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Global Conference on Service Management (GCSM - 2014), Auro
University, Surat, India, Jan 4th to 5th
MACRO TRENDS AND NEW APPROACHES IN PRICING OF PRIVATE EQUITY TRANSACTIONS IN EMERGING MARKETS
MRIDUL ARORA*
MBA (Finance), IBS KOLKATA Consultant, Deloitte HOME ADDRESS: F-12, CLUSTER-9, PURBACHAL, SALT LAKE
CITY, KOLKATA-700 097.
M: 09051263432
E-Mail: [email protected]
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*Mridul Arora is a Consultant in Deloitte working on the Taxation of Private Equity Fund Partnerships. He has also worked for IBM Global
THIS
RESEARCH PAPER includes original research focusing on the analysis and resolution of managerial and academic issues based on analytical studies and models
Conference Dates: 4th & 5th Jan 2014
Acknowledgements:
My sincere thanks are due to Dr.
Rohit Singh, Conference Chair, for
giving me ample time in
completing the paper. Also I am
blessed with the assistance
provided by my parents, friends
and faculty members of IBS,
Kolkata for the support assistance
in conducting the research work in
Minitab Software. Also handy was
the data obtained from Deloitte
Online Resources (Deloitte Center
for Financial Services).
*Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms.
Process Services India Pvt. Ltd., Kolkata. He served as an intern for managing risk at Allahabad Bank HO, Kolkata while pursuing his MBA from IBS Kolkata.
The views expressed here are those of the author and not of Deloitte Center for Financial Services.
Comments-may-be-forwarded-to-the-author.
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
ContentsAbstract ……………………………………………………………………………1
Introduction………………………………………………………………………..2
Literature Review………………………………………………………………….3
Data Sources and Quotes………………………………………….………………4
Pricing Private Equity Transactions……………………………………………….6
Macro-economic Factors and Trends in Private Equity Markets……...………….9
PE structure and Hypothesis Testing………………………………………….…15
Conclusion……………………………………………………………………….18
Limitations and Scope for Improvements……………………………………….20
Figures and Graphs………………………………………………………………21
Data Appendices………………………………………………………………...29
References and Research Sites……………….………………………………….31
A paper on Investment Banking & Structured Finance by Mridul Arora
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
Abstract:
Purpose – Investment banking is a very vast area in the field of banking and
finance and is a very old industry now. The present paper examines factors
like Growth of Emerging Markets, Capital Market Conditions, Hedging and
Diversification Effect, Impact of Real Estate sector and REIT/ETF markets,
IPO, LBO and M&A activities, Participation of Hedge Funds and Mutual
Funds in PE Transaction and role of Corporate Governance.
Findings – The turmoil created by a high volatility in the stock markets that
persisted from the second half of 2007 to 2009 also raised some big
questions about just how risky private equity investments are. In this paper we have analyzed whether
private equity funds value their assets fairly. This is an important question not just from an accounting
and regulatory perspective, but also because fund valuations impact directly on reported performance
figures, which in turn are likely to influence investors’ decisions.
Pricing of Private Equity transactions requires a close understanding of the industry being considered for
investment, valuation parameters in the capital market and estimating these variables. The methods used
to value normal growth companies focus on tangible assets, present value of the future cash flows, PAT,
Operating Profit (EBITDA) and Price/Earnings Ratio (for listed companies). After a flat 2012 year, the
private equity industry faced an intensely competitive deal-making environment worldwide, an overhang
of aging assets waiting to be sold and challenging fundraising conditions in 2013. Risk in PE Funds can
only be diversified by investing in a pool of funds.
Keywords: private equity, fund valuation, fund returns, fund managers
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
JEL Classification: G24, G31, G32
1. Introduction
“An investment company generally is an entity that pools shareholder funds to provide the
shareholders with professional investment management. Typically, an investment company sells its
capital shares to the public, invests the proceeds, mostly in securities, to achieve its investment
objectives, and distributes to its shareholders the net income earned on its investments and net gains
realized on the sale of its investments.”
- AICPA Audit and Accounting Guide for Investment Companies.
Investment Banking carries a rich repository of meanings in the field of banking and finance.
This paper seeks to reflect this range of meanings vis-à-vis management research, managerial problem-
solving and decision-making.
In the world of Finance, Venture capital (VC) and Private Equity (PE)
are the two most popular types of institutional equity investments
among other players like Family Partnerships, Hedge Fund, Venture
Capital, Private Equity, Fund of Funds, Investment Partnerships, Mutual
Funds, Foreign Institutional Investors (FIIs), Banks, Insurance
Companies. Venture capital investments help innovative start-ups,
encouraging them to expand into new international markets and grow as
companies. Both PE and VC Funds are constituted as independent pools of capital, managed by Fund
Management Partnership Teams for maximizing investor wealth. Exit activity has sputtered over the
past three years, and private equity funds are feeling the heat to sell aging portfolio holdings and return
capital to their limited partners. However, VCs only help to bring to the market R&D related
technological innovations.
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
Venture capital funds – the other main type of private equity – raised nearly $160 billion of capital during the boom years of 1999 and 2000, and made early investments in recent successes like Google (in the United States), Skype (in Europe), and Baidu (in Asia). Overall, Private equity funds play an increasingly important role as financial intermediaries in global emerging markets.
11
2. Literature Support
We review the literature on Private Equity as our base for the purpose of
establishing the findings and assumptions used in this paper. By "private
equity" we mean financing for early and later-stage private companies
from third-party investors seeking high returns based on both the risk
profiles of the companies and the near-term illiquidity of these
investment-; (venture capital is a form of private equity that generally
applies to start-ups). As the private sector expanded, an increasing number
of firms had to move beyond their traditional reliance on so-called "friends
and family" for financing if they were to continue to grow and be
competitive. In Brazil, for example, a World Bank report revealed that
about 40% of private bank assets were invested in government securities.
