Look for the PE pedigree

When it comes to investing in equities, small- and mid-cap stocks offer the best potential for appreciation in the long term. On the flip side, an investor can run into daunting losses if he fails to research a company or picks a stock simply on the advice of his broker. Even if an investor has the time and inclination to research, not much information is available on smaller firms. So how does one select a small- or mid-cap stock that can be a long-term outperformer?

While there is no single formula or parameter to pick such stocks, a good indicator is the private equity (PE) or venture capital funding received by a company. A recent study conducted by KPMG-CII claims that it is, in fact, an important factor in the selection process. The report titled, The Positive Power of Private Equity, reveals the transformational impact of PE funding on 17 companies. These firms reported higher growth in sales and profitability, as well as greater spend in research and development, which fuels innovation. They also performed better than the Sensex firms and were better paymasters compared with the non-PE-funded companies (in the same industry).

The small- and mid-cap sector is not a small space to invest in. As many as 40 per cent of the listed companies have a market capitalisation of less than Rs 125 crore (as of May 31, 2010). Nearly 80 per cent of all BSE-listed companies have a turnover of less than Rs 100 crore (as of March 31). A common misconception is that only large, well-established companies receive or benefit from PE capital. Actually, 70 per cent of VC/PE funding in 2008 was for the micro, small and medium enterprises (MSME), defined as having a turnover of less than Rs 500 crore.

In fact, over the past three years VC/PE investments accounted for almost 33-72 per cent of the total equity raised from primary markets. Nearly 1,500 companies had collaborated with PE firms in India till March 31 this year and excelled in key sectors such as IT/ITes, retail, infrastructure and manufacturing. What do PE firms do to make their portfolio companies perform better than the non-PE funded ones? Some companies use the funds to scale up business within their existing domain of products, services and geographies.

Others recapitalise the firm by, say, reducing debt or enabling access to new debt capital and, ultimately, offering shares to the public in what is called an IPO or initial public offer. Some finance more efficient output through technology or staff training and by bringing in new talent, usually at executive or senior management levels. Yet others develop new products or services with marketing and other support. Firms also use the capital to carve out existing products or service lines and acquisitions.

To better a company's reputation with clients, vendors and other financiers, PE investors may impose nonfinancial changes, such as new standards of corporate governance, new business models (rebranding or global joint ventures) and restructuring to more specialised or high-end positions in the value chain. "The key difference between PE and other forms of capital is the strong operational discipline and management bandwidth brought in after funding in the investee firms," says Gopal Srinivasan, Chairman of CII's National Committee on PE.

Another reason for outperformance could be the expectation of high returns. In exchange for long-term risk capital, investors in PE funds expect an average return of 25 per cent. In contrast, stock markets have earned investors an average of 14 per cent per year over the past decade. It makes the firms more aggressive in exploring business opportunities.

An iconic example is Warburg Pincus's investment in Bharti Telecom. It put in $292 million between 1999 and 2001 and offered strategic support to the management, who were also Bharti's promoters. This helped Bharti accelerate its plans to become a national player through acquisitions and organic growth, and to sign global partnerships, while earning healthy returns for its promoters and Warburg. Other companies like Glenmark Pharma, Infrastructure Development Finance Company and Naukri.com also started small but became big names later. So be on the lookout for PE-funded players and you may land a Bharti in the making.

Courtesy: Money Today