Private Equity’s High Pedigree

The duo managing Sri Lanka’s largest private equity fund contend there are more important priorities than buyouts right now

By Echelon.

Published on February 16, 2015 with No Comments

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Conventional wisdom would have it that private equity (PE) investment opportunities should be plentiful in Sri Lanka. Private equity wasn’t available till a few months ago and small to medium sized firms, the main PE industry targets, have had limited other options to raise new equity. Often these firms operate with far less capital than their scale requires, sacrificing growth, distracting management with cashflow challenges and being unable to afford right talent. Often private equity firms take minority stakes, allowing founders to run the businesses.

The other option is a buyout, where private-equity acquires control of a business. Buyout opportunities could also be plentiful in family businesses where a second generation is uninterested in taking it over.

The pedigree of their investors makes Emerald Sri Lanka Fund, joint venture PE fund of NDB Capital Holdings and Zephyr Management, keen to avoid buyouts. IFC, the private sector funding arm of the World Bank, and German and Dutch development funders DEG and FMO have contributed $10 million each, accounting for 60% of the Emerald PE funds eventual target of $50 million. Development funders also seek commensurate returns but also want to help firms grow and create jobs. On the other hand buyouts result in non-core asset selloffs and cost cutting laying-offs. Emerald Sri Lanka Fund Managing Directors Senaka Kakiriwaragodage and Karthik Bhat talk about the likely challenges for the fund in Sri Lanka and the opportunity. They also discuss the challenge of having development funders as investors.

Q: Sri Lanka is enjoying record low interest rates. Will this be a challenge for private equity?
Senaka: For someone looking to raise more finance, they have more options than a few years ago, particularly with regard to borrowing. However, before we started the PE fund, the underlying demographics and macro conditions we were looking at was post-war Sri Lanka growing consistently at about 6% or higher over medium-term. When economies grow at this level, companies have high financing requirements. We don’t believe the banking sector can cater to this entire requirement. We feel there may also be some sectors that are away from the banking sector like ones that don’t own a lot of assets like IT and BPO businesses. For example, I met with a company that had Rs2 billion revenue, with very thin capitalisation. It was surprising that they had come that far with that kind of a capital base. Sooner rather than later, they would have come to a bottleneck and had to strengthen their balance sheet. We are here to bridge this gap.

Karthik: I’ll amplify what Senaka said with three additional points. One, interest rates are low, but a lot of technology and services-oriented businesses may not be able to take advantage of low rates as they don’t have collateral to offer banks. In which case, they may still not have access to funding. Two, we provide long-term patient capital. Looking at bank loans, interest rates may be low, but you still have to service loans, pay interest, manage cash flows, manage the repayment of the principal, and so on. In the case of a PE fund, the patient capital will be available for 4-5 years; therefore, you can undertake value-added projects in the long run without worrying about having to pay back soon. Three, we don’t want to be just the provider of capital. We want to be a value-adding partner to entrepreneurs. So looking purely from an interest rate standpoint may not be the right thing to do;it has to be viewed as an overall package. You have to look at the positives we bring to the table such as access to our networks internationally, business development opportunities, potential technology transfers from developed markets, corporate governance and professionalizing the management team. If you look at other developed markets where interest rate cycles have fluctuated, you will see that the role of PE has remained consistent.

Senaka: Although some attach a notional high cost of capital to equity compared to debt, what you have to realize is that, without an investment the company may not grow. In hindsight, you may say that you have earned a significant return, but unless that equity and those value additions did not come through, the company may have stagnated.

Q: The Emerald Sri Lanka Fund’s investors include three development finance institutions. How does this affect the fund’s strategy? Does the development mindset of these organizations have an impact?
Senaka: Yes, of course. The DFIs are mindful about returns, which is a primary requisite for any PE fund. In addition, they will have other development links and social objectives; for example, job creation. That is primarily why we want to define our fund as a growth fund rather than just a PE fund. Initially, our primary interest will be to provide growth capital, where the money would go into the company and be used to invest, rather than buy secondary stakes. So there is some influence coming from those investor requirements. That’s the underlying growth theme – about developing the economy and not just financial returns.

Karthik: I think we are all on the same page in that respect. We clearly understand the need to create a developmental impact. We understand that economic growth, job creation and supporting entrepreneurship are very important for the DFIs, as it is for us. At the same time, a business needs to be fundamentally viable for us to make the investment, because we also have a fiduciary responsibility to our stakeholders, which includes the DFIs. The broader objective would be to marry these financial goals with the objectives that we set for ourselves in terms of supporting entrepreneurs and creating jobs in the country. There is no reason why we cannot achieve this and be successful.

