Need funds? Consider tapping private equity

Danny Lizares

Private equity (PE) is not just a source of capital but is also a catalyst for growth and expansion.

While owners of businesses can tap the debt markets (where bank loans are currently low and long-term financing readily available), owners who need some form of “hand-holding” can look more towards PE institutions where the alignment of interests plays a critical role in enhancing shareholder value and attaining a vision.

Danny Lizares, country head of international PE firm Abraaj, answers questions about funding growth companies.

QUESTION: Why is private equity (PE) better than getting bank loans, crowd sourcing or getting friends/relatives as partners?

ANSWER: PE has its strengths and drawbacks and, ultimately, it is up to the sponsors/owners of the business to assess whether they see a fit with an outside party investor and their overall strategy and funding requirement.

If the sponsor is simply looking for low-cost credit, then a bank loan will do as a PE fund provider (or any other equity investor) provides high cost of money that is much more than a bank debt.

On the other hand, if the entrepreneur is looking over and above financing cost such as value add in terms of strategic direction and insights, promotion of ESG principles (environment, safety, governance), adoption of best practices, development of KPI (key performance indicators), tapping the funders’ regional or global network and resources, leveraging on those connections, among other value enhancing strategies, then a PE fund would be the logical choice.

Moreover, a PE investor would normally require board representation and representation to key committees of the company. Usually, the PE takes on a pro-active role in the company by contributing in terms of growth strategies but not in day-to-day management. The purpose of all these initiatives is ultimately to enhance shareholder value.

Q: What is the ideal company you look for when investing?

A: A PE fund, in contrast to a venture capital fund (VCF), will only invest in companies with a proven track record and is looking for growth capital to expand an already operating and flourishing business.

Whether the business is sustainable in the coming years, a thorough discussion and evaluation must be made by the potential investor, the owners, and the management team.

The VC fund, on the other hand, is usually a focused or dedicated group that targets specific sectors or industries, and employs sector specialists. It is prepared to invest even on a start-up basis and, as you would expect, requires higher returns for the higher risks they take.

Q: What arrangement will make PEs comfortable in terms of percent ownership, board representation and veto power, and exit timetable?

A: Equity investors will require certain minority rights, and different investors have different requirements.

As a baseline, investors will require board representation (although some may not or may not qualify given their equity stake) clear use of proceeds, and minority consent on matters involving the sale and purchase of assets. Other common minority shareholder rights are tag-along rights, anti-dilution rights, and remedies in the event of a breach or default.

Nurturing companies and helping their owners create value takes time and, as such, we take a long term view in making investments, and five years on the average is sufficient for the type of sectors we invest in.

But the most critical aspect that PE investors look for in assessing a company is, whether there is an alignment of interests with the founder or major shareholder. No matter how good a business is, if there is no alignment of interests with the sponsor, then there is no point in making the investment.

Q: When your group exited a chain of restaurants in 2014, your internal rate of return (IRR) for 8 years was much more than putting your money in the bank. But you made much more in a hospital. What factors do you consider as attractive for each industry? What is the usual premium ceiling you are willing to pay to protect your IRR?

A: The risk a PE is exposed to should be compensated by the return it expects.

Certain businesses may be cyclical than others, and the owner or management team has no control of external variables. Other businesses flourish regardless of global conditions.

Export-oriented businesses are cyclical, and one has to take a view of the business and where it’s at in the cycle. Businesses like food retail, healthcare, education and logistics, tend to be robust and are unaffected by global conditions.

Risks can be further mitigated if the company has a profitable track record, strong brand equity, manageable debts, alignment of interests with the owner, a professional management team and, beyond these, a credible growth strategy.

In terms of returns to the fund, we look more at cash multiples (the absolute amount of money) that is generated by the investment more than the IRR. The returns are highly influenced by your entry and exit price, the cash flows the investor receives in the interim, which is a function of the overall health of the business.

It goes without saying that, as shareholder value is built up over time, both the owners, investors, management teams, and other stakeholders benefit.

Q: Instead of straight equity infusion, when do private equity invest in companies by way of convertible loan notes, where the PE has the right to convert loan to equity at predetermined prices?

A: Different funds have different approaches. It’s a common practice by PE funds to invest in quasi-equity instruments like convertible notes or preference shares while investing in common shares or a combination of all these.

Each type of instrument has a different impact on the balance sheet. A convertible note may be booked as a liability while preference shares will be booked under capital accounts.

A PE evaluates the balance sheet of the company to be able to structure the right instrument, taking into account minority rights and the risk profile of the business in the event it does not go well, or even from a bankability point of view.

Q: PEs impose a “put” option when the key result areas (KRAs) agreed with owners are not met for consecutive years. When is this option really exercised?

A: A “put” is an exit measure that is usually the last option. Only after a careful deliberation and study on why targets fell below budgets, and having exhausted remedies would the PE consider invoking the put option.

Prior to that, an investor will sit with the owner and the team to discuss corrective action plans, defining the action, assigning accountability and setting a time frame.

The corrective action plan may include hiring the right person for the job. If, despite these measures having been set, the KRAs still lag behind and there appears to be neither solution nor willingness on the part of the owners and/or management team to implement the measures, a fund could then resort to the put.

Violations of the terms of investment agreement could also trigger an early put.

Q: For companies expanding, how much investment can you offer? How long does due diligence take and what do you look for in due diligence?

A: The fund I work for will look at investments were there is a need of $15 million or more. In the event the business opportunities require much more, we can explore co-investment, or a separate fund also operated by us could be tapped to provide that particular funding need.

From the time a term sheet or letter of interest is signed, from my experience, it would take about 3 months to disburse the funding requirement.

In terms of due diligence, these would fall generally under three categories: legal, commercial, and financial. Depending on the complexity of the business, other types of consultants or industry or technical experts may be brought into the due diligence.

Q: Can you share with us your personal highs and lows in the course of your investments, or lessons learned in private equity?

A: I have always found the practice of private equity a fruitful and fulfilling experience. I say this because, once an investment is made, the real work begins.

PE requires a long term commitment on the part of the investor and owners and the management in driving the business towards a common goal.

As investors, we do not purport to know more than the owners who built the business. But given our knowledge and investment experience in similar businesses, we can share various insights to help enhance the companies we invest in.

As I mentioned earlier, our investments and track record has been very encouraging. The companies that have adopted best practices, good governance and ESG principles—recognizing investors as genuine partners—have grown substantially throughout our investment holding period, and their values have been validated in the public markets or by third party investors. This is the part that makes PE rewarding.

On the other hand, I have seen companies that have resisted change, adopting best practices and governance. Owners who value loyalty over ability tend to lag behind in our overall investment portfolio, and within their peer groups or industry. It is frustrating.

(Josiah Go is chair of marketing training firm Mansmith and Fielders Inc. and Day 8 Business Academy for SMEs. For the complete interview, as well as interviews with other thought leaders, please log on to www.josiahgo.com)