Mridul arora final paper deloitte banking and finance


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Mridul arora final paper deloitte banking and finance

  1. 1. THIS PAPER RESEARCH includes original research focusing on the analysis and resolution of managerial and academic issues based on analytical studies and models Conference Dates: 4th & 5th Jan 2014 Global Conference on Service Management (GCSM - 2014), Auro University, Surat, India, Jan 4th to 5th Acknowledgements: My sincere thanks are due to Dr. Rohit Singh, MACRO TRENDS AND NEW APPROACHES IN PRICING OF PRIVATE EQUITY TRANSACTIONS IN EMERGING MARKETS Conference Chair, for giving me ample time in completing the paper. Also I am blessed with the assistance provided by my parents, friends and faculty members of IBS, Kolkata for the support assistance in conducting the research work in Minitab Software. Also handy was the data obtained from Deloitte Online Resources (Deloitte Center for Financial Services). * Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms.
  2. 2. MRIDUL ARORA* MBA (Finance), IBS KOLKATA Consultant, Deloitte HOME ADDRESS: F-12, CLUSTER-9, PURBACHAL, SALT LAKE CITY, KOLKATA-700 097. M: 09051263432 E-Mail: --------------------------------------------------------------------------------------- ------ * Mridul Arora is a Consultant in Deloitte working on the Taxation of Private Equity Fund Partnerships. He has also worked for IBM Global Process Services India Pvt. Ltd., Kolkata. He served as an intern for managing risk at Allahabad Bank HO, Kolkata while pursuing his MBA from IBS Kolkata. The views expressed here are those of the author and not of Deloitte Center for Financial Services. Comments-may-be-forwarded-to-the-author.
  3. 3. Contents Abstract ……………………………………………………………………………1 Introduction………………………………………………………………………..2 Literature Review………………………………………………………………….3 Data Sources and Quotes………………………………………….………………4 Pricing Private Equity Transactions……………………………………………….6 Macro-economic Factors and Trends in Private Equity Markets……...………….9 PE structure and Hypothesis Testing………………………………………….…15 Conclusion……………………………………………………………………….18 Limitations and Scope for Improvements……………………………………….20 Figures and Graphs………………………………………………………………21 Data Appendices………………………………………………………………...29 A paper on Investment Banking & Structured Finance by Mridul Arora Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  4. 4. Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets Abstract: Purpose – Investment banking is a very vast area in the field of banking and finance and is a very old industry now. The present paper examines factors like Growth of Emerging Markets, Capital Market Conditions, Hedging and Diversification Effect, Impact of Real Estate sector and REIT/ETF markets, IPO, LBO and M&A activities, Participation of Hedge Funds and Mutual Funds in PE Transaction and role of Corporate Governance. Findings – The turmoil created by a high volatility in the stock markets that persisted from the second half of 2007 to 2009 also raised some big questions about just how risky private equity investments are. In this paper we have analyzed whether private equity funds value their assets fairly. This is an important question not just from an accounting and regulatory perspective, but also because fund valuations impact directly on reported performance figures, which in turn are likely to influence investors’ decisions. Pricing of Private Equity transactions requires a close understanding of the industry being considered for investment, valuation parameters in the capital market and estimating these variables. The methods used to value normal growth companies focus on tangible assets, present value of the future cash flows, PAT, Operating Profit (EBITDA) and Price/Earnings Ratio (for listed companies). After a flat 2012 year, the private equity industry faced an intensely competitive deal-making environment worldwide, an overhang of aging assets waiting to be sold and challenging fundraising conditions in 2013. Risk in PE Funds can only be diversified by investing in a pool of funds. Keywords: private equity, fund valuation, fund returns, fund managers Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  5. 5. JEL Classification: G24, G31, G32 1. Introduction 1 1 “An investment company generally is an entity that pools shareholder funds to provide the shareholders with professional investment management. Typically, an investment company sells its capital shares to the public, invests the proceeds, mostly in securities, to achieve its investment objectives, and distributes to its shareholders the net income earned on its investments and net gains realized on the sale of its investments.” - AICPA Audit and Accounting Guide for Investment Companies. Investment Banking carries a rich repository of meanings in the field of banking and finance. This paper seeks to reflect this range of meanings vis-à-vis management research, managerial problemsolving and decision-making. In the world of Finance, Venture capital (VC) and Private Equity (PE) are the two most popular types of institutional equity investments among other players like Family Partnerships, Hedge Fund, Venture Capital, Private Equity, Fund of Funds, Investment Partnerships, Mutual Funds, Foreign Institutional Investors (FIIs), Banks, Insurance Companies. Venture capital investments help innovative start-ups, Venture capital funds – the other main type of private equity – raised nearly $160 billion of capital during the boom years of 1999 and 2000, and made early investments in recent successes like Google (in the United States), Skype (in Europe), and Baidu (in Asia). Overall, Private equity funds play an increasingly important role as financial intermediaries in global emerging markets. encouraging them to expand into new international markets and grow as companies. Both PE and VC Funds are constituted as independent pools of capital, managed by Fund Management Partnership Teams for maximizing investor wealth. Exit activity has sputtered over the past three years, and private equity funds are feeling the heat to sell aging portfolio holdings and return capital to their limited partners. However, VCs only help to bring to the market R&D related technological innovations. Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  6. 6. 