Chapter 1.

Introduction
1.1 Definition
The Private Equity sector is broadly defined as investing in a company through a
negotiated process. Investments typically involve a transformational, value-added,
active management strategy. Typical forms of private equity include venture capital,
growth and mezzanine capital, angel investing and private equity funds. Private equity
investors seek to obtain a substantial interest in a company in order to have an active
role in firms’ strategic decisions. Their goal is to boost the value of a company and walk
away with substantially more money at the time of liquidating their investment.
Private equity consists of investors and funds that make investments directly into
private companies or conduct buyouts of public companies. Capital for private equity is
raised from institutional investors and can be used to fund new technologies, expand
working capital within an owned company, make acquisitions, or to strengthen a
balance sheet.
The term "private equity" encompasses a range of techniques used to finance
commercial ventures in ways that do not involve the use of publicly tradable assets
such as corporate stock or bonds.
Private Equity Funds: Private equity funds are investment companies that, as a rule, do
not trade in publicly-traded securities. Instead, they normally seek equity stakes (that is,
partial ownership) in private companies. They may also invest in so-called private
placements of securities from public companies. Private equity buyers are extremely
focused on cash-flow and have a reputation as cost-cutters.

1.2 Private Equity: Current Scenario

India has a very vibrant Venture Capital (VC) / Private Equity (PE) industry with USD
32.5 billion invested across more than 1500 VC/PE deals from January 2006 till date.
Economists estimate that India needs about USD 1 trillion of investment over the next
five years to sustain a GDP growth of above 9 percent. This translates to USD 60-100
billion of VC/PE investments requirement over three years, against which industry
estimates that PE investments would be in the range of USD 9-10 billion in the year
ending December 31, 2010.
After a turbulent 2009, private equity investments in India displayed steady signs of
recovery in the first quarter of 2010. The latest quarter registered the highest value of
deals since 2009.
For the quarter ended March 2010, total announced deal value was $1,943 mn, a jump of
more than 185% from $675 mn in Q1 2009. Total deal count in Q1 2010 also increased by
35% to 88 deals, up from 65 in Q1 2009. Interestingly, despite the enormous growth in
deal value on a quarter-on-quarter basis, the deal count decreased by 11% to 88, down
from 99 in Q4 2009.

SECTORAL BREAKDOWN

Top Sectors by Deal Value for the year 2009 ($mn)

Real estate, IT/IT Services and Energy were the most targeted sectors for investment
with deals worth $0.65 billion, $0.62 billion and $0.54 billion respectively. Together, they
accounted for more than 40% of total private equity deal value during the year 2009.

Top Sectors deals in 2009

Sector Volume Deal Value Average Deal Size

Real Estate 20 657 43.8
IT/IT Services 47 621 15.9
Energy 16 538 41.4
Logistics 15 354 23.6
 Telecom 5 336 84
Banking, Finance 32 244 8.4
and Insurance
Manufacturing 34 242 9.3

The major PE investments influencing the deal values of these sectors were investments
in Aricent Inc., Indiabulls Real Estate Ltd., Mohtisham Estates and Ind Barath Power
Infra Pvt. Ltd. The other sectors, which have significantly contributed to private equity
deal value in the year 2009, are Logistics and Telecom accounting for 15% of total deal
value.

Top Sectors by Deal Volume for the year 2009

The most active sectors in terms of deal volume were IT/IT Services and Manufacturing
which lead with 17% and 11% of deal volume respectively in 2009. Other sectors
contributing significantly to deal volume were Banking, Finance and Insurance and
Real estate accounting for 11% and 7% of deal volumes respectively. As seen in the year
2008, 2009 too saw large number of deals in IT/IT Services, Manufacturing, Banking,
Finance and Insurance and Real estate.
1.3 Types of Private Equity

Private Equity investments can be divided into the following categories:

