company for future adversities. The antidilution clauses, veto rights, tag along rights, non-disposal undertakings and right of first refusal on sale are major issues that need to be negotiated with the investors wherein the investment banker's expert knowledge and negotiation skills are put to test. The overall objective should be to achieve a reasonable term sheet that offers good valuation, enough leg room to the management in operational matters, flexibility on strategic issues and not too restrictive in exit mechanisms.

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Corporate Disclosure


The Information Memorandum (IM) forms the main part of the 'offer literature' floated by the company in connection with the proposed deal. The Information memorandum would set out the statement that the company wishes to make to prospective investors, the detailed and complete information necessary for the investors to take informed investment decision, the offering summary and the deal structure. The IM goes out in the name of the investment banker but usually with disclaimers to protect the investment banker from third party liabilities. In such IMs floated for private equity deals, the investment banker has to be careful not to violate the provisions of the Companies Act 1956 and the SEBI guidelines. These statutory provisions stipulate severe punishment for faulty floatation of offer documents if they can be construed as public offer documents. Therefore, it is to make disclaimers clearly on the cover page of the documents with words to the following effect. "Strictly for private circulation only. No part of this Information Memorandum shall be construed to be an Invitation to the Public within the meaning of Section 2(36) of the Companies Act 1956, for the purpose of subscription to the Investment Option detailed herein. This Information Memorandum is strictly meant for private investors and the information contained herein has been provided for the purpose of enabling the intended investors to make an informed investment decision". The Information Memorandum along with other necessary documents such as Company Brochures, product catalogue and Profile, Press cuttings, Executive Summary and a Power Point presentation together form the preliminary offer materials. Though there are no statutory stipulations for the information to be furnished in a private equity deal except for QIP transactions, the investment banker has to ensure that all material information is furnished to the investors.

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Conclusion

Looking at the 2008 crisis and present scenario of global financial system, It is very hard to predict what really lies in the near future for us. This is because the medium terms effect of these hanging situation are unforeseeable. But we must understand the there is only one thing constant in this universe i.e. change. So as long as the universe exists, there will be constant modifications happening in this world. So only we have to modify our habits and also our investment decisions. Coping up with this transformation is always not easy for a company or an individual, and they need help of professionals who can facilitate the change management. Therefore there will be always demand for the services provided by investment banks: nonetheless the characteristics of the suppliers and profitability of the business itself might change. So only Investments banks shall play an important role in providing valuable services to Private equities in making investments and thereby increase profitability. Private equity is a revolutionary concept, which has to be given due credit for bringing growth and advancement in western countries. It wouldn’t have been possible if PE weren’t backing technology companies. India has also seen the largest increase in deal activity among the big Asia-Pacific markets in 2010. Although still far below the 2007 peak of US$17 billion, last year’s total deal value more than doubled from that of 2009 to US$9.5 billion, including venture capital. The PE industry will need to work closely with their investee companies and invest in further educating other Indian promoters about the PE and VC value proposition. India’s PE and VC industry is far from reaching its full potential. The biggest barrier holding it back is lack of regulatory support. Indian policymakers still do not regard PE and VC as a distinct asset class, nor have they given sufficient attention to creating a regulatory environment more conducive to the industry’s growth.

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Bibliography

Investment Banking – A Guide to Underwriting and Advisory Services By Giuliano Iannotta Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals By Stefano Caselli Investment Banking: Concept, Cases, and Analysis By Pratap Subramanyam

Webliography

http://www.ibef.org/ http://cib.bnpparibas.com/ http://www.mergersandacquisitions.in/ http://www.investmentbankingcenter.com/valuations.html http://www.altassets.com/ http://www.mergermarket.com http://www.ft.com/ www.baincapital.com/ http://www.wcgt.in/html/

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Annexure Glossary: Private Equity

“A” round: Financing event whereby venture capitalists become involved in a fast growth company that was previously financed by founders and/or angels. Angel: Wealthy individual that invests in companies in relatively early stages of development. Usually angels invest less than $1 million per startup. The typical angel financed startup is in concept or product development phase. Anti-dilution: A contract clause that protects an investor from a substantial reduction in percentage ownership in a company due to the issuance by the company of additional shares to other entities. The mechanism for making adjustments is called a Ratchet. “B” round: Financing event whereby professional investors such as venture capitalists are sufficiently interested in a company to provide additional funds after the “A” round of financing. Subsequent rounds are called “C”, “D” and so on. BIMBO 'buy-in management buy-out': A BIMBO enables a company to reshuffle its allocation of share capital to bring about a change in management. Internally, a group of managers will acquire enough share capital to 'buy out' the company from within. An outside team of managers will simultaneously 'buy in' to the company management. Both parties may require financial assistance from venture capitalists in order to achieve this end. Bridge financing: Temporary funding that will eventually be replaced by permanent capital from equity investors or debt lenders. In venture capital, a bridge is usually a short term note (6 to 12 months) that converts to preferred stock. 60


