Indian Financial System 2

Various types of funds and their role in funding of an Enterprise & the investment options:

§  In the growth of an Enterprise the various stages of funding are classified as:

Ø  Early stage [seed stage]

Ø  Growth stage

Ø  Later stage

Ø  Sell out stage [ in good or bad condition]

§  The funding for these stages mainly are:

1. Promoters fund
2. Angel fund
3. Venture fund
4. Private equity fund
5. Vulture fund

Venture capital [VC]/ Private equity [PE] capital are used interchangeably and broadly mean and include all the above types/stages

§  As the enterprise grows further the funding needs are met by:

• PIPE [private investment in public equity]
• IPO [initial public offer of securities],FPO [follow-on public offer], Preferential allotment

§  In all the above 2 other funds which also play major role are:

Ø  Hedge fund

Ø  Sovereign wealth fund [SWF]

                                                            

§  Significance of Venture Capital

Ø  An economy that does not have a strong venture capitals sector is one  that displays symptoms of deeper economic problems“  (J.P. Cotis, Chief Economist The Organization for Economic Cooperation and Development [OECD])

Ø  OECD (2000) report identified venture capital as a critical component for the success of entrepreneurial high-technology firms and recommended that all nations consider strategies for encouraging the availability of venture capital.

§  About and various stages of Venture Capital [VC]

Ø  Venture capital (VC) is funding invested, or available for investment, in an enterprise that offers the probability of profit along with the possibility of loss.

Ø   Indeed, venture capital was once known also as risk capital, but that term has fallen out of usage, probably because investors don't like to see the words "risk" and "capital" in close conjunction.

Ø  Venture capitalists often don't tend to think that their investments involve an element of risk, but are assured a successful return by virtue of the investor's knowledge and business sense.

Ø  Venture capital is the second or third stage of a traditional startup financing sequence, which starts with the entrepreneurs putting their own available funding into a shoestring operation.

Ø  Next, an angel investor may be convinced to contribute funding. Generally an angel investor is someone with spare funds and some personal or industry-related interest - angels are sometimes said to invest "emotional money,“

Ø  While venture capitalists are said to invest "logical money" - that is willing to help to give the new enterprise a more solid footing.

Ø  First-round venture capital funding involves a significant cash outlay and managerial assistance.

Ø  Second-round venture capital involves a larger cash outlay and involvement of Private Equity Fund and/or PIPE

Ø  Finally, in the IPO stage, an investment bank is commissioned to sell shares to the larger public.

Ø  Vulture capitalist, a term coined in the volatile financial environment of the 1980s, has been revived to refer to the venture capitalists that  buy up failing  enterprises at rock-bottom prices and attempt re-structuring/ wait for opportune time  to realize value

§ Venture Capital: Focus & Investments

Ø  VCs invest in:

ü   Early stage companies

ü   Companies with growth potential

ü   Unquoted companies

Ø  VC investments are:   

ü   Start-up by nature

ü  In equity capital or a mix of equity and debt

ü  For medium to long term

§  VC also provide capital for:

Ø  Expansion

Ø   MBO [Management buy out: Existing management team buying a business from the current shareholders]  ‘

Ø   MBI [Management buy in: A new management team from outside buying an existing business from the existing shareholders] 

Ø  Turnaround/  restructuring

VC is  actively involved in its investments and it is  a young industry, in particular in emerging markets

§  Impact of Venture Capital

§  VC  Investors have a significant impact: 

ü   On the economic development of their respective markets

ü   Create jobs at a much faster rate than others

ü   Boost domestic economic growth and improve international competitiveness through stronger sales, export and investment growth  

Ø  VC Investors also :

ü   Provide long term risk capital

ü  Improve company performance

ü   Facilitate corporate restructuring / succession

ü  Facilitate and drive industry reform / consolidation

ü   Promote capital market development

ü   Promote transparency and good corporate governance

ü   Promote innovation, research and development

“77% of companies believe that without private equity the business would not have existed at all or would have developed less rapidly.” (BVCA Survey on „Impact of Private Equity in the UK“, 2004)

