Guide to successful investments II

I recently met someone from a renewable energy start up fund that is simultaneously tying up its anchor investors and is looking to make its first investment in India. We were generally discussing about the investment climate and the experiences that private equity investors have had in the last 4-5 years. She then asked me about my experiences and the learning that I have had during this period. That comment prompted some introspection and hence this blog; an attempt to capture my learning in a structured manner. This blog is also a continuation of the first blog I wrote on August 3, 2010 titled, ‘Guide to successful Investments’.

Pricing Power is the key:

Warren Buffet said he rates businesses on their ability to raise prices and sometimes doesn’t even consider the people in charge. “The single most important decision in evaluating a business is pricing power,” Buffett told in a recent interview. “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

A number of factors go into determining the pricing power of a given good or service, including quantum of demand, uniqueness in the marketplace, competition from similar products, consumer perception of the quality of the product etc. Generally speaking, companies that have strong brands and exclusive product or service have good pricing power.

In the real estate private equity market, most funds are now flocking to look for deals in the residential space. This is no surprise; there is far greater pricing power in a residential product where there is large demand and one has to deal with a retail consumer rather than a retail or commercial product where demand is limited and one has to deal with institutional buyers.

The other thing that I have learned is that in a recessionary/stagnant economy, though pricing power might not enable one to raise prices; it certainly gives a business the preference in the mind of customers. In a growing economy, pricing power enables a business to raise prices comfortably. For example, the recent recovery in the markets has enabled all real estate developers to raise residential prices (where they have pricing power). However, no significant price rise was observed in the commercial/retail market where developers do not have the pricing power.

Exit strategy must be clear from day zero – Put/Drag:

Private equity investors, at the time of entry, must be very very clear about their exit options.  Profits accruing to private equity investors can only be monetized on exit and therefore investors should be prepared right at the outset. For a long time, the primary mode of exit has been an initial public offer. However, successful IPO depends upon a lot of factors (besides the performance of the investee company) including global business environment, the economic cycle, capital market conditions, flavour of the markets etc. Because private equity investors have a defined life cycle (unlike entrepreneurs who can continue for a life time); if they are unable to go through an IPO for any reason, exit becomes very difficult and they could be forced to sell at distress values so as to achieve their exit. This (difference in time horizons) is also the genesis of big cultural differences between entrepreneurs and investors.

Post the recent recession, private equity investors are looking at alternate options.  These options include mandatory buy-back or redemption of shares, put option on the promoters or in some cases even a drag clause to sell the company to achieve its exit. One should explore such structured exits, even if it means a slight compromise on the valuations/IRRs.

A strong structure cannot compensate for an inherently bad project/asset

There are many ‘structured’ deals floating around in the markets these days. Structured deals are a very wide encompassing phrase. Typically a structured deal could refer to skewed profit sharing to the fund till it achieves its returns or a back ended promote to the entrepreneur or tight agreement clauses in the form of performance guarantees that have inbuilt incentive/penalty clauses or even guaranteed leasing/revenue from another group company of the promoter. These deals look delightfully straight forward and attractive. The apparent reason of having structured deals is to give some comfort to the investors about the investment or even persuade them to cough up a higher valuation.

In my limited experience, at best, a structured deal can provide some justification for an initial high valuation for an otherwise inherently strong performing asset/project/company. However, structured deals can not and should not be used for justifying investment in an essentially bad project/asset. The reason being that should things go wrong, it is very difficult to actually implement any of these structures in India. The question you should be asking yourself is this: “Would you be doing this deal if this structure is not available?” If the answer is an emphatic no, then please do not proceed. However if the answer is an emphatic yes or a close yes, then one can explore the structures.

Promoter lock in

In most private equity deals, promoter lock in is present as a standard clause. The simple reason for a promoter lock in is that investors draw confidence from the entrepreneur/promoter (along with the business) before making the investment. The investment is as much about the individual as it is about the product/services. The standard way in which this lock in is structured is by putting in a clause that the promoter shares in the investee company are locked in and cannot be sold till a particular milestone is achieved. This works in most cases.

However, in some cases, I have noticed that the promoter is not a direct shareholder in the investee company and holds his shares through a series of holding companies. In such a scenario, it is important that the lock in runs through the entire chain till the link with the promoter is established. You certainly do not want to be in a situation where you have locked in the shares of the investee company but the promoter sells his stake in the holding level companies. Without the entire chain, the lock in becomes meaningless.

Experience of the entrepreneur

There is no substitute for the experience of an entrepreneur. A new guy (even though he has an established brand) can assemble a great team by hiring the right consultants, managers, contractors, vendors etc but, a team is as good as the leader leading it. If the entrepreneur has the relevant experience he would categorically know how things are done, who to get it done from and most of all, why should it be done in the first place!

However, I do not want to say that all new kids are failures; all I am saying is that there is a cost of making them experienced, and someone has bear the cost of their learning! The limited point is that investors have to be conscious of this fact.

Ownership structure of vendors/service providers:

One of the important things to do during the asset management phase is to verify the antecedents of the key suppliers/vendors/service providers of the investee company. Expenses are the easiest and probably the only way through which promoters take out money from the investee company (unless there is scope of collecting revenue by means of cash). I have heard of some many cases of bogus vendors/suppliers getting paid by the investee company for goods/services actually never offered. Usually this is done through multiple small contracts so that it does not come into the materiality net. I have even heard of a case from a friend where the promoter became a silent partner in one of the service providers and encouraged the service provider to charge a higher fee in the investee company! These kind of cases can even be difficult to trace.

More on this topic later! Happy and careful Investing to all of you!