PE firms work to take a public company private (example Dell) or acquire a private company and take the company public.
They generally acquire underperforming companies and focus on improving management, operations, and financial position over a few years.
PE firms raise capital from institutional investors, pension funds, and high net worth individuals and use leverage to magnify returns. For example, if an investment opportunity for the PE firm costs ₹100 and yields ₹10, that amounts to a 10 per cent return on investment (ROI).
However, the ROI would be 20 per cent if the PE firm paid ₹50 and leveraged the other ₹50 (as the return on ₹10 is calculated on 50 as the base principal).
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SPACs, on the other hand, act as a shell company that raises money to acquire a company at better valuations or take a company public. However, the funds would be returned if the SPAC facilitator could not find a suitable company within 18-24 months.
The increase in interest rates over the past year has decimated start-up valuations (start-ups were taken public by SPACs for lofty valuations).
Moreover, the rise in rates also made it difficult for SPACs and the companies they were acquiring to engage in creative financial engineering, vastly limiting valuation potential. Unlike their close relative, the SPAC, the PE fund story continues to unravel by the day.
According to Warren Buffet, PE funds are not perfect reflections of what they claim to be. PE funds generally leverage 3-6 times the earnings level of an acquisition and engage in precarious transactions.
Leverage at such high levels requires stable and low-interest rates to keep the boat from shaking. Greenspan’s foot — a colloquial term to refer to Alan Greenspan’s (former Federal Reserve chairman) monetary policy, which consisted of low and stable interest rates — has been considered one of the primary reasons for the emergence of PE funds on a large scale.
First Republic Bank, which was recently in the news for collapsing following the 2023 banking crisis, had ties with PE firms. The loan book also consisted of loans to Chamath Palihapitiya, an investor known for running SPACs. The rise in interest rates signals an increase in the real value of money and a decrease in the valuation of assets.
The asset now yields a lower relative return than before as the risk-free rate of return offered by government securities increases. Therefore, the rise in interest rates diminishes a PE fund’s ability to go public with an entity at a desired valuation.
Moreover, with rising interest rates, the prospect of leverage becomes tricky due to mounting real and nominal costs on the debt. These, coupled with low growth and poor business prospects, reduce firms’ profitability and leads to poor valuations of assets and companies. Poor valuations and business prospects do not bode well for PE firms.
Thus, it is unsurprising that banks such as Silicon Valley Bank or First Republic Bank found a large part of the loan book under the risk of losses.
Furthermore, companies that went public during low-interest rates such as Zomato and Nykaa have faced severe haircuts in valuations from peak prices (losing over 50 per cent).
Other firms which are yet to go public such as Byju’s have a clear track record of employing leverage to buy out firms.
The use of leverage by a start-up to acquire other start-ups does not paint an optimistic picture of the company’s financial health in a rising interest-rate period. Also, it is difficult to say whether a firm with leverage will be able to command much of a market valuation at the time of its listing.
Oyo Hotels, a start-up backed by SoftBank, was willing to reduce the number of shares sold during the IPO by about two-thirds of the original amount to facilitate listing. The desperate measures taken by technology and PE firms over the past year can be directly linked to the monetary policy executed by central banks worldwide.
No clear path
It is difficult to chart the path PE funds and start-ups will take over the next few years. However, the current macroeconomic indicators highlight turbulent times for firms benefiting from the excess financial froth brought in through the loose-monetary policy of 2020-21.
Nonetheless, the prudent investor who sticks to his circle of competence and avoids risky bets will be able to purchase wonderful stocks at fair prices in the coming times.
(Anand Srinivasan is a consultant. Sashwath Swaminathan is a research assistant at Aionion Investment Services)