The Problem of Short Term

There are various challenges in undertaking a financial evaluation of a project. One has to look at various facets of the returns (IRR, RoI, NPV), profitability (margins, PAT), leverage (debt, loan, deposits), taxability, risks etc. In a typical corporate house or a financial institution, the task of actually plotting a financial model is relegated to analysts/associates who submit their work to the top management. The top management usually has the back of envelope calculations already done and they then try to see if their intuitive calculations are in the same lines as those of the models prepared by analysts/associates. If the results match, typically, the job is done.

In all these years of discussing cash flows with investment bankers, fund managers, promoters, CEOs/CFOs, one thing that I feel most people tend to ignore is the timing of cash flows, or, to say it more explicitly, envisaging short term cash flow problems. Most people get happy with the big picture, profitability, return etc (which in fact is true), but to reach that big picture goal, one might have to go through short term funding problems. And if one is not prepared to handle the short term issues, it can lead to disastrous consequences, often impacting the long term goals.

The assets and liabilities of a firm can be divided into short-term and long-term. Short-term assets broadly include cash, cash equivalents and inventories—i.e., any asset that can be converted into cash in a short period of time. Long-term assets include assets such as land and building, plant and equipment, good will etc. Short-term liabilities include short-term debt and vendor liabilities. Long-term liabilities include long-term debt and equity. Ideally, long term funds (equity plus debt) should provide for fixed or long term assets plus a certain amount of working capital. As long as short-term assets exceed short-term liabilities, a project will not have day to day liquidity problems.

A serious problem arises when, say, the timing of revenue gets delayed. The project will still make the same amount of profit (if not more) but it needs more funds/capital to achieve it. Is there sufficient liquidity in the system to ensure that ‘short term shocks’ are absorbed? Was the model stress tested to ensure that short funding issues are addressed? In these situations, if short-term liabilities suddenly exceed short-term assets, it can force the company to liquidate long-term assets, increase long-term liabilities, or face bankruptcy. When these events take place, the project becomes distressed and can find that the market for both its assets and liabilities has significantly diminished.

Companies fail if they do not have access to adequate cash to meet their short-term liabilities. Enron’s demise was started by discovery of an accounting fraud, but caused by inability to manage liquidity risk. Financial institution bankruptcies in 2008 were accelerated by the inability to manage liquidity risk. Northern Rock suffered from funding liquidity risk following the subprime crisis. The firm suffered from liquidity issues despite being solvent at the time, because maturing loans and deposits could not be renewed in the short-term money markets.  What destroyed MF Global, Lehman Brothers , Bear Stearns, AIG, and other financial firms was the refusal of short-term lenders to continue lending money to the firms.

Coming back to the original point, estimating short term funding issues should be given special importance and thoroughly looked into while undertaking the financial evaluation of a project. It would typically involved preparing short term cash flows rather than just relying on the profitability statement or the annual cash flows. This exercise would give important insights into deciding the capital structure and the quantum of long term capital required. 

Ripley's Believe It or Not

Yesterday, I went to a friend’s place for dinner. This friend of mine works in one of the biggest domestic investment banks in India. As always, we started our discussions on how poorly paid we are, how overworked we are and how a lot of our senior colleagues, though completely undeserving, earn far more than what they should be getting.

We concluded that how some people, by just being at the right place at the right time ride economic cycles and create wealth that would have been so difficult, if not impossible, to make in the normal course of events. I have to admit that some of the cynicism and criticism was unwarranted and harsh from our side. However, we started recollecting the interesting faux pas that we have faced in our professional lives. Some of it was because of the genuine mistakes of the concerned persons; the others reflect the professional caliber of the seasoned people (usually senior professionals) in the financial services industry.

Here is a small list (each one of the below is a real incident):

- A partner in a fund was evaluating a project; his CEO had already given a consent to the deal and the partner was making the financial model of the project. He knew the deal had to be done and so he wanted the projections to justify the valuations that the fund had agreed to. The analyst working on the transaction prepared a DCF model, used aggressive assumptions and did what ever he could, but could not bring the desired valuation. The partner gave him many suggestions to pump up the valuations but after trying everything also, no significant progress was made. Exasperated, the partner finally asked his analyst if he could do a DCF of the PAT instead of the cash flows to see if that gave a better result? (unbelievable but true!)

- Two partners in a fund were discussing the valuation of a company where the fund was about to infuse money; there was some confusion as to whether the USD 350 mn company valuation was pre money or post money. A lot of debate took place and after a series of emails over 2-3 days, they realized that it was a secondary transaction!

