Exit

As seen in Chapter 1, most PE funds invest with a horizon of about 3 - 5 years, though some are comfortable going up to 7 years. They need to exit their holding in investee companies because the funds are structured as close-ended i.e. they have a limited tenure, typically 10 years. Within this period, the stake in investee companies needs to be sold, and the proceeds distributed to investors in the fund, after paying off general partners for their carried interest.

Investments that are not sold on maturity of the scheme are distributed among investors in the fund in the ratio of their contribution.

A fund my exit its investment through any of the following routes:

o Private sale to a financial investor

The financial investor may be another fund, or any other investor who does not have a strategic interest in the industry or company.

There is also a category of investors called ‘strategic financial investors’. Such investors do not have a strategic interest in the industry, but are prepared to hold their stake in the company much longer than a typical financial investor. Rich business groups or individuals are typical strategic financial investors.

For example, in sectors like insurance and telecom, there are limits to foreign investment.

Suppose the foreign investment limit in a sector is 26%. The local promoter who will run the business may not have the capital to hold the entire local stake of 100% - 26%

i.e. 74%.

The local promoter then ties up with a strategic financial investor to hold the remaining local stake for a long period, without participating in the management of the company.

It is normal for the local promoter to assure the strategic financial investor a certain rate of return for his holding period. This becomes the base rate of return for the strategic financial investor. He may earn a higher return if the market conditions are favourable at the time of sale.

The fund that first invested may have earned its targeted return and wish to book the profits, or its view on the industry or management may have changed or the scheme may be close to maturity. Any of these are reasons for the fund to sell.

Financial investors, being professionals, are more discerning in their investments and tough in their negotiations. This could limit the upside of the exiting investor or tough conditions may be attached to the transaction.

Benefit of a sale to a financial investor is that it is possible to conclude the transaction quickly.

o Private sale to a strategic investor (also called ‘trade sale’)

Strategic investors are those that have a strategic interest in the sector of company to which the investee company belongs. For example, an oil refining company that chooses to purchase a chain of petrol pumps. The rationale for the investment being strategic, the investment horizon is extremely long; the investor may never sell the investment, choosing instead, to merge it into its current business.

Most strategic investors are professionals in their own industry, but not financial market professionals. Besides, they need to do a detailed assessment of the fit of the investee company into their current business, and the post-acquisition strategy for integrating the two companies’ employees, clients, supply chain, technology etc. These processes can take time. Therefore, divestment to a strategic investor can take time. However, depending on how good the strategic fitment is between the two companies, it is possible to recover a higher valuation than in the case of sale to a financial investor.

o Sale as part of IPO

Since IPO entails sale to a retail investor who may not be a professional, it is possible to sell the investment at a higher valuation in the IPO. However, IPOs are time-consuming and costly. Depending on market conditions and pricing of the issue, IPOs can also fail.

A failed IPO can become a drag on the company’s valuation for a long time.

Smart companies price their IPOs at a slight discount to the fair valuation. This not only is an insurance against failure of the issue, but also leaves something on the table for the new investors. The goodwill that is generated when these investors make money on the issue boosts the long-term brand image of the issuer in the financial market.

PE investors may choose to sell only part of their stake in the IPO, so that they can sell the remaining stake later at a higher valuation in the stock exchange. Further, if PE investors were to sell their entire stake in the IPO, it would be a very weak signal to the new investors being targeted.

Another factor that comes in is that SEBI regulations mandate a “lock-in” for promoters as part of the IPO. This means that the PE investor will not be able to sell their holding for the lock-in period of say, 1 year, after the IPO. This elongates their holding period

- a reason for some funds to sell before the IPO to other investors, even if there is a compromise on valuation.

o Sale to Promoter Group

As seen in Chapter 6, the share-holders’ agreement may assure a certain return to the PE investor. This means that the promoter is responsible for ensuring that the PE investor earns his targeted return. If the PE investor is unable to recover that from the market, then he can ask the promoter to buy his stake at a price that would yield the target return. Thus, the promised return effectively gives the PE investor the right to

“put” the shares to the promoter group.

Regulatory authorities have held the view that such “put” (and “call” options) are a violation of the Securities Contract (Regulation) Act, 1957. The Law Ministry has approved an amendment, which will make it legal to have “put” and “call” options in shareholders’ agreements.

Self-Assessment Questions

 Which of the following is a statutory role under the Companies Act, 1956?

 Board of Directors

 Advisory Board

 Both the above

 None of the above

 Which of the following are areas where PE Funds can add value?

 Strategic review

 Strengthening capital structure

 Strengthening management

 All the above

 PE Funds have little value to add in structuring ESOPs.

 True

 False

 Budgeting systems initiated by PE Funds in investee companies tend to continue even after they exit.

 True

 False

 Which of the following is / are exit route/s for a PE investor?

 OFS

 Secondary sale

 IPO

 All the above

 Benefit of sale to financial investor is that transaction can be concluded faster.

 True

 False