Contractual Risks in PE Invsts - Dr[1]. Kishore - PRMIA

Dr. Kishore N.K. M.Com., ACS., MDBA., Ph.D., LLB

BEKEM Infra Projects Private Limited

Contractual Risks in

Private Equity Investments

Scheme of discussion:

• PE and related investments

• Investment strategies of PE

• Process of PE and Fund’s Life cycle

• Valuation Methodologies of PE

• Contractual Risks in PE Investments: – Liquidity Preference Rights– Equity Ratchet Rights

• Risks in Pre and Post Money valuation

• Risks in 20 Pressure Clauses of PE

• Brief case study on PE investment

• Recent statistics of PE

PE and related investments

Private Equity – Broadly Defined

• Technically refers to any type of equity investment in an asset in which the equity is not freely tradable on a public market.

• Therefore, PE is:

– Less liquid

– Long Term in nature

Introduction to private equity

"Angel" "Growth""Hedge Funds"

Seed 1st Round2nd & 3rd

RoundEmerging

GrowthLeveraged

BuyoutsMezzanine

DebtDistressed

EquityDistressed

DebtHedge Funds

Age of Company

0 years 0-1 year 1-3 years 3-10 years 10-50 years 10-50 years 10-50 years 10-50 years 5+ years

Stage of Company

Idea Prototype1st generation

product

2nd or 3rd generation

product

Established, slow growth

Established, slow growth

Stressed Stressed Public

Public or Private?

Private Private PrivatePrivate or

PublicPrivate or

PublicPrivate or

PublicPrivate or

PublicPrivate or

PublicPublic

Equity Requirement

$0.2-0.5m $1-2m $2-5m $5-20m $10 - 250m $10 - 250m $10 - 250m $10 - 250m N/A

Return Expectations

70%+ 50-70% 50-60% 40-50% 25-40% 20-30% 30-50% 30-40% 20%

"Venture Capital" "Buyouts" "Distressed Investing"

Angel Investors

• Angel investor is typically a wealthy individual

• Often with a technical industry background

• Able to judge high-risk investments

• Invests in early stage companies up to Rs. 50 lacs

• Expects investment through IPO or subsequent financing rounds

Financial VCs• Most common type of VC

• Is an investment firm, capital raised from institutions and individual investors

• Being formal VC funds, have limits on size, lifetime and exits

• Are entitled to carried interest

• Fund size ranges between Rs. 100 crores to Rs. 50,000 crores

• Exits from IPOs, mergers & acquisitions, and selling on stock exchanges

Strategic VCs

• Typically a small division of a large technology company

• Invests in companies whose success may increase revenue growth of the VC

• May not concern only about the return on investment

• May provide investees with valuable connections and partnerships

• Usually takes a back seat role in funding

Why Angels Invest

• The Person– Familiarity with the integrity and abilities of the management teamOR– Friends, Family & Fools

• The “Cause”– The company is doing something that contributes to a social cause

that is meaningful to the angel…• Curing cancer, improving the environment

– The company is targeting a market segment in which the angel has experience and insight

• Perceived BIG opportunity– The Angel perceives the technology to be disruptive and does

some cursory due diligence that confirms his / her suspicions

Investment strategies of PE

Private Equity strategies

Private Equity

Private DebtCorporate Finance Venture Capital

Leveraged Buyout (LBO) Early Stage

Mezzanine

Growth CapitalLate Stage

Distressed Debt

Turnaround Infrastructure

Private Equity – Corporate Finance Strategies

Finance type Strategy

Leveraged Buyout

Acquisitions of operating companies that are financed with equity and debt

Growth Capital Expanding companies in need of capital to finance high growth or acquisitions

Turnaround Acquisitions of underperforming businesses or businesses in out-of-favor industries in need of either financial or operational restructuring

Private Equity – Venture Capital Strategies

Finance type Strategy

Early Stage Companies that are in the process of developing business plans, products / services have been developed and are marketed to a limited number of customers

Late Stage High growth companies, nearing profitability

Private Debt – Financing Strategies

Finance type Strategy

Mezzanine Investments in subordinated debt issued by operating companies; frequently issued in conjunction with a buyout acquisition and with equity kickers attached, such as warrants or options in order to enhance returns

Distressed Debt Investments in public and private debt securities that are trading at discounts to par value due to financial stress of the underlying company

Infrastructure Investments used to finance the construction or enhancement of distribution networks for electricity, water and gas, and certain transportation assets such as toll roads, bridges and tunnels

Process of PE & Fund’s Life cycle

Process of PE fund

(1) Raise Capital

(2) Evaluate Market Segments

(3) Generate Deal Flow

(4) Select Investment Candidates

(5) Negotiate and Structure Investments

(6) Nurture Portfolio Companies

(7) Liquidate / SellPortfolio Companies

Private Equity Fund Lifecycle

Period Activity

Fund raising

(6 – 18 months)

The first phase of a fund’s life cycle is the fundraising period, during which a fund is marketed to potential investors who commit capital. Capital commitments from investors are essentially promises to fund future investments as a fund manager identifies them.

Investment Period

(5 – 6 years)

Once fundraising is complete, the fund closes and begins its investment period, which typically lasts five years. During the investment period the fund manager calls capital from commitments provided by investors to make investments

Realization Period

( 5 – 8 years)

After the investment period, the fund enters the realization period, which lasts five to eight years on average. During the realization period, investments are sold or liquidated, and proceeds are returned to the investors

Private Equity

Valuation Methodologies

of Private Equity

Valuation methodologies

• Price of recent investment

• Earnings multiple

• Net assets

• DCF or earnings (of business)

• DCF from investment

• Industry valuation benchmarks

Price of recent investment

• Since the previous investment was made recently, the same price may be adopted for the current investment as well

• The validity of the valuation obtained in this way is inevitably eroded over time.

• To adopt price as above, background to the previous transaction and investment must be evaluated (such as volume, rights, strategic considerations etc)

Evaluation of previous investment and business

• Performance and prospects of the business against the assumptions / terms of previous investment

• Extent of compliance with the terms and conditions of investment documents

• Present business environment, including technical, market, economic, legal and regulatory, in comparison with previous investment

Earnings multiple

• Is applying an earnings multiple to the earnings of the business to derive the value of the business.