- A investment banker was having a brainstorming session with his client. The promoter needed funds in his company but did not want to dilute equity. The company did not have the repayment capacity of expensive debt and given the market conditions cheap debt was simply impossible. After a long and draining brainstorming session, the banker suggested that the promoter issue ‘convertible equity’ which could be issued as equity and then later be converted into debt. In this way, he could both retain control and not pay high debt cost in the immediate future. The promoter was stunned!

- In this case, a financial investor had made an investment and exit from the investment in less than 6 months. He had barely managed to recover his capital in the process. While preparing a track record of his performance he listed down each investment and the corresponding IRRs achieved in the same. For this specific investment also he calculated the IRR using the XIRR function in MS Excel. To his utter delight the XIRR function threw up a high double digit IRR ! His joy knew no bounds. My explanation to him that the IRR as method of return computation cannot be applied on investments of less than 1 year duration fell on deaf years. The compendium of track record was shared with the global board of the financial investor.

- My colleague was trying to raise debt for one of his real estate projects. He met senior bankers working in a MNC bank. During one of the discussions, they were evaluating the repayment capacity of the project and how much overall cash the project would throw up. To my colleague’s utter surprise, the bankers were using the PAT figures to assess the project’s repayment capacity. He protested saying that the total cash flow of the project should be considered, i.e., PAT + equity, as that is indeed the total amount of cash flows the project would generate. The idea was shot down by the bankers as they claimed that equity would be “used up in the project” and hence the free cash flow available would only be PAT !!!

The Emperor's New Clothes

When I was a kid, I read this beautiful story by Hans Christian Anderson about a foolish emperor. The story (called “The Emperor’s New Clothes”) is about an emperor who cares for nothing but his appearance and attire and hires two tailors who promise him the finest suit of clothes that is not visible to anyone who is unfit for his position or stupid. The emperor himself cannot see the clothes but pretends that he can, lest he appear unfit for his position. Wearing the “suit”, he comes out in a public procession and everyone keeps up the pretense praising the emperor for the fine suit. However, a child in the crowd cries out that the emperor is wearing nothing at all. The emperor is embarrassed, realizing that the child is correct, but continues with his procession.

Alas this is just a story. In this real world, the child is severely punished by the emperor. What else can explain the sudden resignation of Deven Sharma, the president of rating agency S & P? His historic decision to downgrade the AAA rating  of USA evoked strong responses from everyone. While some praised him for having the courage and conviction to take on the might of the US government, many others, including US policymakers and economists like Paul Krugman, criticized him publicly. The US government alleged that S &P overestimated future government debt by $ 2 tn. S & P countered by saying that the US government had become "less stable, less effective and less predictable". Global markets have remained volatile ever since.

However, the US government seems to have the ‘shoot the messenger’ attitude rather than focusing on the real issue here. It’s not as if one fine day S & P woke up from a deep slumber and downgraded USA. This had been coming in for a while. The following is an extract from an article on S&P’s website dated April 18, 2011.

“ On April, 18, 2011, Standard & Poor's Ratings Services affirmed its 'AAA' ratings on the United States of America(AAA/Negative/A-1+) but revised its outlook on the rating to negative. Our opinion of the recent and expected further deterioration in the U.S. fiscal profile, and of the ability and willingness of the U.S. to soon reverse this trend, was the driving factor in our decision to revise the outlook to negative.

What Our AAA/Negative/A-1+ Sovereign Credit Rating On The U.S. Means

A Standard & Poor's sovereign credit rating represents our opinion on both the ability and willingness of aparticular sovereign government to pay its market debt in full, on time, and according to the terms of the obligation.

For the U.S., our sovereign rating applies to the $9.0 trillion in publicly held debt issued by the U.S. Treasury outstanding as of Feb. 28, 2011.

According to Standard & Poor's ratings definitions, an obligor rated 'AAA' is one that, in our opinion, has extremely strong capacity to meet its financial commitments. 'AAA' is the highest issuer credit rating we assign. By comparison, when we rate an obligor 'AA', we are expressing our view that the obligor has very strong capacity to meet its financial commitments. Under our ratings definitions, the creditworthiness of a 'AA' obligor differs from the highest-rated obligors only to a small degree. We may assign a plus-sign modifier ('AA+') to what we consider to be the strongest 'AA' obligors.

Our negative outlook on our rating on the U.S. sovereign signals that we believe there is a likelihood of at least one-in-three of a downward rating adjustment within two years. We currently expect that if we do lower the rating, it would be by no more than one notch to 'AA+', reflecting only a small degree of deterioration in our opinion of the U.S.'s creditworthiness.”

