Value creation for SMEs through private capital

India’s economic growth has attracted significant foreign direct investments (FDI) over the past two decades. Much of this FDI consisted of investments by venture capital and private equity (PE) firms. Since January 2005, venture capital and PE firms have invested $230 billion of equity capital in India. PE investors are crucial to the success of any high growth economy. These investors put risk capital behind new business ideas and founders, which acts as a catalyst for job creation and economic growth.

In the West, PE investors typically acquire a controlling interest in companies and grow them. However, in India, many businesses are founder owned and founders insist on retaining controlling stake in their companies. Venture capital and PE (VC/PE) investors have had to customise their approach to investing in these businesses for a minority stake. Minority investments have accounted for a significant percentage of the total deal flow.

Founders have increased control and a greater role to play in governance because they generally hold majority stake in the company. Demand for PE capital continues to grow as more and more Indian businesses seek funding. However, deals with good and transparent financial reporting with strong governance mechanisms are few and far between. PE investors face increased risk from weak corporate governance in their position as minority investors.

Concerns of minority investors

In founder-controlled businesses, minority investors are concerned with the misalignment of founder-investor goals, illegal extraction of wealth, and self-dealing transactions. The most prevalent risks for minority investors are misuse of funds and diversion of capital towards personal use or low capital efficiency projects. Many of the founder-controlled companies are family-owned businesses. Often, members of the family constitute the board as well as the management teams of the company.

Many of these companies lack an effective governance structure with adequate checks and balances for conflicts of interest management, transparent decision-making, and articulated strategy to conduct business. Investors, even as board members, are not allowed to partake in decision-making, and are sometimes not privy to decisions taken by the management due to the lack of timely and transparent communication frameworks.

Further, the founders’ unwillingness to involve investors in decision-making, and dilution of their control impacts the ability of minority investors to find timely and suitable exits. Many founder-led private companies are also lackadaisical on corporate compliances.

The VC/PE industry has witnessed some high-profile instances of weak governance across sectors. Governance failures have resulted in businesses winding down, getting entangled in lengthy and expensive legal battles, reputation loss, and has not been a profitable proposition for investors. Often, such a corporate fiasco bears impact on lives and livelihoods across the value chain of the business. Other stakeholders such as regulators, employees are now demanding improved governance and transparent reporting.

For Indian investments, PE investors have introduced provisions in their investment contracts with the companies to strengthen governance systems at the companies, as well as to safeguard themselves in the event of failure. These provisions include clauses in transaction structuring, investor reserved matters, board composition, risk management, and auditors, and exit rights.

Corporate governance

Good governance requires a thoughtful bespoke approach to develop policies and procedures by which a company operates. Corporate governance frameworks for companies include much more than shareholder rights. It extends to include the rights of other stakeholders such as employees, lenders, borrowers, vendors, local communities. An effective corporate governance framework helps management provide timely and transparent communication of operations, communicate policies, practices and accountability in a fair manner with all stakeholders.

Good governance is core to private equity’s value proposition. A well-governed company provides lucrative exit possibilities to the PE investor such as secondary sale, IPO, others. PE investors play a significant role in a company’s performance.

Investors bring expertise in business management, and assist founding teams in developing growth plans and strategy. Depending on the investor’s experience, the investor could also help identify the right organisation design and organisation structure, and assist in augmenting founding teams and professionalising management.

Investors may also bring in expertise to help companies’ expansion to geographies unfamiliar to the founders but are potentially lucrative markets. A well-governed business with a good strategy and a strong team is highly valuable in the Indian private investing market.

On the other hand, founders are increasingly witnessing that strong governance and investor oversight help them attract capital at a premium for their businesses. These reasons have presented compelling case for founders to incorporate effective governance frameworks. Founders are acknowledging the value of institutional funding beyond provision of capital.

Managing Covid-19 crisis

The current level of capital inflow and changing investment landscape considering Covid-19 (driven by the lack of high growth good quality companies) indicate a structural shift in the market. The ability of fund managers to protect capital, control risks, and actively create value will be driven by governance frameworks that ensure adequate checks and balances.

Well-governed companies are utilising the expertise of the institutional investor, including PE investors, on effective ways to manage the Covid-19 crisis. The management teams are consulting with PE investors on cost conservation, and cost-cutting initiatives, seeking their expertise on stress testing business under various recovery scenarios, and manpower planning.

Entrepreneurs are tapping into the expertise of the fund managers on managing the current crisis, including managing lay-offs, improving operational efficiencies and product pricing, as they navigate never before situations. Investors too are actively helping their portfolio companies manage stakeholders, and assist in new ways of engagement in the current scenario. These include for example, tools for remote management of employees, novel ways of engagement with consumers such as through WhatsApp voice messages, increased frequency of communicating business updates with investors and lenders.

Companies that survive the Covid crisis will be better positioned to take advantages of the opportunities and thrive in the aftermath.

The writer is Managing Director at Zephyr Peacock India

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