The much-awaited news of Facebook going public has finally hit the market. This is the stuff dreams are made of. The company was started by college students out of their dormitory and in less than eight years, it goes for IPO and gets a whopping $75-100 billion valuation. Moreover, they got such a good valuation in spite of the fact that their revenue stream of $4 billion last year was meagre, compared to the valuation. But for many other entrepreneurs, the sailing may not be as smooth. With great ideas but small cash flow, coupled with gloomy economic outlook, IPO proposition is associated with significant risk to a business venture.
However, there is a method to madness in this environment. The private equity route has many attractions for a smart entrepreneur with a successful business model. It is reasonable to say that the PE route becomes the preferred one during economic downturns. The table below compares the funds raised through the IPO route and the PE route in the last four years. This also indicates that PEs have been the preferred route in bear markets. This is further supported by the fact that many PEs prefer to enter a bear market due to low valuations and exit in a bullish market for handsome returns on investments.
Around $10 billion was raised last year through PE route while $7.8 billion was raised through IPO. This is the first time since 2008 when PEs raised more money. In 2010, $26.7 billion was raised via IPO while PEs raised only $9.5 billion. This reflects the market environment and the decisions by many houses to postpone their IPOs. The current year has started with the MCX IPO. While the response has been very positive, we have to see whether it is bellwether for the trend this year.
Likewise, the lukewarm response to ONGC disinvestment from the market in general, shows that investors continue to be cautious and choosy. While we cannot conclude that PE is the best way to raise the capital for all, this market has a lot of attraction worth considering.
One of the advantages of PE investments is that, along with the funds, it also brings in business expertise. Since PE investors belong to a comparatively small group, entrepreneurs, while scouting for funds, have to focus and sell the business idea to a few people only, who are also more knowledgeable about the industry, in comparison to retail or institutional investors in general. This group tends to be very focused and hence, understands the true value of the enterprise. Therefore, they can also ensure better valuation for the company. The value of such expertise is much more in the tough environment. With external professionals advising the business, entrepreneurs get full power behind them to focus on the core business. PE investors can also bring wealth of industry experience and contacts, which can add to the value of the enterprise. Some PE firms also have portfolio companies, which can further expand the market and bring in synergy. This can help in expanding products, markets and deals. PEs also help them avoid missing any growth cycle of the business, which otherwise, may be hampered due to tough economic environment. PE deals tend to complete much faster than going through the IPO process. In contrast to IPO, PE’s involvement can save a lot of time and energy in drafting red herring prospectus, scouting for bankers and working with the regulators.
The IPO route has many attractions as well, but one of the key drivers of stock price is predictability. It expects the company management to have a clear idea of performance in the coming months. One of the challenges in a tough economic environment is predicting the future. There tends to be far too many variables in the external environment to allow for clarity of plans. In fact, it is said that the market prefers bad news rather than uncertainty. A market also rewards management depth and maturity in new companies. It is normally difficult to attract a good team when the environment is tough as people tend to be risk-averse in such times. Additionally, once the money is raised through the IPO, one is expected to start providing returns to the investors on the sustained basis via dividends and capital appreciation. A company should also be ready for the public scrutiny by investors, analysts and regulators. The performance in the stock market often impacts the brand of the company, which can impact core business performance. In a tough environment, the risk appetite of institutional investors also reduces substantially. Institutional investors reshuffle their portfolio by reducing exposure to emerging economies and equities, and prefer to park them in safe havens, including alternative asset class such as gold, debt or simply cash. There are more companies to raise capital and lesser number of investors willing to participate. Valuation is impacted due to risk appetite, economic environment backdrop, liquidity constraints and macro global factors. Small and midcaps take most of the hit in such an environment.
The PE route also has its own challenges. Both the investor and the entrepreneur need to be extremely clear about the expectations from the engagement. Entrepreneurs should not feel that the PE involvement is stifling his control over the organisation which he had dreamt of, had sown the seeds and had nurtured the seedling. He has to see that the relationship gives it the right proportion of sunlight, water and manure, so that he can see it growing from seedling into a healthy tree. The PE team often has great knowledge and can twist the relationship to their one-sided advantage. Also, the PE team should be comfortable with the management team. It should be a marriage of the equals and both partners should have full commitment, especially in the tough market environment.
(Rajiv Vaid is a chief operating officer at Daiwa Capital Markets India Pvt Ltd.)