IRJMST Volume 5 Issue 1 Online ISSN 2250 - 1959

International Research Journal of Management Science & Technology

http:www.irjmst.com Page 209

Private Equity Investments: A Literature Review
Authored by: Neerza,
(Research Scholar, M.Phil.)
Department of Commerce, Faculty of Business and Commerce,
Delhi School of Economics, University of Delhi,

Dr. Vanita Tripathi
(Assistant Professor)
Department of Commerce, Faculty of Business and Commerce,
Delhi School of Economics, University of Delhi,

INTRODUCTION

In every developing or developed country, various companies raise capital based upon
their risk appetite. Either they go for conventional methods of financing like bank
borrowing or raising funds through public issue or self-financing. But at some point in
the later stages of its lifecycle, a company has to look for new investments for growth and
development and for various other reasons and that source happens to be costly and too
large to be financed by the company. Private equity is one of such sources of financing. It
fills the gap between self-financing and traditional sources of financing. Private equity,
being a decades old concept, has attracted considerable amount of attention. Despite of
ever growing interest in private equity, significant work has not been undertaken by
academicians on the subject, the reason being, non availability of information relating to
such a secretive economic sector. The existing literature work majorly comprise of issues
including risk-return characteristic and performance of private equity, economics of
private equity market, regulatory aspects of private equity and others aspects.

Private equity is an illiquid asset class. The extended holding period for private equity-
averaging four-five years-attracts investors, as fund managers are able to avoid volatility
that negatively affects the public equities. Few most legendary high-growth companies in
U.S., including Federal Express, Oracle, Apple Computer, and Intel, were initially
finance with private equity which fueled the industrys explosive growth in 1980s and
1990s. Scenario during that period was that the supply of private equity capital was
outpacing the supply of returns on such investments. Diversification and exceptional
excepted returns were the main drivers for investors. Among the Asia-Pacific market,
Indian market saw the highest deal activity in 2010. Favorable fundamentals of PE
market in India and low company valuations on account of high priced corporate debt are
likely to provide competitive deal opportunities for private equity investors.
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The purpose of the study has been undertaken with a view to exploring the theory of
private equity and understanding the various concepts of private equity including private
equity markets, private equity players, private equity investment strategies and activities,
risk-return characteristics of private equity investments as against public equities, idea of
private equity funds, private equity structure, growth and development of private equity
market, emergence of secondaries in private equity and other related aspects. The purpose
of the study is to learn economics of private equity and have an overview of the literature
available around the theory with an aim to recognize various issues that need
considerable attention. This work will help in expanding knowledge about the existence
and challenges of private equity investments, analyzing the value adding capabilities of
private equity managers thereby appreciating the private equity market as a whole.

Study conducted, being exploratory in nature, is expected to highlight private equity and
its various aspects. For studying the concept secondary source of information has been
considered, analyzed and reviewed. In depth review of the available literature has been
undertaken with a view to focus on identifying the issues and gaps that exist therein.

The study has been divided in four sections. First section introduces the reader to the
topic and underlines the purpose of the study. The second section explains the theoretical
framework of private equity and evolution of private equity market. Third section
examines the relevant literature available in context of private equity investments. The
fourth section which is the last section will summarizes and identifies the issues and gaps
exist that in the available literature around the concept of private equity.

IRJMST Volume 5 Issue 1 Online ISSN 2250 - 1959

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CONCEPTUAL FRAMEWORK
2.1 Private Equity
Different academic studies have defined private equity differently depending upon the
nature of different economies. Private Equity is an asset class that is not quoted on public
exchange. Private equity is a source of investment capital from institutions and high net
worth individuals for the purpose of investing and acquiring equity ownership in
companies. Private Equity involves a risky, long term and profitable commitment and
provides a strong financial base and expertise to the companies. Private equity is also
called patient capital as it seeks to profit from long term capital gains rather than short
term regular reimbursements.



Conroy and Harris (2007) argue that in practice the term private equity can be used in
many ways with various subcategories and one way of defining private equity is that it
refers to private investments in all stages of a companys life. Leeds and Sunderland
(2003) have defined private equity as financing for early and later stage private
companies from third party investors seeking high returns based on both the risk profile
of the company and the near term illiquidity of these investments. Prowse (1995) has
defined private equity organizations as financial sponsors acquiring large ownership
stakes and taking an active role in monitoring and advising portfolio companies. Private
equity, according to Bain Capital, is the medium to long-term finance provided in return
for an equity stake in potentially high growth unquoted companies whereas Blackburn
PRIVATE
EQUITY
Provides strong
financial base and
expertise to the
companies
Involves
risky, long-term
and profitable
commitment
An asset class not
quoted on public
exchange
A source of
investment capital
from institutions
and high net worth
individuals
Capital by financial
investors over
medium/long-term
to non-quoted high
growth potential
companies
An umbrella of
alternative
investments
Financing for early
and later stage
private companies
from third party
investors
financial sponsors
acquiring large
ownership stakes
and taking an
active role in
monitoring and
advising
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(2006) argues that private equity funds are themselves entrepreneurial. Moon (2006)
defines private equity strictly as later stage investments, which are typically control-
oriented transactions involving mature companies or includes early state investments by
venture capital firms. Private equity firms typically become active investors through
taking board seats and specifying contractual restricts on management such as detailed
reporting requirements. Burdel (2009) explains private equity as a refuge from the short-
termism and volatility of quoted markets-and a stable platform for rapid, highly focused
growth at crucial points in the development of individual businesses.

Private equities are generally less liquid than publicly traded stocks and are thought of as
long term investments. In case of private equity, all the financial reporting requirements
are reduced resulting in simplified management responsibilities and low transaction cost.
Since private equity is a long term investment alternative, it results in improved decision
making of the portfolio company. Private equity investments are illiquid until a buyer is
found or public offering allows the private equity investor to exit with a profitable return.
Private equity firms typically become active investors through taking board seats and
specifying contractual restrictions on management such as detailed reporting
requirements.

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Figure 1: Features of PE Backed Company


Source: The fourth-wheel-a-Grant-Thornton-Report-2011

As per EVCA, private equity is the provision of equity capital by financial investors-over
the medium or long-term-to non-quoted companies with high growth potential. The goal
of private equity is to help more businesses to achieve their ambitions for growth by
providing them with finance, strategic advice and information at crucial stages of their
development. Private equity is an umbrella of alternative investments. Private equity
covers not only the financing required to create a business, but also includes financing in
the subsequent developments stages of its life cycle. There are different types of private
equity investment funds such as independent, captive and semi-captive funds.
Independent private equity funds are those in which third parties are the main source of
capital and in which no one shareholder holds a majority stake. This is the most common
type of private equity fund. Captive funds are those in which one shareholder contributes
most of the capital, that is, where the parent organization allocates money to the fund
from its internal sources. Semi-captive private equity funds are the funds in which, in
addition to main shareholder contributing a considerable part of the capital, a significant
share of the capital is raise from the third party also. Certain corporate funds fall into this
category.

2.1.1 Venture Capital, Growth Capital, Hedge Funds, LBO, Distressed Investments,
Angel Investing, Mezzanine Capital and Secondaries
Venture capital is a form of private equity that generally apples to start ups. Venture
capital is a subset of private equity and refers to equity investments made for the launch,
early development, or expansion of a business. It particularly emphasizes investment in
entrepreneurial undertakings rather than in mature businesses. Growth capital refers to
minority investments in relatively mature companies that are seeking capital for further
Features of
Private
Equity
backed
company
strong
growth
orientation
focus on
shareholder
value
creation
active board
with PE
directors
taking high
interest in
management
conncetivity
with global
and local
PE partners
business
focused on
medium term
driven by the
need for
liquidity
event
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expansion of their businesses or restructuring their existing businesses. Companies
required growth capital are mature than venture capital companies and able to generate
sufficient profits but enough for expansion, acquisitions or other investments. Private
investment in public equity (PIPEs) is a form of growth capital where publicly traded
stocks are purchase by private investors.

Hedge funds are most often set up as private investment partnerships that are open to a
limited number of investors and require a very large initial minimum investment. Hedge
funds were developed as an alternative to open-end investment funds or mutual funds.
Hedge funds seek a quick flip of their investments with average length of their
investments being 6-18 months. Managers of hedge funds do not make public offering to
investors in general and as such do not face public reporting requirements as a result
investors have little access to the fund related information. Many hedge funds have joined
hands with private equity players to make large buyout deals. Leverages Buyouts (LBO)
refers to purchasing of a company by a small group of investors is largely funded by debt.
LBOs are conducted by acquiring a company using considerable amount of borrowed
funds (loans or bonds) and very little equity. In such transactions, assets of the target
company are treated as collateral against the loans taken for acquiring it. In an LBO,
there is usually a ratio of 90% debt to 10% equity.