§  Key Success Factors for the VC Industry

§  Key success factors are:

§  Conducive fiscal, legal and regulatory environment

§  Reliable shareholder rights/ minority protection

§  Financial reporting standards in line with international best practice

§  Limited market distortions

§  Domestic institutional investors also are active investors in VC funds

§  To improve the environment, the Indian Venture Capital Association [IVCA] has continually lobbied the government for:   

Ø   The need for a common regulatory framework 

Ø  The retention of some special tax privileges

Ø  Permission for pension funds, insurance companies and mutual funds to invest in venture capital funds

Ø  Permission for investment by venture capital funds in instruments other than pure equity (such as equity shares with different voting rights, preference shares, innovative instruments)

Ø   A relaxation of IPO guidelines 

Ø  Inclusion of the services industries other than software and other sunrise and innovative industries

§  The major providers of VC fund are:

Ø  High net worth individuals [HNI]

Ø   Institutional investors like:  

Ø   Pension/Insurance funds

Ø   Banks/NBFCs

Ø  Development finance institutions

Ø   Provident funds

Ø   Trusts, Endowment funds

Ø   University funds

Ø  Sovereign wealth funds

§  Venture Capital: Definition

Ø  Venture capital (also known as VC or Venture) is a type of private equity capital typically provided for early-stage, high-potential, growth oriented business ideas/ventures and/or business with a significant potential for market expansion and the need for additional financing

Ø  Venture capital (VC) is professionally-managed equity money (money for stock), that is repaid by capital gains through the sale of stock. Investors are typically short- to intermediate-term investors

Ø  VC is a pool of money used to fund startup firms in exchange for shares of ownership that are expected to be cashed out within a few years as the successful startups go public or are acquired.

Ø  VC are high-risk, high-return investment and  are essential as a means of financing the rapid growth of à new technology-based firms

Ø  VC is a source of business investment associated with a higher-risk opportunity than conventional financial institutions are willing to bear

§  Angel Fund: Short Notes 

Ø  An Angel fund [AF] is a popular kind of venture capital usually offered to a start-up in exchange for convertible debt or an equity stake

Ø  An Angel Investor [AI]  is a HNI [may also be a firm] providing finance to a start-ups either in exchange for convertible debt or equity

Ø  AF is sort of  a bridge between loans from family and friends and venture capital  though angel investors are themselves often personally connected to the business

Ø  AI take on a great deal of risk when they invest in these start ups and they are also subject to dilution at the start up's IPO

Ø   AI step in when banks and FI finance are not available for start-up due to the riskiness.

Ø  For this AI  usually require a high rate of return say > 30% in exchange for their financing

Ø  AIs informally known as angels or informal investors

Ø  Whilst VCs are typically for funding over $2 Mln but AIs are in for <$2 Mln

Ø  The Angel Fund:

ü   Supports the company at the earliest stage 

ü  Invest their own money

ü  Actively mentor the company

Ø  Hence VALUATION [i.e. realizing  full value] is the key for AI

Ø  The earliest example of a type of angel finance is of a person who provided  finance for theatrical production in Broadway, USA In 1978 William  Wetzel, USA coined to term “Angel”

Ø  One good example is of famous Angel who invested $10,000 in Amazon.com & saw the value raise to $2.6mln [ before the dot.com bubble burst]

Ø  Another famous AI is USA’s Ron “Long Gone” Conway founder of Angel Investors LP  (his ventures failed hence “long gone”!!) and Bill Joy of Sun Microsystems

Ø  In India Amit Agarwala’s Amdale Software Technologies, Pravin Gandhi’s Infinity  Ventures and M/s Narayan Murthy’s and Azim Premji’s  funds are noteworthy efforts

§  Venture Capital Fund [VCF]: Short notes

Ø  Venture Capital [VCF] is a type of private equity [PE] which provide funds for early stage high risk high potential companies

Ø  VCF normally invest in high tech industries in the field of software, IT, bio-tech and besides that in infrastructure , telecommunication, health care, BFSI, green technology, agri-sector etc.