2 2. Literature Support 1 We review the literature on Private Equity as our base for the purpose of establishing the findings and assumptions used in this paper. By "private equity" we mean financing for early and later-stage private companies from third-party investors seeking high returns based on both the risk Private Equity (PE) : Investment vehicles that pool capital for investment in privately owned businesses at different stages of development profiles of the companies and the near-term illiquidity of these investment-; (venture capital is a form of private equity that generally applies to start-ups). As the private sector expanded, an increasing number of firms had to move beyond their traditional reliance on so-called "friends and family" for financing if they were to continue to grow and be Private Equity is the asset class that purchases an equity stake in a company that is not publicly traded on a stock exchange. It offers maximum advantages to both the suppliers and users of investment capital. competitive. In Brazil, for example, a World Bank report revealed that about 40% of private bank assets were invested in government securities. Between 1992 and 1997, the peak years for fund-raising in Latin America, the value of new private equity capital grew by 114% annually, from just over $100 million to over $5 billion. In the emerging markets of Asia (excluding Japan), about 500 funds raised more than $50 billion in new capital between 1992 and 1999. As the transition to market economies in Eastern Europe took hold in the mid-'90s, the rapid growth of private equity told a similar story. PE Fund of Funds (FoF) are raised from pension funds, insurance companies, large corporate, HNWI (High Net-Worth Individuals), etc. With financing patterns heavily biased in favor of a relatively small number of large firms, the premise that demand for private equity financing would be strong was convincing. The case was furthered by the presumption of cooperative local By virtue of their size and track record, however, many of these firms had risk profiles that were PE Fund of Funds (FoF) : A PE FOF is a fund set up to invest in other PE/VC/Hedge funds, which in turn invests in several hedge funds instead of directly taking exposure to instruments/securities. The characteristics of the FoF differ from the investee funds and needs to be evaluated in a slightly different fashion from a risk perspective. unappealing to banks and securities markets. Investors were attracted by Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  7. 7. the severe capital shortages in many emerging markets, which implied low valuations (and hence high returns) for the expanding number of companies hoping to raise capital. In addition, many prospective foreign investors were flush with funds, due to the booming performance of financial markets and venture capital funds in the industrialized countries during the late '90s. Encouraged by improving macroeconomic conditions, the new receptivity of governments to foreign investors, and the prospects of earning high returns, investors are willing to look at higher-risk investments in emerging markets. Both supply and demand should appear to be in perfect harmony for emerging market funds to succeed. 3. Data Sources and Quotes 3 1 To quote, from a Wall Street Journal report, aggregate PE commitments globally are close to $10,000 billion ($ 1 trillion of capital), 1,200 funds are currently seeking $713 billion including 290 Buyout funds seeking $320 billion; 470 Venture funds seeking $85 billion; 25 Mezzanine funds seeking $10 billion; 205 FoF seeking $220 billion. Europe alone accounts for 19% ($580 billion). In the peak years of 2000-2005, PE funds were responsible for one-quarter of all global merger and acquisition (M & A) activity and Leveraged Buyout (LBO) activities. But the promise of private equity in emerging markets has failed to meet expectations. After an initial proliferation of new funds in the mid-'90s, growth has slowed to a trickle, and few practitioners believe that this trend will soon be reversed. Not only have results have been disappointing in absolute terms, they are even worse relative to comparable funds especially in the Europe. Despite the increased investment in the private equity asset class and the potential importance of private equity investments for the economy as a whole, we have only a limited understanding of private equity returns, capital ownerships, and their interrelation. One of the main obstacles has been lack of available data. Private equity, as the name suggests, is largely exempt from public disclosure requirements. Investors in PE funds are called “Limited Partners”. PE funds are managed by the “General Partners.” In this paper, we make use of a novel data set of individual fund performance collected by Venture Intelligence. The Venture Intelligence data set is based on voluntary reporting of fund returns by the private equity general partners as well as their limited partners. Nevertheless, relatively little is known Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  8. 8. about industrial organization of the private equity sector, mostly due to data limitations. This paper aims to fill that gap using a database of fund characteristics and past performance. Referring to Figure-1: The Private Equity Partnership Structure and Figure-2 Investment Structures, virtually all private-equity funds are organized as limited partnerships, with private equity firms serving as the general partner (GP) of the funds, and large institutional investors and wealthy individuals providing the bulk of the capital as limited partners (LPs). These limited partnerships typically last for 10 years, and partnership agreements signed at the funds’ inceptions clearly define the expected payments to GPs. These payments consist of both fixed and variable components. While the fixed component resembles pricing terms of mutual-fund and hedge-fund services, the variable component has no analogue among 4 1 most mutual funds and is quite different from the variable incentive fees of hedge funds. Successful private equity firms stay in business by raising a new fund every 3 to 5 years. If the current fund performs well, and LPs interpret that performance as “skill” rather than “luck”, investors’ demand curve for the new fund will shift out, with the equilibrium conditions requiring that LPs earn their cost-ofcapital after payments to the GP. In response to this demand shift, GPs may alter the terms of the new fund so as to earn higher expected revenue for each dollar under management. Alternatively, they may increase the size of their next fund. They may also do both. Raising the size of the fund may entail additional costs, depending on the production function for the underlying private-equity activities. The ultimate performance of private equity funds is only known once all investments have been sold, and the cash returned to investors. This typically takes over a decade. In the meantime, the reported performance depends on the valuation of the remaining portfolio companies. Private equity houses market their next fund on the basis of these interim valuations of their current fund. In this paper we analyze whether these valuations are fair, whether the extent of conservative or aggressive valuations differ during the life of the fund, and at what stage interim performance measures predict ultimate performance. Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  9. 9. 