- Iqbal Khan
As the unprecedented global health crisis brought on by the COVID-19 pandemic deepens, the Indian economy continues to find itself steadily overwhelmed, with businesses across most industries coming under previously unforeseeable distress. Although there are countless unknowns in this constantly evolving crisis, we see a slow, but imminent, eventual resumption of private equity (PE) investments in the Indian market over the next 12 to 18 months, in the “new normal” post-pandemic world.
PE deal activity: what to expect
PE funds have seen their fair share of disruption since the onset of the COVID-19 crisis – existing portfolio investments that are facing large-scale pandemic-triggered commercial and financial challenges, and navigating an array of regulatory hurdles, have commanded the bulk of their attention.
As unsurprising as the contraction in new PE investments in the current scenario is, the significant volume of uncalled dry powder waiting to be deployed, and the exigencies of fund life cycles, will inevitably push global PE funds back onto the field. On the other hand, sovereign wealth funds, because of significantly longer investment horizons and the absence of cyclical fund-raising pressures, may largely opt for a strategy focused on co-investments, as opposed to the direct investment approach preferred by them in previous years.
Healthcare (especially, pharmaceuticals), FMCG and tech (specifically, fintech and e-commerce) businesses will continue to remain fairly resilient in the current environment.
While these sectors will still have to contend with operational issues brought on by the crisis, they will continue to remain buoyant on the back of the relatively “pandemic-proof” consumer demand, which is fueling their growth. As such, these sectors are, in particular, likely to offer the bulk of the high-quality investment opportunities for takers. In addition, by and large, private companies in these sectors have not yet experienced severe drops in valuations, and this trend is expected to continue.
Further, while PE investor interest in certain other harder-hit sectors may take a little longer to revive, these very sectors may offer the huge valuation opportunities needed for long-term PE investors to go hunting – offering businesses with strong fundamentals priced at sharply marked-down valuation multiples. This would include sectors reliant on discretionary consumer spending, such as tourism, hospitality and aviation, which have notoriously high fixed costs. Moreover, the asset quality impact of the COVID-19 crisis on financial services businesses, including banks and NBFCs, may also create some attractive investment opportunities.
The sweet spot for most PE investors will continue to be significant minority or control deals with leveraged promoters of resilient targets, or with promoters with whom discussions would have failed in the past due to valuation expectations. To bridge continuing valuation gaps, most of the deals going forward will have permissible structured components, such as downside protection through the use of convertible instruments (for e.g., warrants), earn-outs, deferred compensation and the PE investor’s right to acquire additional stake at a pre-agreed valuation methodology.
Finally, on the valuation front, although valuations for resilient private businesses will continue to remain steady, public companies have seen significant volatility and valuation drops during this period. If this continues, PE investors will continue to have an opportunity to do PIPE deals and to consolidate various small market players through the public company platform. Consolidation may also be in play in resilient sectors, such as pharmaceuticals. For example, PE investors may look to acquire multiple small synergistically-compatible API manufacturers to build a larger platform.
Deals moving forward: legal perspective
Given that the IPO-exit drought will likely continue for a while, in addition to valuation concerns, deal-certainty will be on the top of the list for both, promoters trying to be liquid again, as well as, PE funds exiting their investments. Therefore, if pragmatism prevails, most mid-market transactions will either be proprietary in nature, or will be conducted as focused auction processes involving a few key relevant market players. Large transactions, depending upon the sector, may still have multiple takers in the first round.
Moving forward, PE deals are undoubtedly going to see a greater emphasis on ESG, as well as, a more expanded scope of due diligence review of the target company’s operations, including ABC / AML related review. The corresponding transaction documentation can also be expected to contain highly negotiated material adverse effect, force majeure and diligence-out clauses, along with enhanced operational and financial representations and warranties. It is also probable that many PE investors will insist on the relevant target company obtaining appropriate business disruption or “loss of profits” insurance policies, as well as, W&I insurance policies, as conditions precedent to their investments.
Additionally, with valuation assumptions becoming increasingly disputable, parties will have to ensure that adequate methodology illustrations and dispute resolution provisions are incorporated into the deal documentation to resolve any valuation mismatches or deal termination options by either party, in the future.
Provided, there is no vicious W curve of COVID-19 for the economy to contend with, the latter part of this financial year and the early part of the next, could very well see a considerable uptick in PE investments in the Indian market. Even so, we may see astute promoters and PE funds holding-off on exits, and delaying them, until such time as their valuations recover.
- Iqbal Khan is Partner, Shardul Amarchand Mangaldas & Co. Views expressed are the author’s own.