Q: In the context of low interest rates, what is a good return on a PE fund?
Senaka: We will be targeting net dollar returns north of 20%, so our gross returns will be at 25-30%. Again, if we go back to the argument of returns from public markets, public market investors will hardly contribute to the company; they will just rely on the management. So the return potential would be fairly constrained and restricted to management capacity and ability. We would like to bring in additional dimensions. We want to work with the management to explore new horizons. If you look at a typical Sri Lankan export company, India would be the one prime destination with immense potential. We can work with our investors to bring in a lot of value to these companies. Our investor base is also diverse and spans the globe. IFC is the sister company of the World Bank, which has a global footprint, and DEG and FMO are based in Europe. So looking at the overall context, it is an opportunity for the company.

Karthik: There are a few reasons for the higher return hurdle. One, there is a currency risk premium attached to investing outside dollar and European markets. Two, there is an illiquidity premium. This is fundamentally an asset class where investors are locked in for 5-10 years. It’s also unlike debt where you get annual cash flows of 6-7%. This adds to the risk expectation of our investors. There is also the emerging markets premium. Over the longer run, emerging markets provide superior returns,but the risks tend to be higher as well. We try and compensate for this in the ways that Senaka mentioned – being longterm, value-added investors; bringing access to international markets; offering business development opportunities; and professionalizing management and working with them in the journey to build a $ 100 million business from one that is a $ 5 million today.

Q: What are some of the main challenges you are likely to face in Sri Lanka?
Karthik: In my experience, and I’ve worked across investments in India as well, an apathetic management is a typical characteristic across emerging markets. In markets in the US or Europe, good management is a commodity, and they are willing to roll up their sleeves and execute new ideas. This is not always the case in markets like India and Sri Lanka. We will look for three things. One is coachability of the management team. We don’t expect them to know everything, but they have to be willing to listen to external people, implement ideas and brainstorm with their investors. Two is execution capability in the context of day-to-day operations such as fulfilling orders, which can be challenging in emerging markets. Three, and this is non-negotiable, is integrity of the management team.

Senaka: There will be the typical challenges around the exit as we go along. Sri Lanka’s capital market still has to improve in terms of liquidity. There is still time for us to face that challenge, and we will work with the company upfront to have exit options. PE is new in Sri Lanka, so we need to drive the concept too. There will also have to be a lot of education from our side because it may be the first time they are working with a major partner or substantial shareholder. So for this kind of partnership to be successful, the management team needs to be collaborative, willing to listen and approachable.

Q: How does Sri Lanka compare with the West?
Karthik: Contract enforcement tends to be tougher in emerging markets. Therefore, our recourse options are limited if we pick the wrong management team. This is why you have to spend a lot of time understanding text versus subtext in terms of what they say, do and write versus what their actions indicate. We want to spend a lot of time understanding the people that we are going to work with, and hopefully make a good judgment based on that.

bDo you anticipate it will be harder to convince an entrepreneur about control rights when you come in as a minority shareholder?
Senaka: Not really. I have worked with a few companies as IPO clients. There are some companies that do IPOs not necessarily to raise money, but to go to the next level; for succession planning and creating liquidity for the share to create a potential exit route for themselves. You would have seen some examples recently, when family-held companies divested their control rights. So we have seen a slight mindset change and success stories in value creation. If the company takes on PE, there will be some dilution of control, but it’s in the best interest of the company because it’s about taking the company to the next level and putting in the right processes.

Karthik: Entrepreneurs across markets will have some reservations. I don’t think this is specific to Sri Lanka. We’ve also seen that in India, and globally as well. But what is refreshing is that we have met many Sri Lankan entrepreneurs who have been exposed to global best practices, and who are coming back to Sri Lanka to set up companies. They clearly understand that there is a trade-off. They understand our angle that, as investors, we have a fiduciary responsibility to our limited partners, and therefore the rights we are asking for are not unreasonable. They want to use us as a catalyst for change and collectively unlock value over the long term. In that sense, we are aligned. A majority of the entrepreneurs we have spoken to have initially expressed reservations, but when they understand where we’re coming from, they are willing to work with us.

Q: What is your view on buyouts? Is this an opportunity you see in Sri Lanka?
Senaka: Our main strategy is primarily to infuse growth capital. But I think we have some flexibility with regard to certain transactions having a buyout element, but we won’t be majorly driving for buyout transactions.

