Don't buy PE-backed stocks blindly

Though they are likely to have higher governance standards, investors should do their own due-diligence

By the end of September 2017, 24 companies had hit the primary markets this year with their initial public offerings (IPOs), raising Rs 30,682 crore. Of these, 11 were by companies backed by private equity (PE) players who raised Rs 7,450 crore by offloading their stakes.

This is in sharp contrast to 2007, another blockbuster year for IPOs when 100 issues had raised Rs 34,179 crore from the market, but a meagre three of them were backed by PE players (who garnered Rs 240 crore), according to data from Prime Database, which tracks the primary markets. With nearly half of the IPOs that have hit the markets this year being from PE-backed companies, investors investing in the primary markets need to evaluate what a PE's presence implies.

Experts say if a company headed for an IPO is backed by PE players, that is generally positive. "From an investor's perspective, the comfort level is much higher in companies where one or more rounds of investing have already been done by PE players. These institutional investors would have done their due-diligence each time.

Source: Exchange

Hence, there is greater comfort about the company's prospects. Corporate governance and accounting standards followed by the company are likely to be sound. There is also comfort on financials since PE players generally invest in high-growth companies," says Pranav Haldea, managing director, Prime Database.

The presence of a PE player can at times have disadvantages too. "Private equity players understand the markets much better than a promoter does, so they push for the highest possible valuation. Investors need to be wary that such issues could be more expensive (than non-PE backed issues)," says Arun Kejriwal, founder, Kris Research.

Depending on how much stake the PE players own and offload during the IPO, a substantive portion of the money raised would not be used to meet the company's capital needs but to provide an exit to the PE players. Experts say that while there is nothing wrong with this per se, investors need to be cognizant that the money raised is not going to be utilised to further the company's business prospects. 

Retail investors also need to take note of the time horizon for which the PE player stayed invested in the company. They usually invest for six-eight years in companies that are well established but need funds to expand their business. PE investors provide the needed capital.

It takes six-eight years for the new capacity to come online, business to grow, and profitability to increase. It is only after this business cycle gets completed that they offload their stake. "If the private equity investor is leaving in the third or fourth year, there could be an issue. You should check whether the business environment has worsened, competition has heated up, or whether the company's financials have deteriorated," says Shrikant Akolkar, assistant vice-president, Angel Broking.

Next, investors need to also check whether the PE's exit is full or partial.  "A partial exit means that the PE player believes that the company will continue to do well and hence wants to stay invested in it," says Munish Aggarwal, head of capital markets, Equirus Capital. This should be taken as a positive sign.

On the other hand, if the PE player is exiting fully, in that case, his sole objective would be to maximise his returns. "In such cases, investors need to be watchful about valuations," says Haldea.

Irrespective of whether a company is backed by a PE player or not, investors must evaluate the offer thoroughly on business prospects, valuation, and quality of management before betting their money on it.