Between 1992 and 1997, the peak years for fund-raising in Latin America, the value of new private
equity capital grew by 114% annually, from just over $100 million to over $5 billion. In the emerging
markets of Asia (excluding Japan), about 500 funds raised more than $50 billion in new capital between
1992 and 1999. As the transition to market economies in Eastern Europe took hold in the mid-'90s, the
rapid growth of private equity told a similar story.
PE Fund of Funds (FoF) are raised from pension funds, insurance
companies, large corporate, HNWI (High Net-Worth Individuals), etc.
With financing patterns heavily biased in favor of a relatively small
number of large firms, the premise that demand for private equity
financing would be strong was convincing. The case was furthered by
the presumption of cooperative local By virtue of their size and track
record, however, many of these firms had risk profiles that were
unappealing to banks and securities markets. Investors were attracted by
the severe capital shortages in many emerging markets, which implied low valuations (and hence high
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
PE Fund of Funds (FoF) :
A PE FOF is a fund set up to invest in other PE/VC/Hedge funds, which in turn invests in several hedge funds instead of directly taking exposure to instruments/securities.
The characteristics of the FoF differ from the investee funds and needs to be evaluated in a slightly different fashion from a risk perspective.
Private Equity (PE) :
Investment vehicles that pool capital for investment in privately owned businesses at different stages of development
Private Equity is the asset class that purchases an equity stake in a company that is not publicly traded on a stock exchange. It offers maximum advantages to both the suppliers and users of investment capital.
21
returns) for the expanding number of companies hoping to raise capital. In addition, many prospective
foreign investors were flush with funds, due to the booming performance of financial markets and
venture capital funds in the industrialized countries during the late '90s. Encouraged by improving
macroeconomic conditions, the new receptivity of governments to foreign investors, and the prospects of
earning high returns, investors are willing to look at higher-risk investments in emerging markets. Both
supply and demand should appear to be in perfect harmony for emerging market funds to succeed.
3. Data Sources and Quotes
To quote, from a Wall Street Journal report, aggregate PE commitments globally are close to $10,000
billion ($ 1 trillion of capital), 1,200 funds are currently seeking $713 billion including 290 Buyout
funds seeking $320 billion; 470 Venture funds seeking $85 billion; 25 Mezzanine funds seeking $10
billion; 205 FoF seeking $220 billion. Europe alone accounts for 19% ($580 billion). In the peak years
of 2000-2005, PE funds were responsible for one-quarter of all global merger and acquisition (M & A)
activity and Leveraged Buyout (LBO) activities.
But the promise of private equity in emerging markets has failed to meet expectations. After an initial
proliferation of new funds in the mid-'90s, growth has slowed to a trickle, and few practitioners believe
that this trend will soon be reversed. Not only have results have been disappointing in absolute terms,
they are even worse relative to comparable funds especially in the Europe. Despite the increased
investment in the private equity asset class and the potential importance of private equity investments for
the economy as a whole, we have only a limited understanding of private equity returns, capital
ownerships, and their interrelation. One of the main obstacles has been lack of available data. Private
equity, as the name suggests, is largely exempt from public disclosure requirements.
Investors in PE funds are called “Limited Partners”. PE funds are managed by the “General Partners.”
In this paper, we make use of a novel data set of individual fund performance collected by Venture
Intelligence. The Venture Intelligence data set is based on voluntary reporting of fund returns by the
private equity general partners as well as their limited partners. Nevertheless, relatively little is known
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
31
about industrial organization of the private equity sector, mostly due to data limitations. This paper aims
to fill that gap using a database of fund characteristics and past performance.
Referring to Figure-1: The Private Equity Partnership Structure and Figure-2 Investment Structures,
virtually all private-equity funds are organized as limited partnerships, with private equity firms serving
as the general partner (GP) of the funds, and large institutional investors and wealthy individuals
providing the bulk of the capital as limited partners (LPs). These limited partnerships typically last for
10 years, and partnership agreements signed at the funds’ inceptions clearly define the expected
payments to GPs.
These payments consist of both fixed and variable components. While the fixed component resembles
pricing terms of mutual-fund and hedge-fund services, the variable component has no analogue among
most mutual funds and is quite different from the variable incentive fees of hedge funds. Successful
private equity firms stay in business by raising a new fund every 3 to 5 years. If the current fund
performs well, and LPs interpret that performance as “skill” rather than “luck”, investors’ demand curve
for the new fund will shift out, with the equilibrium conditions requiring that LPs earn their cost-of-
capital after payments to the GP. In response to this demand shift, GPs may alter the terms of the new
fund so as to earn higher expected revenue for each dollar under management. Alternatively, they may
increase the size of their next fund. They may also do both. Raising the size of the fund may entail
additional costs, depending on the production function for the underlying private-equity activities.
The ultimate performance of private equity funds is only known once all investments have been sold,
and the cash returned to investors. This typically takes over a decade. In the meantime, the reported
performance depends on the valuation of the remaining portfolio companies. Private equity houses
market their next fund on the basis of these interim valuations of their current fund. In this paper we
analyze whether these valuations are fair, whether the extent of conservative or aggressive valuations
differ during the life of the fund, and at what stage interim performance measures predict ultimate
performance.
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
41
4. Pricing of Private Equity Transactions
Companies in most of the countries raise most of their need for Growth Capital from Private Equity (PE)
Funds. Private Equity capital helps numerous companies raise capital from the investor best suited for
that company. Foreign Institutional Investors, mostly the private equity investors have started
participating in the capital markets in a big way. The increasing interests of foreign investors in Indian
market call for greater research on various properties of this market. Investment Bankers like Bank of
America a.k.a. Merrill Lynch, Barclays Capital, Bain Capital, Sequoia Capital, BNP Paribas, ABN
Amro, Citigroup, Blackstone Group, Silver Lake Partners, JP Morgan Chase, Wells Fargo, Credit
Suisse, Deutsche Bank AG, Standard Chartered Private Equity, Goldman Sachs, HSBC, Morgan
Stanley, Nomura Securities, Daiwa Securities, RBC Capital Markets and UBS AG help to generate the
VC or PE based on a project’s future earnings capacity.