• This methodology is appropriate for investing in established businesses with identifiable stream of maintainable continuous earnings

• The earnings figures for a number of periods may be averaged using a forecast level of earnings or applying a sustainable profit margin to current or forecast revenues.

Essentials to apply earnings multiple

• Multiple should be appropriate, reasonable, and commensurate with the earnings growth prospects of the underlying company.

• Earnings should be adjusted for the surplus assets or excess liabilities and other relevant factors to derive enterprise value for the company

• This methodology may even be applied to companies with negative earnings if the losses are considered to be temporary and one can identify a level of normalized maintainable earnings

Various multiples

Multiple Applicability

P/E

Price / Earnings of comparative company may be used. It signifies the price market is willing to pay for the Company based on its earnings (EPS). Theoretically the company can be purchased at the MPS on the stock exchange

EV / EBIT

EV, Enterprise Value, is the sum of net worth and net financial debt of the Company. EV / EBIT indicates the multiple of EV for the total earnings of the Company

EV / EBITDA

EBITDA is the total cash earnings of the Company.

EV / EBITDA indicates the multiple of EV for the total cash earnings of the Company

Caution required while applying multiples

Multiple Caution

P/E

P / E is a market based approach.

Market capitalization of a quoted company may not reflect the value of the Company but only the price at which ‘small parcels’ of shares are exchanged.

The comparative companies should be similar in terms of business activities, markets served, size, geography and applicable tax rates.

EV / EBIT

This multiple ignores the benefit of depreciation, particularly in case of assets depreciated for accounting purpose over a limited period but practically have a longer economic usable value.

EV / EBITDA

This multiple removes the impact on the value of depreciation of fixed assets and amortization of goodwill and other tangibles. The need of replacement of highly depreciable assets, need for expending additional amounts to be amortized over a limited period have to be factored in.

Net assets

• This methodology involves deriving the value of business by reference to the value of its net assets

• This is likely to be appropriate for a business whose value derives mainly from the underlying value of its assets rather than its earnings. Ex., property holding companies and investment businesses.

• This may also be appropriate if return on assets is inadequate and greater value can be realized by liquidating the business and selling its assets

Caution required while applying Net assets method

• Contingent assets and liabilities may also be included while valuing assets and liabilities of the Company

• An appropriate marketability discount should be applied to arrive at a realistic value of the assets

• The value of the redeemable instruments, if any, should be deducted to arrive at the available value of the assets

Net Assets

DCF from the underlying business

• Discounted Cash Flow (DCF) methodology involves deriving the value of a business by calculating the present value of expected future cash flows

• Is flexible as it can be applied to any stream of cash flows or earnings

• This methodology may be applied for businesses going through a period of great change, such as a rescue refinancing, turnaround, strategic repositioning, loss making, or is in its startup phase etc.

DCF from the investment• Unlike the DCF from the business

earnings, this methodology applies DCF technique to the expected cash flows from the investment itself.

• Where pricing for the return on the investment or floating Initial Public Offer (IPO) is / to be agreed at the time of making investment, this is the appropriate methodology.

• Is particularly suitable for valuing non-equity investment in instruments like debt, mezzanine debt etc since the value of such instruments derives mainly from the instrument-specific cash flows and risks than of the underlying business as a whole

Caution for applying DCF methodology

• Cash flow forecasts, estimation of terminal value, and selecting risk-adjusted discount rate should be appropriate

• Ideally DCF based valuations should be used as a cross-check of values estimated under market based methodologies and should be used in isolation of other methodologies only under extreme caution

Industry valuation benchmarks

• Industry specific valuation benchmarks are used as per the prevailing practice of the industry

• Examples: price paid per bed for hospitals, price per seater for BPO, price per head for schools, price per subscriber for cable-television, mobile, internet companies etc

• These industry norms are based on assumptions that investors are willing to pay for turnover or market share and that the normal profitability of business in the industry does not vary much

• This may be used as a sense-check of values produced using other methodologies

EXIT OPTIONS:• IPOs• Mergers & Acquisitions• Management Buy-out• Sale to Another Fund• Buyback by Promoter/ Company• Stock Market

EXIT

OPTIONS

AVAILABLE

TO

PRIVATE

EQUITY

FUNDS

Duration of Private Equity/ Venture Capital Investment normally ranges from 3-7 years

In case of Buyback by Promoter/Company , the value at which PE Fund would exit is IRR or market-based and is pre decided at the time of investment on a certain valuation

Popular Investment instruments of PE (For issue to PE by investee companies)

Equity shares at a premium Traditional pricing. Ratchet rights may not be involved

Optionally Convertible Preference Shares

ECB guidelines apply and foreign PE / VC may not find it attractive.

Pricing can be in favour of PE. Ratchet rights may be stipulated.

Fewer no of equity shares (with disproportionately higher voting rights) and substantial portion in Preference shares

Market pricing. Deal in favour of PE. Voting control is provided to PE with the differential voting rights. (Present version of new Companies bill bans DVRs)

Cumulative Compulsory Convertible Preference Shares with participating rights

Prospective pricing. Participating rights in residual income. Very popular instrument and widely used in the recent past.

Mix of Equity + convertible equity warrants + preference shares

Multiple convertible instruments. Very complex to structure. Pricing can be manipulated as per the agreement between the parties.

