Why some PE funds do better than others

For once, I do not have to write a cent from my own thinking in a post. The Mckinsey Quarterly article (though dated but clearly in with the theme of these times) sheds light on why fundamental outperformance is the only sustainable source of value creation (very very cliched, but terribly true).

Assuming there are no free lunches, there is so much to the arbitrage a PE fund can seek at the time of entry. A proprietary relationship built on trust and commitment can get you a discount but is not going to entirely contribute to an arbitrage opportunity. Of course, the smarter, seasoned ones can spot smart “buys” or smart “sells” in special situations (how many times a century are you going to have Goldman or a GE with a bowl in front of your house giving you a 10% preferred ?! or dump everything before a bubble ?) but for the majority of homo sapiens, the arbitrage opportunities are not worth too much salt.

Of course, pushing for outperformance means the obvious nitty–gritties – kicking tyres all the time to understand ground realities, understand organizational levers, spending quality time with top management and focussing on continuous improvisation.

But as a Private Equiteer, the piece de resistance is the fact that you can go to sleep every night assured in the fact your investment has appreciated (and is appreciating) even if a gale force hits the markets. That’s priceless !

~Varadha
(varadha.r1@gmail.com)

Entrepreneur and the art of identifying "Tipping Point’

Last week, I chanced upon Graham’s essay on “what start-ups are really like”. A lot of it holds true even in early growth companies (including investors are clueless !). The one thing that stuck me is every single business I have seen seems to go through that one single “Tipping point’ or ‘Inflexion Point’ from which it emerges much stronger or much weaker (hence, takes on a different trajectory post that).

I am not necessarily talking about topline or bottomline (often they could be misnomers for the amount of confidence and dynamism you see in the Management team). It is just that one single event/incident/spark that changes the entrepreneur’s outlook towards the meaning of his business and life. It ironically always comes from outside and from the most unexpected quarters – like a peer outside telling you what a great business this is or one of your suppliers telling you that you are his “fastest growing customer”. Case in point being A.R. Rahman’s music – if the Slumdog Millionaire recognition had not happened, he probably would have coasted along as yet another great Indian music director, only to be relegated to oblivion by the succeeding generation.

It seems it is one such small spark that turbocharges the small motor that is the human mind and makes it spin faster, harder and bigger. To quote from Malcolm Gladwell’s The Tipping Point, it seems like one needs a connector (who are social trend setters) to make one realize his own potential (Johari Window, anyone ?).

As for my tipping point, I do not think I am there as yet…!

~Varadha (varadha.r1@gmail.com)

Private Equity : Absolute Vs Relative return

Coming on back of this great article I read on investing across Geographies, I am tempted to ask ourselves the question – is Private Equity an absolute or a relative return asset class ?

Most people investing in India over the last five years would tell you that private markets have had a much higher volatility and have underperformed the public markets overall (extremely illogical, no reason why size and liquidity premium should be negative). As things stand, if I were allocating assets I would be hard pressed to answer as to why I should choose Private Markets in India over public markets or better still, why I should choose India at all ?

Going by the flights/hotel test (Indian hotels are overpriced and yet overbooked and similar is the case with flights), it seems like India is seeing a bubble, at least for the time being. So are you better off betting on a star-fund manager in India (for the uptick provided by his alpha) or are you better off investing into the beta of a new market. Tough call, is’nt ?

Even in this era of globally mobile capital and minimal information asymmetries, the first movers stand to make an inordinately high return. With internet, new age media and mobile, the window of opportunities are becoming smaller and tighter which also means the rewards for the birds that spot the window are that much higher.

However, as an institutional investor are you looking to maximize returns in the medium term (3- 5 years) or in the long term (15-20 years). It seems like a lot of people are willing to stick their neck out for the long term and back fund managers that deliver superior alpha than piggyback on the next market beta wave. I guess the underlying logic must be sustenance of outperformance in the long run than a flash of brilliance in the medium term.

