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Bimpact: intermediation in private equity deals in India

December 12, 2009 Leave a comment Go to comments

Levitt and Dubner, in their latest collection of seemingly disconnected analyses of economic phenomena that contravene theoretical wisdom, present two interesting case studies in intermediation: street prostitution in Chicago and real estate transactions in Anytown, USA.  (If you have not picked it up already, SuperFreakonomics, is a follow-up to the unexpectedly successful book called Freakonomics by the same two economists turned authors).

The conclusion in the book after examining how pimps and real estate agents provide similar services but different levels of value is summarized as:

Pimpact > Rimpact.

In other words, street prostitutes do better by using a pimp than a homeowner who uses an agent to sell his/her home.   Pimpact (pimp-impact) is measurable because the street prostitute sees income go up (net of the pimp’s fees), safer working conditions and lower risk of incarceration.   On the other hand, homeowners see little more than the convenience of not doing the marketing of their property themselves in lieu of 5% of  fairly large transacted amounts.  Homeowners do not on average see Rimpact (realtor-impact) such as increases in selling price or faster sales by using a broker when compared with selling on their own.

This got me thinking about the value delivered by brokers in India (“Broker Impact = Bimpact” – to carry the nomenclature forward from the book).   India is a completely intermediated market.  Regardless of the  kind of transaction being contemplated, it involves an intermediary: real estate rentals or sales, car buying and insurance, health insurance, getting a driving license, etc.  Many of these markets have evolved such that there are no deals done without brokers.  The value they provide cannot be measured because there are no alternatives.  In several instances, transacting  parties would prefer to deal directly but cannot.

Hence, generally, Bimpact = unknown, but probably minimal if not negative.

Intermediation in private equity

I migrated to Mumbai from the US, where venture capital deals are almost exclusively proprietary.  Even at the growth stage less than 10% of deals involve an investment banker.   In India, during my couple of years of investing here, I have come to realize that every growth stage deal and some emerging ones are banked and shopped extensively.   Even situations where I have personal relationships with management teams have ended up with a banker being selected to test the market beyond my expression of interest.   Why does this difference in levels of intermediation exist?  I attribute it to a mix of cultural propensity to seek “market” value and inexperience with (or distrust of) non-financial contributions made by investors.

Do investment bankers deliver Bimpact?

I do not think bankers are unnecessary; in fact they play a very important role in some instances:

  • when a management team is simply unfamiliar with the investment process and needs to be coached, or
  • when the transaction is large or complex and most businesses are lacking in skills or staff to deal with the spike in complexity and amount of work required to get a deal done (e.g. crossborder transactions,  large fund raises, IPO book building)

For large, complex transactions,  Bimpact = invaluable.

However,  the picture gets murky in the mid-market and for emerging businesses.   I have seen far too many instances of bankers focusing purely on valuation, perhaps because this is the only measure of their performance in the eyes of management teams.   I have heard the refrain “we are looking for the right partner” way too often; it typically means the right investor who is at least in the higher pool of bids.    During the recent turmoil in the world financial markets, I have seen several transactions not close at all because of unrealistic valuation expectations set up by bankers.  Some of these deals would have created a lot of stakeholder value over the next 24 to 36 months as there was no better time for healthy businesses to get well capitalized and make strategic moves.   In my view, bankers should be measured by a better set of metrics than deals completed and valuations expectations met.

For emerging and early growth companies, Bimpact = needs to be measured better.

It can be argued that it is hard to measure factors beyond number of term sheets issued or valuation attained but we could construct a Balanced Scorecard. Some ideas for all of us to measure our intermediaries better:

  • Time to closure: too many deals have very long hang times
  • Long-term value created: normalizing for externalities, how much shareholder value was created between this transaction and the next.  (e.g. share price increase to next round,  valuation at exit)
  • Investor fit: has the quality of governance improved, has the investor contributed to the company in ways other than capital.  This in many ways leads to long-term value created but a qualitative assessment will help identify the extent to which the most recent transaction influenced the outcome.

Some of these bankers are good friends of mine and for the most part they provide a great and very necessary service.  I am not unaware of the harsh realities of their chosen profession:  short memories, revolving doors, compensation cycles from April to March, bonuses tied to fees booked, etc.    But those who keep score to craft league tables and “bulge brackets” and hence influence markets can surely help us measure intermediation better.

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