Ø  High net worth individuals [HNI] and institutional investors [II] are the chief contributors of VCF

Ø  These funds are pooled & managed by dedicated VC fund [VCF] on limited liability partnership [LLP] basis. In India dedicated VCF operated by few Banks/FIs bear full risk

Ø  The VCF is comprised of people with technology, science, research, business and industry experience

Ø  The core strength of a VCF is to identify novel technologies/ideas with potential togenerate high commercial returns at an early stage with well developed business model and an impressive management team. In this process reject 98% of the investment proposals

Ø  VCF invests the financial capital in enterprises that are too risky for standard capital market [equity & debt] or credit market [bank loan]

Ø  VCF spread risks by investing in different investment avenue

Ø  VCF get involved in the business thereby add extra element of skills

Ø  VCF gets significant control over the invested Company’s decision inaddtion to significant ownership and in the process realize high VALUE

Ø  For the management services and risks borne VCF typically charge a AMC fee of ~ 2%  and ~ 20% share in interest/profit earned on investments

Ø  VCF has a fixed life say 3 to 5 yrs [sometimes more] to allow for PEs to step in. Thus VCF is different from PE which typically invest in companies with proven  revenues

Ø  American Research and Development Corporation [ARDC], J H Whitney & Co [1946] and Warburg Pincus are few noted VCFs in USA

Ø  Indian Venture Capital Association [IVCA] is an important body playing leading role in promoting the concept VC in India.

Ø  Technology  Development & Information Company of India Limited is the first VCF in India.

Ø  SEBI (Venture Capital Funds) Regulation 1996 lays down the overall rules for registration and operations of VCFs in India

§  Private Equity [PE] Funds: Short Notes

Ø  Private equity fund is a pooled investment vehicle used for making investments in various equity (and to a lesser extent debt) securities

Ø  A PE fund is which invests its money in private equity often to gain control over companies in order to restructure the company. When the fund gains control of a company, they will usually take the company off the market if it isn't private already, go through a multi-year restructuring process and then relist the company on the stock market

Ø  PE is money invested in companies that are not publicly traded on a stock exchange invested as part of buyouts of publicly traded companies in order to make them private companies

§  The most common investment strategies in PE include:

Ø  Leveraged buyouts [LBO] ( involves use of more debt than equity in financing buyouts)

Ø  Venture capital ( refer notes )

Ø  Growth capital (equity investment in mature firm which has expansion /acquisition program)

Ø  Distressed investments (Rescue financing/special situations funding by debt and equity investment  provided by an investor  to often rescue  companies undergoing operational or financial challenges or corporate restructuring)  And

Ø  Mezzanine capital ( refer to sub-ordinated debt or preferred equity. This financing is resorted by firms to borrow additional capital [from other sources] beyond the  levels the traditional bank/Institutions are willing to finance by loans)

§  Many times PE investments are short term in nature:

Ø  PE fund is a pooled investment vehicle used for making investments in various equity (and to a lesser extent debt) securities according to one of the investment strategies associated with PE

Ø  PE funds are typically limited partnerships with with a fixed term of 10 years (often with annual extensions)                                                                                                                                     A PE fund is raised and managed by investment professionals of a specific private equity firm (the general partner and investment advisor).

Ø  Typically, a single PE firm will manage a series of distinct PE funds and will attempt to raise a new fund every 3 to 5 years as the previous fund is fully invested

Ø  PE’s acquisition price of a portfolio company is usually based on a multiple of the company’s historical income, mostly based on earnings before interest taxes depreciation and amortization (EBITDA)

Ø  PE equity multiples are highly dependent on the portfolio company's industry, the size of the company and the availability of LBO financing/other financing

Ø  A PE fund's ultimate goal is to sell or “exit” its investments in portfolio companies for a return (known as internal rate of return or "IRR") in excess of the price paid.