~Varadha (varadha.r1@gmail.com)

The Coffee talk – art of internal selling

It seems like the biggest battle facing most managers is not so much ideation but enforcing change within the organization. Often, by the time you have understood the concerns/perspectives of various stakeholders (leave alone create solutions to address them), one is exasperated. Which means, little time for actual execution on the ground. Sort of analogous to idle time in Manufacturing – 90% of any manufacturing process is idle time, only 10% is actual processing time.

This was valuable advice given by a colleague of mine – “As one goes up further, the biggest battle is to carry along multiple constituencies – well-wishers, not so well-wishers, peers, sub-ordinates, bosses. ” For you to carry along someone, you first need to know what the other person is thinking – and that is’nt going to happen unless you there is open, informal communication. Unless you have a feel for the undercurrents, you are not going to be able to sail your yacht through. Understanding undercurrents often does not involve a deep dive, but a consistent ability to take mini-dips, socialize ideas, get other people’s perspectives and work on change.

At a personal level, I would like to believe it enriches one’s perspective – ability to read and handle other people, understand their fears/insecurities/turn-ons/turn-offs. For me, the biggest though has been learning to think on my feet – you learn to handle the most unexpected questions and perspectives.

Here is a link to an excellent article that does raise some very pertinent questions on this topic.

~Varadha
(varadha.r1@gmail.com)

Strategic Vs Private Equity Interest in a business

Most businesses in India have at some point of time or the other experienced this conundrum of seceding stake to a Financial Vs a Strategic investor. Since there are plenty of definitions of a Strategic Investor floating around, for the sake of simplicity, we have to define this as someone who has an inherent interest in having a strong say in the day-to-day management of the business vis-a-vis a financial investor who is happy to be a navigator/co-passenger and not meddle with the details.

In most cases, a strategic buyer will offer a higher upfront valuation (because he finds use for a lot of intangibles that the financial investor often does not – not unless he is thinking of synergies within his portfolio). For eg., – brand, distribution channel, sales capabilities, products/IP which unfortunately are not worth much for a PE investor. However, what people often miss out on is the fact there might not be alignment between the entrepreneur’s thinking and that of the strategic buyer even in the short term.

Not every strategic buyer wants to grow the business – case in point being disruptive acquisitions by Google, Microsoft to weed out potential competitors at a nascent stage or better still, Coke’s acquisition of Thumbs-Up or Maaza (both the brands got nowhere after the acquisition). In a lot of cases, it might be the case of defensive strategy to kill a niche competitor before he even becomes a threat to the larger company. Even in the best case where there is alignment, there could often be a case of the acquiree being held captive by the whims and fantasies of the acquirer (who is often using the asset to promote his larger interest). For example, a backward integration strategy could give a larger lever to the acquirer by improving his margins (and hence might reflect in the price), but often could check-mate the acquiree in the medium term as most of its other potential customer might turn away because of softer issues (data secrecy, conflict of interest).

The message is simple – where you see a headroom based on your own capabilities to grow, go with a PE fund. If not, go with a Strategic buyer.

What motivates an entrepreneur ?

One of the toughest questions Private Equiteers deal with is the art of fathoming the motivation behind entrepreneur – is it money, fame, self-fulfilment of driving to fruition an idea or the genuine drive to make a difference to the society ?

The piece I read recently, What motivates an entrepreneur ? is a pointer to some of this. It is a little dated but I presume nothing much else has changed. A majority of people seem to cherish the autonomy of being one’s own boss (Is that a good thing for a private equity fund ? How much space will such a person be willing to secede for other’s ideas).

One of the most important questions we need to pore our heads over is the resilience and dedication of the entrepreneur to the cause at hand. If times go sour, will the person be willing to stick on and improvise on the business ? Or is he a fairweather merry maker who likes the sheer thrill of doing something new all the time and has no qualms shutting the door if the going is not good enough ? Is he going to be happy seeing his face on the cover story of a business magazine or pink daily or is the latest new sedan going to give him the highs ? Or is it the thrill of being acknowledged by his social coterie about his achievements ?