1. Leveraged Buyout
Leveraged buyouts involve a financial sponsor agreeing to an acquisition without itself
committing all the capital required for the acquisition. To do this, the financial sponsor
will raise acquisition debt which ultimately looks to the cash flows of the acquisition
target to make interest and principal payments. Acquisition debt in an LBO is
often non-recourse to the financial sponsor and has no claim on other investment
managed by the financial sponsor. Therefore, an LBO transaction's financial structure is
particularly attractive to a fund's limited partners, allowing them the benefits of
leverage but greatly limiting the degree of recourse of that leverage.
2. Venture capital
Venture capital is a broad subcategory of private equity that refers to equity
investments made, typically in less mature companies, for the launch, early
development, or expansion of a business. Venture investment is most often found in the
application of new technology, new marketing concepts and new products that have yet
to be proven.
Venture capital is often sub-divided by the stage of development of the company
ranging from early stage capital used for the launch of start-up companies to late stage
and growth capital that is often used to fund expansion of existing business that are
generating revenue but may not yet be profitable or generating cash flow to fund future
growth.
Entrepreneurs often develop products and ideas that require substantial capital during
the formative stages of their companies' life cycles. Many entrepreneurs do not have
sufficient funds to finance projects themselves, and they prefer outside financing. To
compensate the risk of failure, venture capitalist's seeks higher return from these
investments. Venture Capital is often most closely associated with fastgrowing
technology and biotechnology fields.
3 .Growth capital
Growth capital refers to equity investments, most often significant minority
investments, in relatively mature companies that are looking for capital to expand or
restructure operations, enter new markets or finance a major acquisition without a
change of control of the business.
Companies that seek growth capital will often do so in order to finance a
transformational event in their life cycle. These companies are likely to be more mature
than venture capital funded companies, able to generate revenue and operating profits
but unable to generate sufficient cash to fund major expansions, acquisitions or other
investments. The primary owner of the company may not be willing to take the
financial risk alone. By selling part of the company to private equity, the owner can take
out some value and share the risk of growth with partners.
4 .Distressed and Special Situations
Distressed or Special Situations are a broad category referring to investments in equity
or debt securities of financially stressed companies. The "distressed" category
encompasses two broad sub-strategies including:
 "Distressed-to-Control" or "Loan-to-Own" strategies where the investor acquires
debt securities in the hopes of emerging from a corporate restructuring in control of
the company's equity;
 "Special Situations" or "Turnaround" strategies where an investor will provide
debt and equity investments, often "rescue financing" to companies undergoing
operational or financial challenges.
5 .Mezzanine capital
Mezzanine capital refers to subordinated debt or preferred equity securities that often
represent the most junior portion of a company's capital structure that is senior to the
company's common equity. This form of financing is often used by private equity
investors to reduce the amount of equity capital required to finance a leveraged buyout
or major expansion. Mezzanine capital, which is often used by smaller companies that
are unable to access the high yield market, allows such companies to borrow additional
capital beyond the levels that traditional lenders are willing to provide through bank
loans. In compensation for the increased risk, mezzanine debt holders require a higher
return for their investment than secured or other more senior lenders.
6. Secondaries
Secondary investments refer to investments made in existing private equity assets.
These transactions can involve the sale of private equity fund interests or portfolios of
direct investments in privately held companies through the purchase of these
investments from existing institutional investors. By its nature, the private equity asset
class is illiquid, intended to be a long-term investment for buy-and-hold investors.
Secondary investments provide institutional investors with the ability to improve
vintage diversification, particularly for investors that are new to the asset class.
Secondaries also typically experience a different cash flow profile, diminishing
the effect of investing in new private equity funds. Often investments in secondaries are
made through third party fund vehicle, structured similar to a fund of funds although
many large institutional investors have purchased private equity fund interests through
secondary transactions. Sellers of private equity fund investments sell not only the
investments in the fund but also their remaining unfunded commitments to the funds.

