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What is Private Equity?
In general, Private equity is a form of equity investment into private companies that are not quoted on any stock exchange. That's what "private" means in "private equity": privately owned and traded stakes in companies that are not subject to public market scrutiny. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from high net worth individuals and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen the balance sheet.
What are PE funds?
The money raised by private equity firms are called private equity funds. It is a collective investment scheme used for making investments in various companies according to one of the investment strategies associated with private equity firm.
Typically, a single PE firm will manage a series of distinct private equity funds and will attempt to raise a new fund every 3 to 5 years as the previous fund is fully invested. A PE fund typically makes investments in companies, known as portfolio companies.
Structure of international PE funds
Most international private equity funds are structured as limited partnerships and are governed by the terms set forth in the limited partnership agreement or LPA.
A private equity fund is raised and managed by investment professionals of a specific private equity firm, known as General Partner (GP). These professionals with their managerial skills and experience may also serve as board members of invested companies with significant involvement in devising and executing the company's strategic plan, with a focus on improving the company's financial performance
Usually, GPs typically get paid 1-2% of the committed capital of the fund as management fees. A share of the profits of the fund's investments, typically up to 20%, known as carried interest, is paid to GPs as a performance incentive. The remaining 80% of the profits are paid to the fund's investors. Before the GPs can receive any carried interest payment, they must achieve a minimum rate of return, termed as hurdle rate (e.g. 8-12%).
Features of PE Funds
PE Funds offers investors another investment option or avenue to their portfolio. Since PE funds participate in the growth of a company before it makes a public offering, there is high potential to make outsized gains, if the company meets the growth aspirations and has a successful IPO. In recent times, private equity investors who were early stage investors in popular businesses such as Facebook and Twitter, made substantial gains when these giants eventually went public for the first time.
Once invested, liquidity of invested funds may be very difficult to achieve before the manager realizes the investments in the portfolio because an investor's capital may be locked-up in long-term investments for as long as six to twelve years. Such investments are viewed as illiquid and non-transparent. Also the risk of complete loss of investment is higher, as often investments are made in businesses that have not yet fully established their models in the market place. Thus, investors expect higher returns as compensation for the risk and illiquidity embedded in such investments. Because there is no continuous trading of the investments within a PE fund, there is difficulty in determining the current market value of such investment in the investor's portfolio. Another drawback for an investor is that the committed capital is typically drawn down in 4 to 5 tranches, which makes the investor's cash flow planning more complex.
Despite these drawbacks, the belief that a few bets will pay off in a big way, is what makes investors invest in PE funds.
Types of PE funds
PE includes variety of fund types. The differences between fund types relates primarily to (a) the stage of the company the fund invests in (early vs. late stage) and (b) the methods used to finance the investment.
A. Venture Capital (VCF) - These are funds that invest in entrepreneurial start-ups that have just the germ of a business idea. Investors, often called "angels" provide seed money for such start-ups. Private equity is invested into young, entrepreneur-led, high-potential companies that are typically driven by technological innovation. These investors hope to sell the company once it becomes profitable. They often provide expertise, direction and contacts to get the company off the ground.
B. Buyout Funds - These are funds focused on acquiring all or the majority of an established and matured business.
Leveraged buyout (LBO) refers to the purchase of all or most of a company or a business unit by using equity from a small group of investors in combination with a significant amount of debt. The targets of LBOs are typically mature companies that generate strong operating cash flow.
C. Growth Capital Funds - These are funds that invest in minority in mature companies that need capital to expand or restructure operations, finance an acquisition or enter a new market, without a change of control of the company.
D. Mezzanine Capital Fund - These are funds that invest in subordinated debt or preferred stock of a company, without taking voting control of the company. Often these securities have attached warrants or conversion rights into common stock.
E. Distress Funds - These funds focus on turnarounds of companies in trouble. Such funds are most risky to invest in. These funds acquire established companies under severe financial strains, with the aim of reviving their fortunes.
F. Fund of Funds - Invests in other private equity funds.
Take Private - If all of a public company is bought, it results in a delisting of that company on the stock exchange. It's done to either rescue a company whose stock prices are falling, giving it time to try growth strategies that the stock market may not like.
Exit Strategies - Private equity investors hope to beat the market in the long run by selling their ownership at a great profit either through an IPO (Initial Public Offering) or to a large public company or by merger with another company.
PE in India
The Indian private equity scenario has undergone a change over the last five years or so. There has been a considerable interest, both domestic as well as international, in the private equity sector which is evident from the fact that the total PE funds (more commonly understood in the Indian context as venture capital funds (VCF)) committed to investments in India has increased exponentially.
In India till 2012, both domestic and offshore VC investing was regulated by the Securities and Exchange Board of India (SEBI) under The SEBI (Venture Capital Funds) Regulations, 1996.
With a view to extending the perimeter of regulation to unregulated funds, on May 21, 2012, SEBI framed the SEBI (Alternative Investment Funds) Regulations, 2012 ('AIF Regulations'). It replaced the VCF Regulations.
Alternative Investment Funds (AIFs) are a newly created class of pooled-in investment vehicles for real estate, private equity and hedge funds. AIFs are basically funds established or incorporated in India for the purpose of pooling in capital from Indian and foreign investors for investing as per a pre-decided policy.
The categories of AIFs are mentioned below:
The Category I AIFs - Those funds that get incentives from the government, SEBI or other regulators and include Social Venture Funds, Infrastructure Funds, Venture Capital Funds and SME Funds.
The Category II AIFs - Those funds that invest anywhere, in any combination, but are prohibited from raising debt, except for meeting their day-to-day operational requirements. These AIFs include PE funds, debt funds or fund of funds, as also all others falling outside the ambit of two other categories.
The Category III AIFs - Those funds trading with a view to make short-term returns and it includes hedge funds.
The AIF Regulations have drastically increased the minimum fund size from Rs. 5 crores to Rs. 20 crores, and the minimum amount that can be accepted from an investor from Rs. 5 lakh to Rs.1 crore.
Several financial services organizations including Reliance, Birla Sun Life, ICICI, Kotak etc have been raising significant amounts of money from Indian HNIs in PE funds. Most of these follow the 2-20 approach : 2% management fee on committed capital and 20% of profits above a hurdle rate of return.
Taxation of PE funds in India
As per the Income Tax Act, 1961 any income earned by a SEBI registered VCF is exempt from tax. IT Act gives SEBI registered Fund a pass-through status whereby the investors in the Fund are directly taxed on any income distributed by the Fund. The tax treatment of the income that is subject to "pass through" status will depend on the nature of the income. Dividend income is tax free in the hands of shareholders, but is subject to a dividend distribution tax payable by the company distributing the dividend. Capital gains tax is charged on the sale of shares of the portfolio companies. Shares held for 12 months or more are subject to long-term capital gains tax.
Long-term capital gains tax is chargeable at the rate of 20% in case of a gain on transfer of shares. Short-term capital gains on sale of shares is chargeable to tax depending on the type of assessee, i.e., for individuals, the rate varies between 10% to 30% and for corporate bodies, the rate is 30% for domestic companies and 40% for foreign companies.
The above rates are further subject to a surcharge at the rate of 10% for residents and 2.5% for foreign bodies, and an education cess of 3%.
The experience so far
Most of the money that has been raised from domestic HNIs in the last few years is invested in funds that have yet to complete their stated tenors. It therefore remains to be seen as to how the investor experience actually turns out. However, challenging market conditions in the last few years and poor conditions for IPOs has made exits very tough for private equity players. The risks are being experienced - hopefully, with better market conditions and healthy exits, the returns too will be experienced by PE investors.
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