Debentures convertible into equity shares at the time of IPO at the IPO price

Pricing can be fair and neutral. Comfort to PE with the periodical interest cash flows and comfort to Investee Company with the non-equity control by PE (till conversion into equity)

Contractual rights and corresponding risks in PE

investments

Liquidity Preference Rights

(and Risks)

Liquidity Preference

• Liquidity preference right applies for liquidation, merger, acquisition, takeover, sale of asset of company, IPO, or any other exit

• If company is liquidated the PE investors (holding liquidity preference rights) will be entitled to get their money back in 1 or more multiples as per the liquidity preference right

(ex: Invst x 1; invst x 1.5; invst x 2)

Liquidity Preference distribution

PE Invst

Rs lacsPE %

shareholding

Liquidity prefer

X

Liquidity pref amt

distributed#

Capital share distributed

*Total

distributed

2500 5% 1 2500 575 3075

2500 5% 2 5000 450 5450

2500 11% 1 2500 1265 3765

2500 11% 2 5000 990 5990

2500 26% 1 2500 2990 5490

2500 26% 2 5000 2340 7340

Liquidity preference distribution if liquidity realization is Rs. 14000 lacs

# PE invst x Liquidity Pref * PE shareholding % x (Liquidity realization – Liquidity pref amt distributed)

Liquidity Preference distribution

PE Invst

Rs lacsPE %

shareholding

Liquidity prefer

X

Liquidity pref amt

distributed#

Capital share distributed

*Total

distributed

2500 5% 1 2500 275 3075

2500 5% 2 5000 150 5450

2500 11% 1 2500 605 3765

2500 11% 2 5000 330 5990

2500 26% 1 2500 1430 5490

2500 26% 2 5000 780 7340

Liquidity preference distribution if liquidity realization is Rs. 8000 lacs

# PE invst x Liquidity Pref * PE shareholding % x (Liquidity realization – Liquidity pref amt distributed)

Liquidity Preference distribution

PE Invst

Rs lacsPE %

shareholding

Liquidity prefer

X

Liquidity pref amt

distributed#

Capital share distributed

*Total

distributed

2500 5% 1 2500 100 2600

2500 5% 2 5000 0 4500

2500 11% 1 2500 220 2720

2500 11% 2 5000 0 4500

2500 26% 1 2500 520 3020

2500 26% 2 4500 0 4500

Liquidity preference distribution if liquidity realization is Rs. 4500 lacs

# PE invst x Liquidity Pref * PE shareholding % x (Liquidity realization – Liquidity pref amt distributed)

Liquidity preference equations

Liquidity preference amount to PE

Liquidity realization amount x PE % shareholding x liquidity preference number

Capital share on liquidation

% PE shareholding x (Total liquidity realization – liquidity preference distribution amount)

Total distribution to PE on liquidation

Liquidity preference amount + capital share distribution

Amount available to other shareholders

Liquidity realization amount – total amount distributed to PE

Equity Ratchet Rights (and Risks)

Anti-dilution price protection provision (Equity ratchets)

• Ratchet is the structure of resetting (adjustment) of equity price and shares allocations depending on subsequent equity allotment price, future performance of company or the rate of growth etc.

• Anti-dilution price protection gives PE the benefit of reduced effective price per share if the company issues its shares at a lower price in a later round (down round)

• Later round price is considered as lower if it is lower than the share value projected to prevail at the later round price

Types of equity ratchets

• Weighted ratchet anti-dilution price protection• Narrow based weighted average anti-dilution price

protection provision

• Broad based weighted average anti-dilution price protection provision

• Full ratchet anti-dilution price protection

Nature of ratchets

• Weighted ratchet: The resetting allotment price is lowered to a price that is a weighted average of the price at which the company issued shares valuing the company at the pre-adjusted price. It has two sub-types viz., narrow based weighted average ratchet and broad based weighted average ratchet

• Full ratchet: The resetting allotment price is lowered to the lowest price, that is lower than PE’s purchase price, regardless of the number of shares issued (but not weighted average price)

Kinds of weighted average ratchets

• Narrow based weighted ratchet: Narrow based weighted average anti-dilution price protection provision might include only equity share capital and convertible preferred shares then outstanding

• Broad based weighted ratchet: Broad based weighted average anti-dilution price protection provision includes equity shares outstanding and issuable upon conversion, warrants, convertible debt, options and any other contingent right to equity shares or equity share capital

Share price adjustments with Ratchets

InvestorNo of shares

Allot price Invest amt

Before adj % shareholding

After adj no of shares

After adj % shareholdin

g

Promoters 10,00,000 80 8,00,00,000 64.52% 10,00,000 63.73%

Private Equity 50,000 125 62,50,000 3.23% 69,095* 4.40%

New Invst - 1 2,00,000 90 1,80,00,000 12.90% 2,00,000 12.75%

New Invst - 2 3,00,000 85 2,55,00,000 19.35% 3,00,000 19.12%

Total 15,50,000   12,97,50,000 100.00% 15,69,095 100.00%

Share price adjustments with weighted average ratchets

* Rs. 62,50,000/90.45; Rs. 90.45 = (Sum invst amt of PE + NI 1 & 2)/(Sum of no. of shares to PE, NI 1& 2)

Share price adjustments with Ratchets

InvestorNo of shares

Allot price Invest amt

Before adj % shareholding

After adj no of shares

After adj % shareholdin

g

Promoters 10,00,000 80 8,00,00,000 64.52% 10,00,000 63.55%

Private Equity 50,000 125 62,50,000 3.23% 73,529* 4.67%

New Invst - 1 2,00,000 90 1,80,00,000 12.90% 2,00,000 12.71%

New Invst - 2 3,00,000 85 2,55,00,000 19.35% 3,00,000 19.07%

Total 15,50,000   12,97,50,000 100.00% 15,73,529 100.00%

Share price adjustments with Full ratchets

* Rs. 62,50,000/85; Rs. 85 = Lower of Allot price to PE, NI 1 & 2)

Ratchet flow chart

PE 1 invests @ x price

Company (Equity Issuer)

Proposal for Follow on Issue

If issue price is > x,

no ratchet

If issue price is < x,

ratchet kicks-in

Reset the price: Sum invst amt

PE 1 + new shares

Reset the price: PE 1 invst amt

Lowest new issue price

Weighted Full

Total eligible shares to PE 1 @: PE 1 invst amt

Reset price as above

Ratchet exercise completes; PE investor gets additional shares

Ratchets in connection with book value of equity shares

In addition to the ratchets connected with down-rounds, ratchets are also structured in connection with book value of equity shares. While ratchets of former type protect the control interests of PE investor, the latter protects the monetary interests of the PE investors even if no down-rounds are made. The following is one of the practices to structure these kinds of ratchets.