The real issue of discussion here is the massive US debt (expected to be close to 75% of GDP), the corresponding deficits and how difficult it would be to close it out. Debts, taken to stimulate the economy in the wake of the financial crisis, have almost doubled since 2007 (as a % of GDP). In the meanwhile, the government has neither been able to raise taxes nor been able to reduce expenditures; nor is there any ideological consensus between political parties on how to handle this situation.

Given this backdrop, S &P’s call, though questionable, cannot be drastically wrong. It could only be right or marginally wrong. The fact that US faces a severe financial challenge is  unquestionable.

Having borne the brunt of public anger and criticism in the sub prime crisis of 2008, the rating agency seems to have learnt its lessons. They do not want to be caught in the same situation as 2008 where they kept on giving high ratings to structured financial instruments only to see them crumble like a pack of cards later.

However, given what we have seen in Greece and Ireland in the recent past, there is no denying that there is a serious threat on the ability of nations to repay their sovereign debt; and the US should be no exception. So Uncle Sam, instead of shooting the messenger, you should focus on getting your house in order and figure a way out to get out of this financial mess.

Bubblegum

Some crazy stuff is happening here. Recently, I read an article on vccircle that left me completely stunned. Flipkart, a company with FY11 topline revenues of approximately Rs 6 crores per month, is raising private equity funding at a $1 bn valuation. I have to admit though that I have no idea about the profitability of the company; but just the thought of a company with a $ 16 mn turnover having a $ 1 bn valuation seems bizarre. Just to give a comparison, Infosys reached a market capitalization of $ 1 bn some where in 1998-99 when its revenues touched $ 100 mn (and this was public market valuation, which are generally much higher than private market valuations)

Hot Internet companies seem to be commanding astronomical valuations these days; both domestically and internationally.

Facebook, the poster boy of the new dotcom frenzy, is currently expected to have a shocking valuation of $ 100 bn when it goes for its IPO later this year. Zynga, the social-network games company, has been valued at $9 bn. Profitless Twitter is said to be worth $10bn. Groupon, the pioneers of group buying, rejected a $6 bn offer from Google and is considering an IPO with a valuation of $15 bn.

It seems that investors are desperate for growth and hence are willing to take on more and more risks. One measure of the frenzy is the astronomical share prices for these Internet stocks relative to their earnings.

Take the example of Linkedin. It had a successful IPO in May 2011. It went public at $45, and the stock increased about 109% on its opening day to reach a price of $94.25. The current price of the stock is close to $80 with P/E ratio of 1200. That compares with an average P-E of 14.2 for the S&P.  For the 12 month period ending on 31/12/2010, Linkedin had revenues of $ 243 mn, net income of $ 15.38 mn and operating cash flows of $ 55 mn. However, the current market cap of the company is $ 7.5 – 8 bn! In the Marwadi school of economics (that I learnt in Kolkata), one of the basic methods of evaluating a business is to see the cash payback period from the business. Even if you assume that the cash flow from operations grows at an annualized rate of 50% per annum compounding (though that is a mathematical impossibility for any extended period) it would take close to 10 years to just recover the capital.

Take an another case - MakeMytrip (MMT) . For the 12 month period ending on 31/12/2010, MMT  had revenues of $ 122 mn and a net income of just $ 4.83 mn. This is the first positive PAT that it has reported; the previous 3 years were losses at the EBITDA level. Cash Flow from Operations is a negative $ 6.33 mn. However, the market cap of the company is an astounding $ 700mn ! In fact, the company has practically had negative cash flow from operations every year for the last 3-4 years (although the revenues have trebled in the last 3 years). Its currently trading at a PE multiple in excess of 150 !! Theoretically, if I buy the entire company today at $ 700 mn and if the revenues keep growing at 50% per annum compounding, then, at the same profit margins, it would take at least 10 years just to recover the capital ! Forget about the returns mate.

Maybe I am missing some big trick here that other shrewd investors are able to see. Coming back to Flipkart, if some investor is giving them a valuation of $ 1 bn now, and assuming that they want to exit in 3-4 years, then say at a 40% IRR, the company is expected to achieve a valuation of  $ 2.7 bn in 3 years in $ 3.8 bn in 4 years. Could be possible, given the way the markets are. 