4. Pricing of Private Equity Transactions 5 1 Companies in most of the countries raise most of their need for Growth Capital from Private Equity (PE) Funds. Private Equity capital helps numerous companies raise capital from the investor best suited for that company. Foreign Institutional Investors, mostly the private equity investors have started participating in the capital markets in a big way. The increasing interests of foreign investors in Indian market call for greater research on various properties of this market. Investment Bankers like Bank of America a.k.a. Merrill Lynch, Barclays Capital, Bain Capital, Sequoia Capital, BNP Paribas, ABN Amro, Citigroup, Blackstone Group, Silver Lake Partners, JP Morgan Chase, Wells Fargo, Credit Suisse, Deutsche Bank AG, Standard Chartered Private Equity, Goldman Sachs, HSBC, Morgan Stanley, Nomura Securities, Daiwa Securities, RBC Capital Markets and UBS AG help to generate the VC or PE based on a project’s future earnings capacity. Pricing of Private Equity transactions requires a close understanding of the industry being considered for investment, valuation parameters in the capital market and estimating these variables. The methods used to value normal growth companies focus on tangible assets, present value of the future cash flows, profit after tax (PAT) , Operating Profit ( EBITDA), market multiples like Price/Earnings Ratio (for listed companies). A “Term-sheet” validates an entrepreneur’s idea, establishes a price for a Buyout/ PE/ VC deal / transaction. An investment can decrease RONA (Return on Net Assets) but increase EVA (Economic Value Added i.e., Current Market Value of the fund less Cost of Capital) so we often don’t consider it while pricing PE transactions. Also, the problem with measures such as RONA and ROI is that they ignore the Cost of Capital so these are also ignored. Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  10. 10. 6 Below are the multiples and their components, used by a majority of companies to assess a PE fund: 1 a) EBITDA • Earnings before interest, taxes, depreciation & amortization • Allows for comparability across industries (asset heavy vs. light) • Disregards financing decisions and tax benefits • Excludes non-cash charges against income (D&A) b) Enterprise Value or Firm Value (EV) • Value of Debt + Equity less Cash on balance sheet • Represents Takeover Value of Company • EV of a public company • Speaking at a conference on innovative businesses looking to go global to clusters of startups in Berlin, Leon Black, Chief Executive of Apollo Global Management, LLC said the average price for private equity deals in the U.S. is 9 times EBITDA. One of the major assumptions resulting from such high valuations is that interest rates will continue to be soft over the next few years, he said. EV of a private company = EBITDA x Exit Multiple c) PE Valuation Measures in Practice • Enterprise Value / EBITDA multiple or EV/EBITDA • Quote value of a Fund as a multiple of EBITDA d) Capital Structure Comments • Equity is the residual claim on Assets • Liabilities have security interest on assets Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  11. 11. • Seniority of Capital Structure • Cost of Capital relates to relative risk of tranche (Refer right side for more details) • Tranche: In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. All the tranches together make up what is referred to as the deal's capital structure or liability Investors demand more return for more risk o Cost of Capital for tranches o Secured vs. Unsecured No two funds of a PE investor have the same pricing method. It depends 7 more on experience from similar price deals, current global capital market trends, client negotiations, 1 government and legal guidelines in that country. Most commonly used method is the Net Asset Value (NAV) method. Collar: In Figure-7, we see that the number of deals with collar have started In structured finance, a collar is an option strategy that limits the range of possible picking up in 2013. As private equity assets are not traded that often there is lack of market price data. Private equity investors usually make commitments to a private equity partnership that draws the capital in the first years of the fund and sells the investments after three to seven years. In the intervening period the investor receives information about the net asset value of all the underlying investments on a quarterly basis. The net asset value is an accounting value that the management team of the private equity team find out. In the case of private equity funds, estimating fair values of their portfolio companies is particularly challenging. As a consequence, quarterly fund valuations – reported by the fund managers themselves – have an inevitably subjective component. This issue has recently attracted considerable attention in the aftermath of the financial crisis. The U.S. Securities and Exchange Commission (SEC) has started independent investigations into conflicts of interests of private equity fund advisors, a main focus of which is the “consistency and comparability of valuation methods” associated with “misleading reporting [on private equity fund performance] to current or prospective investors”. Such investigations are related to the registration of private equity fund advisors with the U.S. SEC following the enactment of the Dodd-Frank Act (Market participants will be required to submit a swap that is identified in the rule for clearing by a derivatives clearing organization as soon as technologically practicable, and no Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 8 1
  12. 12. later than the end of the day of execution.) In particular the International Private Equity Valuation guidelines have been developed in recent years, and are now endorsed by 39 national and international private equity associations. The latest version of the guidelines was published in December 2012. The U.S. industry associations have not endorsed the guidelines. The magnitudes of such ranges can be observed in practice, for example, when comparing the valuations of two separate fund managers who have jointly invested in one company, but independently report to their respective fund investors. There has been increasing anecdotal evidence on such patterns from institutional investors who were invested in both funds, especially since the financial crisis in 2008. While accounting standards, valuation frameworks and industry guidelines have been moving towards standardization of valuation principles, they still inevitably allow considerable discretion with respect to the valuation methodology and input parameters for private companies. The responsibility of fund auditors (who typically audit the funds annually) is primarily to verify and confirm that the chosen method has been correctly applied, the underlying assumptions are adequate, and the derived value is within a reasonable range. As a result, fund managers have various degrees of freedom when valuing their portfolio companies. This raises the possibility that funds are valued opportunistically at certain times. For example, there will be inevitable temptations to present interim performance numbers in a particularly favorable light when raising a follow-on fund, or limiting write-downs during down markets. 5. Macro-economic Factors and Newer Trends in Private Equity Markets The focus of this paper is to determine benchmark pricing and valuation using new approaches for Private Equity transactions from the investment banker’s perspective. The present paper examines the below factors a) Global Economic Outlook in the Emerging Markets Globalization has brought along with it increasing integration of global financial markets, liberalized capital-flows across economies, emergence of sophisticated technologies (recently SEARCC was held in Colombo, Sri Lanka – see snapshot on right) and trading mechanisms, cross-border M&As, global security floatation and syndicated loans. PE has been an established industry in the US and Europe for long enough now. PE Funds also invest in equity or debt of emerging (less mature) markets which tend to have higher inflation and volatile growth. The principal factor affecting an economy’s ability to absorb PE Capital is the number of large scale companies. Private Equity requires that value be created in a limited period of time before capital is returned to investors. Valuation and Pricing of returns from Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 9 1
