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Monday, 10 February 2014 00:00 - - {{hitsCtrl.values.hits}}
Although private equity ownership has a number of important advantages that allows the realisation of capital gain along with value creation in a repeatable fashion, the story in Sri Lanka is that companies seldom consider this option – probably due to the lack of awareness in this regard.
Private Equity (PE) in finance is typically an asset class that consists of equity securities and debt in operating companies that are not publically traded on a stock exchange.
The investment is generally made by a private equity firm, a venture capital firm or an angel investor and each of these investor categories has its own set of goals, preferences, and investment strategies. Nevertheless, the three investor categories aim at providing working capital to a target company to nurture expansion, new product development, or restructure a company’s operations, management, or ownership.
In a recent seminar hosted by Jupiter Capital Partners on ‘Private Equity’ it was emphasised that companies should seek PE funds only if there is a solid plan for expansion and growth as this type of investment does not consider start ups and green field projects.
Private equity fund structure typically consists of four main components, the fund manager, an independent entity, the private equity fund entity, usually an offshore entity, the investor, and the portfolio company.
Requirements for PE investment
According to Jupiter Capital Partners Managing Director Indika Hettiarachchi, there are four main requirements to facilitate PE.
The first requirement for PE to go through is to have a fund manager who has a track record and aims for the business to be a long term and a sustainable one.
The second is to have an exceptional business plan that is precise and to the point. Drawing from his experience, Hettiarachchi noted that in Sri Lanka many of the business plans put forward for PE aims for a growth of 15%, which is not attractive enough for an investor as they always look for a high growth plan.
The third is the alignment of interest which is about the investor and promoter having little or no difference in the objective of going forward with the PE.
The fourth and final requirement is the promoter intention, where it should be about creating wealth and not just a business that is profitable. “An attractive proposal is one where an entrepreneur states he wants to increase the value of his business to about US$ 10 million and have a vision listing in the future. It is important because according to this the exit strategy could be planned and implemented properly,” explained Hettiarachchi.
Emphasising that when investing a company looks at the return target, he said this should be driven not by speculation but by real factors such as growth in business volume, improvement in value addition of products, improvement of margin, entity price, and improvement in return due to better risk management, governance, and overall management.
Process and cycle of PE investment
To educate the audience on the stages of PE, LR Global Financial Consultant and former partner Chanaka Wickramasuriya highlighted the five stages of the investment.
Deal origination: Probably the longest stage of the invest process; this is where views are shared with a potential investor.
The initial dialogue with the investor would include sharing the history and future plans of the company. While many local usually tend to hide certain information that could have an influence on the decision made, 
Wickramasuriya said: “Feel not afraid to share information. Sri Lanka is a small country where everyone knows everyone. Therefore cross reference may happen almost immediately. It is best to share information, even those that a company may not be proud of, early so the chances of the initial dialogue turning sour can be prevented.”
Due diligence: Although this stage could bring in some negative news, it is not a deal breaker unless there are some contingency liabilities.
The goal of due diligence is to identify the risk and return profile of a fund offer. A well structured process contains a top-down macro and a bottom-up manager analysis, allowing the investor to filter the most promising funds. While a consistent framework for fund and fund manager assessment is essential, due diligence process should aim at addressing qualitative and quantitative aspects in addition on focusing on the managers “ingredients for success”.
Typically due diligence should look at three perspectives. The strategy perspective which focuses on the investment strategy of the fund, the return perspective, where evidence should be gathered that that the fund manager stands out from his respective peer group, and the risk perspective, which should aim at providing assurance that the risk is mitigated to the level required by the investor.
Transaction closure: With the third stage introducing the investment to lawyers, Wickramasuriya opined that the legal fraternity is kept away till the last stage since they tend to confuse the relationship.
During transaction closure, clauses that the company or the investor is not comfortable about are dealt with. If a necessity arises changes would be made to the article of incorporation in terms of investment instrument, board representations, and business guidelines.
Post investment: The stage deals with the board representation where few seats will be occupied by the investors with the intention of understanding the business better. Post investment process typically deals with 
continuous monitoring, strategising and engagement outside the board with senior management.
Divestment/ exit: While the entire process could take about three to five years, the execution of this stage takes approximately five months. PE exists are done through trade sales, public listing, and buy back. Although Initial Public Offerings (IPOs) are an ideal way of exit, this seldom takes place.
Importance of business valuation
In the game of private equity, business valuation is key since it is about integrating two different types of operations, pointed out KPMG Sri Lanka Managing Partner Reyaz Mihular.
Having observed that some are willing to take the risk of investing with their “feelings” alone, Mihular stressed it is imperative to look at the numbers since the last thing an investor would like to face is surprises, especially nasty ones.
“Making a decision on investing in a company without looking at unrecorded liabilities is very risky. It is critical to analyse and value an entity before getting involved because typically in private equity a company is buying operations that would be integrated into its own,” said Mihular.
He added that while a price is what a company asks for and an investor is willing to pay, overpricing is in fact a premium because an investor has seen higher value that others may have not.
“That is how deals are done. Some people buy companies that may look least attractive for others simply because the entity to them strikes as valuable,” he said.
Option for business valuation
While the approaches to value a business for PE are many, Mihular shared the three most common methods.
Asset based methodology: As the name implies the methodology is about valuing a company based its assets that would add value to the benefits that flows from the investment. A common argument that comes up, according to Mihular, is why a company cannot be sold based on its net asset value. He noted that at certain instances and situations when assets are the main driver of value, asset based methodology may be the correct methodology for that particular business valuation.
Earning based methodology: A simple and straightforward methodology where a company is evaluated as it is. This looks at the profit alone without taking into account the unusual gains and losses. Based on the “normalised” profits the capital value of the company is assessed. Performances of the recent years are given 
the highest rating.
However, in the earning based method one expects the historical results to continue without looking at the future events and cash flows.
Market margin methodology: A popular method where different market multiples are used, the valuation can be based on ratios such price earnings, price to book, price to sales, and enterprise value.
Best valuation method
Unfortunately there is no best method for business valuation since neither is superior to the other. In different circumstances a particular method may seem relevant than the other.
“To do a business valuation one must assess the value drivers in the target. It is important to understand the target and then look at the factors that affect the investment. Then it should be tailored and analysed to find out the relevant outputs,” noted Mihular.
He added that theoretically the best method is the net present value of future cash flow, an ideal one simply because it looks into a company’s future cash flow. However, since even this method is subject to assumptions, it is always best to double check with the market margin methodology.
Thilan Wijesinghe’s 10-point mantra on pitching companies to private equity investorsWith the private equity sphere not picking up resulting in frustration for many, TWCorp Chairman and MJF Leisure Director Thilan Wijesinghe (former Board of Investment Chairman and Director General) opined: “It would be good to see fund managing companies raise funds through unknown companies. It is important to be educated on the advantage of raising the private equity and not be hung up on control.” Drawing from his experience, Wijesinghe presented to the audience his 10-point mantra on luring PE investors: 1.Know yourself and be willing to take calculated risks. 2.Have your own skin in the game, put your own money in cash and find 3.Clearly identify and define business care. It is necessary to keep it simple. 4.Be brilliant at communicating it. 5.Attract the right type of angel investors 6.Attract right strategic partner equity 7.Control is not essential, focus is 8.Have a sound exit strategy 9.Build reputation of creating shareholder wealth 10.Learn to reinvent your self |