Caveat Emptor

Let me share a recent case regarding illegal construction and sales. A close friend based in Mumbai bought an under construction apartment in Thane in 2010. It was one of those rare instances when he made a big decision in an instant. As soon as he saw that sample apartment, he fell in love with it. Immediately, he booked an apartment on the 22^nd floor; got a bank loan approved, paid the initial lump sum out of his hard earned savings and got the flat registered. He was happy; after all, registration meant that the paper work was properly done and with the property prices going up, he thought that he had made a wise decision.   

However, after a year or so, there was an article in the newspapers about the same builder having constructed some other project illegally and the local corporation body threatening to demolish it. Although, his specific project was not mentioned in the article, he decided to examine the approvals of his project in detail. Only then did he realize that his project did not have a CC (Commencement Certificate) beyond the 14th floor. In effect, he had bought an apartment that not only did not exist physically, but also did not exist in paper. The most shocking part was that the same had been registered as well!!

He was in such a hurry that he did not bother checking out whether the builder had proper commencement certificate or not. He skipped the necessary homework to close the deal quickly, a decision that gave him sleepless nights later! As a real estate investor, I am aware of many such cases. However, my intention is not to put off or scare buyers; rather the intention is to explain some of the process involved in construction approvals so that one is conscious about them while taking property decisions. 

Buying a property without ensuring that the developer has the necessary approvals is one of the most frequent mistakes that buyers make. Home buyers tend to let their emotions and dreams get the better of their senses, fall in love with a beautiful advertisement and make rushed decisions. Buying a property is perhaps the biggest investment that most people make and they should be extremely careful so as to not get duped by corrupt builders. Below, I am laying out a broad list of construction approvals that every buyer should be aware about before signing the dotted line. (Please note that these are construction approvals and have nothing to do with land; which is a separate subject altogether. For reference, I have used Mumbai as an example but it would be as applicable in any other city)

As far as the city of Mumbai is concerned, the Municipal Corporation of Greater Mumbai (MCGM), Mumbai Metropolitan Regional Development Authority (MMRDA), Slum Rehabilitation Authority (SRA) are the Planning Authorities under the Laws pertaining to the Town Planning. All the projects of construction whether residential or otherwise are required to be submitted to the concerned Authority and the plans are sanctioned by such Authorities.

Approved Plans   
First and foremost, please see the approved plans of the project. The local planning authority approves the plans of any development. The approved plans are issued in duplicate, i.e. copies to the owner & architect.

The approved plan bears signatures of owner, architect, municipal stamp of approval with case / file number, date of approval and is signed by the authorized officer of the Corporation. Validity of approved plan is one year and requires revalidation every year thereafter.

Intimation Of Disapproval (IOD)           
Along with approval of plans, the local corporation issues a letter of approval. In Mumbai it is popularly known as the IOD. (Intimation of Disapproval). People get confused with the term IOD. In fact even though it is termed as intimation of disapproval, it is to be read in its positive form; which means the IOD is a letter of approval subject to compliance of terms & conditions mentioned therein.  Validity of Letter of approval (IOD) is one year unless revalidated yearly.

The intimation of disapproval is issued with a list of NOC’s, which the applicant must obtain separately from various departments and government authorities. Final clearance to construct is given once the developer obtains all the NOC’s. The NOC’s assigned to the intimation of disapproval are case specific. However, it would generally include NOCs from the Tree Authority, Storm Water and Drain Department, Sewerage Department, Environmental Department (concerned with debris management), Traffic and Coordination Department, CFO (Chief Fire Officer - Fire clearance)         

Please note that only approval of plans and issue of IOD, is not a development permission unless it is clubbed with Commencement Certificate. However, most developers do start excavation work once they secure the IOD

Commencement Certificate                 
On submission of all required NOCs mentioned in the IOD and on compliance of the IOD conditions, the Commencement Certificate is approved. It is a development permission issued by the Local Planning authority. It is generally issued together with approved plans & letter of approval in other cities except in Mumbai. Validity of Commencement Certificate is typically one year from its date of issue. Only after obtaining the commencement certificate is a developer entitled to start the work.

High Rise Committee Approval

The High-rise committee was set up by the Maharashtra state government due to the surge in projects a few years ago and concerns about the effect it could have on the environment and infrastructure. It studies and clears every building being erected over 70 metres. According to the BMC's construction norms, a high-rise is any building more than 70 metres tall. Usually this means the building has at least 18 to 21 storeys, depending on the height of individual floors, which can vary from 3.2 to 4.2 metres in height.   