Distressed investments are made in companies which are near or currently going through
bankruptcy. Such investments are issued in the forms of corporate restructuring and
rescue financing on account of companys inability to meet its financial and operational
obligations. Angel Investor provides capital for a business startup, usually in exchange
for convertible debt or ownership equity. Anger investors invest in their owned funds,
where venture capitalists manage the pooled money of others. Angel investors bear
extremely high risk and accordingly expect very high return on investments. Mezzanine
financial is a combination of debt and equity financing used by companies for expanded
their business activities. It gives an option to convert debt into equity on account of non
repayment of loan on time and in full. Mezzanine capital is a subordinated debt which is
superior to common equity and occupies a very place in the overall capital structure of a
company. Mezzanine debt holders require a higher return for their investment than
secured or other more senior lenders. Secondaries involve the sale of private equity fund
interests or portfolios of direct investments in privately held companies. Secondary
market makes private equity a more competitive and attractive investment proposition
and will continue to be the driving force behind the growth of private equity industry.
The secondary market has emerged as a tool that enables the private equity investors to
mange their investments in illiquid funds more flexibly by their selling their assets in the
secondary markets.

2.2 Private Equity Fund
Private equity fund is pool of money contributed by a various institutional investors and
high net worth individuals. Private equity funds play an important role as financial
intermediaries in the private equity market. Private equity funds are established and
structured as limited partnerships and these funds with the help of limited partners make
investments in various companies thereby creating a diversified portfolio which managed
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by professional known as general partners. Funds of fund, LBO funds, VC funds, etc are
different types of private equity funds. Private equity funds making investments in other
private equity funds to provide investors with products with lower risk profiles are known
as funds of fund. When private equity funds are used along with large amount of debt, are
known as LBO funds and special funds established for providing venture capital to
nascent businesses are called venture capital funds. Private equity funds seek investments
in undervalued companies. Private equity funds may acquire equity in a target company
independently or in combination with other private equity firms. The combinations
enable them to spread out the risk.

2.3 Private Equity Market
Private equity market can be said to comprise of private equity funds that receive
investments by various institutional investors including pension funds (corporate and
public), foundation, endowments, insurance companies, investment banks and wealthy
families and individuals known as limited partners and are managed by private equity
professionals known as general partners. Private equity market is considered more risky
than the public equity market as returns in private equity market are more volatile as
compared to the returns in public equity market which are comparatively more stable.

Figure 2: Private Equity Fund

Source: Krger Andersen, Thomas. Legal Structure of Private Equity Funds. Private Equity and Hedge
Funds 2007

Metrick & Yasuda (2008) explains that all private equity firms are organized as limited
partnerships where private equity firms serve as general partners and large institutional
investors and high net worth individuals providing bulk of the capital serve as limited
partners. Fenn, Liang and Prowse (1998) describes that the private equity market is an
important source of funds for start-ups, private middle market companies, firms in
PRIVATE EQUITY FIRM
INVESTORS
pension funds (corporate &
public)
Insurance companies, foundations, endowments
high net worth individuals &
families
endowments, NBFCs, etc.
PRIVATE EQUITY FUND
Investment
Investment
Investment
GENERAL PARTNERS
LIMITED PARTNERS
LIMITED PARTNERSHIIP
Ownership of the fund
Fund/investment management
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financial distress, and public firms seeking buyout financing. Gaughan (2007) defines
private equity market as a collection of funds that have raised capital by soliciting
investments from various large investors for the purpose of taking equity positions in
companies. When these investments acquire 100 percent of the outstanding equity of a
public company, we have a going-private transaction. When the equity is acquired
through the use of some of the investment capital of the private equity fund but mainly
borrowed funds, we tend to call such a deal a leveraged buyout (LBO).
2.4 Evolution of Private Equity
With few exceptions, private equity in the first half of the 20th century was the domain of
wealthy individuals and families. The Vanderbilts, Whitneys, Rockefellers and Warburgs
were notable investors in private companies in the first half of the century. J.P. Morgan's
acquisition of Carnegie Steel Company in 1901 represents arguably the first true modern
buyout. Cumming argues that private equity markets experienced a golden age up to the
second quarter of 2007 as massive amount of capital was flowing to private equity funds
up to this period. This rise of private equity has been attributed to superior governance
model of private equity firms as compared to public corporations, regulatory costs
involved in being a publicly trading company, rise of hedge funds in the world of private
equity, emergence of sovereign wealth funds and many other factors. The private equity
industry developed simultaneously in US and Europe soon after World War II.

Emergence of private equity is marked by establishment of two venture capital firms in
1946: American Research and Development Corporation (ARDC) and J.H. Whitney &
Company. Small Business Investment Act of 1958 allowed financing and management of
small entrepreneurial businesses in United States. It was also in the 1960s that the
common form of private equity fund, still in use today, emerged. The first leveraged
buyout may have been the purchase by Malcolm McLean's McLean Industries, Inc. of
Pan-Atlantic Steamship Company in January 1955 and Waterman Steamship Corporation
in May 1955. The approach used in McLean transaction became popular in 1960s and
subsequent buyouts were conducted in the similar manner which resulted in coining of
the term leveraged buyouts. Between 1979 and 1989, it was estimated that there were
over 2,000 leveraged buyouts valued in excess of $250 million. Increased leveraged
buyout activity led to emergence of private equity players in the industry. Among the
major firms founded in this period were: Bain Capital, Chemical Venture Partners,
Hellman & Friedman, Hicks & Haas, (later Hicks Muse Tate &Furst), The Blackstone
Group, Doughty Hanson, BC Partners, and The Carlyle Group.

Private equity funds were raised specifically as venture capital funds or buyout
mezzanine funds. Between 1979 and 1988, the U.S. private buyout market expanded
from less than US $1 billion to a peak of more than US $60 billion. This was largely
facilitated by creation of high yield junk bond market and on account of availability of
such high yield debt huge corporate takeovers were financed including RJR Nabisco by
Kohlberg Kravis & Roberts in 1988. Canadian venture capital market growth was
facilitated through the provision of subsidies by the Government of Canada. Emerging
technology firms and rising demand for risk financing led to growth in Canadas private
equity market. Various political, social, cultural and financial factors were constraining
the growth of private equity industry in U.K. till 1980s. Establishment of Unlisted
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Securities Market, rationalization of tax rates and such other initiatives led to
development of venture capital industry in mid 80s in U.K. and it was found that private
equity investments in U.K. accounts for 1.5 percent of the GDP. Initially development of
private equity market in Brazil did not receive much support from the Government.
During the period from 1992-1994, there existed only one player in the private equity
market in Brazil. The industry began to grow on account of deregulation and
rationalization of restrictions imposed on various sectors. Brazilian economy faced with
crisis during 2000 and 2002 due to currency devaluation and other macroeconomic
factors.

By the end of the 1980s the excesses of the buyout market began to show signs of
bankruptcy with the collapse of Drexel Burnham Lambert and shutdown of the high yield
market in 1989 and 1990 signaled the end of the LBO boom. Beginning 1992, private
equity once again began to experience boom both in venture capital and leveraged buyout
deals as indicated by increase in the size of investor commitments from US $20.8 billion
in 1992 to US $305.7 billion in 2000 outperforming all the asset classes.

Many US-based funds entered into the private equity industry in Mexico during early
1990s making considerable investments in manufacturing, telecom and entertainment.
Major players in Mexican private equity market were Chase Capital Partners, Blackstone
Group and Bank of America Private Equity Partners. Private investments expanded to
other sectors also but due to collapse various economies, technology bubble burst of 2000
and crisis in Brazil led to withdrawal of investments from IT and telecom sector. This led
to emergence of local private equity funds which used to source their capital from foreign
institutional investors and high net worth individuals. The private equity industry in
Singapore was facilitated by institutional support from the Government of Singapore. In
1985, the Economic Development Board (ECB), an institution established to act as a
facilitator of developing self-sustaining enterprises, created its own venture capital fund
whereas private equity in Malaysia got the support of venture capital firms of Singapore.
The government granted various tax incentives and adopted liberalized policies regarding
ownership of venture capital firms. Research shows that by the end of 2007, Malaysia
had 98 venture capital companies. The NASDAQ crash of March 2000 adversely affected
the entire venture capital industry and large amount of venture capital investments were
to be written off during the next two years. Many venture capital investors reduced the
size of their commitments by selling in secondary markets at significantly lower prices.
PricewaterhouseCoopers's MoneyTree Surveyshows that total venture capital investments
held steady at 2003 levels through the second quarter of 2005. Reviving trend of an
Internet-driven environment in 2004 through 2007 once again created a favorable
environment for venture capital investments.

By 2004 and 2005, it was realized that once again multi billion dollars deal can be struck
and large number of transactions can be completed. On account of declining interest
rates, rationalized regulatory and legal standards led to a series of major buyouts once
again becoming common and market observers were stunned by the leverage levels and
financing terms obtained by financial sponsors in their buyouts. Some of the notable
buyouts of this period include: Dollarama (2004), Toys "R" Us (2004), The Hertz
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Corporation (2005), Metro-Goldwyn-Mayer (2005) and SunGard (2005). The beginning
of 2006 recorded largest buyouts resulting in a buyout boom across different economies
including Unites States, Europe, and Asia Pacific region. In 2006, private equity firms
bought 654 U.S. companies for $375 billion. After the credit crunch of 2007-08 the
leveraged finance markets came to near standstill as major lender including Citigroup and
UBS AG announced major write-downs on account of credit losses in 2007, Kohlberg
Kravis Roberts and Goldman Sachs Capital Partners withdrew from the deal involving
the buyout of Harman International, the buyout of Sallie Mae by a consortium of private
equity firms and large investment banks encountered problems on the onset of credit
crunch, etc. The three years up to 2009 saw an unprecedented amount of fundraising
activity, more than $1.4 trillion being raised. However the subsequent economic
slowdown took a heavy toll and the fundraising environment remained depressed
afterwards, with only some $150bn in new funds raised in 2010, slightly up on the total
raised in the previous year.