1.4 The Stages of Private Equity

Private Equity investments can be classified into:

• Seed stage Financing provided to research, assess and develop an initial concept
before a business has reached the start-up phase
• Start-up stage financing for product development and initial marketing.
• Expansion stage financing for growth and expansion of a company which is
breaking even or trading profitably.
• Replacement capital Purchase of shares from another investor or to reduce
gearing via the refinancing of debt.
The above stages can be explained by the diagram which is shown below -:

1.5 Process of Private Equity Investment

The Private Equity Process in 6 Steps:

1. Deal Origination (Deal Sourcing)
2. Due Diligence
3. Deal Negotiation
4. Deal Closing (Acquisition)
5. Post Acquisition Monitoring
6. Exit (IPO, Trade Sale or Buy back)
Deal Origination or as some call it ‘Deal Sourcing’ is how Deal Makers get their deals, a
potential deal can either come through a company owner approaching them or from an
intermediary who will try to bring both parties (Company and Deal Maker) to make the
deal. In some cases, they may just approach companies who are expanding fast and
wish to grow further. In a year, Deal Makers come across hundreds of potential deals -
but only a few are selected.
Due Diligence is what you could call ‘doing your homework’. Before starting detailed
negotiations, investor try to make sure everything is fair and secure. Although Auditors
and Consultants are appointed to conduct the Financial, Tax, Legal and Technical Due
Diligence - they also work side by side to understand the target company and its
industry better. All the information collected at this time, is then used during
negotiation.
At the Deal Negotiation phase, investor set out the terms and conditions (covenants,
representations and warranties) and other deal terms that defines (or makes the deal).
Contracts such as Investment Agreement, Share Purchase Agreement, Management
Agreement, Advisory Agreement etc are drafted to include all items that put the deal
together.
Deal Closing is probably the easiest part but also contains an element of risk. It’s the
conclusion of the deal, the signing of all Agreements and transferring funds from the
buyer to seller, conducting other administrative functions (usually done by a separate
entity) like updating any articles of association etc.
Post Acquisition Monitoring requires the Deal Team (those who have worked on
putting the deal together) to closely monitor the company, both from an operational
and financial point of view against the expansion plan and budgets that were setup
earlier by the company. Improvements to business, from Corporate Governance,
Financial Reporting, and Information Flow to Strategy are made at each level through
either the company’s management or its board.
As the company matures (usually after 2 - 4 years) with the presence of the Deal Team,
investor prepare it for an Exit - either an IPO or a Trade Sale (sale to a larger party,
multi-national or conglomerate) or in rare cases a Buy Back by the owners. By this time,
the company will have grown quite a bit with still plenty of room to grow further.
(There’s a saying, in a deal - always leave something extra for the person buying - it
makes everyone happy.)
And once investor have exited the company, they return their money with the profit
they gained for company after taking their fees for all the effort put in the above
process.
Although this may seem like a linear process - it isn’t exactly so, primarily because
investors deal with a number of companies and each one is at a different stage in the
private equity process.
1.6 Advantages of Private Equity

Investing in a private equity fund has a lot of advantages compared to other investment
areas; here are some advantages of private equity for not only investors but also the
companies that private equity firms acquire:
Advantages for Investors:
 By definition, private equity firms work outside the public eye and do not have
to follow the same transparency standards that public firms and funds must
adhere to. This allows private equity firms to reform the companies without the
constraint of having to report quarterly to the SEBI, ROC or similar distractions.
 Private equity firms generally perform very rigorous due diligence on potential
investments. By utilizing a team of researchers the private equity firm is able to
identify most risks that would not otherwise be found.
 The management receives carried interest, a portion of the profits, so managers
and their staff are motivated to produce good results to investors. Although
carried interest is often criticized for taking money from the investors, it is a very
big incentive for managers.
 Economic Scenario- India is one of the fastest growing economies in the world,
with enormous growth potential in many industries. This means that capital
requirements are high, translating into an ideal hunting ground for PE funds.
 Abundance of skilled labour - India offers a huge advantage in the form of its
highly talented and skilled labor pool, which can lead to the success of the firms
in which investment is made through the private equity route. The funds are not
just bullish about the businesses in India but have also grabbed a fair share of
highly rated managers like Vivek Paul, Rajeev Gupta, Avnish Bajaj, Akhil
Gupta, and Nikhil Khattau. PE funds are invariably on the lookout for high
profile managers, not only to manage their own funds but also as their
representative on the board of companies in which they have invested.
 Success of several sectors - India has firmly established itself as the world’s IT
superpower with almost all major software development companies having an
Indian development centre. It is also becoming the the hub of back office
operations, and a leading provider of BPO and KPO services. This has led to
greater confidence in the future growth potential of Indian companies.
 Mature Financial markets - Capital markets have stabilized in the recent past
 with regulators like SEBI keeping a firm watch on the market development. This
means both increased opportunities as well as an easier and painless exit route
for PE funds. The emergence of entrepreneurs in India who consider PE their full
time occupation is also a positive sign. Besides, there are well established
corporate houses diversifying their surplus investment, as a strategy for their
assets allocation, through PE funds without involving themselves directly in the
operations of target companies.
 Successful M&As- A recent spate of mergers and acquisitions has given rise to
yet another way of exiting from Indian companies for private equity investors.
 Successful track record - The first generation of private equity
players have realized significant success in the last several years. For instance,
Warburg Pincus earned huge returns out from its investments in Indian
companies like Bharti Telecom.