Environmental Clearance

The principal Environmental Regulatory Agency in India is the Ministry of  Environment and Forests (MoEF).  MoEF formulates environmental policies and accords environmental clearance for the projects. Broadly, all projects have been been classified in two categories. Some projects require Environmental Clearance from the Central Level Impact Assessment Authority at MoEF, New Delhi whereas others require Enviornmental Clearance from state level Environmental Clearance authority i.e., State Environment Impact Assessment Authority (SEIAA).

Construction Projects for Environmental Clearance fall under two categories- Category 8(a) Building and Construction projects and Category 8(b) Townships and Area Development projects. No environmental clearance is required if Built-up area of the project is less than 20000 square meter (sq.m) for Category 8(a) and if project area is less than 50 hectare and/or built up area is less than 1,50,000 sq.m for Category-8(b).

Clearance from SEIAA is required for Category-8(a) projects if the built-up area is between 20,000-1,50,000 sq.m and if it exceeds 1,50,000 sq.m then clearance is required from MoEF.

Also, please remember that environmental clearance is required to be obtained before commencement of any construction activity.

NOC from Airport Authority of India

With a lot of construction coming around airport in many cities in India, this is increasingly becoming important. A NOC for height clearance is required for construction projects, such as high-rise buildings or communications masts, which fall within 20 km of an airport. As per norms, construction within a radius of 20 kms around airports is regulated by AAI which issues no objection clearances for the height of buildings. In the funnel area of runways, height restrictions are stricter. 

Plinth Completion Certificate

Once work commences on the site and is completed up to the plinth level, the developer has to submit a proposal for Plinth completion Certificate to the local corporation. The local corporation after verifying the construction work done on  site up  to the plinth level may either accords plinth completion certificate & permit to carry on further construction work as per approved plans  &  conditioned mentioned in CC or refuses to grant plinth completion certificate, if any  deviations found than the approved plan.  In such cases notice are given to stop further work and to get the revised plans approved.

Occupancy Certificate and Certificate of Completion                      

Occupancy Certificate evidences the completion of the building as per the approved plan and compliance of local laws.  Without the Occupancy Certificate, it is difficult to get the water and sanitary connection. The Occupancy Certificate allows the developer to occupy the building but is not considered a final document because it still requires the Certificate of Completion. The Completion Certificate is considered to be the final document to fully occupy the building and connect to utilities.                  

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!

Start up Snob

MBA students are increasingly falling into one of two categories—those hungry to rush into careers as private equity/venture capitalists, and those eager to found a venture-funded start-up. My advice to all of them: Please give due respect to a regular corporate job and please do consider spending a few years working for a large corporate player first.

These business school students and young venture capitalists frequently share common misconceptions about start-ups in this heavily publicized sector. Part of the myth is fuelled by the B schools themselves by feeding hunky dory stories about how quick bucks (ESOP value growing manifold) and careers (big responsibility and fancy designations very early in the career) can be made in start ups.  People joining start ups are seen as star risk takers and a corporate job is seen as one of those ‘regular/methodical’ types. Nobody seems to talk about how badly people lives and careers get affected when start ups fail and sometimes the damage is permanent or the fact that even though the start up might be successful, making money at a personal level could be completely different.

Please don’t get me wrong; I am not a doomsayer. Rather, I am a big risk taker at a personal level and the intent of this blog is to help people take objective and well balanced decisions and not be swayed by bull talk.  Following are the few pointers that young minds should definitely consider while thinking of joining start ups:

Truly understanding the business model of the start up: Please understand the primary business of a business is a product or a service and making money comes along with it. It’s not the other way round. Please please stay away from get rich quick companies. The get rich quick companies almost aren't worth discussion. I've often found anyone who contacts me with more passion and enthusiasm than actual information and conceptual facts about their business, doesn't have one. It usually goes hand in hand with them talking extensively about how much money everyone involved is going to make, and that alone should be why I should or anyone should be involved. This is first sign of warning.

Credibility of the person (including his personal nature): Please check on the credibility of the entrepreneur and specifically his experience of the business/or as an entrepreneur. Please go an extra mile and talk to people who have worked with him in various capacities. Also remember, sharing a personal rapport is very important in a start up. If your boss is not your personality type, you can still get away in a corporate job, but in a startup it becomes really difficult. Remember, most start ups are one man shows and if you cannot get along with that man, the going gets tough even though you may be very good at your work.