Pricing of Private Equity transactions requires a close understanding of the industry being considered for
investment, valuation parameters in the capital market and estimating these variables. The methods used
to value normal growth companies focus on tangible assets, present value of the future cash flows, profit
after tax (PAT) , Operating Profit ( EBITDA), market multiples like Price/Earnings Ratio (for listed
companies). A “Term-sheet” validates an entrepreneur’s idea, establishes a price for a Buyout/ PE/ VC
deal / transaction. An investment can decrease RONA (Return on Net Assets) but increase EVA
(Economic Value Added i.e., Current Market Value of the fund less Cost of Capital) so we often don’t
consider it while pricing PE transactions. Also, the problem with measures such as RONA and ROI is
that they ignore the Cost of Capital so these are also ignored.
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
51
Below are the multiples and their components, used by a majority of companies to assess a PE fund:
a) EBITDA
• Earnings before interest, taxes, depreciation & amortization
• Allows for comparability across industries (asset heavy vs. light)
• Disregards financing decisions and tax benefits
• Excludes non-cash charges against income (D&A)
b) Enterprise Value or Firm Value (EV)
• Value of Debt + Equity less Cash on balance sheet
• Represents Takeover Value of Company
• EV of a public company
• EV of a private company = EBITDA x Exit Multiple
c) PE Valuation Measures in Practice
• Enterprise Value / EBITDA multiple or EV/EBITDA
• Quote value of a Fund as a multiple of EBITDA
d) Capital Structure Comments• Equity is the residual claim on Assets
• Liabilities have security interest on assets
• Seniority of Capital Structure
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
Tranche:
In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. All the tranches together make up what is referred to as the deal's capital structure or liability structure. They are generally paid sequentially from the most senior to most subordinate (and generally unsecured), although certain tranches with the same security may be paid pari passu.
Speaking at a conference on innovative businesses looking to go global to clusters of start-ups in Berlin, Leon Black, Chief Executive of Apollo Global Management, LLC said the average price for private equity deals in the U.S. is 9 times EBITDA. One of the major assumptions resulting from such high valuations is that interest rates will continue to be soft over the next few years, he said.
61
• Cost of Capital relates to relative risk of tranche (Refer right side for more details)
• Investors demand more return for more risk
o Cost of Capital for tranches
o Secured vs. Unsecured
No two funds of a PE investor have the same pricing method. It depends more on experience from
similar price deals, current global capital market trends, client negotiations, government and legal
guidelines in that country. Most commonly used method is the Net Asset Value (NAV) method.
In Figure-7, we see that the number of deals with collar have started
picking up in 2013.
As private equity assets are not traded that often there is lack of market
price data. Private equity investors usually make commitments to a private
equity partnership that draws the capital in the first years of the fund and
sells the investments after three to seven years. In the intervening period the investor receives
information about the net asset value of all the underlying investments on a quarterly basis. The net asset
value is an accounting value that the management team of the private equity team find out.
In the case of private equity funds, estimating fair values of their portfolio companies is particularly
challenging. As a consequence, quarterly fund valuations – reported by the fund managers themselves –
have an inevitably subjective component. This issue has recently attracted considerable attention in the
aftermath of the financial crisis. The U.S. Securities and Exchange Commission (SEC) has started
independent investigations into conflicts of interests of private equity fund advisors, a main focus of
which is the “consistency and comparability of valuation methods” associated with “misleading
reporting [on private equity fund performance] to current or prospective investors”. Such investigations
are related to the registration of private equity fund advisors with the U.S. SEC following the enactment
of the Dodd-Frank Act (Market participants will be required to submit a swap that is identified in the
rule for clearing by a derivatives clearing organization as soon as technologically practicable, and no
later than the end of the day of execution.) In particular the International Private Equity Valuation
guidelines have been developed in recent years, and are now endorsed by 39 national and international
private equity associations. The latest version of the guidelines was published in December 2012. The
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
Collar:
In structured finance, a collar is an option strategy that limits the range of possible positive or negative returns on an underlying to a specific range.
71
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U.S. industry associations have not endorsed the guidelines. The magnitudes of such ranges can be
observed in practice, for example, when comparing the valuations of two separate fund managers who
have jointly invested in one company, but independently report to their respective fund investors. There
has been increasing anecdotal evidence on such patterns from institutional investors who were invested
in both funds, especially since the financial crisis in 2008. While accounting standards, valuation
frameworks and industry guidelines have been moving towards standardization of valuation principles,
they still inevitably allow considerable discretion with respect to the valuation methodology and input
parameters for private companies. The responsibility of fund auditors (who typically audit the funds
annually) is primarily to verify and confirm that the chosen method has been correctly applied, the
underlying assumptions are adequate, and the derived value is within a reasonable range. As a result,
fund managers have various degrees of freedom when valuing their portfolio companies. This raises the
possibility that funds are valued opportunistically at certain times. For example, there will be inevitable
temptations to present interim performance numbers in a particularly favorable light when raising a
follow-on fund, or limiting write-downs during down markets.
