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PEs failed to cash in on magical moments of public equity investing

26 June, 2012

We are in very interesting phase of time. One side, there are PE funds who are sitting on large amounts of funds, not knowing where to invest. On the other side, there are large number of companies (especially in listed space) starving for funds as almost all the fund-raising channels were shut out. Literally speaking, there is no activity in IPO, FPO, QIP, ADR and GDR markets for the companies to raise funds. To summarise, there is large supply of money desperate for investing. And, there is large demand for money desperate for being invested. But still, deal making is still slow with no bridge being built between the supply and demand.

Consistently, Limited Partners (LPs) are complaining that Indian General Partners (GPs) are not generating healthy returns. And, the GPs are attributing the reasons like lukewarm investment returns to a hypothesis that India is slowing and there are no exciting investment opportunities in India. Is that entirely true? Were there really no money-making opportunities in India in the past 3-4 years? Let’s analyse this.

Case study of 2009

For instance, on March 1, 2009, the total market capitalisation of Indian capital markets was about $581 billion. Within 10 months, by December 31, 2009, the market capitalisation went up to S$ 1,304 billion. So, that’s an accretion in market capitalisation to the tune of about $723 billion. Of this, 58 per cent stake is owned by promoters. Hence, of this accretion, about $420 billion belongs to the promoter group. The remaining $305 billion wealth accretion belongs to investor community. That’s true. Just feel it: wealth accretion to the tune of $ 305 billion in 10 months. Such moments of 2009 can be called as “magical moments” or “multi-billion dollar moments”. They may not be regular events. But, they do come. Those are the moments to act.

This wealth creation has happened right at the time when most of the funds were very much present in the game and have been “looking for” wealth creation. Some of the funds have taken advantage of those “irrational panic” moments of 2009. However, most of the funds couldn’t benefit from those moments. When there was wealth accretion of $305 billion in a matter of 10 months, one expects that the “lion’s share” must have been earned by the savvy sophisticated investors such as private equity (PE) funds. Despite being PE funds, several of them have the mandate for pursuing the public equity investing for certain percentage of the total funds. So, this wealth creation of 2009 was very much in the reach of these funds. This is a classic case of “error of omission”.

Error of Omission

There are two kinds of errors. One is “error of commission”, wherein something shouldn’t be done but has been done. The impact of this will be tangible and visible. Second is “error of omission”, wherein something should have been done, but have not been done. The impact of this will be invisible. But, that doesn’t mean that was not an error. So, private equity funds not participating in the 2009 magical moments is a classic case of “error of omission”. One can always make an argument that listed space is not PE fund domain and they are not in the business of timing the market, etc. But, the fact still remains that it was an “error of omission”.

Learning of 2009

Keeping this fact into account, I strongly believe that public market-focused funds must prepare this time for those magical moments. Similarly, the private equity funds shall also not miss those magical moments to the tune of their share of public market focus. If the economy is not doing well and is not expected to do well in the coming few quarters/years, it becomes all the more imperative that the players in the fund managing business have to focus more on the market “mispricing” opportunities. The capital markets tend to move from “irrational panic” to “irrational exuberance” many a times, in the process producing significant “lumpy returns”. It is another matter, how much of this one would they be able to capture. If one is not fully prepared for those magical moments, then get ready for one more “error of omission”. Every time, India’s slowdown may not be the sole reason for underperformance. One can convert India’s slowdown as an opportunity.

Capturing the magical moments

The idea of the article is not to say that traditional private equity can’t produce healthy returns, but it is to highlight the fact that active persuasion of “public equity” investments can be truly rewarding. This needs special focus and razor-sharp analysis by a well qualified team with experience and exposure in the capital markets. Having the right mindset and right team who has made their hands dirty with intensified capital market exposure can enable to capture those “magical moments”.

(Jagannadham Thunuguntla is Head of Research at SMC Global Securities)

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Anonymous . 6 years ago

Great article, there might be companies trading at 2x-3x EBITDA 4x-5x PE and investors feel they are not worth it but the fact is they could be great buying opportunities if you can really understand their business. Markets might not value them because either they dont understand the business model or there is just not enough coverage and sometimes the sector/economy bearness just beats them down.