Karthik: I echo Senaka’s sentiment. Our strategy is predominantly to invest in small and mid-market enterprises seeking expansion and growth capital. Buyouts could be evaluated, but it will be a small portion of our fund. However, this could change down the line, when markets evolve and are more mature.

Q: Is your approach to buyouts influenced by your investors?
Karthik: Yes, we consider investor requirements, but it’s also the lifecycle of the overall market by itself. If you look at how different markets evolve, it tends to be more minority-style investing in the beginning where you closely collaborate with local entrepreneurs because you don’t understand the local ecosystem, and you need someone embedded in the system to manage the company. But over a period of time, you see the evolution to a buyout mindset as well, where entrepreneurs could be less involved and the PE investors could be more hands-on in managing day-to-day operations and affairs.

Q: Are buyouts a reality in India?
Karthik: There are some funds that have moved towards that particular strategy, but in a majority of cases the investment style is minority growth. But this happened over a period of time. You may be a minority investor, but you are actively involved in shaping strategy, working with entrepreneurs in the trenches and making hiring decisions. So for all practical purposes, you are co-managing the company. That’s what we call minority investments with a buyout mindset.

Senaka: Looking at the lifecycle of Sri Lanka’s economy, if an international investor looks to invest in a Sri Lankan PE fund, the underlying theme would be growth because the country needs to achieve 7-8% growth over the next 5-10 years. During this period, the primary prerequisite will be to infuse growth capital into companies. We need to get to where the US was in the 1980s when a lot of conglomerates tried to concentrate on the core business by divesting all non-core businesses. If you talk to conglomerates in Sri Lanka now, divestments are far from their minds. They are still holding on to their portfolios and growing it. Maybe once our economy expands, you will find a situation where you need to focus on some core areas. Then there will be restructuring and buyout opportunities, but I think it is a few years ahead.

Q: The Emerald Sri Lanka is a $ 50 million fund to be deployed over 4-5 years. What is your typical deal size?
Senaka: We are looking at $2 to 6 million per investment. So we are looking at fairly large companies in the Sri Lankan context.

Karthik: Also keep in mind that it doesn’t need to be $2 million deployed upfront. Our focus will be on small and mid-market businesses that have some scale in terms of revenue and product traction. Therefore, if we find a really exciting business that is small today, but has the potential to grow over $4 million in five years, we could start an association with the company by deploying one million dollars. Over the lifecycle of the transaction, it could end up being a $5 million investment. From that perspective, it works well for the entrepreneur because it limits his dilution, and gives him the option to grow his business and take money at the opportune time. From our perspective, there is some risk mitigation because we know more about the entrepreneur and it removes information asymmetry.

Q: Is a controlling stake out of the question in your first few investments?
Senaka: Not necessarily, but I don’t think we will be the driving shareholder. Perhaps we can partner with someone who is looking to take that significant step, and together have a controlling stake. For example, if someone is raising money for an acquisition, we can support them.

Q: In a broad sense, where do you think your first 10 investment opportunities lie? In which sectors?
Senaka: We have seen significant growth in certain sectors such as FMCG. For example, in the manufacturing businesses, companies are looking to recapitalize and expand plants. They are looking at investments even in excess of $5 million. If they take a large loan, it can disrupt their operations because some of them are looking at new markets and product lines.

Karthik: On the domestic consumption side, we are excited by consumer goods and services, healthcare, and education. All these sectors are in some ways recession proof and more reliant on growing domestic consumption. Another broad theme could be export-focused value-added businesses such as processed agri products, IT and knowledge services and logistics, where Sri Lanka is leveraging advantages to go after regional or global markets. There are examples of many successful Sri Lankan companies in these sectors. From that perspective, there are several sectors that we are excited about, and we’re actively looking to source deals and deploy money in them.

Q: When will you deploy your first investments?
Karthik: We are looking to make at least two to three investments over the next 12 months, which could range $5 million to 10 million in total. This also depends on finding the right opportunity and the right people to work with, but we’re ready to hit the ground running.

Q: Any last comments?
Karthik: I want to emphasize to our entrepreneurs whom we have tremendous respect for to view us as a value-adding partner. We are not just here to give them money, we want to be long-term partners and work with them, collectively building businesses and taking them global.

Senaka: When we chat to some of these potential companies, you realise in the first round of discussions that there are many things that can be improved within a short period of time. It could be basic finance functions, MIS or just that the management needs strengthening. Those are some of the obvious value additions that we can do. After that, you can look at longer-term sustainable development. Therefore, if you are looking from a company’s point of view at raising capital, PE will be a good option.

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