Get your ESOPs: Get your ESOPs allotted on day one. This is important. Get it documented. If you hear any of the following, “Oh! We will allot the ESOPs in due course, don’t you trust me? ”, or something like, “Oh, we are still working out the legal structure and have appointed one of the Big 4 firms for the same”, then it is a clear sign that you will most probably never get the shares. Remember it is easier to get the shares earlier rather than later. There are so many cases of promoters/entrepreneurs going back on their promise and the employee being helpless because of lack of any specific written document/agreement. Most of them are also not willing to create an issue about it lest it affects their careers and they be perceived as ‘troublemaker’ employees. Also remember that during this period salaries and bonuses are low because of the uncertainty of cash flows in a start up.

Team building capacity – willing to share wealth and grow: What is the senior management team that the entrepreneur has built? Does he have the ability to attract senior industry talent? This is a big sign of confidence and the proof of the fact that he is willing to share wealth and grow.

Circle of Influence: Check on the immediate circle of friends and business associates of the entrepreneur. This will also help you to get an idea on the both the business and entrepreneur himself.

Passion, spirit, dynamic, an actual business model, experience in the industry they are entering are just a few traits. They know how to command a team, have realistic ideas about what it takes to start a company, how long it takes to really ramp up revenues, and what expenses they'll incur.    

Any thoughts? Agree, disagree, think I'm a startup snob? 

Macro issues for Micro finance

Shares in SKS Microfinance , India's only listed microfinance lender, tumbled to a record low on December 20, 2010 (and could go down further). There seems to be no end to the run of bad luck at India's largest microfinance player. Going by its last close, the SKS share has gone down more than 60% as compared to its peak of Rs 1491 on September 28, 2010. Recently, Citi had come out with a report on SKS with a target price of Rs 600. It is worthwhile to note that Citigroup Global Markets was one of the three lead managers to SKS' IPO (issued at Rs 985). Vinod Khosla, the billionaire venture capitalist and co-founder of Sun Microsystems, was among the early backers of SKS. Khosla’s is part of a new school of thought that believes that businesses and not governments or NGOs, could, and should, lead efforts to eliminate poverty. The idea being that sustainable businesses (which make profits) are better equipped to fight poverty than charitable institutions.

However, the current going for the microfinance industry (MFIs) in India has been very very challenging. After witnessing a large number of farmer suicides, the Andhra Pradesh government passed the the AP Micro Finance Institutions (Regulation of Money Lending) Bill, 2010. MFIs threatened to shut shop in AP and instead expand in other states like Orissa and Chattisgarh. But those governments are also working on a similar Ordinance, following the AP model. Separately, Nobel laureate Muhammad Yunus attacked companies for "misusing and abusing" his original concept and admitted that the reputation of microfinance had been damaged due to Indian companies that charge high interest rates and use heavy-handed tactics to collect repayments. On the business front, there have been no credit disbursements and funding has literally dried up.

Amidst this chaos, there are people who still swear by and believe in the microfinance model and think that the industry will bounce back, sooner rather than later. My friend from Intellecap, Atreya Rayaprolu, has very lucidly presented his thoughts on riding the new wave of microfinance. An interesting read –

Are Investors Ready to Ride the Third Wave of Indian Microfinance?

If the sector tides over the current crisis, in the next few months we could see a Third Wave of Microfinance.

How things change. Less than two months ago the Indian Microfinance industry was riding the crest of a wave, and excitement was palpable among industry stakeholders. Today, the sector is under attack, the almost miraculously reliable flows of repayment down to a trickle, and that of institutional credit virtually dry. And yet, we believe – maybe we are counter-intuitive investment advisers, maybe we are simply incorrigible optimists – that the sector could be on the point of return to a better balance between its commercial and social bottom-lines: a Third Wave.

Microfinance in India has roots in decades-old structures of informal and community financing, and more recently in chit funds and the SHG-Bank Linkage programs. But the modern private microfinance institution (MFI) operating on the Grameen/JLG model has evolved primarily in the last 10 years. The first half of the decade was an unmitigated struggle for them, dominated by not-for-profit NGOs and focused largely on social impact and sustainability via funding from Foundations and DFIs. In the last five years, the sector – or at least the news – has been dominated by for-profit NBFCs, with a focus on rapid growth and scale, fuelled by huge amounts of capital from PEs and backed by professional management.

These phases are what we would refer to as the first and the second wave of Indian Microfinance. The current crisis, triggered by the AP Ordinance, has helped everyone realize that neither a bullock-cart nor a Ferrari is appropriate, and in the real world one needs to find an appropriate balance.

If the sector tides over the current crisis, in the next few months we could see a Third Wave of Microfinance evolving with this balance. Investors with a deep understanding of the drivers and risks of this sector, we firmly believe, should view the current period as the second inflexion point for the sector, and as an excellent opportunity to make ‘value’ investments and ride on this Third Wave.

