Private equity funds - Hedging the capital market?

Business Line, April 5, 2007 R.VAIDYANATHAN The future will see a capital market in which companies will be listed and not shares. Private equity funds and hedge funds will compete to buy companies at the market-quoted prices and then re-distribute it as portfolios to reduce the risks, says R.VAIDYANATHAN.

The phenomenal growth of private equity and hedge funds has generated awe and fear in the global capital markets. Financial journals call it the barbarians at the gate. Trade unions in England and mainland Europe are totally opposed to them. They are perceived as job destroyers, since in the context of restructuring the units financed by them many jobs are lost. There are demands by some politicians and union leaders that the interest paid by these entities should not be subject to tax deductions as they are highly leveraged. The increasing power of these institutions is well-documented. The recent acquisition of TXU Corporation, the US energy group, for $45 billion by Kohlberg Kravis Roberts & Co (KKR) and Texas Pacific group, is evidence of the increasing clout of private equity funds. There are more than 8,000 hedge funds and their combined assets under management exceed $2 trillion. According to recent reports, more than 350 hedge funds manage around $1 billion each. Interestingly, one of the large private equity firms, Blackstone, is planning a listing in the US. Love-hate relationship The private market has leapfrogged compared to the traditional listed public markets and this has given a new lease of life to institutions that are merely financiers. These private equity funds are significantly different from traditional banks insofar as financing modes are concerned. Their monitoring mechanism is continuous. Executives in these funds spend upwards of 50 hours a week on the companies they finance and extract the maximum by way of results. The funds do not hesitate to change CEOs if they think that results are not forthcoming. That probably explains the love-hate relationship between the corporate chiefs and the hedge funds. In a sense, these private equity funds have injected a significant amount of professionalism in running companies and there is no sentimentality or family consideration. A report by Thompson Financial (in

Financial Times London March 8, 2007) suggests that the net returns of the funds outperformed the S&P 500 19 per cent to 9.7 per cent for the 12 months to last September and 14 per cent to 9.7 per cent for the last 20 years. In other words, the two decades of performance makes the funds attractive for investors. There are two types of criticism of private equity funds. One relates to their `private' nature and that thry are not under public regulations such as the Sarbanes-Oxley Act or the SEBI Act. As the providers of the funds are satisfied with the performance of these funds, the criticism of not being public cannot be a major one. The boards of public institutions private or public sector may not have the relevant business expertise or experience. These funds choose board members based on their ability to increase topline and profits. Interestingly, many funds have shown innovation even though they are accused of not looking beyond two/three years. In the case of hedge funds, the strategy in the 1990s known as macro strategy involved looking at the macro picture and focussing on groups of metals or commodities or stocks and trying to maximise gains by hedging or arbitrage. More than two-thirds of the assets came under this strategy. But in the recent past an equitydriven strategy is being adopted, under which fall more than a third of the assets. Here, again, the focus is on superior returns by squeezing the last drop of the corporate lemon. This involves ruthless cost-cutting and unsentimental appraisal of projects and extraordinary compensation to senior executives who are in fear of losing their jobs at any time. Does Listing Really Help The traditional model adopted from the latter part of the 19th century suggests that corporates generate funds from millions of shareholders and the exchanges and regulators protect their interests and the corporates maximise the wealth of the shareholders. This scheme of things on paper unfortunately does not get translated wholly in the real world. A large number of shareholders are owners only on paper and the controlling group is usually able to appoint directors including the "independent". Very rarely is a CEO thrown out for nonperformance. Most ordinary shareholders do not understand the technological complexity of modern business. The accountability is more in terms of filling up hundreds of forms as mandated by the exchanges or the regulators and, yet, neither can question the CEO for getting lesser returns. The `shareholder' model In other words, the so-called "shareholders-as-owners" model has flaws and these are addressed by the private equity funds. For every paisa given by private equity funds, the CEO is made to sweat and show concrete results, in terms of margins, profits, etc. These are monitored on a daily/weekly basis. Ordinary shareholders cannot even ask such questions.

The other issue is regarding the usefulness of the "listed shareholder" model in contemporary times. The nature of private equity funds/MFs/hedge funds/pension funds, is such that they are much better buying and selling companies than shares. The earlier model was aggregating small amounts from individuals. The current model is large funds monitoring the performance of corporates. It is no more an issue of small drops made available to corporate CEOs. It is the availability of large funds demanding the last drop of results from them. Even in the Indian market, private placement plays a much larger role then the public market. In 2005-2006, of the total domestic resources raised Rs 1,23,750 crore more than Rs 96,000 crore (nearly 80 per cent) came from private placements. Of course, a chunk of it is was in the form of debt (see Table). This shows that, even in the Indian situation, the role of the private market is large, though the private placement route would be mainly through government or government-related institutions, such as banks or insurance giants. Also, the institutions that provide funds do not extract the maximum. The cosy relationship between the institutions and the corporates is a bane of the Indian economic system; rarely has a CEO been pulled up for non-performance. The traditional way was for companies to access funds from institutions which would conduct due diligence before lending. But the focus was on protection of interest and principal. Then came the mass market, individual investor, exchanges and regulators which perhaps increased the transaction cost. Now, the lender/investor is not just interested in protecting his interest and principal, but in enhancing returns and removing the slack in the organisations. He is a lender and a tough task-master. Future Possibilities The future will see a capital market in which companies will be listed and not shares. Private equity funds and hedge funds will compete to buy companies at the market-quoted prices. The prices will fluctuate depending on the company's future prospects. In other words, funds will buy into the full value of the company not just the equity or the debt value and then re-distribute it as portfolios to reduce the risks. The other category that will be listed will be individuals with special skills sportspersons, film actors and professionals such as heart surgeons or tax lawyers. Individuals will be promoted on the spot and the futures markets based on their future potential. The life of such listing may be limited to the active professional life of the categories such as sportspersons or film personalities. Also, specialised executives will be listed on cross-country basis since selecting and retaining competent executives is a big challenge. The individuals may be `owned' by an entity, which may lease him or her for few years at a price.

Challenging times are ahead for capital markets and regulators. But, unfortunately, we seem to be debating 19th century issues in 20th century idioms. Perhaps, we are not adequately prepared for the barbarians at the gate! (The author is Professor of Finance and Control, Indian Institute of Management Bangalore, and can be contacted at vaidya@iimb.ernet.in. The views are personal and not those of his organisation.) (This article was published in the Business Line print edition dated April 5, 2007)