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Good Governance, Biz Ethics Count In PE Deal-making

By Raja Lahiri

  • 28 Nov 2011

Private Equity (PE) in India has been playing a significant role in providing growth capital to Indian entrepreneurs and has helped them achieve their growth aspirations in a lot of ways. In my view, Indian PE players perform a key role in bringing global corporate governance practices to the investee companies and contribute by sharing their knowledge of global best practices with Indian entrepreneurs.

As the Indian PE industry reaches the maturity curve, conflicts and concerns regarding corporate governance practices in investee companies are being observed.

It is often said deal momentum is good but valuation differences are significant to close deals. Assuming the sound underlying business drivers and good entrepreneurship abilities of the founder, PE funds are closely evaluating quality of governance standards, reliability of financial statements and business ethics of potential investee companies.

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PE funds are willing to pay a premium for companies with good governance and ethical standards, and increasingly shying away from transactions which indicate weak governance and ethics.

In my view, there are certain perspectives that possibly are becoming relevant in the current PE deal environment:

Valuation Focus Is Good But Not Great

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         While it is very important to achieve the desired valuations, too much focus on pricing and valuation may not necessarily be the best strategy for the company. 

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         Raising capital is one of the key decisions that an entrepreneur has to make. However, more important is the realistic probability that the company is able to meet the targets. 

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         Setting realistic expectations for the incumbent PE player is the key and needs to be driven by the entrepreneur. 

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         We have often seen high valuations and unrealistic business plans being signed off at the time of fundraising and the inability of the entrepreneur to meet these targets becoming triggers for future conflicts and suspect corporate governance and accounting practices.

Revenue Growth Is Good But Bottom Line And Cash Flow Are What Matter Finally

         While the revenue growth story is a fantastic story line, probably the focus on profitability and bottom line is the key to derive value.

  •         The urge to achieve revenue growth should not, in any way, dilute the importance and need to drive profitability and cash flows. Let us not forget that the underlying driver of the business remains profitability and cash. 

    Transparent & Good Governance And Business Ethics Are Value Differentiators For PE Funds

             In my view, transparency and good governance standards are the ‘building blocks and infrastructure’ for businesses to grow and are clearly becoming more important in the Indian market.

             Investors are willing to pay a premium for higher transparency and good governance standards since these are important ‘intangibles’ which are getting valued implicitly by PE investors while deciding on valuations and deals.

             On the contrary, businesses with weaker governance standards are not finding it too easy to close transactions. 

  •          International investors and corporate houses are increasingly becoming concerned with increasing regulations on FCPA and Anti-Bribery Rules, as well as accounting standards and reporting mechanisms.

    Intangible Value Drivers For Good Governance

             With effective corporate governance based on core values of integrity and trust, companies will have competitive advantage in attracting and retaining talent and generating positive reactions in the marketplace. If you have a reputation for ethical behaviour in today’s marketplace, it engenders not only customer loyalty but also employee loyalty.

  •          These would drive two key business drivers – attracting and retaining quality clients and quality people.

    It’s possibly important to recognise the need to gauge the impact of good governance standards and practices in valuations and raising funds from PE funds.

    As Warren Buffet had said, “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”

    Not only the valuations and pricing can be measured and quantified, but also the importance of the intangible value of business practices and governance standards which would attract the appropriate investor class and drive the growth agendas for Indian entrepreneurs.

    (These are personal views and not views of the Organisation).

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