Often, a lot of entrepreneurs I have met are not so much motivated by money (especially in an Indian context where ostentatious display of wealth is still not taken very well by the society) but more by self-fulfilment (whether it be desire to make a difference to society or to prove oneself that one can do it). If you cannot get this pulse right and touch the right nerve, no amount of external pressure or coaxing/cajoling is going to make the entrepreneur come out of his shell and look beyond the obvious.

Surely tougher than it sounds, is’nt it ?

~Varadha
(varadha.r1@gmail.com)

Entrepreneurial Motivation

One of the toughest questions Private Equiteers deal with is the art of fathoming the motivation behind entrepreneur – is it money, fame, self-fulfilment of driving to fruition an idea or the genuine drive to make a difference to the society ?

The piece I read recently, What motivates an entrepreneur ? is a pointer to some of this. It is a little dated but I presume nothing much else has changed. A majority of people seem to cherish the autonomy of being one’s own boss (Is that a good thing for a private equity fund ? How much space will such a person be willing to secede for other’s ideas).

One of the many things that we need to pore our heads over is the resilience and dedication of the entrepreneur to the cause at hand. If times go sour, will the person be willing to stick on and improvise on the business ? Or is he a fairweather merry maker who likes the sheer thrill of doing something new all the time and has no qualms shutting the door if the going is not good enough ? Is he going to be happy seeing his face on the cover story of a business magazine or pink daily or is the latest new sedan going to give him the highs ? Or is it the thrill of being acknowledged by his social coterie about his achievements ?

Often, a lot of entrepreneurs I have met are not so much motivated by money (especially in an Indian context where ostentatious display of wealth is still not taken very well by the society) but more by self-fulfilment (whether it be desire to make a difference to society or to prove onself that one can do it). If you cannot get this pulse right and touch the right nerve, no amount of external pressure or coaxing/cajoling is going to make the entrepreneur come out of his shell and look beyond the obvious.

Surely tougher than it sounds, is’nt it ?

~Varadha

(varadha.r1@gmail.com)

Snow balling – the art of making close calls

One of the many things that Private Equiteers lose sleep over are close calls – viz., calls where they are indifferent to the alpha and beta errors (viz., they cannot decide if the investment opportunity is poor enough to let it pass without a blink or compelling enough to justify a scamper).

As a sheer coincidence, I have been reading Snowball about the life of Warren Buffet for the last two weeks. The book is a nice read and a strong recommend from my side. This one is extremely special since it potrays him as an ordinary human being with the pulls and pressures from various walks – the sacrifices his wife and family made, the mistakes he made with investments and of course, the surprising gamut of emotions that lies behind this witty, numbers driven legend.

We keep coming across this all the time in real life as well – it seems most people handle this by procrastination or asking for more and more data (which only serves to deepen the agony because data after a certain point is hardly conclusive. For every good reference you get, there is a so-so reference as well).

Buffet seems to build on the same pithy-ism that Lincoln used many years ago “Reputation is like fine China. It takes a lot to build but one small mistake can make it come crashing down.”

Warren Buffet’s take on this is simple. If the investment goes wrong, what is the worst damage that can happen to your reputation ? Or in other words, if the company throws up a year later, are people going to tell you ” See, I told you so; The guy/company was no good..” or are they going to say ” hmm… the guy was good..may be just tough circumstances”.

Remember, that an investor can never substitute a manager just like the converse is true. A lot of investors expect positivities to flow in to further their “alpha” like market multiples, new innovations, growth beyond the company’s comfort zone etc. Buffet’s take on this is simple : Do not budget for these – if they happen, it is a windfall. But do not plonk money on the table assuming angels from heaven will come and help the investment grow. Simply put, do not expect significant increases in managerial capabilities drive investor’s alpha.

Hmm..Simple but powerful insights. I guess the difference is in execution, as always.

~Varadha (varadha.r1@gmail.com)

Gin and the art of banker maintenance

I caught up with an investment banker (who I know fairly well) to get his thoughts and perspectives on the relationships he has with various stakeholders – entrepreneurs, lawyers and of course, PE funds. As the evening progressed, it became more clear to me that this eco-system seems fragile and delicately balanced. While most PE funds are of the view that investment bankers hamper deal making efforts, bid up prices creating a swirl in this entire system. But a more realistic world view would give them credit for the subtle/subliminal influence they exercise over market and decision makers.