ANONYMOUS . 6 years ago

Refreshing article. Quite well made argument. If PE funds are in the business of making money, then both private equity and public equity assume equal significance.

As rightly said, the capital markets tend to move from “irrational panic” to “irrational exuberance” many a times, in the process producing significant “lumpy returns”. It is another matter, how much of this one would be able to capture.

So, need to be seen who will be prepared for next big lumpy returns.

Ravi Srinivas . 6 years ago

Good article, but perhaps overlooking certain fundamental tenets of PE investing. Typical PE investments are done with strong and active governance structures in place i.e. hands on the wheel, foot on the pedal, and a lot of say on the board. This is not to be mistaken with the governance structure of a public company, wherein it’s largely a compliance ‘thing’, with institutional investors playing a very passive role. This means that for a typical PE investor who is used to playing a participatory role in a private company, public markets become a ‘spray and pray’ exercise, i.e. invest and hope the management, or the market, delivers the returns. IMHO, the real opportunities perhaps lie in transformational-type investments, i.e. buy-outs, public-to-private, turn-arounds etc that will allow the PE investor to drive towards the end game. This makes a lot of sense, particularly if one were to believe that valuations attributed by public markets are suppressed.

Phoenix . 6 years ago

Finally, another original article!

I do believe however that some PEs have infact bought stakes in publicly quoted securities and they too are heavily underwater.

Moreover some investors will argue that valuations are still not attractive enough. Few others will argue that vauations will go down further for justifiable reasons.

Besides it not simply a valuation game. What if the investment underperforms the index ! These are some of the other aspects to study.

The skill sets in both are not exactly the same. As Ravi above points out, “real opportunities perhaps lie in transformational-type investments, i.e. buy-outs, public-to-private, turn-arounds etc”.There are PEs who focus on this.

PE Practitioner . 6 years ago

The views posited are simplistic at best and uninformed at worst. PE is about buying cheap and selling high. This cannot be done in 10 months – as the author points out in his flawed “magical moments” thesis. PE funds lock up money from investors for 10 years – and their job is is diversify the investors portfolio away from traditional asset classes like fixed income and public equity (stock markets). Indeed, PE activity picks up when stock markets swoon, but it takes a few years for the asset to be attractive enough to exit at a acceptable PE exit multiple.

The focus on PE is illogical. Why did mutual funds not beat the market during these magical moments ? They have a mandate for public investing and have a well qualified team in capital markets. Why did the average risk adjusted return from mutual funds underperform in 2009 ? It is very easy to comment after the fact – as researchers are wont to do. It takes a practitioner to excercise investment judgement and make money.

Rohit . 6 years ago

The article would make a little more sense if it was written for hedge funds/mutual funds rather than PE funds. LP’s would not like GP’s to use their cash to trade the market and take short term bets. Some funds did end up making huge multiples by buying and selling stock within a time frame of 6-8 months in 2009, but that’s not what they are getting paid 2/20 for.

Sai Ranganathan . 6 years ago

This Article highlights the fact that PE Funds Clearly missed a Great Investment Opportunity. As most PE Funds Investments Period gets Completed by 2012-13 , the failed to invest and Create Value for their Investors.This would affect their Track Record and they would face difficulty in Future Fund Raising Plans.This will also lead to Consolidation among 400 PE Funds which are siting on Huge Cash underutilized.

Capital Advisor . 6 years ago

In Retrospect surely a lot more ‘magical moments’ can be traced..perhaps even without going all the way back to 2009.. In 2009 also, PE’s were busy investing and most of investments perhaps will yield decent returns/ exits over there horizon of 4-5 yrs .. Perhaps mandate if PE’s is value investing in growth companies .. The analysis of the author suggests that even without Cherry Picking Securities, a broad based ‘Market Portfolio’ can yield exuberant returns, if you can time the ‘Magical Moments’ through Razor Sharp Analysis… Request the author to kindly guide us on “Magical Moments” for 2012-13, if he can pick up on that..

