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 !!!

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. 

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!

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.

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. 

Guide to successful investments

Paul Kedrosky’s research had pointed out, it takes a VC to invest $50 million and be in the industry for seven years to make a good VC. Since the last 4 years, I have been working in a real estate private equity fund. I have been involved in deals worth more than USD 100 millions and although I have not completed 7 years in the investments business, I would like to believe that I am nearly there in becoming a good investor.

Here are my key learnings of the last few years:

Understanding the business: This sounds so obvious and simple and yet is the most difficult part to achieve. Often it does not require very sharp intellect but rigour, perseverance and patience of a good learner. The best guide in understanding the business is not research reports but by actually experiencing the business. The best real estate fund managers have been developers, some of the finest VC investors have been technology entrepreneurs themselves. The rationale is obvious; people who have been there and done that know the nuances of the business better than others and hence can evaluate a deal much more easily. If you do not have the business experience it is a good idea to actually ‘work’ in such a company before hand. So you can work at a developer’s office, a solar power generating company, a bio gas plant etc for 10-15 days to get a first hand knowledge of the challenges faced in such businesses (before evaluating real estate or a clean energy deal). This is difficult to achieve, but if possible, is one of the best ways to evaluate a deal.

Understanding the business model of the customers of the business in which you are investing: Following are some of the basic questions that should be asked:

- Can they afford the product that your company is making?

- What choices do they have?

- How easy/difficult is it for them to substitute your company?

- What is the dependency on your company and the overall industry?

Conversations with industry experts are often an easy and quick way to have insights. This also gives an idea about the competitive scenario prevailing in the market and the kind of challenges your investee company could face. For example, if investors had the patience of studying the financial statements of retailers in 2005, 2006, 2007, it would have clearly shown the huge losses and the big problems that the retailers were facing. One need not wait for a Lehman crisis to understand the troubles of investing in shopping malls.

Entrepreneur: It is a well accepted fact that the biggest factor in an investment decision is the entrepreneur himself. Everything else becomes secondary. I wont dwell too much on this; just 2 points:

- Spending time with the entrepreneur. It is very important to spend atleast 50-60 hours with the entrepreneur before putting money on him. This need not be in serious meetings in the office but could be for a drinking session or a lunch/dinner meeting with friends. The idea is to know him personally. It is surprising how much information one can get in casual settings rather than a Q & A session in the Board Room.

- Another important factor is to also know about the circle of influence of the entrepreneur. Who are the key people that he/she listens to? It is very important to touch base and connect with such people.

All said and done, at the end of the day, there is some amount of crystal ball gazing that takes place and there is no substitute for great insight. Happy Investing !