5. Macro-economic Factors and Newer Trends in Private Equity Markets
The focus of this paper is to determine benchmark pricing and valuation using new approaches for
Private Equity transactions from the investment banker’s perspective. The present paper examines the
below factors -
a) Global Economic Outlook in the Emerging Markets
Globalization has brought along with it increasing integration of global financial markets, liberalized
capital-flows across economies, emergence of sophisticated technologies (recently SEARCC was held in
Colombo, Sri Lanka – see snapshot on right) and trading mechanisms, cross-border M&As, global
security floatation and syndicated loans. PE has been an established industry in the US and Europe for
long enough now. PE Funds also invest in equity or debt of emerging (less mature) markets which tend
to have higher inflation and volatile growth. The principal factor affecting an economy’s ability to
absorb PE Capital is the number of large scale companies. Private Equity requires that value be created
in a limited period of time before capital is returned to investors. Valuation and Pricing of returns from
PE funds seem to be lack-lustre because at times we concluded that the only emerging markets with
enough capital flows were the BRICs plus South Africa. However, in today’s globalized world, the
investable opportunities are much broader. Emerging markets go up and down (See Animation on right).
For PE funds, it is much more certain that value can be created and an exit achieved in a limited time Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
91
period if the fund is large enough with a significant group of owner of companies for equity financing.
China’s a big market, so private equity will continue to play in it. (refer figure-10: China and Brazil
leading the share of Private Equity Investments in Emerging Markets)
Chinese investors are looking abroad for attractive investment opportunities to create value and long-
term returns. India is one of the BRICs and it was the fastest growing PE market. And it has a
reasonably active stock market, that’s been there for a long while and the PE firms have been there
longer than in China. There have been some issues with taxation where the Indian government has
basically tried to change rules for investors retroactively and that type of policy uncertainty is really
scaring away PE firms from investing in India.
The amount of activity in any individual market tends to be driven in any given year by whether there
were a handful of large transactions. I think saying that, emerging markets are here to stay. There’s more
capital available in the emerging markets than ever before. What really was a focus on the BRICs is now
expanding beyond the BRICs into the frontier markets. So when we take a look, for example, at Latin
America, surely Brazil is the big market and quite a bit of focus is there and will continue to be there.
Growth is returning to European Economic Recovery and European GDP grew by 1.5% during 2012.
Germany had the strongest GDP growth at 3%. Chinese GDP growth slowed to 8.9% even as the
Chinese Central Bank makes efforts to contain inflation by raising interest rates. (Refer Figure-11: GDP
Growth Rates over the last decade)
GDP growth dropped in many of these emerging markets in 2013, but they were still higher than the
mature markets like the U.S. and Europe, and are expected to rise over the next couple of years by 2020.
A slowdown in emerging markets, continuing troubles in credit markets, and persistently high
unemployment still pose risks to economic growth in Europe. In Japan, growth has been strong due to
the new economic policy. However, risk stemming from the impending increase in the national sales tax
persists. After a period of deceleration, China is stabilizing due to strong industrial production, improved
exports, and a rebound of credit creation. However, the need for banking reform remains critical. In the
United Kingdom, economy appears to be on the mend, triggered by easing of economic stress in Europe
and recovery in the U.S. There is now concern that the housing market is exhibiting signs of a bubble. In
India, economic growth continues to decline, inflation remains too high at an average of 7.25% and
business confidence is poor. The best path forward for India involves structural reforms that have yet to
be implemented.
b) Capital Market Conditions and Bond Ratings
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
From the rise and fall of the junk bond market in 1980s through dotcom craze climb and collapse in
1990s and to the swelling and bursting of the subprime credit bubble , GDP growth in developed and
developing markets with record-low interest rates in the US and Europe has helped to fuel PE investor
confidence. Capital markets suffered heavy losses in 2011 and 2012 due to high volatility. One feature
of stock markets that everyone agrees on is that markets are volatile. Over the last three years, the
returns on the Nifty index have had an annual standard deviation of around 8%. (Refer figure-14:
Calculation of Std. Deviation of Monthly Returns). This means that in a given year, there is a wide range
of possible moves for the market. For example, the market went up by 24% in 2012. In 2011, the
market was down by 28%. In Figure 4: Volatility and Liquidity Metrics of a
random PE fund, it can be observed that the VaR for a fund at 99%
confidence level is 5.10% while the same fund has a VaR of 3.60% at 95%
confidence level.
Higher the confidence level, lower the rejection level. Hence as an investor, the PE fund is better.
c) Sources of Risk and Diversification Effect
Risk in PE Funds can be reduced, although not eliminated, by investing in a portfolio of different stocks
from the pool of funds. There are thousands of PE Funds available today for both Debt and Equity.
Improving debt markets should help put wind in the sails of more PE deals. PE firms are continuing to
diversify into new lines of business. And that’s blurring the line between PE and asset managers. The
creation of a ‘side-pocket’ or a special purpose vehicle (‘a synthetic side pocket’) for illiquid
investments creates a special purpose vehicle (SPV) to which it conveys the hedge fund’s illiquid assets
in return for shares or security interests, thereby separating illiquid assets from other more liquid assets.
It then transfers those shares or security interests to its redeeming investors as payment ‘in kind’ of the
redemption price that is owed to those investors. The SPV would liquidate the illiquid assets at some
point in the future, when market conditions are more favorable and it is able to do so, and then distribute
the proceeds to the SPV’s shareholders or beneficial owners. Once an investment enters a side pocket
account, only the present participants in the hedge fund will be entitled to a share of it. Future investors
will not receive a share of the proceeds in the event the asset's returns get realised.
PE Fund Managers have to price companies based on the entry and exit time for the investments, capital
structure of the funds- Debt, Equity and Hybrid. Bain Capital is a private equity and VC firm investing
in such sectors as retail and consumer products, communications, and information technology across
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
Value at Risk (VaR):
Value at Risk measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. Thus, if the VaR on an asset is $ 100 million at a one-week, 95% confidence level, there is a only a 5% chance that the value of the asset will drop more than $ 100 million over any given week.