• Optionally convertible cumulative participating redeemable preference shares will be issued at premium to equal the determined value at the time of PE investment for the equity shares of the Company.

• The intrinsically prevailing value of the equity share will be arrived at at the end of each year

• If share value as in 2 is greater than in 1, no ratchet kicks-in; If share value as in 2 is lower than in 1, no ratchet kicks-in.

• As per the ratchet, either of the following two or a mix of the following two will be effected at the option of the PE investor:

i) for the payable preference dividend amount, PE investors will have to be allotted equity shares at value that will compensate the PE investor in value terms for his total investment and this dividend receipt.

ii) Convert the preference shares into equity shares at the relevant valuation as on the date of opting for conversion

Risks in

Pre-money and Post-money valuation

Pre-money and post-money valuation

• The following are the two valuation concepts in connection with computing the % of shareholding a PE gets for its investment in the company:

• Pre-money valuation

• Post-money valuation

Pre & post money valuation equations

Pre-money valuation

Post money valuation – PE investment

Post money valuation

PE investment / PE ownership percentage or Pre-money valuation + PE investment

Share price Pre money valuation / no of pre money shares; or

Post money valuation / no of post money shares

New shares issued

PE investment / share price

Total outstanding shares

Pre money shares + new shares issued

Pre money and post money valuation - illustration - 1

Pre money valuation

Rs. 100 crores

Investment amount proposed

Rs. 25 crores

Post money valuation

Rs. 125 crores

PE’s percentage shares

Rs. 25 / 125 x 100 = 20%

Pre money and post money valuation - illustration - 2

Post money valuation

Rs. 100 crores

Investment amount of PE

Rs. 25 crores

Pre money valuation

Rs. 75 crores

PE’s percentage share

25 / 75 x 100 = 25%

Rights and Risks associated with

20 Key Pressure-Clauses

in PE investments

1/20 Key pressure clauses of PE investment

Dividend Rights:

• Dividend policy of the investee company during the period of PE investment is influenced by PE.

• The dividend policy is formulated in a tax efficient way

• Usually, on account of taxation, PEs do not encourage periodical dividend payments

• PE investor holds an overriding right to veto the payment of any dividend.

2/20 Key pressure clauses of PE investment

Nature (kind) of shares for PE investors:

• PE investors usually invest in either Equity or preference depending on the legal provisions prevailing in the host country

• Since ratchet rights have to be accommodated, generally PE investors prefer convertible preference shares over equity shares. However, since veto rights are available only for equity shareholders, PEs prefer to hold a mix of preference and equity.

• PEs also prefer to hold golden shares (with additional rights).

• Differential Voting Right (DVR) shares are considered in India. However, the new companies bill prohibits issuance of DVR shares.

3/20 Key pressure clauses of PE investment

Liquidation Preference:

• Liquidation preference accords a right to the PE investors to receive certain amount of the realized amount out of liquidation of the Company in preference to other shareholders.

• This preference amount may be equal to the amount of the original amount invested by the PE investor or a multiple of it.

• In India liquidation preference rights may not be possible on equity shares and hence PE investors prefer ‘cumulative participating preference shares’

4/20 Key pressure clauses of PE investment

Redemption Rights (Equivalent to sell-back right in India):

• PEs demand that the Company shall buy back its own shares from investors. PEs insist that the other shareholders (usually promoters) should not participate in the buy back scheme thereby facilitating their shares to be bought back by the Company.

• Valuation of the buy back of the shares is subject to the guidelines issued by the competent authorities.

• Alternately and / or simultaneously, as per the terms of the investment agreement, promoters will have the obligation to purchase the shares from PE investor at a price to yield the required rate of return

5/20 Key pressure clauses of PE investment

Anti dilution (Price protection ratchets / Price protection rights):

• PEs hold anti-dilution protection rights to protect the value of their stake in the Company if new shares are issued at a valuation which is lower than that at which they have originally invested. Such subsequent or follow on issue round is termed as ‘down round’.

• These rights are termed as ratchet rights. Ratchets could relate to price of follow on issue price or valuation of the equity share even in the absence of a subsequent equity issue.

6/20 Key pressure clauses of PE investment

Right of first refusal (ROFR):

• ROFR right provides that if any shareholder (usually promoter) intends to dispose of shares, such shares must be first offered to the PEs (if ROFR right is held) at the same terms and conditions the shares are intended to be sold.

• These rights ensure that the promoters do not sell their shares to persons whom PE would not like to be shareholders of the Company.

• These rights also ensure that the promoters do not sell their shares at unusual terms to their preferred persons

7/20 Key pressure clauses of PE investment

Drag along (Bring along) rights:

• A drag along provision creates an obligation on the other shareholders (usually promoters) of the Company to sell their shares to a potential purchaser if and when PE shareholder votes to sell its shares to the potential purchaser

• These rights will be useful in the context of a sale where potential purchasers intend to acquire substantial majority (usually 100%) of the shares of the Company in order to avoid having responsibilities towards minority shareholders after the acquisition.

8/20 Key pressure clauses of PE investment

Tag along (Co sale) rights:

• A tag along provision creates an obligation on the other shareholders (usually promoters) of the Company to ensure that the potential purchaser agrees to purchase an equivalent percentage of PE’s shares at the same price and under the same terms and conditions.

• This right may have the effect of making the shares more difficult to sell.

9/20 Key pressure clauses of PE investment

Pre-emption right :

• Preemption is the right of PE investor to participate in a financing to the extent necessary to ensure that, if exercised, its percentage ownership of the Company’s shares will remain the same after the financing as it was before.

• In Indian term sheets, it could even mean rights of PE to decide whether certain items can be taken up by the Board or General Meeting in the agenda.

10/20 Key pressure clauses of PE investment

Representations:

PE investors insist on representations from the issuer Company (and from the Promoters) to be included in the investment agreement / term sheet confirming about the information disclosed and that the deal (investment by PE) is subject to the facts, information, statements furnished by way of representations.

