Private Equity: Higher risks — Higher Opportunities
Since the 1980s private equity funds have become visible players on the world investment map. These are alternative investment asset institutions are considered to be a cyclical industry and sometimes are quoted as a greed-based business. However, their role for industrial performance should not be underestimated. As the World Economic Forum research states, industries where private equity funds have been active in the past five years grow more rapidly than other sectors, whether measured using total production, value added or employment.
Moreover, although emerging markets only account for a small share of private equity activity, the share is increasing.
The past years Ukrainian M&A market has seen private equity funds investments. However, for Ukrainian realities the coverage of private equity activity in our country remains rather limited. For this reason, we asked our panelists to tell us about attractive Ukrainian investment targets for private equities, typical investment strategies, peculiarities of their M&A activity and subsequent risks.
Private equity funds indeed are quite active in the Eastern Europe, including Ukraine. It should be noted that most private equity funds have taken quite a long time to decide how the markets really work in Ukraine and which industries may turn out to be profitable.
Basically the investment strategies relates to potential growth of a certain business over industry. Such growth may either relate to the market volume or unmet demand. Prospective business, interesting for private equity funds, may include food processing, health care etc. as the big population of Ukraine always shows good demand for particular goods or particular services.
Other potential investment strategy relates to consolidation of an industry. Several players in a particular industry will with time consolidate and such a target will potentially be interesting for an exit strategy.
Private equity funds are not control players, which is a problem for Ukraine where minority shareholders interests are not well protected most of the time
It should be noted that PEFs usually have the lifetime of a particular fund and at the end of that lifetime the financial investor (such as private equity) should either sell the target to a strategic buyer or carry out an IPO. Therefore, investors are usually looking at a potential exit strategy at the time of the acquisition.
With regard to control, usually private equity funds are not control players, which is a problem for Ukraine where minority shareholders interests are not well protected most of the time. In this regard most PEFs try to have some veto or approval rights which may guaranty themselves with the help of foreign holdings. Another strategy will be to restructure the group to have a joint stock company where the rights of minorities are more protected as the holding company.
A private equity fund usually appoints a financial analyst or controller into the target to oversee the operations. In general, it should be noted that private equity funds do play a huge role for Ukrainian business as they bring quite a lot financial expertise and business consulting into business development throughout several years of their joint cooperation.
Before the financial crisis of the late-2000s, private equity funds (PEFs) were quite active on the Ukrainian M&A market. At that time, they primarily targeted rapidly growing financial and real estate industries, which then became the most affected by the crisis.
Today we are seeing some renewal of interests of private investors in Ukrainian companies, but in completely different areas: agriculture, technology, and energy.
A number of our clients who earlier invested in real estate and banking now are exploring the possibility to invest money in the three areas listed believing that they will be more or less stable in the current market conditions and be able to ensure quick returns on investments made. This change in the direction of PEFs is in line with global trends. The evidence of this is that more and more of Eastern European companies in recent years underwent an IPO on the world’s largest stock exchanges are engaged in agricultural, technology or energy businesses.
Most often private equity funds enter the Ukrainian market via purchase of shares or equity interest in a target company
Most often private equity funds enter the Ukrainian market via purchase of shares or equity interest in a target company. This is rarely a combination of share/equity interest purchase and financing. The amount of stock being purchased depends on the way in which each particular fund does business: some funds invest money only through majority stake acquisitions and exercise full control over the target, while some other purchase only minority stakes and do not engage in the target’s business at all. Also, this depends on the target, its financial condition, management and potential for growth. In our practice, we also encountered a step-by-step acquisition, when the purchase price for the next portion of shares was calculated on the basis of the financial results of the target.
Among purchasers of a Ukrainian business, private equity funds are likely to be most sensitive to the level of risk they are willing to accept and ways to reduce it. Therefore, PEFs will almost never agree to purchase a stake in the business without having conducted at least legal (and sometimes financial) due diligence. Moreover, private equity funds will insist on broad warranties and a long list of indemnities covering all significant deficiencies discovered during the due diligence or during the preparation of the disclosure letter. Furthermore, PEFs will require beneficial owners of the business to provide their personal guarantees and to accept joint and several liability.
The reverse approach will apply to any future sale by the private equity fund of its stake in a business when the PEF would be unwilling to give any warranties or indemnities, other than capacity and title warranties.
Private equity funds may split their initial equity investments into two forms: classic equity and debt-like equity — preference shares
As the core aim of PEFs is to maximize the return on their investment in the short term perspective (three to five years), the PEF will insist on its right to exit from the business through the sale of its shares to third parties or, based on the put option, to other shareholders. Private equity funds will also prefer to have a drag along right in respect of other shareholders. While, in return, PEFs may agree to a call option and other shareholders’ drag along right, they will do so only if the minimum level of return on their investment is guaranteed.
Finally, private equity funds may split their initial equity investments into two forms: classic equity and debt-like equity — preference shares. While the former enables a PEF to control activities of the business and to influence the decision-making process (often through the use of its veto power in relation to certain matters), the latter will ensure that the guaranteed return is received by the private equity fund (in the form of dividends or sale proceeds) before other shareholders receive their return.
The current tense climate on global debt markets seems to favour lending by investment funds and other non-banking players. Banks have recently decreased the levels of financing even more trying to cope with the European debt crisis, which demands that banks be recapitalized due to their exposure to government bonds of European periphery countries.
However, it does not seem likely that investment funds will use this chance in order to increase their share of the Ukrainian debt market. The Ukrainian economy still seems to be very fragile and capable of falling into a new wave of recession. Moreover, most of the biggest Ukrainian companies operate in sectors highly exposed to a sharp decrease in demand which could follow a new recession in Ukraine and in wider Europe.
Another factor making lending by investment funds less likely has its roots in the recession of 2008. Some of the large borrowers used ineffective Ukrainian law and corrupt judiciary in order not to pay their debts. Different schemes with mortgaged property effectively defrauded Ukrainian and international lenders of huge sums, sometimes leading to lengthy litigations.
Therefore, I believe that investment funds will continue working with their existing clients with whom they have well established relations.