Buyout: a sector of the private equity industry. Also, the purchase of a controlling interest of a company by an outside investor (in a leveraged buyout) or a management team (in a management buyout). Carried interest: It’s a share in the profits of a private equity fund. Typically, a fund must return the capital given to it by limited partners plus any preferential rate of return before the general partner can share in the profits of the fund. Clawback: A clause in the agreement between the general partner and the limited partners of a private equity fund. The clawback gives limited partners the right to reclaim a portion of disbursements to a general partner for profitable investments based on significant losses from later investments in a portfolio. Down round: A round of financing whereby the valuation of the company is lower than the value determined by investors in an earlier round. Due diligence: The investigatory process performed by investors to assess the viability of a potential investment and the accuracy of the information provided by the target company. Earn out: Arrangement in which sellers of a business receive additional future payments, usually based on financial performance metrics such as revenue or net income. Exit : Private equity professionals have their eye on the exit from the moment they first see a business plan. An exit is the means by which a fund is able to realise its investment in a company - by an initial public offering, a trade sale, selling to another private equity firm or a company buy-back. General partner: This can refer to the top-ranking partners at a private equity firm as well as the firm managing the private equity fund. Holding period - This is the length of time that an investment is held. 61


Institutional buy-out (IBO) - If a private equity firm takes a majority stake in a management buy-out, the deal is an institutional buy-out. Leveraged buy-out (LBO): The acquisition of a company using debt and equity finance. As the word leverage implies, more debt than equity is used to finance the purchase, eg 90 per cent debt to ten per cent equity. Normally, the assets of the company being acquired are put up as collateral to secure the debt. Limited partners: Institutions or individuals that contribute capital to a private equity fund. LPs typically include pension funds, insurance companies, asset management firms and fund of fund investors. Management buy-in (MBI): When a team of managers buys into a company from outside, taking a majority stake, it is likely to need private equity financing. An MBI is likely to happen if the internal management lacks expertise or the funding needed to 'buy out' the company from within. Management buy-out (MBO): A private equity firm will often provide finance to enable current operating management to acquire or to buy at least 50 per cent of the business they manage. In return, the private equity firm usually receives a stake in the business. Mezzanine financing: This is the term associated with the middle layer of financing in leveraged buy-outs. In its simplest form, this is a type of loan finance that sits between equity and secured debt. Because the risk with mezzanine financing is higher than with senior debt, the interest charged by the provider will be higher than that charged by traditional lenders, such as banks. Portfolio: A private equity firm will invest in several companies, each of which is known as a portfolio company. Public to private: This is when a quoted company is taken into private ownership – more recently by private equity firms. Historically, this has involved a large company selling one of its divisions. 62


Ratchets: This is a structure that determines the eventual equity allocation

between groups of shareholders. A ratchet enables a management team to increase its share of equity in a company if the company is performing well. The equity allocation in a company varies, depending on the performance of the company and the rate of return that the private equity firm achieves. Recapitalisation: This refers to a change in the way a company is financed. It is the result of an injection of capital, either through raising debt or equity. Secondary buy-out - A common exit strategy. This type of buy-out happens when an investment firm's holding in a private company is sold to another investor. For example, one venture capital firm might sell its stake in a private company to another venture capital firm. Term sheet: A summary sheet detailing the terms and conditions of an investment opportunity. Venture capital: The term given to early-stage investments. There is often confusion surrounding this term. Many people use the term venture capital very loosely and what they actually mean is private equity. Vintage year: The year in which a private equity fund makes its first investment

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DIP Guidelines with respect to Qualified Institutional Placements As far as QIP transactions are concerned, there are statutory stipulations under the DIP guidelines with regard to the mandatory information to be furnished by the company in the information memorandum. In a QIP the merchant banking firm has added accountability since it has to perform a due diligence on the issuer company. The important information to be furnished by the company in the 'QIP Information Memorandum' is listed below: x Summary of the Offering and Instrument x Risk Factors x Market Price Information and details of trading volumes as prescribed. x Use of proceeds o purpose of the issue; o break-up of the cost of project for which the money is raised through issue; o the means of financing such project; and o proposed deployment status of the proceeds at each stage of the project. x Industry Description x Business Description x Organizational Structure and Major Shareholders x Board of Directors and Senior Management x Taxation Aspects relating to the Instrument x Legal Proceedings x Capitalization Statement x The audited consolidated or unconsolidated financial statements prepared in accordance with Indian GAAP shall contain the following: o Report of Independent Auditors on the Financial Statements 64

o Balance Sheets


o Statements of Income o Schedules to Accounts o Statements of Changes in Stockholders' Equity o Statements of Cash Flows o Statement of Accounting Policies o Notes to Financial Statements o Statement Relating to Subsidiary Companies (in case of unconsolidated financial statements) x Management's Discussion and Analysis of Financial Condition and Results of Operations x Accountants x General Information The QIP memorandum should be numbered and circulated privately and also placed on the website of the company and the stock exchange and also sent to SEBI within 30 days of allotment for record.

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Investment Banking & Private Equity

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