According to the report published on The European Private Equity Market Outlook,
June 2010, the global economy started recovering during 2010 at multi-speed with
different economies recuperating at different rates as indicated by V-shaped rebound in
case of emerging economies and a sluggish, U-shaped recovery of many advanced
economies. The IMF Global Financial Stability Map, 2010, highlights that risk appetite
of investors has declined globally during 2009 and 2010 and the financial risks associated
with various investments have heightened. EMPEA-Coller Capital Survey in April 2011
confirmed that Limited Partners are of the view that emerging market allocation for
Private Equity will increase from 13 percent at present to 18 percent in coming two
years time. LPs surveyed expect that Emerging Asia PE funds will earn the highest
returns of any investment class, with nearly 78 percent of LPs expecting net annual
returns of 16percent or more (Returns from Indian PE, KPMG, 2011). India now ranks
sixth after the US, UK, Spain, France and China value in terms of PE deal value, though
it overtook China briefly, in 2010.

2.4.1 Private Equity Market Structure
The organized private equity market has three major players and an assortment of minor
ones. All the players in the market interact with each other in terms of flow of securities,
dollars and other services and claims. The assortment of agents and advisers help the
players in various issues relating to raising equity or advising on the best alternative
available for investment.

Investors
A variety of investors invest in private equity market. Povaly (2007) argues that most
institutional investors invest in private equity for financial reasons because it yield higher
risk adjusted returns as compared to other alternatives and there exist a greater scope for
diversification. Banks may invest in private equity and create lending opportunities for
firm in which their partnership exists. Nonfinancial corporations may invest in early stage
developing ventures that may fit with their own competitive and strategic objectives.
Fenn, Liang, and Prowse (1997) analyzed that public and corporate pension funds were
the largest groups supplying a significant portion of capital raised by limited partnerships
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followed by endowments and foundations, bank holding companies, and wealthy families
and individuals. Insurance companies, investment banks, nonfinancial corporations, and
foreign investors were the remaining major investor groups. During the period 1980 to
1995, limited partnership went from managing less than 50 percent of private equity
investments to managing more than 80 percent.

Intermediaries
Intermediaries are the private equity funds which are established as limited partnerships
and mange an estimated 80 percent of private equity investments (Prowse, 1997). Under
this arrangement institutional investors are the limited partners and a team of professional
private equity managers is appointed to serve as general partners to the fund. IFSL
Research (2008) emphasizes that about fourth fifth of the private equity investments flow
through specialized intermediaries, while the remainder is invested directly in firms
through co-investments.

Issuers
Issuers are the firms where private equity investments are made by the investors. Issuers
comprise of those having no other alternative source of financing such as no access to
bank loan or public equity market. Issuer firms vary majorly in their sizes and motivation
for raising capital. Middle market companies raise funds for expansion or incorporating
change in the financial structure whereas some firms will be needing funds in the form of
venture capital for starting up their businesses having high potential for growth
(specifically firms developing innovative technologies) or later stage financing in the
form of growth capital when other alternatives investments are not available like public
equities. Also there are public companies seeking buyout capital (issuing a combination
of debt and private equity) or distressed financing when faced with financial and
operations difficulties. Public companies raise private equity to avoid costs involved in
being a public company (registration, regulation, disclosures etc.).

Agents and Advisors
Agents and advisors in the private equity market act as information providers. Their
role involves evaluation of potential partnerships for investment by investors, raising
funds and providing advisory services regarding various investment alternatives, thereby
reducing the information costs. Advisors assist investors in deciding various investment
aspects relating to structure, timing and pricing and also help in negotiating deals.
Whereas agents act a link between private equity companies engaged in finding out
equity capital and limited partnerships searching for institutional investors. (Fenn, Liang,
and Prowse, 1997)

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Figure 3: Private Equity Market Structure



INVESTORS
Corporate pension
funds
Public pension funds
Endowments
Foundations
Bank holding
companies
Wealth families and
individuals
Insurance companies
Investment banks
Non financial
corporations
Other investors
INTERMEDIARIES
Limited partnership
-Managed by independent
partnership organizations
-Managed by affiliates of
financial institutions
Other intermediaries
-Small Business Investment
Companies (SBIC)
-Publicly-traded
Investment Cos.
ISSUERS
New Ventures
-Early stage
-Later stage
Middle market private
companies
-Expansion (capital
expenditure & acquisitions)
-Change in capital structure
(financial restructuring &
financial distress)
-Change in ownership
(retirement of owner &
corporate divestiture)
Public Companies
(Management or leveraged
buyouts, financial distress,
special situations)
Direct Investments (of BHC-affiliated SBICs and venture
capital subsidiaries of non financial companies)
Dollars
Limited
partnership
interest
Dollars

Equity claim
on
intermediary
Private equity securities
Dollars,
monitoring,
consulting
Private
equity
securities
Investment advisers
to investors
Placement agents
for partnerships
Placement agents
for issuers
Evaluate limited partnerships
Manage "funds of funds"
Locate limited partners
Advise issuers
Locate equity investors
Source: Structure of Organized Private Equity Market, The Economics of Private Equity Market, Stephen D. Prowse,
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2.4.2 Private Equity Financing in Different Stages of Company Development
Fund requirements vary with different stages of corporate development along with the
various private equity activities undertaken.

Seed financing
Seed financing is required for research, assessment and development of an idea or initial
concept before a company has reached the start-up phase. The investors mainly comprise
of angels, entrepreneurs and former (EVCA, 2007). It involves providing small amount
of capital required for developing a business idea.

Start up financing
Financing involves capital provided for product development and initial marketing
activities. Businesses are in the creation stage and have still not started the operations.
After the formulation and finalization of business idea or plan, various venture capitalists
join the entrepreneur in setting up the business. Such projects are risky and require capital
for research and development only.

First and Second Stage Financing (Post Creation Financing)
Business after its development requires capital for commercialization and production of
productions. As the business progresses it will be needing working capital.

Third Stage Financing (Expansion/Development)
Capital is required for expansion of growth companies. During this phase the company
would be reaching breakeven and in order to increase the production, expanding the sales
level, introducing new products/services or entering into mergers/acquisition deals with
other companies would need bridge financing, rescue or turnaround financing.

Transfer/Succession/Exit: PIPEs, Leveraged Buyout (LBO), Management Buyout
(MBO), etc.
PIPEs (Private Investment in Public Equities) involve selling of publicly traded common
shares or some form of preferred stock or convertible security to private investors.

Figure 4: Private Equity Financing in Different Stages

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2.4.3 Private Equity Business Cycle
According to Jain and Manna (2009) research study on Evolution of Global Private
Equity Market the business cycle of a private equity comprise four stages:

Phase I: Establishment of Investment Fund
In this phase limiters partners involving pension funds, hedge funds, sovereign wealth
funds, bilateral development institutions, multi-lateral development banks, wealthy
individuals, insurance companies, etc. contribute towards the development of private
equity fund. These institutional investors usually have no professional expertise as a
result of which professional fund managers are appointed to manage private equity funds.
The time duration of private equity fund ranges from six months to one year.

Phase II: Buying Equity Stakes
The fund collected through various institutional investors is then used to purchase equity
stakes in high growth potential companies. Such investments are usually made within a
period of five years from the establishment of private equity fund. Private equity
investments are made in various ways. For example, in case of direct investments the
interests of venture capital and private equity investors are aligned, under funds of fund
strategy collected amount is invested in other funds, whereas collateralized fund
obligations involves securitization of private equity funds of fund, etc.

Phase III: Exit the Investments
Private equity funds take infinite control of the target company. Their strategy involves
acquiring the target company, adding value to it and then realizing gains by disposition
their position of from the companys capital structure. This process takes around three to
five years only. They believe in timely and profitable exit so that they can capture new
SEED CAPITAL FINANCING
START UP FINANCING
FIRST STAGE & SECOND STAGE FINANCING
EXPANSION /DEVELOPMENT
TRANSFER/SUCCESSION/EXIT
ANGEL INVESTORS
VENTURE CAPITALISTS
INV
PRIVATE INVEST. IN PUBLIC EQUITIES
INITIAL PUBLIC OFFERING
SECONDARIES
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targets and for this process to happen favorable and smooth functioning public markets
must exist.

Phase III: Reimbursement
Capital redeemed after the exit is redistributed amongst the investors depending upon
their contribution in the form of initial investments. This way a private equity business
cycle completed and fund manager may call private equity capital for establishing
another private equity fund.

