The Hindu Business Line : On SME valuation

“I am thinking of equity dilution and raising some growth capital,” says a young entrepreneur friend of mine. The new generation SME (small and medium enterprise) entrepreneurs want change, and they want it fast! But the question is, given the existing market situation, the attitude of bankers and volatile micro- and macro-economic conditions, will their demand be met? Even so, will the tipping scale favour these buoyant and often well-educated next generation SME corporate leaders?

SME Idiosyncrasy

Across sectors, there are innumerable unlisted, family-owned/promoter-run SMEs. Despite having solid growth potential, the managements of these privately-held SMEs often remain wedded to the status quo and are wary of new management perspectives and fresh growth capital. Their fears on loss of control and equity continue to dominate strategic decision-making.

From the investors’ side, until recently, PE (private equity) firms’ adherence to ‘ticket’ size often made SME deals unattractive to the former, with a typical first tranche investment being less than even $5 million. However, things are slowly starting to change from both ends — with younger entrepreneurs open to equity dilution in exchange for sustained growth and PE houses raising specialised funds just to cater to the SME market.

While it’s easy for us to say ‘lets put two and two together’, the SME idiosyncrasy is acting as a big gulf. Let’s examine the peculiarities in the light of the current financial environment;

Hedging mindset

We all know that markets do not particularly care for conglomerates, and would rather have individual businesses speak for itself. While SMEs are no big conglomerates, most of them have high real-estate investment. This is due to their ‘hedging mindset’.

The first generation entrepreneurs believed that it was important to own land and building while running their core business. The real-estate was a hedge to be liquidated in case the business failed to repay banks and creditors, for instance — it was plan B, a safety mechanism.

While the unfortunate SMEs have closed shutters long ago, even the most profitable stable companies continue to hold huge real-estate investments.

While this is not wrong, from an investor perspective (PE and others), simply owning land may not fetch a high multiple unless there is a clear synergistic value with respect to the core business.

For instance, a company which generates an operational cash flow of Rs 10 crore cannot expect a good valuation purely because it owns land worth Rs 100 crore. It is time entrepreneurs are sensitised to the fact that business performance should be viewed in isolation and banking on non-core asset price inflation may not necessarily benefit.

Gearing and banking

Pressures on net margins are often a result of high gearing and interest rates. SMEs, especially those whose businesses involve commodities, find their liquidity squeezed when working capital requirements peak. When it comes to long-term borrowings, bankers’ adherence to collateral-based lending remains a key impediment.

This, in turn, accentuates the liquidity crisis. In a milieu of rising interest rates and non-negotiable working capital/long-term borrowing terms, it is of utmost importance for the promoter to review his capital structure.

In doing so, he must lay down a meticulous short-term plan focussing on reducing debt through a combination of internal accruals and fresh equity.

Agreed that the cost of equity is higher, but sometimes reducing dependence on debt will release pressure on margins and allow more funds to be redeployed towards a growing business. It needs to be emphasised nevertheless that this strategy will work best for companies with a sound business model and good scalability potential.

Moving from centralised management to an institutionalised one: Separation of ownership and management is a well-known concept. For a company that is on its early growth stages, it is important that skills of the personnel be mapped to the position that they enjoy in the management structure.

A strategy, however well laid out, remains on paper if it is not supported by a strong management bandwidth. It is hence time for the SME entrepreneurs to build strong top management and middle management teams, which would ensure execution of the vision.

Time to face the external investor: Till recently, PE investments showed that late stage investments in India continue to be higher than early stage investments. However, booming consumerism and global outsourcing opportunities have made SMEs an attractive investment for PEs, which have now worked around their problems of ‘ticket size’.

News on dedicated funds for small investments is increasing in number. These funds seek to provide both managerial and financial expertise to their investee SME companies and, in doing so, typically reckon a position on the board.

In addition to this, sector-focussed funds aim to apply value by drawing synergies within their portfolio investments. That said, many deals continue to fall through due to differences in valuation expectations. The reason being PE houses require a risk premium for the execution risk they envisage in the SME investment.

Also, holding high value non-core assets may prompt the promoter to demand a higher multiple and this is not seen in the same light by the PE investor.

Finally, in matching the business strategy with the existing management bandwidth, a lot of management assistance may be required from the PE end to deliver promised returns. And it is only natural that they demand compensation for this — mostly in the nature of a higher stake or a lower multiple.

Investment bankers, the middle men

It is time investment bankers focussed on the peculiarities of SMEs in assisting them raise external equity funds. Unlike a large established organisation, where processes and organisational structure are fairly in place, the operational issues and strategic insights needed in an SME are comparatively deeper.

It is important to understand the underlying concerns before one focuses on completing a transaction. Matching the right private equity partner with a client can be value adding only if the SME idiosyncrasy is mapped to the strategic advantage that a PE player can bring.

Hence, its not just valuation, it is getting a wider sense of the business fundamentals and clearly demarcating the business and execution risks. The fact that most low-profile SMEs have relied on their auditors and lawyers for advise on growth opportunities without willingly approaching an investment banker is probably due to the fear of the latter’s ‘transaction-oriented’ approach. It is time for investment bankers to understand the SME idiosyncrasy.

It is important to empower SMEs and for that we need willing equity partners to participate in the long-term fundamentals of the company. From the SME side, major internal changes are needed before facing an external investor.

A non-myopic solution would be a change in mindset and sensitivity to the predicament of the equity partner. Understanding the SME idiosyncrasy will result in a new manager for the SME, a better investment banker and a happier equity partner.

(The author is Assistant Vice-President, Investment Banking, Brics Securities Ltd.)