Representations are also stated as recitals. Recitals usually form part of the agreement. PE investors prefer to include the representations in the agreement rather than in recitals since as per the legal interpretation, recitals are considered as jointly agreed upon statements / situations than a cover to the other party.

If any representation is found inaccurate subsequently, PE will have a right to initiate corrective action including accelerating the investment as per the terms of the investment.

11/20 Key pressure clauses of PE investment

Warranties:

PE investors insist on warranties from the issuer Company (and from the Promoters) to be included in the investment agreement / term sheet to provide the investors with a complete and accurate understanding of the current condition of the Company and the past history so that the investors can evaluate the risks of investing in the Company prior to investing in the Company.

The warranties typically cover areas such as legal existence of the Company, financial statements, business plan, assets, liabilities, material contracts, employees and litigation.

If any warranty is is found inaccurate subsequently, such an event will be considered as breach of the agreement and the PE will have a right to be reimbursed for the loss / expenses etc with an additional right to rescind the investment agreement itself.

12/20 Key pressure clauses of PE investment

Consent Rights:

PE investors normally hold consent rights which provides that that certain actions cannot be taken by the Company without the consent of the PE investors or of a majority % (as specified)

These consent rights need not confine to only board agenda items

13/20 Key pressure clauses of PE investment

Board Seats:

PE investors will require a right to nominate one or more directors to be appointed on the Board of the investee Company.

PE investors may also require a right to appoint a Board Observer who can attend all Board Meetings but will not participate in any board decisions.

14/20 Key pressure clauses of PE investment

Information Rights:

PE investors will require right to receive information on a regular basis concerning the financial condition and budgets along with a general right to visit the company and examine its books and records.

15/20 Key pressure clauses of PE investment

Registration Rights:

These are specific only to USA since SEC requires the registration of the securities to be eligible for offering for public sale (Offer for Sale). The registration process involves the Company providing significant information about its operations and financial condition which can be time consuming and expensive.

In India this clause is non-existent. However a corresponding clause to this in India is that PE investors insist that the Company do not recognize PE investors under promoter group and also should endeavor to avoid PE investors being recognized as promoters under law. This will help PE investors not to be subject to the lock-in requirement of the promoters’ shares at the time of IPO of the Company.

16/20 Key pressure clauses of PE investment

Conditions Precedent:

Term Sheet / Investment agreement of PE investors will include a full list of conditions to be satisfied before investment will be disbursed.

Usually Conditions Precedent to signing of the investment agreement and Conditions precedent to releasing of the investment amount to the investee Company will be separately laid down clearly in the term sheet and the investment agreement respectively.

Conditions to be fulfilled in advance

17/20 Key pressure clauses of PE investment

Tranche Disbursements:

PE investors will have a right to release the investment amount in one or more tranches (stages / phases) dependant on achievement of targets or milestones claimed to be achieved in the business plan of the Company.

While the investment price may be determined at the time of signing of the investment agreement itself, the investment amount is structured to be released in tranches (stages) to ensure that the Company is growing as per the growth guidance issued by the Company / Promoters.

18/20 Key pressure clauses of PE investment

Exit Options / Rights:

PE investors will reserve right to exist in various ways including: - Initial Public Offer (IPO)- Offer For Sale (OFS)- Merger- Take Over- Strategic Sale

19/20 Key pressure clauses of PE investment

Non Compete Clause:

PE investors will require the promoters to sign non-compete agreements so that the promoters will not nurse their interests to promote and develop other companies which may eat in to the business of the investee Company or which may stand competition to the investee company.

Usually the Non-Compete agreements will carry a tenure of about 5 years from the date of investment.

Cant

20/20 Key pressure clauses of PE investment

Special Audit:

PE investors will require the Company’s financials to be audited by a special auditor usually appointed by them in addition to the statutory auditor of the Company.

The costs of the audit and the audit fee for the special auditorr have to be borne by the Company.

Special Auditor submits his audit report to the PE investor with a copy of the audit report to the Company. In addition to the usual financial audit, he may also comment on the status of the compliance of the conditions of the terms and conditions of the investment agreement signed by the Company with the PE investor.

Pros and Cons of Private EquityAdvantages for Company Disadvantages for Company

Faster Growth More complex accounting and reporting

Unsecured Finance Investor veto rights

Employee ownership (in the case of MBO)

Accountability to investor

Strengthens financial position Investor’s involvement in board decisions

Facilitates obtaining other forms of finance

Restrictive covenants for managers / operations

Funding is committed until exit (unlike bank loans)

Warranties to be given by promoters / company

Management and relationship advise

Investor’s objective / motive is exit at good return

Challenges to PE in India

Area Challenge

Value of Private Equity

-Important to be an active investor to understand the value add from PE-Must trade-off value, growth and risk-Analyzing the relative merits of a potential non-PE investment-No relevant experience to guide

Market conditions

-Developing business plans and best practices for privately held and family run Indian firms-Questions of global competitiveness-Discarding what is irrelevant and possibly damaging for Indian companies

Exit Strategy -Market and business tolerance for public offerings-Family business reluctant to relinquish control-Inevitability of an Initial Public Offer (IPO)

Others - PE sponsors more susceptible to volatility in the global debt market-Increased regulations-Lower IRR on existing PE portfolios

Case study on PE Investment and

associated risks

CLSA Private Equity Investment in Apar Industries Limited

Apar Industries Limited:USD 250 million Apar is the largest player in transformer oil division with 50% market share. It is second largest player in the aluminium power conductor business with 25% market share. It is largest exporter of aluminium power conductors from India.

.