The are responsible more often than not for market creation (seeding and germinating the thought of raising further capital to grow and manage”commercial expectations” – it is a pity they do not get paid for it; Quite ironic really since management consultants get paid tons for the same type of “intangible” advice; Imagine if McKinsey told GE that they needed capital to grow and tap emerging markets – do you think they would give it for free ?); Bankers also help improve market intelligence, help compare notes/offers, provide easy reference checks for everyone in the system( promoters to do a ref check on funds and vice versa), notes on competing offers, honesty around expectations and suggestions on deal structuring.

However, I gather that there is a lot of bitterness that flows back and forth in this banker-PE relationship which I think is a sign of immaturity and inability on both sides (with PE taking a larger share of the blame) for their inability to carry the other constituent along – sort of like what happens in a democracy. A parochial, short-term urge would tell you things would be so much smoother and faster for you if the other party did not exist but an objective, long-term, libertarian view would suggest otherwise.

So, what is the morale ? Be nice to bankers and pray they would realize your value as well. You never know which phone call of theirs can uproot all of your hard work and when. All the stuff I had talked about a professional relationship holds, more than ever for a banker.

Of course, it remains to be seen what bankers as a tribe hold about their PE brethren. That is a story for another day by another soul ! That is best left unsaid by me.

~Varadha (varadha.r1@gmail.com)

Retail participation in Private Equity

There has been a lot of press in recent times about the surge in retail participation in Private Equity in India. I recently got a call from my Relationship Manager at my bank who wanted to check if I would be interested in investing (a minimum of INR 1 Million) into a Private Equity fund floated by a reputed business house. What was shocking was the complete lack of knowledge about the product, the risks it posed and the liquidity window for the fund. He kept insisting that my investments would grow at about 25% every year and I could pull out the money after 5 years. There was pretty much little else he knew – nothing about how NAVs would be calculated and how frequently, and what would be modus operandi for providing liquidity, what type of companies would be invested into and how would they be monitored and how would the carry be shared with the GP (was the hurdle rate 10% at an individual deal level or at a collective fund level).

I did find out that he was getting incentivized 2% of the money raised as his commission. Apparently with mutual fund commissions having dried up (because of SEBI’s ruling), there are a lot of banks that are peddling these products to almost anyone and everyone.

Hmm… this got me thinking about the great ULIP scam in the earlier part of this decade. Every bank (under the garb of bancassurance) sold unwitting customers an investment cum life insurance product called ULIP which was, guess what, intended to make everyone (except for the customer) happy. With an administrative fee that ranged from 30-60% on the first year premium (half of which rolled back to the banker as incentive) and a steady trail of 8-10%, it sure did make money – but not for the customer. I must have been one of the biggest suckers – for inspite of being a retail banker, I got sold this product by one of my fellow bankers who promptly quit (after collecting his big, fat bonus). The worst part of it was that I could not surrender the product for 3 years because of a lock-in clause – so I had to throw good money after bad money, to get some of the good money back.

Cutting back to the chase, I am not against improving retail participation in Private Equity funds. But I am against it first time investors investing into first time funds without understanding the risks and the time horizon associated with it. To top it all, there is no one to regulate this – I am not sure if this falls under the purview of SEBI. I feel strongly that there ought to be a strong regulation to improve disclosures and ensure that there exists a certain level of mandatory disclosures upfront and on an ongoing basis before investors can plonk down their money.

Investing into Private Equity is far far riskier than investing into a listed stock or even into a close ended mutual fund (where one can cut one’s losses and pull out the money should things go wrong) and one has the ability to monitor NAV’s at regular intervals of time. Putting money into a blackbox which promises a high return.

This presents more than ever a case for a “smart intermediary” like a mutual fund – who can pool in the capital and add the smartness that is ever so required. This is critical when there are already increasingly strident voices from the existing LPs on making money in India.

Would love to hear other’s views on this…

~Varadha
(varadha.r1@gmail.com)