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Private Equity Negotiations)

Private Equity Negotiations)

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Definition Private equity is medium to long-term finance provided in return for an equity stake in potentially high growth unquoted companies. Some commentators use the term “private equity” to refer only to the buy-out and buy-in investment sector. Others, in Europe but not the USA, use the term “venture capital” to cover all stages, i.e. synonymous with “private equity”. In the USA “venture capital” refers only to investments in early stage and expanding companies. To avoid confusion, the term “private equity” is used throughout this Guide to describe the industry as a whole, encompassing both “venture capital” (the seed to expansion stages of investment) and management buy-outs and buy-ins.

What is private equity? Private equity provides long-term, committed share capital, to help unquoted companies grow and succeed. If you are looking to start up, expand, buy into a business, buy out a division of your parent company, turnaround or revitalize a company, private equity could help you to do this. Obtaining private equity is very different from raising debt or a loan from a lender, such as a bank. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of your success or failure. Private equity is invested in exchange for a stake in your company and, as shareholders; the investors’ returns are dependent on the growth and profitability of your business.

000) plus further investment for the first few years of the fund. Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund. active management strategy. .000. which pools contributions from smaller investors to create a capital pool. government regulations etc. or a recapitalization. Private Equity investments can be divided into the following categories: • Venture capital: an investment to create a new company. a sale or merger of the company they control. or a company where value can be unlocked as a result of a one-time opportunity (Changing industry trends. The acquisition normally entails a change of ownership • Special situation: investments in a distressed company. or expand a smaller company that has undeveloped or developing revenues • Buy-out: acquisition of a significant portion or a majority control in a more mature company.The Private Equity sector is broadly defined as investing in a company through a negotiated process. Investments typically involve a transformational. Considerations for investing in private equity funds relative to other forms of investment include: • Substantial entry costs.) Private equity firms generally receive a return on their investments through one of three ways: an IPO. value-added. with most private equity funds requiring significant initial investment (usually upwards of $1.

This is balanced by the potential benefits of annual returns which range up to 30% for successful funds. The risk of loss of capital is typically higher in venture capital funds. private equity fund investment is for those who can afford to have their capital locked in for long periods of time and who are able to risk losing significant amounts of money. and lower in mezzanine capital funds. such as stocks and bonds.• Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as "illiquid" investments which should earn a premium over traditional securities. it is very difficult to gain access to your money as it is locked-up in long-term investments which can last for as long as twelve years. . private equity can provide high returns. • If a private equity firm can't find good investment opportunities. limited partners typically have no right to demand that sales be made. which provide interim investments to companies which have already proven their viability but have yet to raise money from public markets. Once invested. which invest in companies during the earliest phases of their development. with the best private equity managers significantly outperforming the public markets. • Consistent with the risks outlined above. it will not draw on an investor's commitment. Given the risks associated with private equity investments. Distributions are made only as investments are converted to cash. For the above mentioned reasons. an investor can lose all of its investment if the fund invests in failing companies.

com . assess and develop an initial concept before a business has reached the start-up phase Start-up stage Financing for product development and initial marketing. • • • The above stages can be explained by the diagram which is shown below -: Source: private-equityonline. Replacement capital Purchase of shares from another investor or to reduce gearing via the refinancing of debt.Private Equity investments can be classified into: • Seed stage Financing provided to research. Expansion stage Financing for growth and expansion of a company which is breaking even or trading profitably.

or high net worth individuals. Ketan Parekh was arrested and put out of action by SEBI. Some of the big deals during these periods were: • HFCL (Rs 735 crores at Rs 1. SEBI Concerns: Between the years 2000 and 2007. There was continuous surge in the stock markets and in 2001. when the market was in its infancy. there were over 20 companies that had either planned or made allotment of shares during this period through modes such as preferential and private placements of equity. mutual funds. a lot of water has flown under the bridge and there have been many calls to call in for greater regulation of these funds and their target companies in India because: .38 crores at Rs 825 per share).A PERSPECTIVE The Indian stock markets witnessed tumultuous times during the years 1999-2000.450 per share). While preferential allotment was seen in companies where the promoters' stake is low. Between 1999 and 2000. • Pentasoft Technologies (Rs 798 crores at Rs 798 per share) • Trigyn Technologies (Rs 606.050 per share and Rs 1. FIIs.000 crores were raised by private placement of equities. around Rs 6. the king pin of these surges.039 crores at Rs 1. the private placement was made to companies (in the form of strategic investment).000 per share). • Zee Telefilms (Rs 800 crores at Rs 1.PRIVATE EQUITY INVESTMENTS IN INDIA. Back then.