The PE Investor:

Credit Lyonnais Securities Asia (CLSA) is Asia’s leading independent brokerage and investment group. It is active in equity broking, capital markets, mergers and acquisition, asset management services, and private equity investments

Investment vehicle:

CLSA CLSA PE Limited, Hongkong Aria Investments Partners Shinny Limited, Mauritius

The PE Transaction:

Private Equity investment:

In September 2005, CLSA Private Equity was issued 3,445,978 shares as 5.4% cumulative compulsory convertible preference shares with participating rights for Rs. 185 per share. Convertible on 11 th October 2006 into equity shares resulting in 14.21% equity stake of Rs. 10 each at a premium of Rs. 175 per share

• Number of shares: 3,445,978• Converted into equity on 11-10-2006: 3445978 equity shares of Rs. 10 each with a premium of Rs. 175 each• Market Price of Share (MPS): On date of conversion (pre-bonus): Rs. 246; Post-bonus : Rs. 188; Highest till

Jan 2008 (post-bonus): Rs. 450;• Bonus issue on 18-Jan-2007: 1:3 ratio; Initially issued: 3,445,978 + bonus: 1,148,659 = 4,594,637

Rights & Risks: • Board seat (Directorship) to be reappointed during the currency of the Investment Agreement• Right to appoint observers; Right to call for special audit; • Identified material adverse events; • Obligation on Company and Promoters to ensure exit by way of strategic sale / FPO• Tag along and drag along rights • Information rights• Pre-emptive rights• Anti dilution rights (read implied ratchets)

Recent Key statistics related to PE investments

PE Funds raised

Location 2002 2003 2004 2005 2006 2007

India 160 260 823 2,637 4,859 5,831

Asia 2,991 3,322 11,463 28,010 41,113 50,671

PE: funds raised & investments made (amount in US $ mio)

PE investments made

Location 2002 2003 2004 2005 2006 2007

India 1,050 865 1,479 2,424 7,520 17,273

Asia 9,112 17,580 19,010 33,596 62,818 82,955

PE Investments versus FDI

Investment 2002 2003 2004 2005 2006 2007

PE 1,050 865 1,479 2,424 7,520 17,273

FDI 5,035 4,322 6,051 7,722 19,531 45,455

PE Investments in India: FDI & GDP

(amount in US $ mio)

PE investments versus GDP

Value 2002 2003 2004 2005 2006 2007

PE Investment 1,050 865 1,479 2,424 7,520 17,273

GDP 495,651 575,245 666,305 778,666 873,659

Most active international players in 2007

Fund manager Nationality Firm Type Deal value (US $ mio)

Temasek Holdings Singapore Govt affiliate 3,152.2

CVC International US Bank private equity arm 2,057.8

Goldman Sachs US Bank private equity arm 1,883.0

Blackstone Group US Independent VC / PE firm 1,136.8

India Equity partners US Independent VC / PE firm 1,098.9

AIF Capital Hong Kong Independent VC / PE firm 1,008.2

Macquarie Bank Australia Bank private equity arm 1,000.0

Avenue Capital US Independent VC / PE firm 717.8

Carlyle Asia US Independent VC / PE firm 701.0

Dubai International Capital

UAE Investment Company 637.8

Most active Domestic players in 2007

Fund manager Nationality Firm Type Deal value (US $ mio)

ICICI Venture Funds India Bank Private Equity arm 1,106.5

New Silk Route Advisors India Independent VC / PE firm 443.0

IL&FS Investment Managers India Independent VC / PE firm 324.6

Beacon India Advisors India Independent VC / PE firm 273.2

IDFC Private Equity India Bank Private Equity Arm 268.8

Indivision Investment Advisors India Independent VC / PE firm 217.0

UTI Venture Funds India Independent VC / PE firm 156.6

Zeus Inframanagement India Independent VC / PE firm 127.5

Jacob Ballas Capital India Independent VC / PE firm 119.3

ChrysCapital Management India Independent VC / PE firm 117.9

Stage-wise investments (amount in US $ mio)

Stage 2003 2004 2005 2006 2007 2008*

Bridge loan 0.0 0.0 0.0 0.0 11.3 0.0

Buyout (M/LBO) 126.0 564.9 174.5 1,280.2 967.9 70.0

Expansion 204.2 468.5 1,168.3 3,074.7 7,096.1 4,166.1

Franchise funding 0.0 0.0 0.0 0.0 15.2 0.0

Mezzanine / Pre-IPO

4.7 7.3 112.2 1,236.0 800.4 442.7

PIPE financing 526.7 438.3 910.6 1,290.3 5,581.2 1,028.6

Seed / R&D 0.0 0.0 0.0 7.0 31.7 0.0

Start-up / early stage

17.2 0.0 58.4 627.2 2,768.7 1,142.7

Turnaround / restructuring

27.2 0.0 0.0 5.1 0.0 0.0

Total 906.10 1,479.2 2,423.9 7,520.5 17,272.4 6,850

* First half of 2008

Investments by Industry (no of deals)

Industry 2003 2004 2005 2006 2007 2008* (HY)

Agriculture / fisheries 0 0 0 1 1 1

Computer related 6 10 8 15 22 6

Conglomerates 0 0 0 0 0 0

Construction 1 1 1 8 11 2

Consumer prod/ servi 0 3 3 20 7 6

Ecology 0 0 0 0 0 0

Electronics 1 2 1 6 16 3

Financial services 8 4 10 39 72 23

Information Tech 6 4 19 28 47 24

Infrastructure 0 3 4 19 13 6

Leis / Entertainment 1 0 7 4 3 1

Manufac – heavy 3 6 18 23 13 17

Manufac – light 1 0 2 4 1 2

Media 2 2 0 6 5 2

Medical 6 8 20 22 28 15

Mining & metals 0 0 0 6 10 3

Retail / wholesale 0 3 2 6 9 5

Services non-fin 11 5 3 22 21 15

Telecommunications 1 3 8 6 23 11

Textiles & Clothing 0 2 10 13 11 5

Transport / distribut 3 3 18 34 30 17

Travel / Hospitality 0 0 7 9 9 8

Utilities 1 4 6 11 9 7

Total 51 63 147 302 361 179

Select PE transactions in 2007Investee Ind Amt $

mn% Investors

Computer Age Mgmt services Computer related

90.0 Advent Intnl Corp / South East Asia Venture Investment (SEAVI)

ICSA (India) Computer related

22.0 Goldman Sachs (Asia)

Infotech Enterprises Computer 63.9 13.0 General Atlantic LLC

Divya Sree Developers Construction 100.0 TPG-Axon Capital LLC

Jaypee Infratech Construction 815.3 ICICI Venture Funds Mmgt Co.

