Private Equity

Hemchand J

Private Placement
Private placement can be made both by companies that have already gone public in the past and by those that have not. Private placement is the act of placing a new issue of shares with a group of selected financial institutions. Though the intention of private placement is fund raising, they are sometimes made to accommodate certain strategic objectives.

Private Equity and Investment Banking

Over the years, private equity has thrived for investment banks as a major service area in helping companies raise equity capital privately. Private placement market for equity is large. Venture capital and Private Equity funds are two popular types of institutional equity investments, there are other investors such as Mutual Funds, FIIs, banks and insurance companies, most of whom are collectively known as Qualified Institutional buyers (QIBs).

Private Placements
Private placements are mostly organized by investment banks acting as arrangers. Companies also issue equity capital to their promoter groups, working directors, employees and group companies. Such allotments also amount to private placements. But they do not concern investment bankers. In the context of private equity, it would be to bring in external investors such as a QIB, strategic partner or a joint venture investor.

Venture Capital
Venture capital is rightly called as financing of innovation. It is the financing of start up businesses with a view to grow them into large commercially successful business. It is defined as capital for investment which may easily be lost in risky projects, but can also provide high returns; also called risk capital.

Venture Capital
The term start up typically refers to the early stage in the life of a company that has been formed to set up a technology backed business venture or a technology development venture with an intention to commercialise the same. Venture capital involves significant risk taking on the part of the venture capitalist since young businesses are subject to high rates of mortality.

PIPE
Private Investment in Public Equity occurs when private investors take a sizeable investment in publicly traded corporations. This usually occurs when equity valuations have fallen and the company is looking for new sources of capital. When private equity is infused into a listed company it could be classified as PIPE investment. Initially it was associated with the kind of last resort capital.

PIPE
Private: It is a private placement transaction between a limited group of investors and a listed company. Investment: It is a direct investment in a company. It involves purchase of securities in the primary market. Public: It is used by a listed company. Equity: It is an equity or equity linked investment.

Private Investment in Public Equity

Private Equity in unlisted companies applies to early stage and later stage unlisted companies. Usually when the company is in early stage, a debt convertible is structured so that it can be converted into equity as and when the company achieves pre set milestones. Other alternatives are preference capital or convertible preference shares.

PIPE placement
PIPE placement is identical to that for unlisted companies except that it is made by a listed company. Listed companies suffer from several constraints including regulatory restrictions. Qualified Institutional Placement (QIP) is exactly similar to PIPE except that it should be made only to QIBs. The issue should be only for pure equity or convertible instruments.

Valuation
Valuation methodologies for private equity deals can be broadly classified as follows: The transaction multiple approach which uses certain capitalization factors such as revenue or Profit after tax or Operating Profit (EBITDA) or a market multiple such as the PE ratio (in the case of listed companies) to arrive at present valuation of a company.

Discounted cash flow method

This method uses free cash flow approach and tries to arrive at the present value of a company based on estimated future cash flows discounted at the expected rate of return for equity investors. The method is appropriate for companies with a stabilized cash flow model. If this method is used, the multiplier method may then be used as a cross check to ensure that this method is not over optimistic.

Valuation vs. Pricing

For unlisted companies, raising capital , equity valuation arrived at is relevant and not the price per share. Price per share is not important until the company reaches IPO stage. The price per share varies based on issued capital at the pre issue stage. Price per share may not be a corrected indicator of value.

Valuation guidelines
As per Government guidelines the share price is calculated under two methods; the net asset value method and the Profit Earning Capacity Value (PECV) method and fair value is determined as follows: Fair value = (NAV + PECV)/2

The NAV method

The computation of NAV should be based on the latest available audited balance sheet. If there is a fresh issue of shares being contemplated either for cash or otherwise, the FACE VALUE of the fresh issue equity capital is added to the existing net worth in determining NAV.

The PECV method

The PECV (Profit Earning Capacity Value) will be calculated by capitalizing the average of the after tax profits (average 3 years) at the following rates: 15% in the case of manufacturing companies 20% in the case of trading companies. 17.5% in the case of intermediate companies, i.e companies whose turnover from trading activity is between 40% and 60% of total.

PECV method
If additional issue of shares is involved, the end use of the funds has to be considered to ascertain the generation of return on such capital. The return shall be computed as follows: Profits from fresh issue = (Fresh Capital * Existing PAT) /2 * Existing Networth.

PECV method
The above profits shall be added to the existing profit after tax and the total shall be divided by the expanded capital base to arrive at the future maintainable earnings per share. If the fresh capital is not proposed for any revenue generating activity, no return should be assumed there from. However, expanded capital base shall be considered for determination of earnings per share.

Illustration Based on Assets

From the Liability side Existing Equity capital Share Premium Free Reserves Total Less Misc.expenses Adjusted Net worth (in lacs) 1131.10 1235.19 3051.44 5417.73 10.96 5406.77

From the Asset Side

Fixed Assets 5701.21 Net Current Assets 5527.89 Capital Work In Progress 1266.25 Investments 151.00 Total Assets 12646.35 Less Debenture Redemption res. 0 Long Term Liabilities 7239.58 Adjusted Net worth 5406.77

Illustration
Face Value of Proposed Capital Proposed Net Worth Existing Shares No.of new shares Total no.of shares (Post issue) NAV Per share 507 5913.77 113.11 50.70 163.81 36.10

Based on Earnings
Operating profit for previous years PBT Weight Wt*PBT 212.25(2003-4) 1 212.25 543.78(2004-5) 2 1087.56 1397.40(2005-6)3 4192.20 Average profits 915.34 Tax at normal rate 274.60 Average PAT 640.73

Calculation of PECV
Average PAT 640.73 Contribution from fresh issue 30.04 Expected Future Profits 670.78 Total Shares post issue 163.81 EPS Post Tax 4.09 PECV at 8% capitalization 51.19 Fair value 36.10 + 51.19 average = 43.64 Less Dividend 2 = 41.64(As per CCI formula)