Advantages for Company:

 Private equity managers are paid very well and so it is easy to attract high
caliber, experienced managers that tend to perform very well. The same goes for
lower level employees at private equity firms, they tend to be the top young
business school graduates. This helps the company to utilize best talent in the
industry without shelling out even a single penny from its pocket.
 PE helps a company to prepare for stock market listing (IPO) as the exit route of
investment. It opens up enormous opportunities for companies to raise funds.
The continuous scrutiny by stock market participants, SEBI & ROC facilitates
efficiency improvement and proper strategic decisions.
 PE helps those companies which cannot raise money from the market. By private
equity company get money from the investors, which help in the growth of the company.
1.7 Disadvantages of Private Equity
Disadvantages for Investors:
 Difficult to access for small & medium investors- private equity Limited
Partnership funds may only be marketed to institutions and very wealthy
individuals; in addition the minimum investment accepted is usually more than
£1mn.
 Relative illiquidity –Private Equity funds normally invest in a unlisted space
 and they find it difficult to exit the investment at their wish, since it require
concentrated efforts to find a suitable investor for unlisted company. Even in the
listed space, the impact cost remains very high due to sheer magnitude of scale.
 A long term investment perspective is necessary to achieve gains for a private
equity investment programme because the investment programme depends on
the company growth. It depends on the gap between entry and exit of the
investor.
 Political condition - India, being divided into a number of states, causes an
investment decision to be affected by politics. Changes in regulation and
infrastructure development are often sidelined due to friction and conflict
between the state and the federal government.
 Competition from China - China is a direct competitor of India and most of the
private equity investors, eyeing the Asian region, draw a comparison across both
the countries to decide where their money should be parked. The new state-ofthe-
art airports in China bear a stark contrast to the abysmal conditions of the
terminals in India’s main cities.
 High costs - private equity managers charge relatively high fees for managing
capital committed by external investors (generally around 2%) and, if the fund
performs well, take a sizeable proportion (generally 20%) of realised returns in
excess of investment hurdle rates.
Disadvantages for Company:
 It is a lengthy process since private equity managers conduct detailed market,
financial, legal, environmental and management due diligence, which could take
several months before they make final decisions on investing.
 Entrepreneurs have to give up some of their company’s shares to a private equity
investor, i.e. control. Because investor have some control over the company, so it
is not easy for the entrepreneur to take decision independently. He have to take
advice of the investor to take decision and it causes delay in the process.
 The private equity managers have control over the timing of a sale of (a part of)
the business.
 Lack of promotion in investment across sectors - PE funds are
being channelized into only a few sectors like IT, infrastructure & real estate and
telecommunications, to the exclusion of the remaining industries, desperately in
need of funds for growth.
1.8 Ways of Investment
There are two types of listed private equity investment companies - those which invest
directly in companies and those that invest in funds which invest in companies (fund of
funds). Some private equity investment companies invest in both direct investments
and funds offering a hybrid of the two approaches set out below.
Direct investors
The investment company has a private equity team who invest directly in companies,
subject to the stated objective of the company. The managers’ aim is to help these
companies develop and progress, and sometimes restructure, in order to increase the
long-term value of the companies so these companies can be sold at a profit.
Fund of funds investors
In a fund of funds, the investment company invests in a portfolio of private equity
funds which invest in companies. Funds of funds aim to diversify across a range of
investment strategies and different sectors providing access to a range of managers.
1.9 Top 10 Private Equity Deals
• The top 10 private equity deals accounted for more than 36% of total private
equity deals in 2009. In 2008, top 10 deals accounted for about 40% of total deal
value for the year
• The largest deal by value was KKR’s $255 mn buyout of Aricent, followed by
Siva Ventures investment in S Tel Ltd. and TPG’s $200 mn investment in
Indiabulls Real Estate.
• Top deals occurred across various sectors, with 3 of the top 10 deals in Real
Estate.
Top Private Equity deals in 2009
S. NO. Industry Target Buyer Price
($mn)
1. IT/IT Services Aricent Inc. Kohlberg Kravis Roberts & Co. 255
2. Telecom S Tel Ltd. Siva Ventures Ltd. 230
3. Real Estate Indiabulls Real TPG Capital Inc. 200
Estate Ltd.
4. Logistics Krishnapatnam 3iIndia Infrastructure Fund 161
Port Co. Ltd.
5. Real Estate Mohtisham Oman Investment Fund 125
Estates
6. Agriculture Karuturi Emerging India Focus Funds, 124
Global India Focus Cardinal Fund,
Ltd. Elara
 India Opportunities Fund,
Monsoon India Inflection Fund
Ltd.
7. Hospitality & Capricon New Silk Route Partners 124
Travel Hospitality
Services
Pvt. Ltd.
8. Healthcare & Max India Goldman Sachs 115
Services
9. Real Estate Century Real Goldman Sachs Whitehall Real 104
Estate, Seven Estate Fund
Star
Hotel Project
10. Energy Ind-Barath Bessemer Venture Partners 100
Power India,
Infra Pvt. Ltd. Citi Venture Capital
International,
Sequoia Capital India