Punj Lyod Construction 198.7 Avenue Capital / Blackstone / DKR Oasis / Kingdom capital / Warburg Pincus

Soma Enterprise Construction 102.9 India Reit Fund Advisors

Heritage Foods Consumer products

8.9 Carlyle Asia India

BGR Energy Systems Electronics 32.6 4.0 Citi group Venture Capital Intnl

Havell’s India Electronics 112.1 11.2 Warburg Pincus India

Sudhir Gensets Electronics 65.0 15 GE Commercial Finance; Goldman Sachs

AK Capital Services Fin services 9.1 13 Global Technology Investments LLC

Anand Rathi Securities Fin services 22.7 19.9 Citi group Venture Capital Intnl

Angel Broking Fin services 37. 12.5 IFC (world bank group)

ARCIL (Asset Reconstruction) Fin services 13.7 9.2 Ankar Capital Management LLC

Bombay Stock Exchange Fin services 79.8 8.0 Atticus Mgt LLC; Caldwell Asset Mgt, Urbana Corp

(contd) Select PE transactions in 2007

Investee Ind Amt $ mn

% Investors

CDSL Central Depository Fin services 4.1 5.0 Croupier Private Equity Partners

Centurian Bank of Punjab Fin services 41.6 5.3 ICICI Venture Funds Mgmt Company

City Union Bank Fin services 18.7 12.5 Argonaut PE, Blue River Capital, FMO (Netherlands Devpt. Fin Company)

Delhi Stock Exchange Fin services 10.3 20.0 Kuwait Privatization Project Holding Co., New Vernon PE, Noor Financial Invst Co, Passport Capital

Future Capital Holdings Fin services 23.5 10.0 Och-Ziff Capital Mgmt Group

HDFC Fin services 649.9 5.6 3 Logi Capital

ICICI Bank Fin services 598.3 2.9 Dubai International Capital

IDFC Fin services 185.9 10.0 Khazanah Nasional Bhd.

India Infoline Investment Fin services 76.4 22.5 Orient Global Pte.

Karnataka Bank Fin services 36.2 5.0 IFC (world Bank)

Karvy Stock Broking Fin services 44.0 IFC (world bank)

Magma Leasing Fin services 15.0 FMO Netherlands Devp. Fin Corp.

M&M Financial services Fin services 6.6 1.4 Chrys Capital Mgmt. Co

Mahindra Forgings, Mauritius Fin services 4.9 10.0 Promethean Investments LLP

Manappuram General Finance & Leasing

Fin services 11.8 30.0 India Equity Partners; Sequoia Capital Limited

National Stock Exchange Fin services 345.0 15.0 General Atlantic; Goldman Sachs; SAIF Partners

(contd) Select PE transactions in 2007Investee Ind Amt $

mn% Investors

Religare Enterprises Fin services 15.6 5.0 Merrill Lynch Global Principal Inv.

Shriram Transport Finance Company

Fin services 82.1 5.7 Infinite India

SKS Micofinance Fin services 11.3 IDFC Private Equity Co.

Spandana Spoorty Innovative Financial Services

Fin services 12.0 Blue Ridge Capital; IFC; UTI Venture Capital Funds Mgmt. Co.

YES Bank Fin services 48.6 5.0 Khazanah Nasional Bhd.

Intelenet Global Services IT 200.0 100.0 Blackstone Advisors India; Intelenet Global Services Mgt. Team

RT Outsourcing Services IT 7.9 Motilal Oswal Venture Capital Advisors

V Soft IT 10.4 iLabs

Ansal Properties – SPVs Infra 29.4 49.0 IL&FS Investment Managers

B. Seenaiah & Company Infra 38.4 7.0 Amansa Capital Pte; IDFC; L&T Capital Company; L&T Infrastructure Finance; Lehman Brothers

Indu Projects Infra 33.9 Citigroup Venture Capital Intnl.

KMC Constructions Infra 35.0 Baring Pvt Equity; ICICI Venture

Patil Infrastructure Holdings Infra 56.7 26.0 One Equity Partners

Ramky Infrastructure Infra 28.3 13.5 IL&FS Invst Managers; Sabre Capital

Sea King Infrastructure SKIL Infra 500.0 26.0 Future Capital Holdings

Subhash Projects Infra 61.4 20.0 Citigroup Venture Capital Intnl.

(contd) Select PE transactions in 2007Investee Ind Amt $

mn% Investors

Aparna Constructions Real Estate 100.0 JP Morgan Asset Mgt

DLF Assets Real Estate 400.0 DE Shaw India Advisory Services

DLF Assets Real Estate 200.0 Lehman Brothers

Emaar MGF Land Real Estate 100.0 1.5 JP Morgan Asset Mgt; & others

QVC Realty Real Estate 100.0 IL&FS Investment Managers

Shriram Properties Real Estate 100.0 Infinite India

Vatika Group Real Estate 254.8 10.8 Beacon India Advisors; Goldman Sachs; Wachovia Capital

Firstsource Solutions Services 22.4

42.0

6.0

4.5

Galleon Partners;

SUN Group

Apollo Hospitals Ent Health 103.5 12.0 One Equity Partners LLC

Fortis Healthcare Health 20.0 3.2 TCK Advisors (Trikona Capital)

GVK Biosciences Health 25.5 Sequoia Capital

Max Healthcare Institute Health 74.0 IFC (World bank)

Great Offshore Shipping 40.8 5.0 Carlyle Asia India

Quipo Infrastructure Equip Infra renting 34.0 31.0 GIC Special Invsts Pte; IDFC PE

Vandana Luthra Curls &

Curves (VLCC)

Health care 11.3 Indivision Investment Advisors

Bharti Artel Telecom 2013.5 5.0 Temasek Holdings Advisors India

Bharti Infratel Telecom 1000.0 10.0 AIF; Citigroup; Goldman Sachs; India Equity Partners; Dubai Invst Corp; etc

