Portfolio Company: Life Inside a Private Equity Fund

A portfolio company is a business that a private equity fund has bought into, whether a slice of it or the whole thing. The years that follow are far less dramatic than the purchase: numbers due every month, a board that sits four times a year, accounts audited once, a budget signed off before the year starts, and seven decisions the company can no longer take alone.

Almost everything written about this subject is written about two days. The day a company was bought, and the day it was sold. Between those two days sit several years in which the same small handful of acts repeat: a pack arrives, somebody reads it, a meeting happens, one item off a short written list is agreed or refused, and then it all happens again next month. The repetition is not the dull part surrounding the work; it is the work, and the two dramatic days are consequences of it. Counting the repetition is the quickest correction to anyone's sense of what a private equity fund does with its years.

What is a portfolio company, and what changes the day after completion?

Start away from finance. Imagine a cousin puts money into the family sweet shop. Before, he was a relative who asked how business was going over dinner. After, he wants the month's takings on one sheet by a fixed date, he sits down formally four times a year with an agenda, and there is a short list of things the shop may not do without asking him first: mortgage the premises, take in a new partner, change what the shop sells. Not one thing about making sweets has changed. Everything about who has to be told what, and by when, has.

A portfolio company is that shop, scaled up and written down. The business keeps its staff, its customers, its supplier terms and its work. The fund arrives with an information obligation, a meeting rhythm, and a written list of decisions that now need a second signature. Becoming a portfolio company changes a company's information and authority arrangements, not the daily work of the business.

Take one holding and count through it. Nilgiri Growth Partners Fund II, invented, entered Sahyadri Diagnostics Private Limited, invented, in Fund II's Year 1 Q3 at Rs 55,00,00,000. Where that money went matters: it bought existing shares from the founding shareholders, so not one rupee of it reached Sahyadri Diagnostics itself. The people selling received it. A further Rs 15,00,00,000 went in at Fund II's Year 4 Q1, taking the fund's total cost in the holding to Rs 70,00,00,000, and the position was sold in Fund II's Year 7 Q2 for Rs 2,03,00,00,000.

What does the company have to send the fund, and how often?

Five things, and they are five separate obligations rather than one general duty to keep an investor informed. Each of the nine shareholders agreements of Nilgiri Growth Partners Fund II carries the same five, so any comparison between two of its holdings is a controlled one. Every one of the five below is a contracted term of that one arrangement, agreed between the parties to it, and not a standard, a market practice or anything required of anybody.

Look at what the five are for, read down the last column. Item 1 buys time. Item 2 buys decisions. Item 3 buys an independent opinion on items 1 and 2. Item 4 buys a yardstick, without which the monthly pack is a set of numbers with nothing to be compared against. Item 5 exists because the other four are all on a cadenceHow often something happens, fixed in advance rather than decided occasion by occasion., and some things cannot wait for the next date on a calendar.

Whose report is whose, and why are there two numbered lists?

Two numbered lists of reporting obligations live in this subject, and they run in opposite directions. Confusing one for the other is the single mistake worth heading off before it starts. The five-item list above is the company reporting to the fund; there is a separate six-item list which is the fund reporting to its own investors, and they are different documents produced by different people for different readers.

Sahyadri Diagnostics sends a pack to Nilgiri Growth Partners Fund II. The five-item list runs that way, from the company up to the fund, and the fund is the reader. Nilgiri Growth Partners Fund II then sends its twelve investors a capital account statement each quarter, an unaudited quarterly report, an audited annual report, a letter from the manager alongside the quarterly numbers, a notice for every capital call and every distribution, and an annual valuation report from the independent valuation agent. The six-item list runs the other way, from the fund out to its investors, and an investor is the reader. The contents of those six, how they are built and what an investor should look at first are covered separately; the six are listed above only so that the two lists never get mistaken for each other.

Why is fifteen business days a contracted term rather than a rule?

Because somebody negotiated it. An account that simply states "the pack is due within fifteen business days" leaves a reader believing that is how it is done, and that reader has learned something that was never true. The fifteen is a number two sets of lawyers agreed on for these invented parties. A different agreement would say ten, or twenty, or the last working day of the following month, and none of those would be more or less correct than this one.

Why does anyone argue about it? Because the number is a trade. A company closing its books properly needs time; an investor watching nine holdings wants the numbers while they still describe something current. Fifteen business days is roughly three working weeks. The pack for a month therefore lands about three weeks after that month has finished, and the board reading it at a quarterly meeting may be reading numbers older still. The due date is not administrative housekeeping; it sets how stale the freshest thing the fund holds is allowed to be.

What actually happens at a board meeting, and in what order?