2.4.4 Private Equity in India
Venture capital and private equity industry has emerged as a potential source of capital
for the corporate sector and over the years, they have made their presence felt in Indian
economy too. Evolution of private equity in South Asian market can be linked to the
emergence of venture capital firms in mid 80s. Initially the venture capital funds showed
similar characteristics of private equity funds. Institutions like ICICI and IFCI played an
important role in the emergence of private equity market in India. ICICI launched a
venture capital scheme to encourage start up ventures in the private sector specifically in
the technology sector. Later IFCI sponsored and helped in the development of Risk
Capital and Technology Finance Corporation of India Ltd. that further supported newly
start up businesses. Commercial banks like Canara Bank came up with its own venture
capital fund. Various regional venture capital funds also came up which then led to
establishment of various PE funds in early 90s. Period of 1995 and 2000 witnessed
increased flow of foreign private equity investments and among them leading foreign
firms that penetrated Indian PE market were Baring PE Partners, CDC Capital, HSBC
Private Equity, Warbug Pincus, etc. In 1996, Securities Exchange Board of India issued
regulations with regard to venture capital funds. Indian private equity market slowed
down in 2001-03 on account of technology boom burst of US followed by a revival in
2004 with increased domestic private equity players flooding the market.

Indian private equity market has been emerging as an attractive destination in terms of
corporate financing as an alternative source of financing against the conventional sources.
The major factors that contribute to the flow of private equity investments in Indian
markets are increasing risk appetite of investors, increased domestic liquidity, favorable
macro economic fundamentals, growth in savings, growth in overall economy, booming
secondary market acting as buyer to private equity investments, changing regulatory
system, etc. The number of private equity deals in India increased from 82 in 2004 to 439
in 2007 to s further decline of 399 in 2008 (Private Equity Impact, 2009, Venture
Intelligence). Private equity in India has mainly targeted banking and financial services
sector, construction and real estate and information technology and media sectors. Also,
if we compare the performance of private equity backed companies with non private
equity backed companies, the former has performed better over a period ranging from
2000 to 2008. At the end of 2007, before the distortions induced by the financial crisis,
the average long-term return was around 10.7% over a 10-year period in India.

BhartiAirtel Warbug Pincus deal considered as one of the most successful private
equity deal in India which gave motivation to the entire private equity market in India
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followed by success stories of LBO deal of Infomedia by ICICI Venture in 2003 and
private equity deal of Shriram Transport Finance Corporation (NBFC) and Chrys Capital.
Gopinath (2009), believes that Indian private equity is not regulated but various foreign
venture capital funds are regulated by SEBI. There are no explicit regulations for the
private equity fundraising and investment activity in India. The first half of 2008
(H12008) has seen sustained momentum of M&A activity which had peaked during
2007. The total value of deals (M&A and PE) announced in the first
halfof2008wasUSD24.6billion as againstUSD50.7billionduringthe same period in 2007.
There were 458 deals in the H12008, as compared to530 deals during the same period in
2007. [Report on Investing in India by KPMG]. Recent and few potential private equity
deals in India are GMR Infrastructure PE deal for Rs. 600 cr. for financing the
construction of highways, IOT Infrastructure & Energy Services Ltd to raise Rs. 100 cr.
From India Infrastructure Development Fund (IIDF), Trivitron Healthcare is looking at
raising around $100 million from private equity players in European and US markets, and
LIC Housing Finance planning to raise 5 billion rupee fund, which will be managed by
LIC Housing Finance's asset management unit.

Private equity firms in India in addition to private equity funds are now raising
mezzanine funds, private investment in public enterprises (PIPEs) funds, real estate and
infrastructure funds. Mezzanine funds typically invest in debt instruments with small
exposure to equities. PIPE funds invest in stocks at a discount to the current market
value. On account of deprecation in the rupees value against the U.S. dollar, private
equity investors are finding difficult to exit their low valuing investments whereas
companies valuations being low are expected to attract competitive private equity
investments.

A study conducted by Venture Intelligence shows that during the year 2000 and 2008
private equity motivated growth of the Indian economy through value creation for Indian
corporates in the form of higher sales and profitability levels, investing in Research &
Development resulting in greater innovation and higher wage payments to PE
professionals. The success of the growth of Indian economy has been built by many
successful business stories. Among the Asia-Pacific market, Indian market saw the
highest deal activity in 2010. Favorable fundamentals of PE market in India and low
company valuations on account of high priced corporate debt are likely to provide
competitive deal opportunities for private equity investors. Indias PE and VC industry
has still not reached its full potential on account of absence of regulatory environment
conducive for the industrial growth. PE investors have ample capital available in the form
of dry powder for funding the deal activity in India in coming years.

According to a recent study on Indian Private Equity conducted by Bain & Company
Inc., the bulk of new capital will continue to come from foreign institutional investment,
foreign direct investment and foreign venture capital investment, the reason being Indias
favorable regulatory regimes. KPMG Internationals global survey, June 2008,
highlighted that India was likely to see the largest growth in its share of foreign
investment in the next 5 years as indicated by the fact that India has been a preferred
place investments by foreign investors.
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2.4.5 Private Equity Market Performance
Year 2010 has been the year of recovery for private equity worldwide markets from the
2008 credit meltdown on account of bursting of U.S. housing bubble and subsequent
recession across the world economies.

Source: IVCA Bain India Private Equity Report, 2011

According to a recent study on of private equity investors and their portfolio companies
conducted by KPMG (2007), large global private equity investors are setting up India-
dedicated funds or increasing the allocation for Indian investments in their global
portfolios.

Source: Private Equity Investing in India, KPMG, 2007

Deal making in 2010 was strong across nearly every sector of Indian economy.
Particularly PE and VC deals included energy (33 deals, US$2.2 billion), banking and
financial services (43 deals, US$1.1 billion) and telecom (8 deals, US$900 million)all
of which saw their investment values more than double in 2010 from 2009. The 55
investments in real estate last year continued to make that sector one of PEs favorites
whereas long stay of the economy in IT & IT-enable services ended in 2010.

698
665
186
71
180
2006
2007
2008
2009
2010
Recovery of global private equity market
Global Buyout Deals ($ B)
50
8
2002
2007
Increase in average deal size
Average Deal Size ($ million)
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Note: Other includes consumer products, hotel & resorts, retail, shipping & logistics, textiles, education and other
services
Source: Bain IVCA VC/PE research survey 2011

Biggest challenges and barriers to the PE/VC industry in India









Source: Bain IVCA VC/PE research survey 2011

The average stake in the deal from 2005 to 2010 remained around 23-24 percent whereas
considerable private equity investments were received for later stage developments of the
company followed by early stage and growth stage in 2008. PIPE deals declined in 2010
as valuations
increased in
capital markets
and PE investors
remained cautious.
It is expected that
financial services,
healthcare and
consumer products
will draw the most
private equity
interest over the
next two-three
1.3
0.9
0.2
0.7
0.5
2.2
0.6
1.1
1.5
0.5
Other
Telecom
Media & Entertainment
Engineering & Construction
Manufacturing
Engergy
Healthcare
BFSI
Real Estate
IT & ITES
Annual VC/PE investments in India; total deal size $9.5B
Annual VC/PE investments in India (deal size in $ B)
Mismatch in valuation expectations
Volatile marcroeconomic fundamentals (eg. high
inflation, etc.)
Tough competitive environment
Non-supportive regulatory environment
Difficulty in getting access to capital
Bad corporate governance and
so on
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years.
Top Five Private Equity Exits in 2011
Date Target Seller Exit Type Exit Value
($mn)
31 May Intelenet Global
Services
Blackstone
Advisors India
M&A 426.55
1 Oct Patni Computer
Systems
General
Atlantic
M&A 245.37
14 July Kotak
Mahindra Bank
Warburg Pincus
India
Open Market 171. 53
28 July Idea Cellular ChrysCapital
Investment
Advisors
Open Market 170
22 August Bangalore
International
Airport
Siemens Project
Ventures
M&A 134.78

Source: VCC Edge






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Investments Exits

Source: VCC Edge


Source: The Mint, November 9, 2011


Source: The Mint, November 9, 2011

247
306
6,432.90
8,969.50
Jan-Sep 2010
Jan-Sep 2011
Private Equity Activity
PE Investments ($ Mn.) No. of Deals
6
6
8
9
13
49
3
5
1
Real Estate
Retail
Media and Entertainment
Manufacturing
BFSI
Infrastructure
Pharma/Health
IT/ITeS
Others
% share of Investment, Sep 2011
% share of Investment
Year Deal
Volume
Deal
Value
($mn)
2007 114 2,638
2008 63 1,130
2009 120 2,483
2010 176 5
2011 (till 15 Dec) 110 2,502



Year Deal
Volume
Deal
Value
($mn)
2007 600 19,151
2008 584 13,929
2009 369 4,361
2010 406 8,412
2011 463 9,525

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Source: The Mint, November 9, 2011

21
9
19
6
15
8
9
6
9
Infrastructure
Manufacturing
Retail
IT/ITeS
Others
Sector-wise allocation
No. of Deals
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REVIEW OF LITERATURE