  13. 13. PE funds seem to be lack-lustre because at times we concluded that the only emerging markets with enough capital flows were the BRICs plus South Africa. However, in today’s globalized world, the investable opportunities are much broader. Emerging markets go up and down (See Animation on right). For PE funds, it is much more certain that value can be created and an exit achieved in a limited time period if the fund is large enough with a significant group of owner of companies for equity financing. China’s a big market, so private equity will continue to play in it. (refer figure-10: China and Brazil leading the share of Private Equity Investments in Emerging Markets) Chinese investors are looking abroad for attractive investment opportunities to create value and longterm returns. India is one of the BRICs and it was the fastest growing PE market. And it has a reasonably active stock market, that’s been there for a long while and the PE firms have been there longer than in China. There have been some issues with taxation where the Indian government has basically tried to change rules for investors retroactively and that type of policy uncertainty is really scaring away PE firms from investing in India. The amount of activity in any individual market tends to be driven in any given year by whether there were a handful of large transactions. I think saying that, emerging markets are here to stay. There’s more capital available in the emerging markets than ever before. What really was a focus on the BRICs is now expanding beyond the BRICs into the frontier markets. So when we take a look, for example, at Latin America, surely Brazil is the big market and quite a bit of focus is there and will continue to be there. Growth is returning to European Economic Recovery and European GDP grew by 1.5% during 2012. Germany had the strongest GDP growth at 3%. Chinese GDP growth slowed to 8.9% even as the Chinese Central Bank makes efforts to contain inflation by raising interest rates. (Refer Figure-11: GDP Growth Rates over the last decade) GDP growth dropped in many of these emerging markets in 2013, but they were still higher than the mature markets like the U.S. and Europe, and are expected to rise over the next couple of years by 2020. A slowdown in emerging markets, continuing troubles in credit markets, and persistently high unemployment still pose risks to economic growth in Europe. In Japan, growth has been strong due to the new economic policy. However, risk stemming from the impending increase in the national sales tax persists. After a period of deceleration, China is stabilizing due to strong industrial production, improved exports, and a rebound of credit creation. However, the need for banking reform remains critical. In the United Kingdom, economy appears to be on the mend, triggered by easing of economic stress in Europe and recovery in the U.S. There is now concern that the housing market is exhibiting signs of a bubble. In India, economic growth continues to decline, inflation remains too high at an average of 7.25% and Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  14. 14. business confidence is poor. The best path forward for India involves structural reforms that have yet to be implemented. b) Capital Market Conditions and Bond Ratings From the rise and fall of the junk bond market in 1980s through dotcom craze climb and collapse in 1990s and to the swelling and bursting of the subprime credit bubble , GDP growth in developed and developing markets with record-low interest rates in the US and Europe has helped to fuel PE investor confidence. Capital markets suffered heavy losses in 2011 and 2012 due to high volatility. One feature of stock markets that everyone agrees on is that markets are volatile. Over the last three years, the returns on the Nifty index have had an annual standard deviation of around 8%. (Refer figure-14: Calculation of Std. Deviation of Monthly Returns). This means that in a given year, there is a wide range 10 of possible moves for the market. For example, the market went up by 24% in 2012. In 2011, the 1 market was down by 28%. In Figure 4: Volatility and Liquidity Metrics of a random PE fund, it can be observed that the VaR for a fund at 99% confidence level is 5.10% while the same fund has a VaR of 3.60% at 95% confidence level. Higher the confidence level, lower the rejection level. Hence as an investor, the PE fund is better. c) Sources of Risk and Diversification Effect Value at Risk (VaR): Value at Risk measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. Thus, if the VaR on an asset is $ 100 million at a one-week, 95% confidence level, there is a only a 5% chance that the value of the asset will drop more than $ 100 million over any given week. Risk in PE Funds can be reduced, although not eliminated, by investing in a portfolio of different stocks from the pool of funds. There are thousands of PE Funds available today for both Debt and Equity. Improving debt markets should help put wind in the sails of more PE deals. PE firms are continuing to diversify into new lines of business. And that’s blurring the line between PE and asset managers. The creation of a ‘side-pocket’ or a special purpose vehicle (‘a synthetic side pocket’) for illiquid investments creates a special purpose vehicle (SPV) to which it conveys the hedge fund’s illiquid assets in return for shares or security interests, thereby separating illiquid assets from other more liquid assets. It then transfers those shares or security interests to its redeeming investors as payment ‘in kind’ of the redemption price that is owed to those investors. The SPV would liquidate the illiquid assets at some point in the future, when market conditions are more favorable and it is able to do so, and then distribute the proceeds to the SPV’s shareholders or beneficial owners. Once an investment enters a side pocket Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  15. 