Explained: Why PE firms do debt deals and what leverage they really have over founders
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A note purportedly written by Café Coffee Day founder VG Siddhartha, who apparently committed suicide earlier this week, has shaken up the usually quiet and closed-door offices of private equity firms.

In the note, he claimed mental stress due to harassment by tax authorities and pressure by a PE investor to buy its shares back. This has put the lens on the investment practices of private equity firms. Some market commentators have ended up blaming the PE firms for what they call “unfair” business practices.

Here is an attempt to provide a primer on PE and its basic structure, and answering some questions that a lay reader may have after Siddhartha’s untimely death.

What is private equity?

Private equity firms collect pools of capital from those managing pension funds, banks, insurers, large corporate houses as well as wealthy people and families to invest on their behalf in other companies. They are like closed-ended mutual funds and typically, but not necessarily, invest in privately held companies.

However, their risk appetite, much like their returns expectations, is much higher. For instance, a PE firm investing in India would aim to generate around 20-30% annual returns as against 7-10% one may get via fixed deposits and similar low-risk debt instruments. In developed markets, the returns expectations are much lower.

PE firms can either buy a small stake or a controlling stake in companies. In developing economies like India, the firms typically buy minority stakes as was the case with Siddhartha’s Coffee Day Enterprises Ltd. In large markets like the US, the firms usually take a controlling stake. Increasingly, they are doing so even in emerging economies such as India.

In both cases, they come as financial investors with an aim to sell the stake or the company in three to seven years. They distribute the money they make to their own investors, after keeping a part of the profit—typically, 20%.

Do PE firms lend like banks?

No, they do not. PE firms typically invest by buying equity shares or, as is more common in India, convertible preference shares or a combination of both.

Preference shares allow them to invest without effectively taking control. In fact, holders of preference shares do not have voting rights in the board decisions. But, as directors they keep an eye on the overall direction of the company. They can potentially become equity shareholders by converting their preference shares into equity shares.

Some PE firms have separate credit arms. For instance, KKR has a credit business. It provides debt via its non-banking financial companies and separate India-focused credit funds.

Some PE firms may also lend a part of their fund corpus. In a few cases, PE firms invest via debentures that carry an interest rate and can be converted into equity shares after a few years.

The form in which the PE firm invests depends on the need of the investee company, the risk appetite of the investors and the entrepreneurs’ willingness to become answerable to external investors. Debt investments make founders less answerable to investors and avoid equity dilution, but add an interest liability.

According to law firm Khaitan & Co’s partner Mayank Singh, PE firms prefer structured debt instruments as these have an upside based on the price of the underlying equity.

These would be typically structured as non-convertible debentures, redeemable preference shares and, in certain cases, shareholder loans, he said.

“The nature of instruments depends on various factors that may include the stage of investment (early-stage, growth-stage, pre-IPO etc.), the financial performance of the company and the residential status of the investor,” Singh said.

Why would a company borrow from a PE firm?

Companies end up borrowing outside the banking channels if banks are not lending to them due to their own risk assessment. Then, companies borrow from shadow bankers like NBFCs or take alternative debt from credit funds operated by PE fund managers.

Both NBFCs and the alternative credit providers charge a higher interest rate than banks to account for the risk they take. A similar comparison could be microfinance institutions, which charge 20-22% interest from even poor borrowers while their own cost of capital is about 10%. The difference in the cost of borrowing and the lending rate is not all profit, but factors in the higher cost of administering the loan and the higher risk element.

How much leverage does a PE firm have over the entrepreneur? Is it fair to say PE deals are debt transactions in disguise?

Equity deals of privately held companies—which are not listed on stock exchanges—come packed with a shareholder agreement that gives special rights to the PE firm. These include a ‘tag-along right’ that is invoked if the promoter wants to sell his/her stake to a third party and allows the PE firm to also sell its stake on similar terms.

Many a time, though not always, the agreement has a clause where the promoter commits to buy the stake back from the PE firm or facilitate a third-party transaction where another investor buys the stake at a predetermined price or a formula that gives a minimum return to the original investor.

Such equity shareholder agreements usually become void once a company goes public after listing on a stock exchange.

In a way, a share buyback clause could be construed as a debt deal, where an investor is guaranteed at least a basic return. Investors can also include a ‘put’ option at the time of an investment, which gives them the right to sell their shares to the founder.

However, according to Khaitan’s Singh, such a generalisation is incorrect. According to him, put and call options tend not to be open-ended and are structured to kick in only when there is a default as per previously agreed pacts.

“These options are also typically intended to occur at the fair market value of the securities at the point of invocation and are structured in accordance with the legally permissible framework,” he said.

When the investment is via debt, the investors enjoy control over certain collaterals just like a housing mortgage. In most cases the collateral is the promoter’s equity shares or some other physical asset.

“A debt obligation is far more severe in terms of an enforcement action including initiation of insolvency proceedings. Further, put and call options are usually included in private equity documents as ‘fallback’ options and are not the preferred exit routes in most cases. So, there is no certainty on occurrence of such events – thereby taking away from the ‘debt flavour’ of such options,” Singh said.

Are PE firms unregulated? What is the regulatory view on enforceability of put and call clauses in transactions?

The Securities and Exchange Board of India (SEBI), India’s capital markets regulator, has defined disclosure norms for sources of funds and the mode of operations for PE firms.

Depending on the structure of the fund managed by the PE firm, the fund may or may not come under SEBI’s purview. Indeed, SEBI doesn’t regulate most international PE firms and their funds. However, many of these funds are answerable to the US Securities and Exchange Commission as a lot of money comes from American investors.

Put and call clauses have been a major cause of tension between promoters and investors over the years. Promoters, unable to provide an exit and unwilling to pay a premium to an investor looking to exit, have claimed in the past that put and call options are akin to external commercial loans and violate other norms.

SEBI clarified through a notification in October 2013 that such clauses were valid, subject to compliance with regulations, Khaitan’s Singh said.

The RBI also (through notifications in 2014) clarified that options attached to equity shares and compulsorily and mandatorily convertible preference shares or debentures issued to non-residents by unlisted companies were permitted if such instruments didn’t provide any guarantee of an assured return or an exit price at the time of investment.

Put and call options are common internationally and are enforceable voluntarily or via arbitration. These are not limited to PE dealmaking but are common in stock market deals through a derivatives platform. These are also common in mergers and acquisition agreements.

The recent Tata-NTT DoCoMo case showed that, if the predefined buyback price is not as per existing norms, the breach of agreement can lead to an arbitration award in favour of the investors. Some grey areas remain on this front, but one thing is clear that in most cases the two parties knowingly agree to such clauses.

“Promoters are typically well advised and are fully aware of obligations they are undertaking,” Singh said.

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