Every portfolio company of this fund has a board of five. At the four holdings where Nilgiri Growth Partners Fund II holds more than half the votes, it appoints three of the five directors. At four of the remaining five holdings it appoints one of the five. At the ninth, Vaigai Edutech Private Limited, invented, it appoints no director at all and attends as an observer instead. The observer arrangement is covered separately. Control here is a matter of contract and seats rather than of a share register, so no percentage of any of these companies enters the account.

A quarterly meeting is four things, and the order they come in is the whole of the difference between a useful meeting and a wasted one.

First, the standing itemA subject on the agenda of every meeting, whether or not anything about it has changed.: the three things the investment case actually depends on, written down when the fund arrived and read out at every meeting since. Second, the numbers, already in every director's hands because the board packThe papers circulated to directors before a board meeting, so they arrive having read them. went out in advance. Third, the decisions that are genuinely the board's to take. Fourth, anything needing the fund's agreement as a shareholder, a different act by a different party and minutedRecorded in the written record of what a meeting decided. separately.

A board meeting where management spends the first hour presenting the monthly numbers has spent its most valuable hour on a document everybody in the room has already read. An hour spent that way is the commonest way a fund can attend twenty-three meetings across a holding and get very little from any of them. Nothing was hidden and nobody behaved badly. The agenda simply put the reading before the thinking.

Where is the line between monitoring a company and interfering with it?

Readers expect this line to be a matter of judgement, temperament or how forceful a particular investor happens to be. It is not. In this invented arrangement it is written down, and it has a number attached: seven. Seven reserved matters sit in the shareholders agreement of every one of this fund's nine holdings, and they are the line.

The seven are, numbered as the agreement numbers them: 1 issuing new shares or any instrument convertible into shares. 2 selling the business or any material part of it. 3 borrowing above a limit each agreement sets. 4 changing the company's constitutional documents. 5 appointing or removing the chief executive or the chief financial officer. 6 approving the annual budget. 7 entering any transaction with a related party. Note where item 6 lands. The budget the company must produce under obligation 4 of the reporting list is approved as reserved matter 6, so those two items are the same event seen from two sides.

Now the distinction that does the work. A reserved matter is a veto held under a contract. A board seat is a vote held in a room. A veto and a vote are different instruments and behave differently: the fund holds all seven reserved matters at all nine holdings, including the five where it appoints one director or none, and it holds a majority of the board at only four. A holder with seven vetoes can stop a great deal and can compel almost nothing, and that asymmetry is what a minority position actually is.

So three zones, and a fund can always say which one it is standing in. Asking a question about anything at all is monitoring, and the company may answer briefly or at length. Requiring one of the seven is exercising a right that was bought and paid for at entry. Requiring anything that is on neither list is interfering: the fund has no instrument for it, and whether it happens depends on who is in the room rather than on what anybody agreed.

What does the fund actually do with the pack when it arrives?

Receiving a document is not reading it, and reading it is not using it. A fund watching nine holdings at twelve packs a year is handed something like a hundred packs a year across the portfolio, and without a routine it reads all of them and remembers four. A fixed three-step routine with a defined ending turns a pack from a filing into a control, and it runs on every pack whether or not anything looks interesting.

Step one, read it against the three things the investment case depends on. The same three were written down when the fund arrived and do not change from month to month. Step two, compare it with the budget the fund approved as reserved matter 6. The approved budget is the only reason there is anything to compare against at all. Step three, decide the one question that actually has consequences: is there anything here that needs the fund to act as a shareholder, rather than as a reader? Almost always the answer is no, and the routine ends there, and ending cleanly is exactly what a defined ending is for.

What does a whole holding period actually add up to?

Now count it. The count is the correction. Sahyadri Diagnostics entered the portfolio at Fund II's Year 1 Q3 for Rs 55,00,00,000 and left it at Fund II's Year 7 Q2 for Rs 2,03,00,00,000. On this fund's clock, where a quarter is a quarter of a year counted from the fund's own final close, that entry sits at 0.75 years and that exit at 6.50, so the holding periodThe time between a fund's entry into a company and its exit from that company. is 5.75 years exactly.

Run the contracted cadence across it. Twelve packs a year for 5.75 years is 69 monthly information packs. Four board meetings a year for 5.75 years is 23 quarterly board meetings. Together that is 92 scheduled information events, every one of them fixed in advance by a contract signed before any of them happened.

Against those 92, count the dated transactions in the entire life of the holding. There are three: the Rs 55,00,00,000 entry in Fund II's Year 1 Q3, the Rs 15,00,00,000 follow-on in Fund II's Year 4 Q1, and the Rs 2,03,00,00,000 sale in Fund II's Year 7 Q2. Ninety two scheduled information events against three dated transactions is about thirty one to one, and the entire Rs 2,03,00,00,000 arrived at the last of the three.