15. account, only the present participants in the hedge fund will be entitled to a share of it. Future investors will not receive a share of the proceeds in the event the asset's returns get realised. PE Fund Managers have to price companies based on the entry and exit time for the investments, capital structure of the funds- Debt, Equity and Hybrid. Bain Capital is a private equity and VC firm investing in such sectors as retail and consumer products, communications, and information technology across diverse sectors such as infrastructure, technology, media, telecom, financial services, engineering and manufacturing, and business and consumer services among other sectors. The firm has some $14 billion currently under management and has invested in more than 225 companies since 1984. Investments include beleaguered toy retailer KB Toys and about 45% of pizza chain Domino's (Bain sold off about a third its stake in Domino's 2004 IPO). Credit-rating provides indicative guidance to the prospective investors on the degree of risk involved in the timely repayment of principal and interest. Thus ‘credit rating’ also reduces the risk of investing in the PE market by differentiating it from other securities/instruments with the help of predetermined standards called ‘grades’ (typically these grades are symbolically represented, viz. A, AA, AAA etc.). Credit rating is a source of reliable information for many users as rated instruments speak themselves 11 1 about the soundness of the company and the strength of the instrument rated by the credit rating agency. d) Real Estate Industry and Private Equity PE investors mostly invest in real estate industry in their mature life cycle to affect financial or operational restructuring. In emerging markets and BRIC countries like India (Figure-13: Actual GDP Growth Rates from 2007 to 2012 for BRIC Countries), as the real estate industry in India matures further and pursues international competitiveness, the volume of PE transactions will increase. KKR, CVC, 3i, JP Morgan, Macquarie and Forstman Little are the leading Real Estate PE funds created by a large number of Limited Partnerships and acting as the General Partner (GP) for making a substantial side-byside investment in these funds. Together with real estate investment trusts REITs: (REITs), real estate private equity funds have filled the equity gap that REITs were created for the specific purpose of encouraging occurred as real estate financing integrated with global capital flows. widespread ownership of real estate by small investors. A REIT Beyond obvious liquidity differences, private equity funds differ from is an entity, otherwise taxable as a REITs in several important ways. While most REITs have annual total U.S. corporation, that meets certain technical requirements and equity return expectations (dividends plus appreciation) in the range of 10 that elects REIT status. The key difference between a conventional percent to 14 percent, real estate private equity funds have annual equity U.S. corporation and a REIT is that a REIT is allowed a tax deduction return expectations of at least 15 percent and generally in excess of 20 for dividends paid to its shareholders. In order to qualify for Markets Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emergingthis special treatment, a REIT must distribute at least 90% of its net income exclusive of capital gains to its shareholders. 12 1
  16. 16. percent. Real estate private equity funds invest in situations with relative frequency higher risks than REITs in order to achieve their target returns. Another distinction between real estate private equity funds and REITs is that REITs tend to own stabilized income-producing properties with a long-term operating focus, while private equity funds generally hold properties for three to five years and generally invest in non-stabilized assets. In their pursuit of higher returns, real estate private equity funds tend to use significantly higher leverage than REITs. It is important to bear in mind that a property with rents growing at 2 percent to 3 percent annually, with a current yield of 9 percent and 70 percent leverage at a 6.5 percent interest rate, can achieve large return targets for real estate private equity funds. Also, strong buyer demand amidst a limited supply of homes for sale has resulted in properties selling faster and at the highest prices since 2009. These market conditions, including low interest rates, have driven growth in real-estate markets globally. Private equity investments in India's real estate projects have grown more than 75% over the past year, even as mutual funds and other investors have shunned this sector because of rising interest rates and falling revenues. That explains why investments in real estate projects by various private equity funds have soared, rising to $1,656 million in 2011, from $944.7 in the previous year, according to accountancy and advisory firm Grant Thornton, while mutual funds reduced their exposure to the sector drastically during this period. Peter Hobbs, Managing Director of Research for IPD, added, “This development provides fund managers unprecedented insight into global real estate risks. The new model reflects the changes in private real estate risk forecasts in a more timely fashion than traditional methods.” e) Private Equity and Nature of Transactions (Transfer Pricing, IPO, LBO, Structured Debt and M&A): PE firms depend on a global transfer pricing methodology to benchmark their services at different points in their fund’s investment cycle. In emerging markets, PE firms are subjected to tax audits based on their capital commitments. Transfer pricing needs to be considered on any loans to private equity backed companies. In 2013, there were 57 Private Equity companies still in the pipeline having $11.8 billion in value ultimately making up about 10% of the IPO pipeline. PE firms are very opportunistic in trying to take advantage of any windows that open, especially given the old deals that they still have not exited, their LPs [limited partners] are pretty eager to monetize those stakes and move on. Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  17. 17. Now since pricing seems to be right in the emerging markets, these firms lever up and so Tech companies tend to be more richly valued than other businesses. According to Figure-3: Sectors/Industries for Private Equity Investments, the IT and ITeS sector being a less capital-intensive sector as compared to the Infra sector, typically receives higher volume of investments (not necessarily high value) as against other sectors, especially during early stages of businesses being set up. Even in this quarter, more than 75% of the volume of deals in this sector was in the early stage. This quarter has also witnessed a couple of big deals in the online services and IT services segments. With the exponential growth and importance of e-commerce, a few of the leading online (e-commerce) companies have seen success and are now looking to leap into the next phase of growth by expanding their operations and hence attracting investments. And, with many PE firms focusing on the SME segment, we can expect more such investments in the small and medium-sized IT services companies which offer niche services. In M&A markets, the quantity of private equity and trade capital chasing opportunities are enhancing multiples for top quality assets, whereas lower quality opportunities struggle to obtain interest and consequently attractive price. In a seminal piece on private equity, Jensen (1989) argued that leveraged buyouts (LBOs) create value through high leverage and powerful incentives. He proposed that public corporations are often M & As: In a merger, corporations come together to combine and share their resources to achieve common objectives. The shareholders of the combining firms often remain joint owners of the combined entity. An acquisition involves the purchase of the assets or shares of one firm by another where the acquired firm’s shareholders cease to be owners of that firm. In a merger a new entity may be formed subsuming the merging firms, whereas in an acquisition the acquired firm becomes the subsidiary of the acquirer. A merger is principally a legal