101
diverse sectors such as infrastructure, technology, media, telecom, financial services, engineering and
manufacturing, and business and consumer services among other sectors. The firm has some $14 billion
currently under management and has invested in more than 225 companies since 1984. Investments
include beleaguered toy retailer KB Toys and about 45% of pizza chain Domino's (Bain sold off about a
third its stake in Domino's 2004 IPO).
Credit-rating provides indicative guidance to the prospective investors on the degree of risk involved in
the timely repayment of principal and interest. Thus ‘credit rating’ also reduces the risk of investing in
the PE market by differentiating it from other securities/instruments with the help of predetermined
standards called ‘grades’ (typically these grades are symbolically represented, viz. A, AA, AAA etc.).
Credit rating is a source of reliable information for many users as rated instruments speak themselves
about the soundness of the company and the strength of the instrument rated by the credit rating agency.
d) Real Estate Industry and Private Equity
PE investors mostly invest in real estate industry in their mature life cycle to affect financial or
operational restructuring. In emerging markets and BRIC countries like India (Figure-13: Actual GDP
Growth Rates from 2007 to 2012 for BRIC Countries), as the real estate industry in India matures further
and pursues international competitiveness, the volume of PE transactions will increase. KKR, CVC, 3i,
JP Morgan, Macquarie and Forstman Little are the leading Real Estate PE funds created by a large
number of Limited Partnerships and acting as the General Partner (GP) for making a substantial side-by-
side investment in these funds. Together with real estate investment trusts
(REITs), real estate private equity funds have filled the equity gap that
occurred as real estate financing integrated with global capital flows.
Beyond obvious liquidity differences, private equity funds differ from
REITs in several important ways. While most REITs have annual total
equity return expectations (dividends plus appreciation) in the range of 10
percent to 14 percent, real estate private equity funds have annual equity
return expectations of at least 15 percent and generally in excess of 20
percent. Real estate private equity funds invest in situations with relative
frequency higher risks than REITs in order to achieve their target returns.
Another distinction between real estate private equity funds and REITs is
that REITs tend to own stabilized income-producing properties with a long-
term operating focus, while private equity funds generally hold properties for three to five years and
generally invest in non-stabilized assets. In their pursuit of higher returns, real estate private equity Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
REITs:
REITs were created for the specific purpose of encouraging widespread ownership of real estate by small investors. A REIT is an entity, otherwise taxable as a U.S. corporation, that meets certain technical requirements and that elects REIT status. The key difference between a conventional U.S. corporation and a REIT is that a REIT is allowed a tax deduction for dividends paid to its shareholders. In order to qualify for this special treatment, a REIT must distribute at least 90% of its net income exclusive of capital gains to its shareholders.
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funds tend to use significantly higher leverage than REITs. It is important to bear in mind that a property
with rents growing at 2 percent to 3 percent annually, with a current yield of 9 percent and 70 percent
leverage at a 6.5 percent interest rate, can achieve large return targets for real estate private equity funds.
Also, strong buyer demand amidst a limited supply of homes for sale has resulted in properties selling
faster and at the highest prices since 2009. These market conditions, including low interest rates, have
driven growth in real-estate markets globally. Private equity investments in India's real estate projects
have grown more than 75% over the past year, even as mutual funds and other investors have shunned
this sector because of rising interest rates and falling revenues. That explains why investments in real
estate projects by various private equity funds have soared, rising to $1,656 million in 2011, from
$944.7 in the previous year, according to accountancy and advisory firm Grant Thornton, while mutual
funds reduced their exposure to the sector drastically during this period. Peter Hobbs, Managing
Director of Research for IPD, added, “This development provides fund managers unprecedented insight
into global real estate risks. The new model reflects the changes in private real estate risk forecasts in a
more timely fashion than traditional methods.”
e) Private Equity and Nature of Transactions (Transfer Pricing, IPO, LBO, Structured Debt and M&A):
PE firms depend on a global transfer pricing methodology to benchmark their services at different points
in their fund’s investment cycle. In emerging markets, PE firms are subjected to tax audits based on their
capital commitments. Transfer pricing needs to be considered on any loans to private equity backed
companies.
In 2013, there were 57 Private Equity companies still in the pipeline
having $11.8 billion in value ultimately making up about 10% of the IPO
pipeline. PE firms are very opportunistic in trying to take advantage of any
windows that open, especially given the old deals that they still have not
exited, their LPs [limited partners] are pretty eager to monetize those
stakes and move on.
Now since pricing seems to be right in the emerging markets, these firms
lever up and so Tech companies tend to be more richly valued than other
businesses. According to Figure-3: Sectors/Industries for Private Equity
Investments, the IT and ITeS sector being a less capital-intensive sector as
compared to the Infra sector, typically receives higher volume of
investments (not necessarily high value) as against other sectors, Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
M & As:
In a merger, corporations come together to combine and share their resources to achieve common objectives. The shareholders of the combining firms often remain joint owners of the combined entity.
An acquisition involves the purchase of the assets or shares of one firm by another where the acquired firm’s shareholders cease to be owners of that firm. In a merger a new entity may be formed subsuming the merging firms, whereas in an acquisition the acquired firm becomes the subsidiary of the acquirer. A merger is principally a legal process and a follow up to an acquisition of controlling interest.
especially during early stages of businesses being set up. Even in this quarter, more than 75% of the
volume of deals in this sector was in the early stage. This quarter has also witnessed a couple of big
deals in the online services and IT services segments. With the exponential growth and importance of e-
commerce, a few of the leading online (e-commerce) companies have seen success and are now looking
to leap into the next phase of growth by expanding their operations and hence attracting investments.
And, with many PE firms focusing on the SME segment, we can expect more such investments in the
small and medium-sized IT services companies which offer niche services.