Bradford and Smith (1997) have analyzed growth and shape of private equity market
over the years and the motives, benefits and expectations of such investors. Emphasis has
also been made on potential costs involved in bringing in such sources of finance and
suggestive measures that can be adopted to delay the raising of additional equity from
outside on account of finding exit vehicle for encashment of their position. The volume
of private equity investments increased from under $5 billion to over $100 billion in
United States throughout 1980s and 1990s. As per Securities Data Corporation during
1995, out of the 600 IPOs that took place, over two-third of the 60 computer-related
companies, had previously sold stock to private equity investors (a total of 41 private
equity deals involving participation by 92 different investors had been done before the
company went public). In a study published by Federal Reserve Bulletin, around $70
billion private equity capital was raised from non-venture sources where the company is
still privately owned but has passed the initial stage of venture capital financing during
the period 1980-1994. Earlier private equity investments were done largely in the form of
Leverage Buyouts which later replaced by investments in pre-IPO companies. The study
revealed that out of 786 private equity investments between 1991 and 1993 44% of the
investments were backed by venture capital. Such significant investment by venture
capitalists along with changes in the regulatory system which allowed participation of
corporate and public pension funds in private equity led to emergence of limited
partnerships. Many investment banks also participated with a view to diversify their
investments and create better returns but end up becoming active players as they used all
their experiences, financial expertise and business connections to invest in small to
medium-sized enterprises which resulted in increased funding available for deals and the
competition in private equity market. Study shows that investors expectations are
inclined towards abnormal returns when the minority investments are made in illiquid
securities of small sized firms which are relatively fragile. Considerable value addition
can be made when private equity investors invest in a company as an institutional private-
equity partner having more experience and knowledge than the companys management,
extensive relationships with other investment groups will help the company to arrange for
another round of financing and market-timing skills of private equity partner can add
value to the companys IPO. Research has taken information about the IPO history of
private equity. 41 firms that had private capital infusions out of the 60 computer-related
firms that went public during 1995, seven had more than one private capital investor
and two firms had as many as six different investors. Some firms raised multiple rounds
of financing, while others received a series of rounds with different investors. In order to
obtain private partnerships, half of the companies had given away 40 percent to 70
percent of their stock ownership and a third of the firms had given in between 10 percent
to 40 percent. Complex legal issues, additional reporting requirements, etc are some other
costly propositions which a company has to face when bringing in private equity partner.
It was also seen that many private equity investors have push their companies into IPO
during 1995 irrespective of whether the company was ready for it or not. The companies
that went public were the most successful firms in the investors portfolio and IPO
returns from such companies were expected to balance the lower returns and losses from
other alternatives in the portfolios. Entrepreneurs can encourage auction based deals
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thereby negotiating investors expected return, reviewing alternative financing options,
get advisers like retired financial executive, consultants, etc. to have guidance on various
matters and so on.

Leeds and Sunderland (2003) analyzed that during mid 1990s private sector was believed
to be the primary source of investment and development in emerging economies as
variety of factors contributed to such scenario including low interest rates, declining
inflation, high growth rates in these economies accompanied by favorable regulatory
system, ever rising demand for capital by various domestic companies and competitive
environment. Private equity provided a mid-point along the financial spectrum. Research
highlights various factors that attracted private equity investments during 1990s were
shortage of capital in emerging markets, favorable macroeconomic fundamentals,
opening up of the government to foreign investments and incentive of earning abnormal
returns. Despite of such favorable circumstances, research found that emerging
economies have failed to provide expected returns to investors as compared to similar
investments in advanced economies (U.S. and Europe). One of the major factor
responsible for such disappointment was that fund managers used the existing models
(applied in case of advanced economies) for analyzing and valuing the targets despite of
different accounting standards, nature of markets, corporate governance policies and exit
routes between emerging and advanced economies. Private equity funds in emerging
markets were simply an adaptation of U.S. venture capital model and sharp rise in
dollars value against other currencies has also been the reason behind low returns from
emerging economies. So, there emerged a need to change the existing model, financial
institutions sharing the risk with their private counterparts and foreign funds becoming
more local. There was a need that in order to align their business model, fund managers
must appoint local professionals have more knowledge and understanding of the
emerging market economy and the investment climate. This scenario changed as
indicated by increased rates of FDI in Asia (19 percent), Eastern Europe (27 percent) and
Latin America (19 percent) between 1992 and 1998. Study highlights the importance of
rethinking and reconstructing the investment strategies adopted in emerging economies.
For example, looking beyond the traditional exit strategies like IPO and adopted creative
strategies like mezzanine fund or recapitalization, promoting sound corporate governance
standards with regard to disclosures, management accountability, audits, etc., improving
access to public equity markets and making sure that they function well for successful
exit of private equity investments to happen, imparting proper specialized training to the
fund managers and so on.

Moon (2006) examines that in order to make sound equity raising decision cost-benefit
analysis of both public and private equity must be made. Public equity market is
considered highly efficient and liquid, equity can be raised smoothly due to large number
of public companies operating in the market, option of diversifying the investments and
providing financial flexibility on account of increased credibility in the eyes of
stakeholders and shareholders. But raising capital from public market involves substantial
costs. The way private equity is structured and operates is completely different from the
public equity market. It is considered that private equity investors add value to the
company in which they invest. There exist difference between the incentives of general
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partners of private equity firms and managers of firms that invest in the equity of public
companies. According to a study of Kaplan and Schoar (2005), it was analyzed that over
long periods of time, private equity firms have produced average returns to investors that
are almost equivalent to the returns on public equities. Research found that the skills
required to succeed in private equity market are much broader than those required to
invest in public market. Private equity investors provide investment irrespective of
market conditions and the process involves is rigorous due diligence of a business,
financial and legal nature. Private equity plan is a wealth creation plan as compared to the
compensation plan of public equity. Other benefits of private equity are less politics on
account of smaller boards, number of useful contacts for a portfolio company, better
goodwill with the management team due to interactive and pleasant discussions regarding
their compensation/incentive, etc. Public and private equity are related to each other in
some or the other way. For example, studies show that public companies that undergo
management buyout demonstrate better operating performance, when venture capital
backed companies choose to go public, they face less costs in going public and so on.
Research explains that for the development of private equity markets there is need for
well functioning public equity markets. Black and Gilson have argued that public market
supports venture capital by serving as an important means of exit for these investors and
hence in this way both these markets compliment each other.

Conroy and Harris (2007) evaluated that the average net returns to investors in private
equity have not been nearly as attractive as many investors presume. It has been found
that risks are often devalued whereas returns are usually overvalued in private equity
investments. But when investments are made in superior private equity funds the returns
outperform the returns from public equities as indicated in a recent study conducted by
National Venture Capital Market (NVCM) where investors earned average annual returns
of 14.3 percent in PE funds as compared to 11.2 percent on S&P 500 and 12.6 percent in
case of NASDAQ. Investments in top funds accompanied by value adding strategies
being adopted by fund managers are the key reasons behind the success in private equity
investments. Study also highlights various challenges involved while measuring private
equity returns: non availability of information for pricing of private equity investments,
illiquid nature of such investments and information asymmetries and investor skills. In
one study conducted by Kaplan and Schoar (2005) it was reported that private and public
equity carries equivalent risk. Another study by Lerner, Schoar and Wong (2005)
segmented returns based on the form of institutional investor and the main findings were
that endowments significantly outperformed while investment advisors and banks did
poor. It has been concluded that private equity investments have a small potential for
huge payoffs along with a material probability of complete loss of capital. Research
showed that firms investing only in private equity business and quoted on exchange
provide quite limited liquidity as compared to other public stocks and their average
annual returns estimates are lower and risk estimates are higher after adjustments.
Whereas contradictory results were shown by a research of Venture Economics, where
mean returns from private equity outperform public stocks and bonds and private equity
ratio shows lower risk as measure by standard deviation and beta. Author summarized
that addition of private equity to portfolio significantly improves the efficient frontier
relative to the case with only public bonds and stocks.
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Cumming and Walz (2007) analyzed the drivers behind institutional investors investing
in private equity firms. They conclude that institutional investors are inclined to invest in
PE firms in economies which have strong disclosure standards, favorable legal
environment, stable economic growth and strong financial markets. The authors are of the
view that private equity managers are inclined to overvalue their investments with a view
to attract more institutional capital/funds. The study finds that less experienced private
equity managers and those involved in early stage investments are more likely to
overvalue their unrealized investments. Other factors contributing to overvaluation are
weak legal system, less stringent accounting standards, and unstable market conditions.