process and a follow up to an acquisition of controlling interest. characterized by entrenched management that is prone to cash-flow 13 1 diversion and averse to taking on efficient levels of risk. Consistent with Jensen’s view, Kaplan (1989), Smith (1990), Lichtenberg and Siegel (1990), and others provide evidence that LBOs create value by significantly improving the operating performance of acquired companies and by distributing cash in the form of high debt payments. This evidence have been replicated by studies in Europe (Phalippou and Gottschalg, 2009, Phalippou, 2007), though they raise the issue of certain survivorship biases in data employed which might imply no median outperformance relative to the market even for large and mature PE houses. This by itself does not necessarily refute Jensen’s original claim; it could simply be that PE funds keep the value they create through fees. The puzzle that the evidence on median return of PE funds raises is thus more about why their investors (the limited partners) choose to invest in 13 asset this 1 class as a whole, an issue investigated by Lerner and Schoar (2004) and Lerner, Schoar and Wong (2007). According to Thomson Reuters, worldwide private-equity-backed M&A activity was $321.4 Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  18. 18. billion in 2012 – flat compared with 2011. However, the year started off slow, with deal volume off significantly in the first two quarters. Volume picked up steam in the third quarter and achieved a blistering pace in December, with many deals closing so that sellers could monetize gains at 2012 tax rates. f) Corporate Governance and Private Equity Private equity funds differ from other types of investment funds mainly in the larger size of their holdings in individual investee companies, their longer investment horizons, and the relatively fewer number of companies in individual fund portfolios. As a result, it is reasonable to expect private equity managers to have a greater degree of involvement in their investee companies compared to other investment professionals, such as mutual fund or hedge fund managers. And because of their greater involvement, private equity managers are naturally expected to play a greater role in influencing the corporate governance practices of their investee companies. Private-equity funded firms display higher standards of corporate governance than firms that do not receive such funding. The difference arises from the application of developed country standards of CG arising from the investors that own the private equity funds. These funds are primarily owned by developed country investors. The strategies through which these occur are: reconstituting the board of directors, influencing senior executive recruitment, and changing the firm's operating and strategic rules. Emerging market economies like India usually display low standards of CG. Certainly, sound governance does not invariably equate to strong performance. There is no guarantee that well-governed companies will produce smooth exits and high returns for private equity managers, although a number of studies have indicated positive correlations between governance and stock performance. However, there is an implicit understanding among most private equity managers that poorly governed companies are more prone to failure. Hence, 14 there is a strong element of self-interest for private equity managers to ensure that their funds 1are invested only in well-governed companies or in companies that are willing and able to improve their governance, and to avoid investment in poorly governed companies which demonstrate no inclination to improve their governance. Private equity managers often seek to protect their investments and ensure optimal exit strategies through legal contracts as well as through vigilance and engagement. Legal contracts relating to private equity investments often contain clauses giving the private equity investor certain rights, such as the right to veto a material decision by the board (where the private equity investor holds only a minority position), or the right to force the company to redeem the securities sold Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 14 1
  19. 19. to the private equity investor should the investment turn out to be unprofitable. One could argue that this is a more reactive or less preferred form of protection. The problems at the investee company are likely to have reached a critical level if the private equity manager must resort to such contractual rights for resolution. 6. PE Structures and Hyp0thesis Testing Hypothesis – A positive outlook influences investors to pay a higher price for a given investment opportunity and get higher prices at the time of disposal of the investment, encouraging investors to pay a higher price for the PE transactions. This study uses weekly data from1999 to 2012 and employs comprehensive tools like Regression testing to examine the inter-relationship between some of the most important macro-economic factors affecting the valuation of a Private Equity fund in an emerging market. Overall, the private capital investment thesis continues to remain challenging for emerging markets. The macro environment for private equity continues to be strong and long-term prospects for emerging economies remain attractive, as growth rates are expected to exceed those of the United States and other major developed economies. As a result, funds are expected to flow back to emerging economies in the medium term. Moreover, with the Fed making it clear that its actions will be governed by US interests only, it may be just the trigger for some emerging economies to wake up from their policy slumber and move ahead with critical reforms to restore economic confidence. Policy challenges, high inflation, wide current account and fiscal deficits, and slowing growth are challenges that may discourage foreign 15 investments in markets such as Brazil, India, South Africa, and Turkey, irrespective of the Fed’s 1latest action. As a result, any attempt to benchmark returns is not only comparing apples and oranges, but is actually comparing apples to potatoes to fish. Any attempt at such benchmarking involves meaningless normalizations. So, a global equity index (see Emerging Markets VC and PE Index in this paper’s Data Appendices) consisting of developed and emerging markets countries across the large, mid, and small cap size segments—to guide asset allocation and construction of the target date and core fund lineup over short to long term year-range. Such a framework, which is based on an advanced and well-documented Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  20. 