In M&A markets, the quantity of private equity and trade capital chasing opportunities are enhancing
multiples for top quality assets, whereas lower quality opportunities struggle to obtain interest and
consequently attractive price. In a seminal piece on private equity, Jensen (1989) argued that leveraged
buyouts (LBOs) create value through high leverage and powerful incentives. He proposed that public
corporations are often characterized by entrenched management that is prone to cash-flow diversion and
averse to taking on efficient levels of risk. Consistent with Jensen’s view, Kaplan (1989), Smith (1990),
Lichtenberg and Siegel (1990), and others provide evidence that LBOs create value by significantly
improving the operating performance of acquired companies and by distributing cash in the form of high
debt payments. This evidence have been replicated by studies in Europe (Phalippou and Gottschalg,
2009, Phalippou, 2007), though they raise the issue of certain survivorship biases in data employed
which might imply no median outperformance relative to the market even for large and mature PE
houses. This by itself does not necessarily refute Jensen’s original claim; it could simply be that PE
funds keep the value they create through fees. The puzzle that the evidence on median return of PE
funds raises is thus more about why their investors (the limited partners) choose to invest in this asset
class as a whole, an issue investigated by Lerner and Schoar (2004) and Lerner, Schoar and Wong
(2007). According to Thomson Reuters, worldwide private-equity-backed M&A activity was $321.4
billion in 2012 – flat compared with 2011. However, the year started off slow, with deal volume off
significantly in the first two quarters. Volume picked up steam in the third quarter and achieved a
blistering pace in December, with many deals closing so that sellers could monetize gains at 2012 tax
rates.
f) Corporate Governance and Private Equity
Private equity funds differ from other types of investment funds mainly in the larger size of their
holdings in individual investee companies, their longer investment horizons, and the relatively fewer Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
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number of companies in individual fund portfolios. As a result, it is reasonable to expect private equity
managers to have a greater degree of involvement in their investee companies compared to other
investment professionals, such as mutual fund or hedge fund managers. And because of their greater
involvement, private equity managers are naturally expected to play a greater role in influencing the
corporate governance practices of their investee companies. Private-equity funded firms display higher
standards of corporate governance than firms that do not receive such funding. The difference arises
from the application of developed country standards of CG arising from the investors that own the
private equity funds. These funds are primarily owned by developed country investors. The strategies
through which these occur are: reconstituting the board of directors, influencing senior executive
recruitment, and changing the firm's operating and strategic rules. Emerging market economies like
India usually display low standards of CG. Certainly, sound governance does not invariably equate to
strong performance. There is no guarantee that well-governed companies will produce smooth exits and
high returns for private equity managers, although a number of studies have indicated positive
correlations between governance and stock performance. However, there is an implicit understanding
among most private equity managers that poorly governed companies are more prone to failure. Hence,
there is a strong element of self-interest for private equity managers to ensure that their funds are
invested only in well-governed companies or in companies that are willing and able to improve their
governance, and to avoid investment in poorly governed companies which demonstrate no inclination to
improve their governance. Private equity managers often seek to protect their investments and ensure
optimal exit strategies through legal contracts as well as through vigilance and engagement. Legal
contracts relating to private equity investments often contain clauses giving the private equity investor
certain rights, such as the right to veto a material decision by the board (where the private equity
investor holds only a minority position), or the right to force the company to redeem the securities sold
to the private equity investor should the investment turn out to be unprofitable. One could argue that this
is a more reactive or less preferred form of protection. The problems at the investee company are likely
to have reached a critical level if the private equity manager must resort to such contractual rights for
resolution.
6. PE Structures and Hyp0thesis Testing
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
Hypothesis – A positive outlook influences investors to pay a higher price for a given investment
opportunity and get higher prices at the time of disposal of the investment, encouraging investors
to pay a higher price for the PE transactions.
This study uses weekly data from1999 to 2012 and employs comprehensive tools like Regression testing
to examine the inter-relationship between some of the most important macro-economic factors affecting
the valuation of a Private Equity fund in an emerging market.
Overall, the private capital investment thesis continues to remain challenging for emerging markets. The
macro environment for private equity continues to be strong and long-term prospects for emerging
economies remain attractive, as growth rates are expected to exceed those of the United States and other
major developed economies. As a result, funds are expected to flow back to emerging economies in the
medium term. Moreover, with the Fed making it clear that its actions will be governed by US interests
only, it may be just the trigger for some emerging economies to wake up from their policy slumber and
move ahead with critical reforms to restore economic confidence. Policy challenges, high inflation, wide
current account and fiscal deficits, and slowing growth are challenges that may discourage foreign
investments in markets such as Brazil, India, South Africa, and Turkey, irrespective of the Fed’s latest
action.
As a result, any attempt to benchmark returns is not only comparing apples and oranges, but is actually
comparing apples to potatoes to fish. Any attempt at such benchmarking involves meaningless
normalizations.
So, a global equity index (see Emerging Markets VC and PE Index in this paper’s Data Appendices)
consisting of developed and emerging markets countries across the large, mid, and small cap size
segments—to guide asset allocation and construction of the target date and core fund lineup over short
to long term year-range. Such a framework, which is based on an advanced and well-documented
methodology, is designed to include the full range of investable stocks across all countries, regions,
sectors, styles, and sizes. Consequently, it can help investors gain access to the global investment
opportunity set as well as avoid key dysfunctions associated with many fund lineups, including
benchmark misfit and underperformance.
The European Private Equity and Venture Capital Association (EVCA) guidelines represent a good
framework how to structure a Report for PE funds. Most of the report might have different layouts, but
the respective information can normally be extracted from those reports. In order to align the valuation
methodologies of private equity funds the EVCA, as well as other trans-national associations, developedMacro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
151
and published accounting rules need to be adapted by their members. Even if common and standardized
valuation methodologies are established, the net asset value (NAV) cannot reflect a market price similar
to a stock price.