Ø  A private equity firm is an investment manager that makes investments in the private equity  of operating companies through a variety of investment strategies including LBO, VC, Growth capital etc

Ø  PE firm is often described as a financial sponsor and each firm will raise funds that will be invested in accordance with one or more specific investment strategies

Ø  For example Kholberg Kravis Roberts & Co [KKR] is a US based Private Equity Firm managing a PE fund styled “KKR 2006 Fund, L.P.” with a committed funds of $ 17.6 billion and part of its Private Equity Portfolio Investments are in Energy Future Holdings Corporation, First Data Corp, Hospital Corporation of America, Nielsen Company, NXP Semiconductors

Ø  Some of the largest PEs are Goldman Sachs, Carlyle Group, Blackstone

Ø  Some known Indian PE firms are ICICI Venture, Premji Invset, Venture India,Nadathur Investment, Ojas Venture Partners, Infosys founder Naryan Moorthy’s fund

§  The PE firm generate return (IRR) thru:

Ø  Debt repayment

Ø  Cash flow from operations

Ø  Operational and cost efficiency

Ø  Multiple expansion: I.e. selling the business for higher multiple of earnings than originally paid

§  The exit strategies for PE fund are:

§  An IPO of the portfolio company

§  A sale of the portfolio company to a strategic acquirer through a M&A also known as a trade sale

§  A sale of the portfolio company to another private equity firm, also known as a secondary sale

§  At inception, institutional investors make an unfunded commitment to the limited partnership, which is then drawn over the term of the fund

§  Generally PE funds are structured as limited partnerships [LPs] and are governed by the terms set forth in the limited partnership agreement (LPA). Such funds have a general partner (GP), which raises capital from cash-rich institutional investors, such as pension plans, universities, insurance companies, foundations, endowments and high net worth individuals, which invest as limited partners (LPs) in the fund

§  Terms of PE Fund LPA  inter-alia, are the following:

Ø  Term of the partnership: the partnership is usually a fixed-life investment vehicle that is typically 10 years plus some number of extensions

Ø   Management fees: an annual payment made by the investors the fund's manager to pay for the PE firm's investment operations which is typically 1 to 2% of the committed capital of the fund        

Ø   Share of Profits (Carried Interest): a share of the profits of the fund's investments ~ up to 20%, paid to the PE  fund’s management as performance incentive. The remaining 80% is paid to the fund's investors 

Ø   Hurdle or Preferred return: a minimum rate of return (e.g. 8 - 12%) which must be achieved before the fund manager can receive any carried interest payments

Ø   Transfer of an interest in the fund: PE funds are not intended to be transferred or traded, however they can be transferred to another investor which is with the consent of and at the discretion of the PE fund's manager

Ø   Restrictions on the General Partner: the fund's manager has significant discretion to make investments and control the affairs of the fund.

Ø  However, the LPA does have certain restrictions and controls and is often limited in the type, size or geographic focus and tenure of investments

§  Vulture Funds [Short Notes]:

Ø  A Vulture Fund is a PE Hedge Fund that invests in debt issued by  a weak or dying firms

Ø  A Vulture Investor buys up Assets [including real estates]  and Financial instruments [ like securities, debts ,bonds] below cost from distressed entities

Ø   A Vulture Investor may purchase the controlling shares of a company in order to liquidate, thereby realizing a higher yield return on investment than the original purchase price.                    

Ø   Real estate  could be purchased from a borrower who is no longer able to make payments on their loan and needs to sell the property in order to improve their balance sheet  or retain their credit rating

Ø   Whereas as Angel Investors provide seed money in the hope that the investment will work the  Vulture Investors rescue others from their own mistakes

Ø   Vulture Investors serve a necessary function within the economy by reintegrating capital and other resources into well-managed and properly run ventures 

Ø  Vulture funds focus on debt target not only corporate but also sovereign debtor states. For example in Argentina vulture funds bought up a significant portion of the country's external public debt at very low prices (sometimes only 20% of their nominal value), and then attempted to cash them when Argentinean economic crisis exploded but met with resistance/little success                                     

Ø  A related term is "vulture investing", where certain stocks in near bankrupt companies are purchased upon anticipation of asset divestiture or successful reorganization. A prime example in the U.S. is K-Mart where the real estate held by the company was the anticipated payout for investors who bought stock during their bankruptcy proceedings.    