20. methodology, is designed to include the full range of investable stocks across all countries, regions, sectors, styles, and sizes. Consequently, it can help investors gain access to the global investment opportunity set as well as avoid key dysfunctions associated with many fund lineups, including benchmark misfit and underperformance. The European Private Equity and Venture Capital Association (EVCA) guidelines represent a good framework how to structure a Report for PE funds. Most of the report might have different layouts, but the respective information can normally be extracted from those reports. In order to align the valuation methodologies of private equity funds the EVCA, as well as other trans-national associations, developed and published accounting rules need to be adapted by their members. Even if common and standardized valuation methodologies are established, the net asset value (NAV) cannot reflect a market price similar to a stock price. Empirical analysis shows that the difference of the net asset value of a company and the price of a company – reflected through the selling price a few months later – could largely differ. On the other hand an internal study by Capital Dynamics analysed that the ability to predict the correct value of a company and the performance of a private equity fund are positively correlated, i.e. good private equity managers have a good understanding of the value of their underlying portfolio companies. In addition, the management team tends to keep the changes of the valuation between different valuations periods very limited; e.g. during the investment period of a fund the value is usually kept at cost over a longer time period. Due to the turmoil in the public markets the US accounting rules (US Mark-to-Market Valuation: A measure of the fair value of SAS 70 Certification: accounts that can change over time, mark-to-market valuation (details given on the right). As described in FAS such as assets and liabilities. Mark to market aims to16 provide a realistic Issued by the Auditing Standards 157 (Fair Value Measurements), PE Funds are required to comply with appraisal the American Institute or institution's of Board of of an 1 company's Public current Accountants financial Certified IAS 39 (Financial Instruments: Recognition and Measurement) and IFRS situation. (AICPA), SAS 70 provides guidance to service auditors when assessing 7 (disclosure of information about the the internal control of a service significance of Financial Instruments to an entity, and the nature and organization and issuing a service auditor’s report. SAS 70 also extent of risks arising from those) and SAS 70 certification (Reports on provides guidance to auditors of financial statements of an entity the Processing of Transactions by Service Organizations). that uses one or more service Service Every private equity firm must ‘fairly value’ every single one of its organizations. organizations are typically entities investments, the criterion being a holding’s likely current sale value. For that provide outsourcing services that impact the control environment those that do not trade publicly, buyout houses and their auditors must of their customers. Examples of service organizations are insurance approximate the value as rigorously as they can, guided by the pricing of and medical claims processors, trust companies, hosted data Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets centers, application service providers (ASPs), managed security providers, credit processing organizations and clearinghouses. GAAP) were changed and private equity managers should also apply the
  21. 21. recent leveraged buyouts (LBOs) and valuations of comparable public companies. Auditors require a robust and well-documented determination of fair value by the private equity fund in order to agree to the valuation methodology. Whether this change in the accounting rules will also affect the volatility in the net asset value is currently open to debate and has to be analysed at a later point in time. In summary, net asset values are accounting values and not market prices for PE funds like they are for other types of funds, especially Mutual Funds. Nevertheless, these accounting values have to be taken into account if someone wants to calculate the risk of private equity before the end of the fund’s lifetime. But it is important to bear in mind what integrating net asset values actually mean and how great their influence is in different methodologies. Private equity explicitly focuses on the combination of ownership and control to maximize the alignment of interests. The management of an investee company is expected to contribute a substantial fraction of their net wealth into the most junior part of the capital structure. Fund managers co-invest into their own funds and, occasionally, in the individual companies, which they then closely monitor from the board as external directors. In addition to this, fund managers share 20% of the profits that the private equity fund generates – their “carried interest” provided the internal rate of returns (IRR) exceeds a certain hurdle rate, which is traditionally 8 percent. Common for all sub-asset classes of private equity is the concept of investing via closed-end funds with a finite lifetime, usually structured as private limited partnerships and incorporated in favorable jurisdictions like Delaware for U.S. funds or the Channel Islands for European vehicles. Private equity funds have a normal contractual lifetime of ten years, with an optional extension of up to three more years. The first five to six years represent a fund’s investment period. Instead of paying the entire amount of capital upfront when the fund is raised, fund investors (Limited Partners, LPs) commit capital to a private equity fund, which the fund manager (General Partner, GP) then calls when a new investment is identified or fund management fees are due. Following the expiration of a fund’s investment period with no more capital, the GP has another five to seven years to realize all investments. This arrangement gives private equity funds a self-liquidating character. An exception are ongoing management fees, though, these are regularly funded from realizations in the second half of a PE fund’s 17 1 lifetime. 7. Conclusion It is found that successful private equity funds are shifting their focus by adapting to new market realities and growth opportunities in emerging markets. With this in mind, it can be explored that our hypothesis – “A positive outlook influences investors to pay a higher price for a given investment Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  22. 22. opportunity and get higher prices at the time of disposal of the investment, encouraging investors to pay a higher price for the PE transactions and vice versa”. Private Equity funds are able to switch gears or make adjustments where needed, continuing to drive the kinds of changes that have made them one of the most investor friendly and profitable investment vehicles globally. Recently, Delhi-based Moolchand Healthcare will invest Rs.500 crore to acquire existing hospitals and develop new greenfield ones. The expansion will be funded from a private equity infusion of Rs. 100 crore from Sequoia Capital, with the balance coming from internal accruals and debt. "We are planning to be among the country's largest multi-speciality healthcare providers," said Shravan Talwar, chief executive officer of Moolchand Healthcare, which runs one multi-specialty hospital in Delhi. In the emerging market countries, Asia and China clearly are at the top of the list for Private Equity investing activity as EBITDA is the highest for these 2 markets in Figure-5: Cash Positions for Private Equity Investments. The obvious conclusion is that the model does work successfully in the emerging markets. Supporting this, assistance with M&A is another key area in which