For instance. the disclosure is bare minimum. this way the transaction in them is at par with the securities issued through the public issue. they are bought by all kind of investors. The difference between the two is on the disclosure. the companies are not required to inform the utilization of funds raised through the private placement. the disclosure is broad and the companies are mandated to inform their shareholders through public announcement and annual reports about the utilization of the funds raised. In the case of public issue.• The securities issued by companies through the private placement route get listed and traded on the stock exchanges after allotment. from . just like a public issues. Therefore. In the case of private placement. It is these new firms which know the target market very well who form the basis for new investment by all Private Equity Firms across the words. PE(Private Equity) has come a long way from providing fuel (funds) to the fiery growth of India Inc. through the secondary market. including the retail. • In turn. It helps investor companies with a whole host of activities — from forging strategic alliances to assisting in corporate governance. Primary factors attracting these funds in India being a vibrant market and democracy which fosters entrepreneurship as well as new firms. India and Private Equity Investments India has been on the radar for many Private Equity firms(also known as PE firms in common parlance).

virgin indutrsies and companies concludes some basic. yet vital and important points: It is observed that by and large. since it’s too early to comment on companies that received money in ’07. which allowed global business interactions to become much . tea. the following study has been undertaken by me: Analyze the performance of companies receiving PE funding. spread across sectors like gems and jewellery.Beginning of PE activity in India: The Indian private equity (PE) market roughly started in 1996-1997 and it scaled new heights in 2000 primarily because of the success demonstrated by India in assisting with Y2K related issues as well as the overall boom in the Information Technology (IT).providing management advice to budgeting. I intend to compare the performance of companies receiving PE funds with those of their peers in the corresponding Economic Times sectoral indices that did not get any such funds. I am in the process of analyzing data for approximately 100 listed companies. such as greater recognition and increased media attention. On an average. companies which received funding seemed to do much better than their peers on the following parameters — profitability.To gauge the activities of these firms as well as their investment patterns in India. The Stages of PE Investment in Indian Scenario 1996-1997 . cash profits. There were some intangible benefits too. a preliminary analysis of the Private Equity funding in new. sales and investor returns. aviation. shipping. edible oil and garments. to name a few. Telecom and the Internet sectors. I did this by tracking deals concluded before January ’07.

the investing in India came “crashing down” when NASDAQ lost 60% of its value during the second quarter of 2000 and other public markets (including those in India) also declined substantially. For example: (a) The average deal size more than doubled from $4. the total value of such deals done in India in 2000 was $1. 2001-2003 . Consequently.easier. In fact. As Figure 1 shows.14 million. the PEs started investing less money and in more mature companies in an effort to minimize the risks. have been growing at 12%-14% a year.PE becomes risk averse and activity declines: Not surprisingly. and (d) Investments in Internet-related companies fell from $576 million in 2000 to $49 million in 2001. 2004 onwards . during 2001-2003. and since some sectors.14 million in 2000 to $8.This decline broadly continued until 2003.52 million in 2001 (b) The number of early-stage deals fell sharply from 142 in 2000 to 36 in 2001 (c) Late-stage deals and Private Investments in Public Equity (PIPEs) declined from 138 in 2000 to 74 in 2001. the number of deals and the total dollars invested in India has been . investors renewed their interest and started investing again in 2004.16 billion and the average deal size was approximately US $4. including the services sector and the high-end manufacturing sector.Renewed investor interest and activity: Since India’s economy has been growing at 7%-8% a year.

commonly known as “Business Process Outsourcing” or BPO) sectors. 2003 and the first half of 2006. We forecast that the total investment in 2006 is likely to be $6.2 billion in 2005. For example. US $1. Figure 2 shows the division across various sectors with respect to the number of deals in India in 2000. This is partly because the growth in the Indian economy is no longer limited to the IT sector but is now spreading more evenly to sectors such as biotechnology and pharmaceuticals. entertainment and media.increasing substantially.65 billion in investments were made in 2004 surpassing the $1. and gems and jewellery. autocomponents. These investments reached US $2. and during the first half of 2006.3 billion. real estate and infrastructure. .16 billion in 2000 by almost 42%. travel and tourism. retail. PE investment expands beyond IT and ITES: A very important feature of the resurgence in the PE activity in India since 2004 has been that the PEs are no longer focusing only on the IT and the ITES (IT Enabled Services. textiles. PE firms have already invested $3.48 billion (excluding debt financing). a number that is more than five times the amount invested in 2000. healthcare and medical tourism.