Ø  Asset Reconstruction Companies are good examples of Vulture Funds and Vulture Investing  

Ø  Asset Reconstruction Company of India Ltd [ARCIL] (sponsored by leading Indian Banks and is the first ARC in India), UTI-led ASREC, IFCI-promoted Assets Care Enterprise (ACE) and Pegasus Asset Reconstruction Company, ACTIS, ISARC (Indian SME Asset Reconstruction Company L are some of the ARCs in India

Ø  The Rationale for and role of Asset Reconstruction Companies [ARC] in India:

Ø   The total amount of stressed assets in India is Rs 2 lakh crore or $20 billion

Ø   In the banking system, high level of NPAs can be serious drag on overall performance of economy on account of diversion of its management and financial resources towards recovery of NPAs

Ø  Greater the resources needed by banks to reserve for losses, lesser is the amount of capital they can leverage. Consequently it makes the banks risk averse in providing new loans leading to credit crunch in the financial market, amounting to economic and financial degradation                 

Ø  ARCs are established to acquire, manage, and recover illiquid or NPAs from lenders, unlocking value trapped in them via an institutional platform.

Ø   Relieving banks of the burden of NPAs would allow them to focus better on managing the core business including new business opportunities.

Ø  The transfer NPAs to ARCs should help restore depositor and investor confidence by ensuring the lender’s financial health. ARCs are meant to maximize recovery value while minimizing costs.

Ø   ARCs can also help build industry expertise in loan resolution, besides serving as a catalyst for important legal reforms in bankruptcy procedures and loan collection.

Ø   ARCs can play an important role in developing capital markets through secondary asset instruments.

Ø   In India, Vulture Funds in the shape of Asset Reconstruction Companies are skewed towards financial restructuring rather than maximizing profit. They stay invested longer than an average vulture fund

Ø  Vulture funds are common in the US. That is because debt can be easily traded there. In India lack of well developed and regulated debt market hamper VFs

Ø   In India, the ARCs  role of is of a fund primarily limited to single-credit transactions. Portfolio deals are out of bounds/rare at the moment 

Ø   Some ARCs are out rightly buying businesses in auction processes in India. This bucks the trend of them being mere financial investors

Ø   Some ARCs are basically debt collection agencies, working on behalf of banks
Their objective is to clean up the system rather than merely generating profit

§  Strategies followed by ARC:

Ø  After acquiring the NPA from the sellers, the ARC will implement the resolution strategy for the underlying assets of the non performing loan.

Ø  The ARC has been given powers by the SARFAESI Act [The Securitization and Reconstruction of Financial Assets And Enforcement of Securities Interest Act 2002(Securitization Act 2002)] to execute the resolution of NPA whereby it can: 

ü   Restructure the loan.

ü   Sell or lease part/whole of the assets or the business to a third party.

ü   Change the management structure by introducing its own personnel in the management. (presently this section has been kept in abeyance by the regulator)

ü  Restructure the business operations including diversification of business operations or discontinue the loss making business segment. 

Ø   Disposition Strategies: A number of sales techniques are possible:

ü   Portfolio sales

ü  Open outcry and sealed-bid auctions

ü  Securitization

ü   Equity participation transactions

  

§  Hedge Funds: Short Notes

Ø  A Hedge Fund is an investment fund open to a limited range of investors that undertakes a wider range of investment and trading activities than Mutual Funds

Ø   Hedge Fund which is allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, going long, leverage, program trading, swaps, arbitrage, and derivatives.

Ø   Hedge Funds are alternative investment vehicles.

Ø  A  hedge fund is a  vehicle for holding and investing the money of its investors.