Durga Prasad . 6 years ago

It seems the existence of magical moment opportunities now after all the weakness in the capital markets over the last 2 years. The worst seems to be over (?), however, nothing is certain in Capital markets. We still have Euro crisis to solve/ settle, US economy slowdown, fight backlashing of outsourcing by developed countries, asset classes having appreciated quite quickly (esp. India) over the last few years which makes further appreciation little difficult, …

It’s easy to say there were magical moments in 2009, however, it is difficult to spot a short period of magical moments. Had a PE fund experienced magical moments (in stock markets) , it would have stayed a little longer to wipe out all the ups it just experienced. It would have performed similar to a MF and it would be a PE cum MF. There are magical moments in every asset class. So chasing magical moments could be good thought ? The PE fund needs to first look at its objective and be certain if wants to move away from its core competence.

Regarding special focus and razor-sharp analysis by a well-qualified team, it is definitely better to have a good team to provide returns in equities, but is it enough? When we look at the Brokers/ Experts, they seem to contradict their statements every now and then. Even regular updates (short term) on IPP data, GDP growth rate pushes an expert to a take a u turn based on the market sentiment. So, even with a good team, it’s difficult to spot the magical moments. If the PE overruns the magical moments/ does not experience the magic moments, will it be forced to stay in the public markets and become another regular secondary market player?

Anon . 6 years ago

To Capital Advisor,

The author hopefully knows his job. His expectation is that we hopefully should know ours. Why do you expect the author to guide us? He never claimed to have a crystal ball in his article! If he finds his magical moment, it is highly unlikely he will share it with us. That is our job!

CAPITAL ADVISOR . 6 years ago

Thats precisely the point….there is not Crystal Ball that can predict the magical moments…. the exercise at best can be done in retrospect… Thus the point made by the author that PE’s missed any magical moments is at simply arbitrary and uninformed..

Raj . 6 years ago

I agree with PE investor. Diversification of portfolio happens at the level of money managers (insurance, pension funds, family offices, FoFs etc.) who are sitting on large amounts of cash and allocating it across asset classes of which PE is just one. The mandate to a PE is to go after a certain risk profile and not in turn play the role of a diversified money manager. Also capturing alpha through momentary lapse of reason in capital markets is what hedge funds are for. The problem here is we are mixing PE as an asset class and companies that call themselves PE firms.

Karthik . 6 years ago

Case Study of 2009? This article is a joke

Rohan . 6 years ago

This article fails to bring any value to the table. After the time has passed, anyone can look back and comment that this period was a ‘magical moment’ and funds should have captured it. Further as rightly mentioned earlier, this article is more appropriate for hedge funds (with no restrictions on investing in any securities) compared to PE funds.

PE Person . 6 years ago

good PE fundamentals does not usually include investing in public companies …due to limitation of the mandates (hence the word ¨private¨ equity) and unattractive valuations..Pe is about sector expertise and intelligent investing ..also investments are for a period of 3-6 years … for example..if you say you want to invest USD 30 mn at 2-3x EBIDTA in a public company …that is not going to be seen in a good light by the LP´s…overall this article seems quite retrospective … equities will earn you 6-7% in more developed markets and PE investments demand a higher return …if you start investing in public equities ..might as well shut down the firm and put all the money in a mutual fund .. also PE is not about stock picking !

Neyha.srivastava@gmail.com . 6 years ago

You forget that if the LP wanted exposure to the public markets he would choose a manager accordingly. Just because the public market is offering a good opportunity do you suggest the manager forgt his original mandate and be opportunistic. Seriously is the investor interest of no relevance.

Reader . 6 years ago

The author’s intent seems to be to persuade atleast a few PEs into giving his research team a mandate to identify such “magical moments” stocks, as it appears from the last lines in the article on the right teams with the dirty hands. This article should probably viewed in that light instead of getting into the whole PE vs hedge fund debate.

Anonymous . 6 years ago

Totall useless article

PEs failed to cash in on magical moments of public equity investing

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