9 100 Role played by PE in the growth of Indian economy Since 2004.2 100 2003 49.3 1.  . India has witnessed a tremendous rise in Private Equity financing.0 29.13 3. not only as a source of finance to innovation but through other functions that lie at the core of high tech Development.18 9. 25.8 100 2006(Q1&Q2) 23.1 12.Percentage of the number of deals by PEs in various sectors Sectors IT & ITES Financial Services Manufacturing Medical & Healthcare Others Total 2000 65.0 2.8 7.3 8. Indian companies are creating partnerships with PE firms on a scale that has not been witnessed before.3 37.7 19. PEs plays a critical rule in the innovation process. Is this good for the Indian economy? What kind of value does this relatively new form of financing offer to Indian entrepreneurs? Roles played by PE in the growth of Indian economy –  PEs not only provides resources of funds to the new ventures but also focuses on identifying and upgrading both product/process innovation and management functions in accordance to the global economy.5 3.

 PEs bridge between sources of finance.  PEs typically also add value to their portfolio companies through assistance in strategic decisions in the day to day management of the firms. The following list is given as an example and sets out the path that negotiations most frequently take. entrepreneurs. In the end. Presenting your business plan and first analysis During the first contacts. covered. and customers by providing not only the required sources of funds but also an added value of technologies and requirements. The Process of Negotiation and Enquiries: There are several stages in the negotiation process between you and the private equity investment manager. if you wish. . you should be willing to provide any additional information requested.  PE capitalists with technology & entrepreneurial background generate more value added than PEs with financial background. by a confidentiality letter (23). you will discuss your business plan in more detail. But every negotiation is different. scientists. the fund managers will want to confirm their initial impressions: • • • • Does your company have the potential to achieve sustained growth? Does the management team have the necessary skills? Does the probable return on investment justify the risks taken? Does the investment match the fund's investment criteria? During these presentations. suppliers.

The relationship now beginning is for the long term. do they continue to back up the companies they invest in by offering follow-on investments?. do they help companies in difficulty by bringing in external experts?.You should decide with the fund manager whether your respective goals and limits are compatible and will allow a real partnership. Initial negotiations If the first contact is satisfactory. can you meet the heads of the companies concerned?. the investor will begin to negotiate the conditions of the transaction with you and will offer you an initial memorandum. how many companies have already been divested?. Some questions you can ask them might include: How many investments do they manage?. has the fund management company been present since the beginning?. you should ask to see a simplified presentation of their portfolio and the initial results of their investments. you should bear in mind that the people with whom you are negotiating are the same people you will be working with for several years. Throughout these initial discussions and subsequent phases. When the discussions with a potential private equity firm have begun. have they encouraged “business matching” for the companies in their portfolio?. so you can judge their performance and the support they bring to the companies in their portfolio. Your relationship should be trusting and balanced if it is to survive the inevitable difficult periods and strategic differences that will follow. are the founders still present in the company they have invested in?. This will set . is the fund consistent in its investments?.

debt and quasi-equity to respond to the specific needs of each business. etc. Your advisors have an important role to play in helping you select the best proposals at each stage of the negotiations. Examples are mezzanine finance or subordinated debt (24). preferential rights. The financial structure of the operation should contain a good balance between the risks and returns anticipated by both parties. Mezzanine finance is less well-known and refers to loan finance that is halfway between equity and secured debt. investment conditions. You need to analyse the nonfinancial aspects of the alliance under consideration: the role of the board of directors. Several sophisticated financial instruments are available to organise the investment and fund managers frequently use a combination of equity. and are unsecured and convertible on exit. a developing company or a disposal. • • Equity and debt are the classical means of financing. It is not enough simply to compare the valuations you are offered. how the shares could be sold. Together with the private equity firm. you need to work out the value of your company or project. The investor will then take each section of your business plan and verify or change it using his knowledge of the sector and his previous investments. either unsecured or with junior • .out the broad guidelines for future negotiations. exit strategies. strategy. The structure will obviously be different depending on the type of operation envisaged: whether it is a start-up. Also the legal and financial structure of the operation will be discussed. Quasi-equity instruments combine the features of debt and equity.