Empirical analysis shows that the difference of the net asset value of a company and the price of a
company – reflected through the selling price a few months later – could largely differ. On the other
hand an internal study by Capital Dynamics analysed that the ability to predict the correct value of a
company and the performance of a private equity fund are positively correlated, i.e. good private equity
managers have a good understanding of the value of their underlying portfolio companies. In addition,
the management team tends to keep the changes of the valuation between different valuations periods
very limited; e.g. during the investment period of a fund the value is usually kept at cost over a longer
time period.
Due to the turmoil in the public markets the US accounting rules (US
GAAP) were changed and private equity managers should also apply the
mark-to-market valuation (details given on the right). As described in FAS
157 (Fair Value Measurements), PE Funds are required to comply with
IAS 39 (Financial Instruments: Recognition and Measurement) and IFRS
7 (disclosure of information about the
significance of Financial Instruments to an entity, and the nature and extent of risks arising from those)
and SAS 70 certification (Reports on the Processing of Transactions by
Service Organizations).
Every private equity firm must ‘fairly value’ every single one of its
investments, the criterion being a holding’s likely current sale value. For
those that do not trade publicly, buyout houses and their auditors must
approximate the value as rigorously as they can, guided by the pricing of
recent leveraged buyouts (LBOs) and valuations of comparable public
companies. Auditors require a robust and well-documented determination
of fair value by the private equity fund in order to agree to the valuation
methodology. Whether this change in the accounting rules will also affect
the volatility in the net asset value is currently open to debate and has to
be analysed at a later point in time.
In summary, net asset values are accounting values and not market prices
for PE funds like they are for other types of funds, especially Mutual
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
Mark-to-Market Valuation:
A measure of the fair value of accounts that can change over time, such as assets and liabilities. Mark to market aims to provide a realistic appraisal of an institution's or company's current financial situation.
SAS 70 Certification:
Issued by the Auditing Standards Board of the American Institute of Certified Public Accountants (AICPA), SAS 70 provides guidance to service auditors when assessing the internal control of a service organization and issuing a service auditor’s report. SAS 70 also provides guidance to auditors of financial statements of an entity that uses one or more service organizations. Service organizations are typically entities that provide outsourcing services that impact the control environment of their customers. Examples of service organizations are insurance and medical claims processors, trust companies, hosted data centers, application service providers (ASPs), managed security providers, credit processing organizations and clearinghouses.
161
Funds. Nevertheless, these accounting values have to be taken into account if someone wants to
calculate the risk of private equity before the end of the fund’s lifetime. But it is important to bear in
mind what integrating net asset values actually mean and how great their influence is in different
methodologies. Private equity explicitly focuses on the combination of ownership and control to
maximize the alignment of interests. The management of an investee company is expected to contribute
a substantial fraction of their net wealth into the most junior part of the capital structure. Fund managers
co-invest into their own funds and, occasionally, in the individual companies, which they then closely
monitor from the board as external directors. In addition to this, fund managers share 20% of the profits
that the private equity fund generates – their “carried interest” provided the internal rate of returns (IRR)
exceeds a certain hurdle rate, which is traditionally 8 percent.
Common for all sub-asset classes of private equity is the concept of investing via closed-end funds with
a finite lifetime, usually structured as private limited partnerships and incorporated in favorable
jurisdictions like Delaware for U.S. funds or the Channel Islands for European vehicles. Private equity
funds have a normal contractual lifetime of ten years, with an optional extension of up to three more
years. The first five to six years represent a fund’s investment period. Instead of paying the entire
amount of capital upfront when the fund is raised, fund investors (Limited Partners, LPs) commit capital
to a private equity fund, which the fund manager (General Partner, GP) then calls when a new
investment is identified or fund management fees are due. Following the expiration of a fund’s
investment period with no more capital, the GP has another five to seven years to realize all investments.
This arrangement gives private equity funds a self-liquidating character. An exception are ongoing
management fees, though, these are regularly funded from realizations in the second half of a PE fund’s
lifetime.
7. Conclusion
It is found that successful private equity funds are shifting their focus by adapting to new market
realities and growth opportunities in emerging markets. With this in mind, it can be explored that our
hypothesis – “A positive outlook influences investors to pay a higher price for a given investment
opportunity and get higher prices at the time of disposal of the investment, encouraging investors
to pay a higher price for the PE transactions and vice versa”.
Private Equity funds are able to switch gears or make adjustments where needed, continuing to drive the
kinds of changes that have made them one of the most investor friendly and profitable investment
vehicles globally. Recently, Delhi-based Moolchand Healthcare will invest Rs.500 crore to acquire
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
171
existing hospitals and develop new greenfield ones. The expansion will be funded from a private equity
infusion of Rs. 100 crore from Sequoia Capital, with the balance coming from internal accruals and
debt. "We are planning to be among the country's largest multi-speciality healthcare providers," said
Shravan Talwar, chief executive officer of Moolchand Healthcare, which runs one multi-specialty
hospital in Delhi.
In the emerging market countries, Asia and China clearly are at the top of the list for Private Equity
investing activity as EBITDA is the highest for these 2 markets in Figure-5: Cash Positions for Private
Equity Investments.
The obvious conclusion is that the model does work successfully in the emerging markets. Supporting
this, assistance with M&A is another key area in which private equity firms will be able to support their
companies going forward. Overall sentiment in Western Europe has held up better than might have been
expected given the scale of current economic travails. This perhaps reflects the fact that many GPs have
dealt with problems in their portfolios and focused their new investment activity on more defensive
sectors like ITeS and Infrastructure. In keeping with this, across the BRICS, the outlook in Brazil
remains broadly positive, it is more split in India and China, with some investors in the former having
become notably bearish.
A number of other considerations — low private equity penetrations, lack of financing generally in the
market, lack of a strong venture capital market — ultimately the combination of all those is a need for
capital. And then we combine that with the rising middle class and increased consumerism, and we
think, long term, private equity will continue to look at the emerging markets as a great investing
opportunity.