Gaughan (2007) has discussed the growing role of private equity and hedge funds in
various mergers and acquisition deals during the fifth merger wave in which there was
substantial increase in deal values during 1990s. According to the study, ever increasing
costs of being a public company on account of which many public companies became
inclined towards private ownership, regulatory practices and audit requirements are the
factors that primarily contributed to a series of mergers and acquisitions. Research argues
that private equity investors can either take minority interest or majority position in the
equity of a company; either they can buy 100 percent equity of a company by making it a
leveraged buyout deal or through organizing venture capital fund and allowing the targets
the benefit of having access to more financing options. According to the author, targets
sold through private equity exit strategy (IPO) continue to have acquisition opportunities.
During 2005, many private equity firms joined with other private equity firms to
complete many leveraged deals and at the same time private equity firms were competing
against each other while bidding for various takeover targets. The various private equity
bidders were Kohlberg Kravis Roberts, Apollo Management, Warburg Pincus, Carlyle
Group, Bain Capital, etc. It was found that the borrowing capacity of the private equity
buyers has increased on account of their enlarged fund sizes. Study highlights the various
sources through which private equity firms raise their capital are various institutional
investors and wealthy individuals. They invest in private equity funds in the anticipation
of higher returns but have to bear the high risk involved along with the illiquid nature of
such funds. Thompson Venture Economics has reported that the average rate of return on
private equity funds has been 12.5 percent over the period 19952004. These returns
were higher than the returns on equity in the market resulted in high management fees
being charged by private equity managers. Hedge Fund Industry was reported to be as
large as $1 trillion, having around 8,000 active hedge fund managers in United States.
They account for as much as half of all the trading on the New York Stock Exchange
(Hansard, S. (2005, November 14) Standardized hedge fund reporting). In hedge funds
only limited numbers of investors were invited to participate in the fund and they were
expected to remain happy with whatever returns are given to them but with the collapse
of an emerging and distinguishing firm having expertise in managing investments having
lost around $2 billion within one month the scenario changed and hedge funds started
looking forward to mergers and acquisition deals, giving competition to private equity
funds.

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Hare and Steelman (2008) have identified various regulatory issues impacting the private
equity investment in banking organizations. Study highlights that acquisition capacity of
private equity firms have increased over time and hence they are making investments in
banking organizations also. Private investments in banks can be done in two ways:
general funds where the investor acquires a non controlling stake and investment is made
in a company which is engaged in a variety of activities thereby not limiting the scope of
funds activity. Another way is investment through bank-focused funds in which the fund
acquires a controlling stake and investment is made in a company established or willing
to establish as a bank holding company. In the former, the investor is not required to
comply with the bank holding company regulations whereas in the latter exist inherent
regulatory implications. Private equity investments in banking organization are driven by
two major factors: volatility in valuation of banking organization and need for capital on
account of indifferent attitude of financial markets. Both private equity investors and
banking organization have the face regulatory environment in which banks operate.
When private equity fund obtains a stake in any banking organization, it requires review
and approval of Federal Reserve Board and some State or Nation regulator and when it
becomes a bank holding or a saving and loan holding company it becomes subject to
limitations in terms of activities, regulation and reporting requirements. Most of the time,
such factors dissuade the investors from acquiring a controlling stake. Banking
regulations are also applicable in case of joint activity where different parties are
involved seeking joint investments. Research argues that a bank holding company can
become financial holding company and can expand the scope of its business activities on
account of two conditions: being well capitalized/managed and obtaining satisfactory
rating. Whereas such is not the case with saving and loan holding companies in which
such conditions are not required for expanding the scope of activities. The study also
discusses the regulatory implications involved in becoming a bank holding or saving and
loan holding company such as filing of application with Fed or OTS accompanies by a
public notice, etc and on becoming a bank holding company, compliance with capital
adequacy policy, prohibition of dividend distributions, imposed collateralized
requirements on credit extension, periodic reporting, examination, obligations, etc. are
the various requirements that are to be considered by the investor. In case when banking
organizations request private equity investment they must create favorable terms and
conditions for them to make investment and treat the capital invested as qualified,
considering issuing voting rights and must understand the objectives and strategies of
private equity firms and the role banks are expected to play if they acquire a controlling
or non controlling share in banking organization.

Lopez (2008) defines private equity investments as investment in private and public
firms. It refers to investments made by private equity professional fund managers in the
equity of private companies. Research found that leveraged buyouts increased from US
$24 billion in 2001 to US $320 billion in 2006. By mid year 2007 they reached around
US $ 200 billion and from then onwards this growth slowed down markedly. Symposium
talks about economic factors that led to increased leveraged buyout activity in the U.S.
market and the factors responsible for slow growth of private equity market from 2007
onwards. Symposium distinguishes between the institutional investors as limited partners
and fund managers as general partners. Limited partners are end investors investing in
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private equity funds. Private equity funds are managed by the professionals from private
equity firms. They manage several funds at once. Their compensation comprise of two
components: percentage of money under management in these funds and portion of
realized gains (through public sector offering or sale of firm to other investors). Leverage
buyout term is used when a firm is acquired using a financing combination of debt
(issued by the company in the form of bonds, loans, etc) and equity (PE). This
combination has changed over time as indicated by increase in the share of equity used in
LBOs and decreased share of loans from banks. As the market began to shrink, the share
of bank holding in buyout deals also decline over the years. On the contrary, the share of
leveraged loan by institutional investors grew from 30 percent to 50 percent till 2006.
The factors responsible for such scenario were: changes in the financial sources on
account of development of loan securitization instruments and changes in the financing
terms and conditions as terms became more favorable for private equity firms, on account
of decline in interest rates and risk premium and debt financing becoming more attractive
and so on. Such changes contributed significantly to the U.S. subprime mortgage crisis.
Value additions made by private equity players involve changes in the capital structure,
full tax deductible interest expenses in debt financing, reduced reporting requirements
and alignment of firms management resulting in increasing the firms value.

Harvey, Lipson and Warnock (2008) have studied the issue of capital raising in emerging
economies and analyzed that distinctive characteristics of emerging economies and
internationalization of the global economy has resulted in the need to review their
regulatory framework. Raising capital in emerging economies has a significant impact on
corporate decision making. The paper studies three issues of financing of corporations in
emerging economies: governance, capital structure and internationalization. Research
argues that by improving governance, companys performance can be enhanced and
capital can be raise on favorable term. It must be understood that legal protection, sources
of monitoring and incentives to managers vary from economy to economy. One step
taken in this regard was the development of anti-self-dealing index which helps in
preventing managers from legally enriching themselves at the expense of shareholder and
to recover the damages if any. Research has shown that many firms around the globe are
family controlled and some researches have found that family ownership is beneficial
whereas others have documented that family firms perform worse. Ferreira and Matos
after distinguishing the independent institutions from grey institutions found that grey
institutions tend to be loyal to corporate management and found that the firm value is
higher when more shares are held by independent institutions. It was found that political
risk influences the capital structure. Study highlighted that firms that internationalize
have higher valuations as compared to those that never internationalize. But over the
years the scenario has changed as market capitalization has been rising before
internationalization and remaining high after.

Ratanpal (2008) elucidate the private equity in India and its presence in the Indian
economy. Goldman Sachs report on Indias growth performance highlighted that the
presence of few major growth drivers like growth-oriented policies of government,
suitable environment and various profitable investment opportunities in infrastructure
development, ever increasing domestic consumption needs, etc. has led to the emergence
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and growth of private equity market in India. According to Ratanpal, India became
number one destination in Asia in 2007 in terms of private equity investments it received
($ 17.5 billion). In Indian the focus of private equity investment has been on providing
growth/expansion capital to the businesses than for buyout purposes as the case in
developed markets. The country has become an attractive investment avenue for private
equity investors on account of fundamental macroeconomic factors of family owned
businesses like small and medium sized enterprises flourished over a period of time
showing multifold increase in their turnovers and contributing about 50 percent of the
total industrial output, requiring fresh capital for growth and expansion; inorganic growth
processes of businesses are being funded by private equity; emerging entrepreneurs
targeting emerging and new consumer demands requiring financing and strategic support
of private equity investors, etc. Majority of the private equity investments were made in
the form of growth capital (contributing 41 percent of the deal value and 49 percent of the
deals in numbers in 2007) followed by private investment in public enterprises (PIPEs)
(forming formed 32% of the total deals in value and 18% in the number of deals in 2007).
Ratanpal observed that over 350 funds were invested in India at the end of 2007 having
their own characteristics within sectors, transaction size, and type of transaction. The
universe of private equity investors consists of large funds such as CVCI, KKR, Actis,
and Blackstone along with large players such as Bain Capital and Morgan Stanley in
Indian and domestic private equity players such as ICICI Ventures, Chrys Capital, ILFS,
and others. Research emphasized the emergence of numerous India-dedicated private
equity funds like such as Fund of Funds, secondary funds, co-investment funds and other
equally attractive investment products.

