There are 1,341 companies in which 120 private equity funds have invested close to $51 billion more than five years ago. As private equity investments in companies approach the five-year milestone, investors start to squirm about exits and collecting a return on their investments. Unfortunately for these private equity investors, an exit has proved to be elusive, thus depressing their return ratios substantially and even leading to the shutdown of some funds and possibly threatening the future of this very important asset class in India. Is this merely a case of a marriage between private equity investors and their portfolio companies gone awry or was there a fundamental mismatch right from the start?
Ask a private equity investor for the firm’s investment process and a typical response is, “We back credible, trustworthy management teams with who we share a strong chemistry, that have the vision to spot large market opportunities and possess deep execution skills to build successful businesses. We think of ourselves as partners to entrepreneurs and add tremendous value through our vast network and experience”.
An investment decision supposedly made on this premise of trust and credibility with the entrepreneur, seems to lose this character in the investor agreement between the entrepreneur and the investor and acquires a strong flavour of distrust and need to protect oneself at all costs.
A typical private equity investment agreement (term sheet) issued by a private equity investor to an entrepreneur and a simplified interpretation of it read like this.
1: Preference shares: Our shares will carry preference over yours. Yes, we are your ‘partners’ in building this business, but we will be treated preferentially.
2: Preferential accumulated dividend – Our shares will carry a 9% dividend from the day we invest. Even if the company doesn’t have enough profits yet to pay dividends, it can keep accruing. We will collect all of our accumulated dividends first as soon as the company is profitable enough before the entrepreneur who built the business can claim any dividend.
3: Voting rights – Our dividend accumulating preference shares will also carry higher voting rights than your shares. Simply put, our vote will be twice as important as yours.
4: Guaranteed return of 25% - We will need a guaranteed return of 25% on our investment. Yes, it’s not a loan or uncollateralised debt but since we are taking a ‘risk’ on you, our special form of equity will get a guaranteed return. If the business doesn’t perform well, we are entitled to our guaranteed returns as bank loans but if it does very well, then we will be entitled to our share of profits, unlike a bank loan.
5: Put option – After five years, we have the right to force you to buy our shares at a price that will give us that guaranteed 25% return. Even if the company doesn’t have the money to buy back our shares, you can mortgage your house, family Jewellery or do whatever it takes to buy us out and give our money back.
6: Drag along/Tag along/Veto rights – If after five years, we change our minds, we can force you to sell your company to anyone at any price. On the other hand, if you want to sell the company or your shares to anyone, we have the choice to either veto it or tag along with you.
7: 3x liquidation preference – Should the company shut down, we will have the first right to take out three times our money from the liquidation proceeds of the company before you get a penny.
8: Board rights/Right to appoint CFO – Since we don’t trust you to not run away with our money nor do we think you can run your business efficiently on your own, we will appoint a disproportionate number of board members, a new CFO and new auditors. However, despite this, if the company still fails, we are entitled to our guaranteed returns and other protections.
Steve Jobs is famously supposed to have told his design team about consumers, “Don’t listen to what they say; watch what they do”. This aptly sums up the subtle tension that permeates entrepreneurs and private equity investors in India.
The investment terms that most private equity firms have adopted in India are a replica of 21st century American private equity investment terms that many first generation Indian businesses are being forced to fit into. Maybe herein lies the most important lesson in private equity investing in India—this display of lack of trust through these investor agreements is perhaps a wrong starting point and possibly a signal that the company does not merit investment in the first place.
Private equity is pivotal to India’s private enterprise-led growth model that can catalyse job creation by private businesses unlike China’s government-led development model. Hence it is critical that this asset class succeeds in India and conceivably by staying true to higher risk-higher reward nature of equity, perhaps the mutual trust between businesses and investors can be restored and the asset class can flourish.
(The author is the CEO of an investment bank and a successful angel investor. Views expressed here are his own.)