Private equity funds

Returns from equities and bonds suffer when inflation surges. Upswings in commodity prices raise the cost of materials, curb corporate profits and push inflations and bond yields higher.

However high inflation can provide opportunities for those with sales exposure to high growth sectors in emerging markets such as infrastructure and consumer goods, those in regulated sectors that let revenues increase in line with inflation and those with links in real assets like hard and soft commodities precious metals oil and gas and real state.

Quality companies with moderately high levels of debt and strong cash flows and interest cover are likely to benefit from an inflationary environment. During periods of high inflation, the value of outstanding debt is eroded if there are sufficient cash flows to support the debt structure, such companies can efficiently use capital for investments.

Performance linked pay or target variable pay does not seem to be the favorite tool of employers only to reward their staff. The concept has also gained prominence in private equity (PE) deal making.

Private equity finds have done away with pure direct investment deals and largely prefer to structure their deals linked to a milestone achieved by the company in which they invest. The reason being the dynamic and wobbly market environment has made the investor community adopt cautious approach towards investment.

The June-September quarter saw a dip in PE deals ($3 billion in 116 companies) as compared to the same period last year ($4.2 billion in 115 companies) according to Venture Intelligence. The financial crisis gripping the world, slow economic growth and weak investor confidence are making many PE funds sit on cash as against making commitments. And the ones that are ready to commit are ensuring that the investee firm performs and are incorporating security clauses akin to prenuptial arrangements that will ensure a downside protection if things go bad.

It is a win-win situation for both the parties. Gone are the days of pure direct investment in the current market environment, PE investors are cagey in making investments and closing a deal has become an enormous task. The criteria had moved towards certain parameters or performances being met by the investee firms so that the fund could get a return on its investment.

Take the case of AIG. Last week, the insurer’s real estate fund worked out a structured deal for an investment of Rs 300 crore in a SEZ project being developed by the Velankani group, in Sriperumbudur, 50 km from Chennai. The clause is linked to Velankani completing the project on time as well as ensuring the rentals. If the Bangalore based developer fails to meet the target, it will have to take a cut in the profit share.

Tables have turned, say I-Bankers, with PE investors being in a much stronger position as compared to the past and are calling the shots. Structured deals are based on two parameters – earning a specified return on investment and a smooth exit at a certain price. So, there are convertible instruments, which many funds prefer to redeem at a preset rate, rather than converting them into equity in a difficult environment.

Then, there is ratchet where a fund can increase or decrease its sake based on the performance or non achievement of goals.

DE Shaw’s investment of Rs 600 crore in International Amusement, promoter of Appu Ghar amusement park, has been a structured deal that is linked to an assured rate of return as well as the firm achieving a certain valuation. Similarly has been the case when Goldman Sachs, Deutsche Bank and Merill Lynch invested in IRB Infrastructure Developers.

On the current PE scenario, though valuation in public markets have corrected significantly; promoters’ expectations have not dropped in line with this. So, there is a lag between private and public market.