One reading is worth pausing on. Sixteen scheduled events a year times 6.25 years is 100, so the hundredth scheduled information event from a single company falls at exactly 6.25 years. The count of dated transactions is not a function of time, so nothing at all happens to the red length at that point, or at any other. The flat line is supposed to look wrong, and the fact that it does not move is the single most useful thing in the whole count.

Now scale it to the whole fund. Summing every holding's period to its exit, or to the record date at the end of Fund II's Year 9 Quarter 2 for the five still held, gives 45.50 holding-years: 5.75, 4.75, 5.75, 6.50, 3.75, 5.75, 5.00, 4.50 and 3.75 for holdings 1 to 9 in order. At the same cadence that is 546 monthly packs and 182 board meetings, being 728 scheduled information events. Against them stand sixteen dated transactions in the fund's whole life: nine entries, two follow-ons, four realisations and the Rs 35,00,00,000 write-off at holding 5. The proportion is 45.5 scheduled information events for every dated transaction.

Nothing follows from those numbers about whether this fund did well or badly. A narrower conclusion does follow: for anybody asking what a private equity professional spends a decade doing, the honest answer is on the green side of both figures, and almost none of the published writing about the subject is about that side.

What does the fund do when a holding stops working?

Less than a reader expects, and what it can do is decided by what it holds rather than by how strongly it feels about the situation. The branches are short and there are only three of them.

Where the fund appoints three of the five directors, it can carry a board vote. Carrying a board vote lets it change the senior officers and set the board's own direction. Where it appoints one of five, it can carry nothing on its own, but it still holds all seven reserved matters, so it can refuse new shares, refuse borrowing, refuse the sale of a material part of the business, refuse a related party transaction and refuse the budget. And in either case it can put in more money, as this fund did with the Rs 15,00,00,000 follow-on at holding 1, or decline to. Not one of those branches is the ability to make a business work, and no arrangement written into any agreement anywhere confers that.

There is a second thing worth naming, and it is uncomfortable. The information usually arrives before the number does. Take holding 6, Vaigai Edutech Private Limited. The fund entered it in Fund II's Year 3 Q3 at Rs 30,00,00,000, and it is carriedHeld at an estimated value, because the holding has not been sold and so has no price. at Rs 21,00,00,000 at the record date, being 0.70 times its cost. The fund's own record says the deterioration had been visible for three quarters before the carrying value moved during Fund II's Year 6. Three quarters, at this cadence, is nine monthly packs and three board meetings in which the information was already in the room. How a carrying value is arrived at, why it lags and what an investor's statement shows are all covered separately. The one fact taken from it here is that the information arrived before the number did.

What does the company get out of the arrangement?

Strip out the flattering answers first. The flattering answers are the ones most people have absorbed already, and most of them cannot be promised by any structure. Two things survive the strip, and the first one is conditional.

Money, sometimes. Whether the company sees any of it depends entirely on where the cash went at entry, and this fund holds one clean example of each. At holding 1, Sahyadri Diagnostics, the Rs 55,00,00,000 bought existing shares from the founding shareholders, so the company received nothing at all and the sellers received everything. At holding 4, Bhavani Speciality Chemicals Private Limited, invented, the Rs 50,00,00,000 paid in Fund II's Year 2 Q4 was subscribed for new shares the company issued, so all of it went into the company and no shareholder received a rupee of it. Same fund, two entries, opposite destinations, and a reader who cannot tell which is which cannot read any transaction in this subject correctly.

And a shareholder who reads the numbers every month and has to answer to somebody for the result. An accountable shareholder is a real difference from one who reads an annual account once and asks nothing, and the difference cuts both ways: attention is useful when it arrives with a question worth answering and expensive when it arrives as another form to fill in. Everything else that gets claimed here, about networks, hiring, systems and discipline, depends entirely on which individuals turn up, and a structure does not produce it.

What ends a company's life inside the fund?

Two things, and only two. The fund sells the position, or the fund writes it off. Holding 1 left by the first route at Fund II's Year 7 Q2 for Rs 2,03,00,00,000, and holding 5 left by the second at Fund II's Year 6 Q4 with its Rs 35,00,00,000 of cost written off, and both are real endings: a write-off is not a technicality, it is a holding leaving the portfolio having produced no cash.

Notice what is not on that list. A fund reaching the end of its own ten year term still has to do something with what it holds, so the end of the term does not end a holding by itself. Neither does the company's own preference. A holding ends when the fund realises it or gives up on it, and everything between the first pack and that day is the reporting cadence running. How a position is actually sold, what routes exist and what each one does to the price are covered separately, as is what happens to a fund as its term runs down.

One figure to end the counting on, and it is a fact about four invented holdings rather than a claim about anything general. The four holdings this fund fully realised were held 5.75, 4.75, 5.75 and 3.75 years. The four periods sum to 20.00 and average exactly 5.00 years. The average is arithmetic on four locked dates in one invented fund, and not a statement about how long a private equity holding is usually held.