Klier, Welge and Harrigan (2009) have documented that private equity market
environment has changed significantly as many successful private equity players have
become active investors in the market. Research has found that there is easy access to
capital on account of increased investments from institutional investors and sovereign
wealth funds to leading private equity firms in anticipation of higher returns from the
market. Financial institutions are willing to provide large amounts of debt for financing
of various buyout deals and the competition between the traditional and new private
equity investors has increased. Private equity firms have changed their management
models and started focusing on operations aspects of managing their investments in
businesses. They have adopted an interventionist model which aims at active
participation and ownership in a relatively related diversified portfolio. The model aims
at exploiting the knowledge of professionals and actively participating in the strategic
decision making and believes that professionals from diverse background create value
throughout the holding period of the investment. There are certain limitations to this
model as interventionist may reduce the tradability of private equity firms investment
portfolio and the cost involved is high as it requires large number of professionals. The
findings of the research were that interventionists managers outperform less active
management models by a considerable margin and substantial value to the investment
portfolio of the private equity firm and such performance to happen, the performance of
such managers must be viewed over a considerable period of time. For measuring the
performance of interventionists tools used were Jensens alpha, Sharpe measure and
Treynor measure.
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Burdel (2009) has examined that secondary market has evolved as a creative tool for
solving complex problems for sellers. Study concludes that secondary market makes
private equity more competitive and attractive investment proposition. It has been seen
that private equity investment durations in company portfolios have increased from four-
five year to ten-twelve years on account of issues relating to credit and illiquid nature of
private equity. Secondary market has given some flexibility to private investors by
providing the opportunity to sell in these markets. Secondary buyers add value to private
equity deals in various ways. Pricing is done based upon the institutional knowledge of
general partners and their relationship with the management, regulatory framework,
balance sheet optimization, etc. Various new transactions in secondary market like
collateralized fund obligations, unfunded swaps, tail end transactions, direct secondaries,
etc. serve specific needs of different holders of private equity assets. Over the years
general partners have also recognized the importance and benefits of secondary markets.
Despite of such positive indicators not much movement is happening in the secondaries.
One major factor behind this is the widening of the gap between sellers and buyers due to
credit problems of 2008 in U.S. market; however, the scenario is changing. Study
concluded that growth potential of secondary market is enormous and is expected to
establish as an attractive tool of private equity industry.

Goy (2010) discussed three issues that affect the ability of private equity investors to win
merger or acquisition deals: myth of dry power, absence of cash-flow lenders and
increasing portfolio issues. Research revealed that private equity has been a major
contributor to the economic growth in U.S. and the management expertise and the ability
of these investors have improved over time. Dry power refers to the committed and
unused equity capital. These commitments come from endowments, pension funds,
sovereign wealth funds and high net worth individuals. It has been seen that banks and
many non banking lender and other institutions have given plenty of liquidity to private
equity groups that fueled various auctions. As a result bank financing declined from US
$29 billion in 2007 to US $ 8 billion in 2008 and further to US $700 million in 2009 (first
half). Portfolio companies of private equity groups have been asking to put more equity
into the business and to get loan compliance, etc. The study concluded that the era of
private equity groups paying high prices for the businesses based on cash flow financing
is over. Well-funded private equity firms will remain in the market but businesses are
likely to what valuations they get from potential investors and their strong interest in the
business.

Metrick and Yasuda (2010) examined 238 private equity funds (buyout funds and venture
capital funds) raised during 1993 and 2006. The study analyzed the expected returns to
the managers and compared the performance the managers of the two funds. The
compensation of managers has a fixed component in the form of management fee which
is a percentage share of the total commitment per year (usually 2 percent) and variable
component known as carry (typically 20 percent of investment return) over and above
the committed capital amount. Research found that buyout managers are more
experienced than venture capital managers and the former can raise more funds than the
venture capital managers. Buyout fund managers were found to earn lower revenue than
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the venture capital fund managers. But buyout fund managers are able to earn higher
revenue per partner and per professional than the venture capital fund managers. The
authors have taken data from a large investor, who invests in different private equity
funds. Based on the collected data, a model is formulated and expected revenue for both
the fund managers has been estimated. Expected revenue is considered to be the function
of investor contract. It was found that many common differences in contracts can lead to
large differences in expected revenue. The study shows that experience has a
significantly negative effect on revenue to buyout funds, but the size dominates and later
buyout funds earn higher revenue than the beginner buyout funds. However, this is not
the case with venture capital fund managers. Scalability of buyout firms allows the
managers to expand the size of their fundsand the size of the capital managed per
partner or professional. The difference lies in the finding that buyout managers skill can
be applied to large companies but venture capital managers skill can be applied to small
companies only. Study reveals that the fundamental difference between buyout and
venture capital funds is that a buyout managers skill can add value to extremely large
companies whereas a venture capital managers skills can make value additions to small
companies.

SUMMARY AND CONCLUSION

The purpose of the study was to understand and explore private equity and related
concepts with a view to gain knowledge about the existence and challenges of private
equity investments, analyzing the value adding capabilities of private equity managers
and understanding the private equity market as a whole. For studying private equity and
its various aspects secondary source of information has been considered and reviewed.
The study has revealed various issues including the performance of private equity in
general and across different economic sectors, regulations and disclosure policies of
private equity, exit strategies being adopted by private equity partners, impact of using
private equity on the capital structure, and the emergence of secondary market in private
equity investments.

Conroy and Harris (2007) have shown that private equity, on an average, has failed to
provide returns that are competent as against the returns of public equity considering the
illiquidity and greater risk involved in private equity investments. Only top private equity
funds have performed consistently better and endowments have outperformed various
other institutional investors. Research has revealed that private equity as a general
alternative investment asset class has been overstated in terms of expected returns and
understated in terms of risk. But in an attempt to compare the PEQR (private equity
returns) and returns from stocks and bonds by Venture Economics, it has been found that
the addition of private equity to a portfolio significantly improves the efficient frontier
than with only public bonds and stocks if few issues relating to private equity are dealt
with like its illiquid nature, non information asymmetries and non availability of ready
market.

Private equity has emerged as an attractive and profitable source of investment between
the self-financing and conventional capital market financing sources. For the 20-year
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period ending September 30, 2005, NVCA (National Venture Capital Association)
reported that investors in the 1750 private equity funds earned averaged annual returns of
14.3 percent as compared to 11.2 percent for the S&P 500 and 12.6 percent for the
NASDAQ. Harris (2011) in his study on Private Equity Performance revealed that in
U.S. private equity market, the buyout funds commitment has increased (from around
$100 billion in 2005 to $180 billion in 2008) whereas the returns (IRR) from such
investments have decreased (from around 9 percent in 2005 to 0.4 percent in 2008).
Whereas 2010 has been a year of recovery for private equity worldwide from the 2008
credit meltdown as is evident from a recovery in buyout deal activity of $71 billion in
2009 to $180 billion in 2010 worldwide. Including real estate, venture capital and PE
investments in infrastructure, deal values in the Asia-Pacific markets rose to US$51.4
billion in 2010, approximately 20 per cent of which was invested across 380 deals in
India (Bain & Company Inc.). Whereas in India, the scenario has not been different as the
return expectations of LPs has dropped to as low as 15-18 percent from 22-25 percent on
account of high inflation and interest rates, volatile markets and political uncertainty.
However, the circumstances are advancing as indicated by private equity investments of
worth $10.11 billion in India during 2011 according to Venture Intelligence as compared
to $8.1 billion in 2010. India is expected to receive investments in sectors such as
renewable energy, clean tech and urban infrastructure projects in 2012. According to
IDFC (Infrastructure Development Finance Company Limited), road sector will continue
to be of interest to private equity investors in the coming years. Private equity firms have
pumped $2.68 billion into real estate firms during 2011 and made 69 investments in the
sector.

Despite of some short-term nervousness of the India market, the economy seems
favorable for private equity investments to grow and evolve. But there are some
fundamental issues to be considered and among them the most essential problem is non-
supportive regulatory environment, disclosure policy and bad corporate governance. The
rapid growth and globalization of the private equity industry has raised demands for
increased regulation and disclosure. This is of great concern for India as at present the
Indian private equity industry is self-regulated (Gopinath 2009). Greater transparency and
consistency in how rules are applied are important preconditions for regulatory reform.
Beuselinck, Deloof and Manigart (2008) have analyzed the role of disclosure in attracting
private equity investments. The study has revealed that increased corporate governance
calls for higher public disclosure in private equity firms and the reason behind positive
relationship between the choice of disclosure by the firms and private equity investments
is the changes in the governance and information environment. There is a need to clearly
define regulations as to what are a private equity firms and the kind of activities they are
allowed to indulge in India. At the same time it is important to create an enabling
environment for the development of a vibrant private equity market by relaxing the
barriers for the industry. Also, research highlights that increased disclosure reduces a
firms cost of capital via a reduction in information asymmetries (Botosan, 1997). It is
expected that corporate governance and due diligence will attract importance in the
coming years. Indias PE and VC industry has still not reached its full potential on
account of absence of regulatory environment conducive for the industrial growth.