(contd) Select PE transactions in 2007

Investee Ind Amt $ mn

% Investors

Dish TV India Telecom 63.0 4.9 Indivision Investment Advisors

Hutchison Essar Telecom 25.0 IDFC Private Equity Co

Reliance Telecom Telecom 346.5 5.0 DA Capital; Fortress Capital; Galleon Partners; GLG Partners; HSBC Principal Invsts; New Silk Route; Soros Fund

Tata Sky Telecom 56.5 10.0 Temasek Holdings Advisors India

Gokaldas Exports Textiles 165.0 70.1 Blaackstone Advisors India

Mudra Lifestyle Textiles 3.3 SIDBI Venture Capital; SBI

S. Kumars Nationwide Textiles 82.0 10.0 Citigroup Venture Capital Intnl

BLR India Transport 11.3 31.0 Reliance Private Equity

DRS Logistics Transport 22.7 Kotak Investment Advisors

First Flight Couriers Transport 26.7 27.7 Temasek Holdings Advisors India

Ocean Sparkle Limited Shipping 18.0 India Equity Partners

Reliable Autotech Shipping 4.6 17.0 BTS Investment Advisors Private

Adani Power Utilities 229.6 8.0 Tano India Advisors

KVK Energy & Infrastructure Utilities 26.0 Old Lane, LP

Lanco Amarkantak Power Utilities 8.0 5.8 International Finance Corporation (IFC)

Moser Baer Photo Voltaic Utilities 100.0 CDC Group; GIC Special Investments Pte; IDFC PE, IDFC Company

Select PE transactions in 2008 (first-half)

Investee Ind Amt $ mn

% Investors

Ashoka Buildcon Construction 180.3 15.6 IDFC PE Co.

Nagarjuna Construction Construction 50.0 3.2 Blackstone Advisors India

ICOMM Tele Telecom 12.4 Tano India Advisors

Parag Milk Foods Food items 14.1 Motilal Oswal Venture Capital

Mahindra & Mahindra Fin service Fin services 105.6 11.2 Standard Chartered Private Equity

Totem Infrastructure Infra 7.4 Aquarius Investment Advisors (India)

Mahindra & Mahindra Manufacture 172.4 3.7 Goldman Sachs (India) LLC

Maithan Ispat Manufacture 18.5 IL&FS Investment Managers; Orix Corp

Shakti Pumps (India) Manufacture 0.2 9.1 Mayfield

Anil Printers Media 7.4 Tano India Advisors

Apollo Hospital Enterprises Medical 13.9 1.9 Apax Partners India Advisors

Gland Pharma Medical 30.4 3 Logi Capital

Healthcare Global Ent Medical 20.0 Premji Invest

Parabolic Drugs Medical 7.0 BTS Investment Advisors Pvt.

Sai Advantium Pharma Medical 20.0 12.0 ICICI Venture Funds Mgmt. Co.

Punj Lloyd Upstream Metals 30.0 12.0 IFC (world bank)

DLF Assets Real estate 450.0 Symphony Capital

Select PE transactions in 2008 (first-half)

Investee Ind Amt $ mn

% Investors

Maytas Properties Real Estate 153.3 Infinite India Investment Management

Vaishnavi Group Real Estate 28.0 Actis Capital LLP

Shriram EPC Services 3.5 1.1 Asiabridge Fund, Bessemer Venture Partners, Chrys Capital Mgmt. Co., ICICI Venture Funds Mgt. Company

Aditya Birla Telecom Telecom 640.0 20.0 Providence Equity Partners

Bharti Infratel Telecom 250.0 2.5 KKR Asia

TV 18 Home Shopping Network / HomeShop 18

Telecom 10.0 25.0 SAIF Partners

Reid & Taylor (India) Textiles 209.6 25.4 GIC Special Investments Pte.

TVS Logistics Services Transport 25.1 Goldman Sachs (Asia)

ACME Tele Power Utilities 100.8 3.4 Jacksons Heights Investments, Monsoon Capital LLC

KLG Power Utilities 50.1 20.0 TPG Growth, LLC

Shree Maheswar Hydel Power Utilities 24.0 Henderson Equity Partners

Sophia Power Utilities 403.8 37.5 DE Shaw India Advisory Services

Select PE Exit transactions in 2007

Investee Amt $ mn

Deal %

Seller Investor

Nagarjuna Construction Company Ltd

16.4 2.1 ICICI Venture Funds Mgmt. Co. Ltd

Indian investors

Punj Lloyd Ltd 54.5 2.2 Standard Chartered PE;

Temasek Holdings

Chinese Investors

Godrej Beverages 53.9 51.0 Godrej & IL&FS The Hershey Co. (US)

MTR Foods Ltd 100.0 Aquarius Invst;

JP Morgan Partners

Orkla ASA (Norway)

Federal Bank Ltd 10.6 2.2 IFC (world bank) Indian investors

Sharekhan 118.2 85.0 General Atlantic; HSBC PE; Intel India

Citigroup VC Intnl

NIIT Ltd 48.4 10.0 Intel Capital (India) Indian investors

Gammon Infrastructure 17.9 3.5 Och-Ziff Capital Mgt Co. Gammon Cooling

PVR Ltd 3.2 3.7 ICICI Venture Funds Calderys (Finance)

Sintex Industries 256.4 25 Warburg Pincus Indian investors

Apollo Hospitals 30.3 5.3 Temasek Holdings Indian investors

Aurobindo Pharma 23.2 2.5 Standard Chartered Indian investors

Subhiksha Trading 18.6 5.0 ICICI Venture Funds Prudential ICICI

Trinethra Pvt. Ltd 76.8 90.0 India Value Funds Aditya Birla

Select PE Exit transactions in 2007

Investee Amt $ mn

Deal %

Seller Investor

New Delhi Television 7.7 General Atlantic Prannoy & Radhika Roy

Welspun India Ltd 5.0 4.3 ICICI Venture Funds Indian Investors

Deccan Aviation 104.6 20.0 Deccan Aviation, ICICI Kingfisher Radio; UB

Ocean Sparkle Ltd 18.0 APIDC Venture Capital India Equity Partners

Thank you!