Sri Lanka’s Private Equity Market Story
Private Equity (PE) can be generally defined as making an investment in a company, usually a private company, with the aim of holding for a medium term period and with the aim of earning a return by way of dividends or capital gains.
More specifically private equity is an asset class consisting of equity securities and debt in operating companies that are not publicly traded on a stock exchange.
A private equity investment will generally be made by a private equity firm, a venture capital firm or an angel investor. Each of these investor categories has its own set of goals, preferences and investment strategies; however, all provide working capital to a target company to nurture expansion, new-product development, or restructuring of the company’s operations, management, or ownership.
PE is not a very old concept. It started gaining popularity around the globe during the past 10-20 years.
Private equity ownership has a number of important advantages that allow to create value and realise capital gain in a repeatable fashion.
Not very popular in Sri Lanka
However PE has not picked up well in Sri Lanka for various reasons, and this is mainly because of the lack of awareness that has been created in the local market and also because Sri Lanka has not been properly projected in the international PE landscape.
South Asia focused Sri Lankan PE firm Jupiter Capital Partners, recently organized a seminar for the purpose of creating awareness amongst the local stakeholders with regard to PE, its process, important elements, the risks involved, legal aspects etc.
Important elements for PE transaction
Jupiter Capital Managing Director (MD), Indika Hettiarachchi speaking on the topic “PE investments: Concept and Requirements”, stated that there are four main elements that need to be looked at when considering a PE funding requirement.
“These are not text book stuff but things we have realized by doing several deals,” he added. The first element according to him is to have a business with an operational history.
“Typically PE investors do not fund startup companies. Therefore when we receive a proposal, we expect a track record of at least a couple of years,” Hettiarachchi said adding that the promoters should have some experience in the company over a few years.
The business also should have shown some decent growth and it should be a well-managed company with a sustainable business.
He further stated that the company needs to have a very good business plan and this is the second element. It needs to have a solid growth plan either organically or inorganically. “One of the things that we notice in most business plans is the non existence of a high growth plan. Most of them just want 10-15 percent growth. This is not enough for PE and if that’s the rate of growth you’re looking at you can get bank funding, you don’t
Being a smaller market and coming under the South Asian region, is a big disadvantage to the country
need PE,” he said.
Also speaking about the alignment of interests, which is the third element, Hettiarachchi emphasized that this was the most important element.“When we invest in a company we look at the track record of the promoters and shareholders and in that evaluation one main thing that we look at is the alignment of interests,” he noted.
This means the interests of the promoters and the investors should be aligned for the deal to work. There are so many aspects to this and alignment can come in so many forms and shapes. For an example, he cited the shareholding structure of a business where promoters have a significantly low shareholding and investors a proportionately high shareholding and explained that its a case for misalignment of interests.
“Because when promoters have a smaller shareholding they are not getting any benefit from the fast growing business and that would not motivate him to do his best. At the same time he doesn’t have much to lose since he anyway has a smaller stake,” he explained.
Citing a further example for alignment of interest, the MD spoke of funding a newly formed subsidiary of a listed hotel group.If a large hotel group with so many hotels comes with a proposal for a new hotel, even though they sell their track record, brand name etc, they want the investor to invest in a new subsidiary.
He pointed out that it is not attractive to them because the value is in the main holding company. The final element according to Hettiarachchi is the promoter’s intention and plan to increase and realize wealth.
He stated that one weakness he sees in Sri Lankan entrepreneurs is that they don’t often think in terms of creating wealth. They mostly focus on running the business and making profits but they don’t translate that in to wealth creation.
“For example we can say Bill Gates is worth $70 billion, it’s not the money he earned running the business but the value he created for himself by making good businesses,” he said.
When an entrepreneur speaks in terms of creating a Rs.10 billion worth business in 10 years that would be a proposal that interests PE firms since there is a return for them as well.For example a small startup BPO company may approach a PE firm with a plan to sell the business after reaching a particular capacity and that would attract the PE firm more since they know that he has a motivation to cash in his efforts after someyears.
“This is important because then when we invest we can also accordingly plan and time our own exit while fitting our plan with his,” he said.
He further observed that most private companies do not keep proper and accurate books. They sometimes underreport their revenue and profits while often overcharging expenses. But when an entrepreneur is interested in realizing wealth this can change.Because if the entrepreneur wants to go for an IPO, say in 5 years, he knows that the price he’s going to get at the IPO will depend on his books and the profits he records in his accounts. Therefore he knows that he has to show good results and he will not underreport revenue and profits. Not only that, he will try to manage costs as well. This will also solve a lot of problems for investors and give them confidence to invest in that company.
Quantification leads to justification
Meanwhile Financial Consultant and former LR Global partner, Chanaka Wickramasuriya addressing the gathering on the investment process cycle of a
The risks and benefits should have been assessed by the promoter before coming to a PE investor. This is very important from an investor’s perspective
typical institutional PE house stated that entrepreneurs are very intuitive creatures and they operate on their gut and feel.
“It’s a strong form of rationale but they have not quantified it and it takes place in their head and they operate on this holistic intuitive basis,” he said.
However Wickramasuriya noted that unfortunately PE houses are not intuitive but was also quick to add that it’s not that the individuals in those organizations are not intuitive but the organizational structure and the way they work is not intuitive but very structured and formal.“As an entrepreneur, you need to be able to quantify your intuitiveness. For example you need to articulate why you think your product and the market is going to grow and substantiate these things with quantifiable, tangible facts and figures,” he noted.
Those are in turn the things that the operating partner can take back to his investment committee to sell and not the intuitiveness of an entrepreneur. It will be a good exercise for the entrepreneur as well.
“When you articulate things like your competitive positioning, think of it in those terms and strongly articulate it,” Wickramasuriya said adding that quantification leads to justification or it at least supports justification.
Why you need the money?
According to him, the first question a promoter needs to ask himself is, should he get debt or equity? If he decides on equity then what is the purpose?
“This means you should have gone through the mechanics and the quantification of that decision. The question is why should you be getting equity, where arguably you don’t have to make any recurrent cash outflows like in debt, but you will have to part with part of your shareholding,” he noted.
As opposed to having got debt where you pay a certain interest and the principle amount but at the end of that the entire shareholding is still yours.
Accordingly the risks and benefits should have been assessed by the promoter before coming to a PE investor. This is very important from an investor’s perspective and it immediately aligns their interests together since the promoters know for sure that they want equity.
Why PE as opposed to public equity?
Wickramasuriya stated that the reason people go for PE is in situations where the business expansion is not generating enough cash flow for it to pay off its debts and also the business expansion is not generating enough profit or dividend to go public either.
“You need equity capital and you need equity capital that is going to take a while to start generating profit and that’s what PE investors are looking for since that’s the space or gap they fill,” he said.
Need to position in global PE market
Meanwhile speaking on the sidelines of the seminar, Hettiarachchi pointed out that for PE to operate funds are needed and Sri Lanka doesn’t get much funds. “This is because we are not being featured in the global PE market,” he said. He further stated that being a smaller market and coming under the South Asian region, is a big disadvantage to the country.
“When money is given for the South Asian region, most of it is absorbed by larger markets like India but no body from Sri Lanka goes and makes a case in the market,” Hettiarachchi noted.
According to him, Jupiter Capital is currently striving to create a name for Sri Lanka in the PE market.