It is incredible how events in a few months have changed perceptions of an entire sector. A year ago, VC/PE investors who had not made an investment in the microfinance industry felt left out, and rued missing the bus. The SKS IPO – the first in the Microfinance sector - was around the corner and everyone in the financial markets was waiting with bated breath. We were fielding calls from people who had forgotten our existence, wanting to spend time understanding the microfinance business. We spent even more time meeting people at all levels from other NBFCs, the Retail Banking sector, and Business schools, all of whom were stumped by the simplicity of the Microfinance model.

A year later, the sector has become one of the most maligned and viciously attacked. The build-up to the SKS IPO saw a number of debates not only on the merits of a ‘social’ organization (with an intended mission of alleviating poverty) accessing the capital markets, but also on the ethics and morality of stakeholders who realized financial gains before the listing. Meanwhile, the growing flow of capital into the sector fuelled a seeming mania for higher valuations that overtook the customers’ needs. The post-listing euphoria was cut short by the unceremonious firing of the SKS CEO, and threw up a host of issues around corporate governance and transparency.

Finally, the linking of suicides in AP to over-indebtedness and coercive practices led inexorably to the AP Ordinance and the current crisis. The founding father of the Microfinance industry in India, the still redoubtable Vijay Mahajan, has spoken about ‘an imminent collapse of the industry’, ‘death of the Microfinance model in its current form’ and ‘a lot of things not [being] right about the sector'.

As an eventful 2010 draws to a close, murmurs are still audible about some of the largest companies in the sector being on their death-beds. However, there is an increasing sense that the dust is beginning to settle, at least from a media attention viewpoint. It may take a few more months of coordinated effort to tide over the liquidity crisis, and several months of introspection and intellectual sweat to evolve the model for the next stage, but there is sufficient evidence on the ground to suggest that Microfinance as a business is here to stay, albeit with significant changes in strategy and business models.

In the first wave of Microfinance, promoters were central to the success of the organizations (mostly NGOs) and creating a social impact on the ground was the key focus. In the second wave, the focus was on the organization, with investors infusing huge amounts of capital and professional implementation of systems and processes with the objective of achieving growth and scale. In our view, we could now see the birth of a Third Wave, with the client at the center of the model, and everything that the Promoter or the Company does driven by her needs.

In this model, we expect to see many client-centric innovations. Organizations are likely to develop a product portfolio that consists of a far wider offering than the “any-color-as-long-as-it’s-black” Grameen product (Customizations to cash-flows of the client? Partnerships for non-financial products?). Operating and delivery models should see plenty of redesign (JLGs and centers giving way to individual lending? Banking Correspondents operating with MFIs?), and credit-appraisal systems will be strengthened and formalized. All of this will eventually lead to a range of services being offered to the client (both financial and non-financial), based on a more complete understanding of the needs of the end-customer, and more sophisticated service offerings and transaction types. Delivering these improved services will require significant changes in the way data is captured and mined.

The current transition period presents, we believe, a tremendous opportunity for those investors who wish to come in at attractive valuations and ride on this Third Wave. Investors in the sector during this period are likely to reap rewards that provide a far more equitable balance between generating financial returns and having a real positive social impact on the client, her communities and the country. Now that is something worth investing in.

One year of Entrepreneurship

Wikipedia defines entrepreneurship as follows - Entrepreneurship is the act of being an entrepreneur, which is a French word meaning "one who undertakes innovations, finance and business acumen in an effort to transform innovations into economic goods". With the state of the economy and the nation where it is, entreprenuership is clearly a hot topic in India. There are innumerable startups that are coming up in this country, and virtually in every conceivable sector, be it manufacturing, telecom, Information technology, energy, infrastructure, real estate, financial services. Almost everyday one hears about people leaving their safe corporate careers to tread into the murky waters of entrepreneurship. It seems that a wave of entreprenurship has been unleashed in this country and nothing, not even the global economic crisis, can stop or even slow this. Amidst, this a friend has completed one year of a start venture in India. This is his insightful message for all of us, a worthy read-

Dear Gang,

I completed a year of entrepreneurship, this month. The year was extremely exciting and offered edge of the seat drama (but no horror episodes, thankfully). There is never a dull moment when you need to figure out how to get revenue through the door or pay the bills or convince an employee to stay on. As we complete one year, we realize that we had aimed for soo much more in this year (after all we were highly ambitious folks). But, we realize that we have learnt soo much more this year (after all we didn't know much of what we were getting into). The journey has been exciting, so I thought I should share some insights from this journey

a. When we started, we were negotiating an agreement which would cover us for two years and had future upside.. We ended up only "negotiating". We gave up in January and we understand that the client is still negotiating.. Thank God for our low patience levels...