private equity firms will be able to support their companies going forward. Overall sentiment in Western Europe has held up better than might have been expected given the scale of current economic travails. This perhaps reflects the fact that many GPs have dealt with problems in their portfolios and focused their new investment activity on more defensive sectors like ITeS and Infrastructure. In keeping with this, across the BRICS, the outlook in Brazil remains broadly positive, it is more split in India and China, with some investors in the former having become notably bearish. A number of other considerations — low private equity penetrations, lack of financing generally in the market, lack of a strong venture capital market — ultimately the combination of all those is a need for capital. And then we combine that with the rising middle class and increased consumerism, and we 18 1 think, long term, private equity will continue to look at the emerging markets as a great investing opportunity. It is believed that the immediate risk of Eurozone failure remains low. In addition, it is believed that the Eurozone will “return to feeble growth” by the end of 2013. Europe could be condemned to a prolonged Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets
  23. 23. period of low growth if it continues to experience low investment besides PE funds having a long 5-year investment period and a 10-year life in most cases. We also noticed that due to restricted information disclosure, only LPs have access to the fund’s performance. Therefore, it can be safely concluded that Private equity is still an inefficient market. In this paper we also analyzed whether private equity funds value their assets fairly. This is an important question not just from an accounting and regulatory perspective, but also because fund valuations impact directly on reported performance figures, which in turn are likely to influence investors’ decisions as to whether to invest in new funds. Our results can be summarized in a caveat “interim performance is no guarantee of final performance”. Fund managers must re-think the professional expertise required for these tasks, recognizing that the analytical and negotiating skills required to make an investment are not the same as those required to enhance corporate value during the post-investment phase. Initially, the industry relied too heavily on former investment bankers trained to "do deals," collect their fee, and move on to the next transaction. They badly underestimated the amount of hands-on time required to monitor the portfolio company performance. Attending periodic board meetings, reading financial reports, and observing performance from afar is not sufficient. Instead, professionals must take on the difficult and time-consuming tasks of strengthening corporate governance practices, restructuring management, and re-positioning the PE Fund-Strategies for a profitable exit together with fund value enhancement. It is an important of this business, says one fund manager. "When you sign the deal is when the real work starts, not ends. Finding the right skill set in emerging markets is tricky. 19 1 Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 20 1
  24. 24. 8. Limitations and Scope for Improvement Through this paper, we have stressed upon the need to look at important factors regulating the Private Equity Market and have also briefly discussed the way to analyze and compute an index which can find out a measure of evaluating a PE Fund. The unexpected turn of events over the recent past, have forced the fund managers to share more information as required by the investors in order to attract investments. So it is now possible to develop such measures using the available information from them. Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 20 1
  25. 25. 9. Figures and Graphs Figure-1: The Private Equity Partnership Structure Insurance company LP Pension fund GP Portfolio Large corporate HNWI The PE fund Company A Company B Company C Company D Manager Company E Company D Figure-2: The Private Equity Investment Structure Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 21 1
  26. 26. Figure-3: Sectors/Industries for Private Equity Investments Source: Deloitte Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 22 1
  27. 27. Figure 4: Volatility and Liquidity Metrics of a random PE fund Source: EVCA Risk Measurement Guidelines Figure-5: Cash Positions for Private Equity Investments Source: NSE Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 23 1
  28. 28. Figure-6: Private Equity Fundraising 2(Pool of Funds) Source: Venture Intelligence Figure-7: Private Equity Deals with Collar SOURCE: MERGERSTAT FACTSET Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 24 1
  29. 29. Figure-8: Capital raised in Emerging Markets on a rise Figure-9: GDP share of Emerging Markets Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 25 1
  30. 30. Figure-10: China and Brazil leading the share of Private Equity Investments in Emerging Markets Figure-11: GDP Growth Rates over the last decade Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 26 1
  31. 31. Figure-12: Projected GDP Growth Rates from 2011 to 2013 Figure-13: Actual GDP Growth Rates from 2007 to 2012 for BRIC Countries Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 27 1
  32. 32. Figure-14: Calculation of Std. Deviation of Monthly Returns Source: Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 28 1
  33. 33. Presentation on 19.04.2012 Appendices Data Appendices Proposal to serve Edward Jones | 23
  34. 34. Data Appendices, References and Sources Deals ^ Index > Consolidated Emerging Markets Data Set (All figures in %) Deals- Fig. 7 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 PE Fund- Fig.6 GDP Growth Fig11 PE SD f15 6.4 7.7 7.5 7.43 7.65 5.65 6.54 5.69 5.09 4.85 6.29 3.63 4.78 4.48 8.45 9.35 8.43 7.45 7.89 10.45 13.60 16.02 17.61 15.40 6.91 7.10 5.02 6.34 4.3 4.5 5.5 6.65 8.54 7.54 6.75 5.6 6 2.1 3 4.5 6.2 5.4 7.2 6 6.5 5 7 8 6 6.23 4 10 9.45 5 6 5.32 Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 30 1
  35. 35. Data Appendices, References and Sources 10. References and Research Sites International Monetary Fund (2010) - How did Emerging Markets cope in the crisis Regulatory Uncertainty and Market Liquidity - [Online] - Retrieved on 21 November 2013 from: Anecdotal Evidence cited in this paper is taken from an interview conducted by the authors from Latin American Private Equity Analyst and European Venture Capital Journal Asian Academy of Management Journal of Accounting and Finance AAMJAF, Vol. 6, No. 1, 89–108, 2010 [online] [Accessed 1 December 2013] from <> Sectors/Industries for Private Equity Investments information from <> European Private Equity and Venture Capital Association (EVCA) guidelines retrieved from Calculation of Std. Deviation of Monthly Returns obtained from <> Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 31 1 2 1
  36. 36. Data Appendices, References and Sources Do all the good you can, by all the means you can, in all the ways you can, in all places you can, at all the times you can, to all the people you can, as long as ever you can. — John Wesley ******************************* Macro Trends and New Approaches in Pricing of Private Equity Transactions in Emerging Markets 32 1