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So far little research has been conducted on the exit routes of private equity investments.
As per EVCAs special paper on Guide on Private Equity and Venture Capital for
Entrepreneurs, 2007, there are five different ways in which an investor can exit from an
investment including (1) trade sale either in the form of merger and acquisition or sale of
a companys shares to industrial investors, auction sale being one exception to this
secrecy rule; (2) entrepreneur or management team repurchase where a company is
repurchased by its management team; (3) sale of investment to another financial
purchaser often termed as secondary market investor involves selling of equity stake by
one financial investor to another when company reached the state of development; (4)
initial public offering where securities are floated on public stock market and; (5)
liquidation which is a least favorable exit option exercised by the investor on account of
failed attempt to save a company. According to Venture Intelligence, private equity firms
were able to find exit routes for their investments in only 74 companies in 2011-including
only 4 via IPO-compared with 174 exits in 2010. Private equity firms also look for M&A
(mergers and acquisitions) and public market sales to cash in on their investments. The
Economist (2011) emphasized that there is a queue of private equity owned firms waiting
to go public in U.S. and Thomson Reuters considers that 39 of them have already filed an
IPO. The exit values hit a record high in 2010, with activity strong across all sectors as
indicated by $726 million exit of Paras Pharmaceutical being the highest and $112
million exit of RFCL Ltd. Recently, selling their stakes to NBFCs (Non Banking
Financial Companies) had emerged as an alternative exit option for private equity
players. Many private equity firms after restructuring and doing mezzanine debt deals at
25-26 percent, sold them to NBFCs at 17-18 percent and exited. However, the role of
NBFCs is been redefined as they are directly investing in various projects and doing debt
deals instead of buying debt papers from private equity firms. Also, it has been seen that
many private equity firms are setting up NBFCs to either lend to real estate firms or
invest in debt. Not much literature is available on the effect of using private equity in the
capital structure of a company. Considering the advantages and limitations that private
equity brings in for companies. It is still debatable that whether the inclusion of private
equity in the capital structure of a company is profitable or not.

Burdel (2009) emphasized the emergence of secondary market has an attractive and
viable investment proposition as it provides liquidity to the private equity investments.
Among the several healthy exit options was sale in secondary market to other private
equity firms like that of Metropolis Healthcare by ICICI Ventures (US$85 million) in
2010. Sambanju (Co-head, Paul Capital, 2011) had said that the advantage of acquiring
an LP interest in the secondary market is that you can already see the assets and you can
evaluate the value of these assets, without taking unnecessary risks and wondering
whether or not the future capital is going to work well. According to him, the Indian
secondary private equity market has not evolved fully yet as compared to the mature
markets of U.S. and Europe. Also, RBI has set up a working group comprising RBI
officials and market analysts to look after the enhancement of secondary markets
liquidity in India.

The analysis of the various aspects of private equity investments reveals that the
fundamentals of world economies are changing and a shift is indicated in the private
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equity investments from U.S. and European economies towards Asian markets and more
particularly in emerging markets like those of China and India. The study of the literature
shows that private equity preferences have changed for both the investors and the
companies seeking investments. Considerations regarding private equity market
regulations for better corporate governance practices and removing information
asymmetries, innovative exit options, changing role of LPs and GPs, and creating
environment conducive for the growth and development of private equity market, must
be undertaken.
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Summary Table
Serial
No.
Author(s) Year Purpose of
Study
Description Methodology Conclusion
1 Metrick
and
Yasuda
2010 To examine
expected
returns and
performance
comparison
of BO and
VC
managers
238 private equity
funds (buyout
funds and venture
capital funds)
raised during 1993
and 2006 were
examined
Mean, Median,
Quartile
Deviation, and
regression
analysis,
BO managers are
more experienced
than VC managers;
BO mangers can
raise more funds
than the VC
managers
2 Goy 2010 Factors
determining
the ability of
the private
equity
investors to
win M&A
deals
Dry powder,
absence of cash
flow lenders and
increasing
portfolio issues are
the key factors
affecting
performance of PE
investors
EBITDA for
analyzing the
flow of cash
from banks
and other
financing
sources,
Only well-funded
private equity
firms will remain
in the market.
Businesses will
look for strong
interest and
reasonable
valuations for their
businesses
3 Brudel 2009 How the
secondary
market has
evolved as a
creative tool
for solving
complex
problems for
sellers?
Analyzing PE
data from
Thomson
Venture
Economics,
Preqin, Dow
Jones and so
on
secondary market
has added value in
terms of providing
pricing
information,
opportunity to sell
in these markets,
variety of
secondary
transactions serve
the needs of
different investors
4 Klier,
Welge and
Harrigan
2009 Analyzing
how private
equity
market
environment
has changed
significantly
Easy access to
capital due to
increased
institutional
investments and
SWF, availability
of large amount of
debt, developing
operational
expertise of PE
managers
For measuring
the
performance of
interventionists
tools used
were Jensens
alpha, Sharpe
measure and
Treynor
measure
adopted an
interventionist
model;
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5 Ratanpal 2008 private
equity in
India and its
presence of
PE market in
the Indian
economy
India became
number one
destination in Asia
in 2007 in terms of
private equity
investments it
received ($ 17.5
billion)
Analyzing the
GDP growth
rate of the
Indian
economy,
consumption
and
investment,
growth of PE
in India 2002-
2007
Key drivers for PE
growth in India are
SMEs, govt.
policies, conducive
environment,
development
opportunities in
infrastructure, etc.
6 Harvey,
Lipson and
Warnock
2008 studied the
issues
relating to
capital
raising in
emerging
economies
distinctive
characteristics of
emerging
economies and
internationalization
of the global
economy has
resulted in the
need to review
their regulatory
framework
Various
research
studies have
been analyzed
Improved
governance, less
political
uncertainty, and
internationalization
of an economy
would contribute
towards better
capital raising
decisions
7 Lopez 2008 Studying the
economics of
private
equity
investments
Private equity is
defined as
investments in
private and public
companies; talks
about the factors
that had let to
increased LBO
activities, etc.
Findings of a
symposium
held at Federal
Reserve Bank
of San
Francisco have
been
summarized
PE investors add
value by way of
positive changes in
capital structure,
reduced reporting
requirements,
aligning firms
management; share
of leveraged loan
declining; etc.
8 Hare and
Steelman
2008 identified
various
regulatory
issues
impacting
the private
equity
investment
in banking
organizations
Private
investments in
banks can be done
in two ways:
general funds and
bank-focused
funds and are
driven by factors
including volatility
in valuation of
banking
organization and
need for capital
Conceptual
analysis of the
regulatory
implications
for both
private equity
investor when
investing in a
bank or a bank
seeking private
equity
acquisition
capacity of private
equity firms have
increased over
time; regulatory
implications
involved in
investing in banks
are of application
with Fed or OTS
accompanies by a
public notice, etc
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9 Gaughan 2007 discussed the
growing role
of private
equity and
hedge funds
in various
mergers and
acquisition
deals
increasing costs of
being a public
company on
account of which
many public
companies became
inclined towards
private ownership,
regulatory
practices and audit
requirements are
primarily
contributed to a
series of M&A
Data from
Thomson
Venture
Economics,
and research
work
hedge funds
started looking
forward to mergers
and acquisition
deals, giving
competition to
private equity
funds
10 Cumming
and Walz
2007 analyzed the
drivers
behind
institutional
investors
investing in
private
equity firms
private equity
managers are
inclined to
overvalue their
investments with a
view to attract
more institutional
capital/funds
study finds that
less
experienced
private equity
managers and
those involved
in early stage
investments
are more likely
to overvalue
their
unrealized
investments
institutional
investors are
inclined to invest
in PE firms in
economies which
have strong
disclosure
standards,
favorable legal
environment,
stable economic
growth and strong
financial markets
11 Conroy
and Harris
2007 evaluated
that average
net returns to
investors in
private
equity have
not been
nearly as
attractive as
many
investors
presume
challenges
involved while
measuring PE
returns: non
availability of
information for
pricing of PE
investments,
illiquid nature of
such investments
and information
asymmetries and
investor skills
Study by
Kaplan and
Schoar (2005)
and Lerner,
Schoar and
Wong (2005)
used for
measuring the
PE returns in
comparison to
public equities
Investments in top
funds accompanied
by value adding
strategies is the
key reasons behind
success in PE
investments; PE
investments have a
small potential for
huge payoffs
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12 Moon 2006 Sound equity
raising
decision
calls for
cost-benefit
analysis of
both public
and private
equities
Broader skills are
required to succeed
in private equity
than in public
market; PE firms
have produced
average returns
equivalent to
public equity
returns
Study of
Kaplan and
Schoar; Black
and Gilson
PE investors
provide investment
irrespective of
market conditions;
plan is a wealth
creation; less
politics; better
goodwill; but PE
market are public
equity market
complement each
other
13 Leeds and
Sunderland
2003 Examined
the factors
that
contributed
to private
sector
performance
as a primary
source of
financing
fund managers
must appoint local
professionals;
rethinking and
reconstructing the
investment and
exit strategies;
alignment of the
business model
Explored the
key reasons
behind
scenario
prevailing
during 1990s
in emerging
economies and
how private
equity proved
beneficial
low interest rates,
declining inflation,
high growth rates
accompanied by
favorable
regulatory system,
ever rising demand
for capital by
various domestic
companies and
competitive
environment
14 Bradford
and Smith
1997 analyzing
growth of
private
equity
market over
the years
Analysis also
comprise of the
motives, benefits
and expectations of
PE investors and
potential costs
involved in
bringing in such
sources of finance
Securities Data
Corporation;
study by
Federal
Reserve
Bulletin;
Complex legal
issues, additional
reporting
requirements, are
costly
propositions;
whereas value
addition calls for
PE investor
networking, more
experience and
knowledge.

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References

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