b. Our initial strategy was to enter Africa and South East Asia as that was the buzz word in the investor circle. Though we had initial success, these markets took a long time to decide. We needed to keep the cash box ringing and therefore had to continue to build on India. This focus on India has helped us gain a lot more confidence and keep the cash box ringing.. Don't go by strategy & excitement of investors, the cash box is king..

c.Some team members who were planning to join us on this journey, took much longer to decide (some haven't yet). While others who we felt would not join, have been essential elements in our growth. Everyone has a different view of risk and return, be prepared for surprises on both elements.

d. Our business plan executed more of less as per plan. However, any line item in the plan (either on the revenue or expense side) does not match with the plan. Its just sheer coincidence, not the plan.. By the way, revenues are always delayed and expenses are always early..

e. The support for entrepreneurship has been immense. I have met many of my friends over the last year (I took advantage of their hospitality) and also got insights for free. The support from all quarters is truly amazing..

Satish can be reached at satishkashyap@gmail.com

Optimism Bias

Optimism bias is a well-established illusion of being over- optimistic about future events. The basic idea is that when people judge their chances of experiencing a good outcome they estimate their odds to be above average. But when they contemplate the probability that something unpleasant will happen to them, they estimate their odds to be lower than those of other people. A great number of academic studies have been done on this subject. Some of the well established cases of optimism bias are as follows:

- People expect to complete personal projects in less time than it actually takes to complete them

- Second-year MBA students overestimated the number of job offers they would receive and their starting salary

- Vacationers anticipate greater enjoyment during upcoming trips than they actually expressed during their trips.

- Newlyweds almost uniformly expect that their marriages will endure a lifetime despite the large proportion of marriages that end in divorce.

- Most smokers believe they are less at risk of developing smoking-related diseases than others who smoke.

Optimism bias is also quite common in financial markets. Equity analysts are known to consistently overestimate the earnings and growth potential of companies. In financial appraisal of projects, optimism bias is demonstrated in the systematic tendency for appraisers to be over-optimistic about key project parameters; be it capital costs, works duration, operating costs and revenue. 

In the last 4-5 years, the real estate investment community seems to have been a victim of optimism bias. This is most exemplified in the severe under estimation of time/duration required for construction/operation of project investments. For fund managers who have made investments in major parts of Asia (China, Vietnam, India, Indonesia) in the last 4-5 years, under estimation of timelines is the one area in which they all concede to have erred. The experience has shown how easy it is to fall into the optimism bias trap and start believing that once the finance is secured and the contracts awarded, things just roll on in an automode. Following are some of interesting reasons (these are all true) by which projects have gone significantly delayed:

-  The approvals have been delayed because the municipal corporation has switched from a manual system of approvals to an electronic system of approvals and there is a bug in their software. We have submitted the building plans in a CD but their software is unable to read it.

-  There is labour shortage because of the Commonwealth games being held in the country. All the labourers from the neighbouring states have been called in for the Commonwealth games and hence work on the site has slowed down.

-  Number of labourers have gone down because many labourers have registered themselves under the NREGA scheme (a rural employment scheme implemented by the government) and are unwilling to work

-  After we submitted the Building Plans, the parking laws have changed and the new parking regulations are yet to come out; once the new regulations come out, we have to revise our plans and resubmit the application

- This is the first such project of this scale in the city limits and the officers in the municipal corporation are unable to understand whether to give or reject approvals. They require more time to evaluate the plans

-  The municipal corporation will not give the operational clearance to the building unless it is cleared by the irrigation department. The irrigation department is yet to establish its own standards setting the benchmarks for giving its clearance

- The contractor has turned rogue and is asking for more advances and has threatened to slow the work if we don’t pay up quickly

- The Building plans require approval by both the urban development body and the municipal corporation. Since political adversaries are currently running these bodies, one body always delays or blocks the scheme approved by the other

There is no way a fund manager investing in projects could have foreseen such situations; and such situations sometimes do have an impact on the IRRs. But the harsh reality is that such unique events do happen with regular regularity. Therefore, in every investment, an investor has to incorporate for the unknown event that could have an unknown impact, against his optimism bias!

P.S: It is believed that the only section of the population that isn't susceptible to the optimism bias are people with major depressive disorder. Probably funds should consider hiring some of them.