1.10 Ways of Exit

There are different ways in which a private equity investor can exit from an investment:
A. Trade sale
A trade sale, also referred to as M&A (Mergers & Acquisitions), of privately held
company equity is the most popular type of exit strategy and refers to the sale of
company shares to industrial investors.
The trade sale is agreed in private and makes both the buyer and the seller less
vulnerable to the external pressures of a stock market flotation. It is often advisable to
keep the transaction a closely guarded secret because clients, suppliers and employees
may interpret a trade sale negatively. These negative signals become even stronger if
the negotiations fail.
B. Entrepreneur or Management Buy-Out
The Buy-Out of the funds stake by its management team is becoming more and more
successful as an exit strategy. It is a very attractive exit for both the investment manager
and the company’s management team if the company can guarantee regular cash flows
and can mobilize sufficient loans. The accounting and financial aspects of this exit need
to be studied very carefully.
C. Sale of the investment to another financial purchaser (called a
secondary market investor)
One financial investor may sell his equity stake to another one when the company has
reached the stage of development or when the current development of the company no
longer corresponds to the investment criteria of the original fund. This can also occur if
the financial support required maintaining the company’s development has exceeded
the capacity of the fund. This strategy has the advantage of enabling an exit when the
team does not want a trade sale or a stock market flotation.
D. IPO (Initial Public Offering): flotation on a public stock market
A stock market flotation may be the most spectacular exit, but it is far from being the
most widely used, even in stock market booms.
A stock market flotation should correspond with a genuine wish to make the company
more dynamic over the long term and to profit from the growth possibilities offered by
a stock market. Therefore, the equity share placed on the market (the float) must be
sufficiently large to ensure liquidity – the reward for appealing to the market. A
flotation is not an end in itself but the beginning of a long process of development.
A stock market flotation always leaves company open to the risk of an unwanted bid
whereas equity held by an investor that company has chosen can be better managed. If
company decides to opt for this route, it must be minutely prepared over a long period.
E. Liquidation
This is obviously the least favorable option and occurs when the efforts of the head of
the company and the investors to save the company have not succeeded.