It is believed that the immediate risk of Eurozone failure remains low. In addition, it is believed that the
Eurozone will “return to feeble growth” by the end of 2013. Europe could be condemned to a prolonged
period of low growth if it continues to experience low investment besides PE funds having a long 5-year
investment period and a 10-year life in most cases.
We also noticed that due to restricted information disclosure, only LPs have access to the fund’s
performance. Therefore, it can be safely concluded that Private equity is still an inefficient market. In
this paper we also analyzed whether private equity funds value their assets fairly. This is an important
question not just from an accounting and regulatory perspective, but also because fund valuations impact
directly on reported performance figures, which in turn are likely to influence investors’ decisions as to
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
181
whether to invest in new funds. Our results can be summarized in a caveat “interim performance is no
guarantee of final performance”. Fund managers must re-think the professional expertise required for
these tasks, recognizing that the analytical and negotiating skills required to make an investment
are not the same as those required to enhance corporate value during the post-investment phase.
Initially, the industry relied too heavily on former investment bankers trained to "do deals," collect
their fee, and move on to the next transaction. They badly underestimated the amount of hands-on time
required to monitor the portfolio company performance. Attending periodic board meetings, reading
financial reports, and observing performance from afar is not sufficient. Instead, professionals
must take on the difficult and time-consuming tasks of strengthening corporate governance practices,
restructuring management, and re-positioning the PE Fund-Strategies for a profitable exit together with
fund value enhancement. It is an important of this business, says one fund manager. "When you sign the
deal is when the real work starts, not ends. Finding the right skill set in emerging markets is tricky.
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
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201
8. Limitations and Scope for Improvement
Through this paper, we have stressed upon the need to look at important factors regulating the Private
Equity Market and have also briefly discussed the way to analyze and compute an index which can find
out a measure of evaluating a PE Fund. The unexpected turn of events over the recent past, have forced
the fund managers to share more information as required by the investors in order to attract investments.
So it is now possible to develop such measures using the available information from them.
9. Figures and Graphs
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
201
Figure-1: The Private Equity Partnership Structure
LP Insurance company
Pension fund
Large corporate
HNWI
GP The PE fund Manager
Portfolio Company A Company B Company C Company D Company E Company D
Figure-2: The Private Equity Investment Structure
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
211
Figure-3: Sectors/Industries for Private Equity Investments
Source: Deloitte
Figure 4: Volatility and Liquidity Metrics of a random PE fund Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
221
Source: EVCA Risk Measurement Guidelines
Figure-5: Cash Positions for Private Equity Investments
Source: NSE
Figure-6: Private Equity Fundraising 2(Pool of Funds)
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
231
Source: Venture Intelligence
Figure-7: Private Equity Deals with Collar
SOURCE: MERGERSTAT FACTSET
Figure-8: Capital raised in Emerging Markets on a rise
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
241
Figure-9: GDP share of Emerging Markets
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
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Figure-10: China and Brazil leading the share of Private Equity Investments in Emerging Markets
Figure-11: GDP Growth Rates over the last decade
Figure-12: Projected GDP Growth Rates from 2011 to 2013
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
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Figure-13: Actual GDP Growth Rates from 2007 to 2012 for BRIC Countries
Figure-14: Calculation of Std. Deviation of Monthly Returns
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
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Source: Globalfunddata.com
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets28
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Presentation on 19.04.2012
Appendices
Proposal to serve Edward Jones | 23
Data Appendices
Data Appendices, References and Sources
Deals ^
Index >
Consolidated Emerging Markets Data Set (All figures in %)
Deals- Fig. 7 PE Fund- Fig.6 GDP Growth Fig11 PE SD f15
1999 6.4 8.45 4.3 7.2
2000 7.7 9.35 4.5 6
2001 7.5 8.43 5.5 6.52002 7.43 7.45 6.65 5
2003 7.65 7.89 8.54 7
2004 5.65 10.45 7.54 8
2005 6.54 13.60 6.75 6
2006 5.69 16.02 5.6 6.23
2007 5.09 17.61 6 4
2008 4.85 15.40 2.1 10
2009 6.29 6.91 3 9.45
2010 3.63 7.10 4.5 5
2011 4.78 5.02 6.2 6
2012 4.48 6.34 5.4 5.32
Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets30
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Data Appendices, References and Sources
10. References and Research Sites
International Monetary Fund (2010) - How did Emerging Markets cope in the crisis - Regulatory Uncertainty and Market Liquidity - [Online] - Retrieved on 21 November 2013 from: www.imf.org
Anecdotal Evidence cited in this paper is taken from an interview conducted by the authors from Latin American Private Equity Analyst and European Venture Capital Journal
Asian Academy of Management Journal of Accounting and Finance AAMJAF, Vol. 6, No. 1, 89–108, 2010 [online] [Accessed 1 December 2013] from <http://web.usm.my/journal/aamjaf/main.html>
Sectors/Industries for Private Equity Investments information from <https://www.deloitte.com/view/en_US/us/Industries/index.htm >
European Private Equity and Venture Capital Association (EVCA) guidelines retrieved fromhttp://www.evca.eu/uploadedfiles/EVCA_Risk_Measurement_Guidelines_January_2013.pdf
Calculation of Std. Deviation of Monthly Returns obtained from <http://www.globalfunddata.com/equity/funds/home >
http://articles.economictimes.indiatimes.com/2012-05-11/news/31669329_1_private-equity-
vasan-healthcare-abhay-pandey
http://evca.eu/
http://online.wsj.com/user/profile/myprofile
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Data Appendices, References and Sources
Do all the good you can, by all the means you can, in all the ways
you can, in all places you can, at all the times you can, to all the
people you can, as long as ever you can.
—John Wesley
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