etc. the investor may opt to syndicate the operation among several investors. special voting rights. If the amount invested is especially large or the investment is judged particularly risky. allows the company to put off some interest payments and is less dilutive for the entrepreneur than a pure equity financing structure. By limiting his total investment to each one of these stages. The negotiation may anticipate stock buy-backs (or warrants) for the management team once the company has achieved certain objectives set out in the business plan. Although more common for mature businesses. The lender requires a higher rate of return than on senior debt because the loan is unsecured and he may allow part of the interest to be paid off later in exchange for the option of transforming some of the loan into equity. a special right to information. Staged financing enables the investor to release his financing at certain stages such as during the development phase or launching of a product. • Preferential or priority shares are also used.). who limits his individual risk in the operation. This financing structure imposes a lighter burden on the cash resources of a developing company. this type of financing is being used more and more for small operations. Syndication offers an obvious advantage for the investor. or when it needs to increase its production facilities. These allow certain categories of shareholders a preferential right under specific circumstances (priority in receipt of dividends. but there are also advantages for you: .access to security. the investor ipso facto limits his risk. when the company enters foreign markets.

and the basis of his ability to give money back to his own investors and to benefit from part of the eventual added value. The price proposed by the investment manager depends on his profitability objectives. in the long term. and for yourself. . For you. accept it. For the fund manager the price will be the basis on which his eventual performance is judged. .it allows the company to benefit from the combined experience of the syndicate. than small gains in the valuation process. The price negotiated for the equity is of crucial importance. In order to assure their affiliation to a well-known private equity firm. This amount could simply be the exact amount of capital required but you might also choose to give up more capital than you need to avoid having to make further calls on external finance (which take up much time and effort). If the price proposed is close to what you wanted. it determines how much equity is transferred and the consequences for the control of the business. When he approached his own investors. he presented them with a profitability objective (known as the internal rate of return) and committed himself to doing his best to achieve it by selecting the best businesses and negotiating the correct entry prices. .it allows you to draw on relatively more finance than if a sole investor were present. The provision of capital is more important for your company.-it avoids a single investor holding a significant part of the equity. some entrepreneurs accept a lower entry price than they would have received from less well-known investors.

This is when the transaction is legally secured. allowing him a certain amount of remuneration during initial development. Similarly. The investment manager may finance part of the investment with convertible bonds. They may also have a veto on any stock-split operation that could dilute their investment. . you will embark upon the last stage: negotiating the final terms and conditions. But the investor will impose a period known as “vesting”. the management team could lose certain subscription rights.Final negotiations and Enquiries If this in-depth analysis of the company proves satisfactory. which he can convert back to equity in the next phase of the company’s life. These clauses allow the investors to be sure that their interests are aligned with those of the management team they have invested in. This requires the stock option beneficiaries to stay in the company for a minimum amount of time before they can benefit from the preferential conditions of the stock options. The investment managers will propose different types of shareholdings. The legal and financial framework will be finalised based on the preliminary agreements reached during the preceding stage of negotiations. if the company does not achieve certain objectives laid down in the development plan. Equity-based compensation plans generally make up a significant portion of the rewards available to the entrepreneur and his team. The investment managers may insert anti-dilution clauses giving them a right of first refusal over any future issue of equity to outside investors.

and draw up the final legal acts: the shareholders’ agreement detailing the rights and obligations of each party (e. arbitration procedures. changes required to the statutes. employment contracts for the management team. In doing so. You will now formalise your own personal equity stake and that of your team.g. lending banks and mezzanine funds will prepare the technical documents relating to the transaction. the composition of the Board of Directors. a reciprocal right of veto over certain decisions. you should also employ the services of a legal and tax advisor . At this stage. . the policy in place for distributing dividends. warranty letters. with any adjustments made in the event of new or unforeseen elements arising during the due diligence process. They will finalise the contracts that will organise your future relations.The final price is determined using the valuation calculated during the first phase of negotiations. transfer of preferential shares. timetable for business and financial reporting). you need to determine the following: -The value of the company -How earnings are divided -How the company is managed -Future relations between shareholders -The investor’s exit strategy The lawyers will draw up the acquisition documents. etc. Investment bankers. the investment protocol (the price and number of shares).

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