Investing in private equity

Raising funds through equity is probably an easier option for any company today. People and institutions who provide money to companies through equity become shareholders/ owners in the company to the extent of their funding.

And when this equity is raised through private sources, i.e. not through stock markets then it is called Private Equity. Private equity is defined as an asset class consisting of equity securities and / or debt in operating companies that are not publicly traded on a stock exchange.

Today private equity is a very lucrative investment type for the affluent class. Other than providing diversification to their portfolios, private equity investments also lure them by promising higher than average returns.

Also, there are reasons beyond monetary benefits which are involved like, mentoring  startups, giving advice on various issues, and networking. An investor who is interested in private equity can invest through three routes.

1Using referrals and single-handedly investing in companies through private equity. This is a time taking process and one needs to be thorough with details of the companies and management one wishes to invest in. And one will also become a mentor to the management.

2Investing through private equity funds which are managed by investment professionals who invest in companies on behalf of the investor. This type of investment has more credibility in comparison to the first option and is easier.

3Using websites like smergers.com and vccedge.com which provide an online platform to both investors/lenders and business owners. Investors can create their profile on such websites and then choose the company of their choice to invest in.

These websites list the companies on their platform only after doing some pre-qualified checks from their end. This kind of platform, which directly helps the investor and the entrepreneur connect and sign a deal, is surely way quicker than conventional methods.

Whatever mode that you opt for investing in the private equity space, the principles won’t change. At the end, it is indeed a high risk game.

Though gross returns at exit for investments were as high as 25% from year 1998 to 2005, they have fallen sharply for the funds invested between 2006 and 2009 yielding only 7% at exit which is even lesser than equity market’s average return of 12% as seen in a Mckinsey report dated February 2015. Returns have been very volatile from 2009 to 2013 with highs of 20% and a low of 8%.

Once the business owners get capital in hand, in some instances they start to diversify their investment in lots of other things rather than their core business. This creates problems in generating returns and also there is loss in focus as well. Another bad point for private equity investment is that the gestation time period for these investments is too long which makes the investor lose his/her patience and there are no exit opportunities available. Over a time period from 2004 to 2013, the average holding period of investments have increased from 3.5 years to 5.2 years.

And it is very difficult to measure the valuations of these companies while making investment decisions. For instance, take the ecommerce sector. The growth rate of these companies are not matching with the current valuations.

Concern over losses

Even Flipkart got devalued recently by asset managers like Morgan Stanley and T Rowe Price Group. Investors are marking down valuations of companies as there is huge concern over losses and slowdown in sales growth.

A recent Goldman Sachs report says that private equity funding has declined by 25% year-on-year from $2.5 billion in 2015 to $1.9 billion in 2016. But the number of deals has picked up by 52% year-on-year in 2016.  Sources say that the average deal size has declined by 51% to $4.3 million. As per the report, it is becoming more difficult for the new players to enter this space and has also led to the acquisition of weaker and smaller private equity companies.

One has to understand the dynamics of the business before pumping money in a company through private equity. As an investor you should be able to understand the business model and its ability to grow at a consistent and rapid pace.

These days only businesses with disruptive ideas in innovation are making it big. The Big Five namely Google, Facebook, Amazon, Microsoft and Apple understand this and continuously invest in companies in the disruptive technology space. Smart people following their lead and invest their monies in similar spaces.

(The writer is MD at Sinhasi Consultants)