Ø   Hedge funds trading styles are quite variable from one fund to another

Ø   Hedge funds are speculative funds which make large bets on market movements. They utilize borrowed money to substantially leverage their returns (and losses)

Ø  Hedge Funds are private collective investment vehicle which are active in the global capital markets, mainly based offshore and are virtually unregulated

Ø  The wide spread in return on investment between Hedge Funds and Mutual Funds [MF] is primarily due to differences in trading strategies and due to Hedge Funds not subject to rules and regulations governing MFs 

Ø  The fund itself has no employees and no assets other than its investment portfolio and cash           

Ø  The portfolio is managed by the investment manager which is the actual business and has employees

Ø  The service providers to Hedge Funds are Prime Brokers, Custodians, Administrators and Distributors

Ø  Normally by law the Hedge Fund is restricted to manage no more than 100 investors and sets high minimum investment amount > $1 Mln

Ø  Typically Hedge Funds charge 2% management fee and 20% profit sharing 

Ø   Quantum Fund [By George Soros], Long Term Capital Management [By Jhon Meriwether], Amaranth Advisors, Goldman Sachs are leading global Hedge Funds                                                   Hedge Fund India, India Capital Fund and Absolute India Fund are some Indian Hedge Funds

§  Sovereign Wealth Fund [SWF]: Short Notes

Ø  A sovereign wealth fund (SWF) is a state-owned investment fund composed of financial assets such as stocks, bonds, property, precious metals, commodities and other financial instruments                  

Ø   SWF is a fund set up by a country with large foreign exchange reserves to help manage those reserves.

Ø  Typically SWFs purchase long-term securities to try and enhance investment returns beyond what central banks typically earn holding government debt.                                                             Examples of SWFs include the Government of Singapore Investment Company and the Abu Dhabi Investment Authority.

Ø   Some SWFs are held solely by a Central Bank, which accumulates the funds in the course of its management of a nation's banking system.

Ø   This type of fund is usually of major economic and fiscal importance

Ø  Other SWFs are simply the state savings which are invested by various entities for the purposes of investment return and which may not have significant role in fiscal management                                  

Ø  The accumulated funds of a SWF may be the foreign currency deposits, gold, SDRs and International Monetary Fund reserve positions held by Central Banks and monetary authorities, along with other national assets such as pension investments, oil funds, or other industrial and financial holdings.

Ø   The difference between SWF and Foreign Exchange Reserve [Fx reserve] held by the Central Banks is that SWFs can be characterized as maximizing long term return, with foreign exchange reserves serving short term currency stabilization and liquidity management.

Ø   Many central banks in recent years possess reserves massively in excess of needs for liquidity or foreign exchange management [like Central Bank of China with an Fx reserve of ~ $2 bln]    

Ø  The accumulation of Fx reserve up to a limit and the associated costs up to an extent are justified to manage risks relating to liquidity, currency fluctuations, financial  shocks. Beyond that there is need to earn better return hence the creation of SWF.

Ø  India’s Fx reserve [in March10] is ~ $ 279 Mln managed by RBI and there is still debate about pros and cons of creating India SWF. 

Ø   The first SWF is created by Kuwait Investment Authority in 1953 with surplus Fx reserves from commodity (crude oil) sale.

Ø   Government of Singapore Investment Corporation and Temasek Holdings are example of SWFs created thru surplus from non-commodity operations.

Ø  Norway's Government Pension Fund Global [1990] is an example of SWF initiated by other than Central Bank

Ø  The SWFs invests in various energy assets like coal, oil, gas and in agricultural , water ,real estate and infra assets across the globe.

Ø   Some countries avail SWFs for strategic purpose and to promote and protect their long term interest and securities besides financially helping the countries in which they invest

Ø   There is valid apprehension that some SWFs may be used for objectionable  purpose or inimical to the interest of other sovereign nations

Ø  India is unable to create SWF mainly due to worries on current account deficit [countries with SWF have favorable/surplus  trade and current account balance]

Ø   However a portion of the Fx reserve is now sought to be used for infrastructure development thru the aegis of India Infrastructure Finance Company Limited [IIFCL]