Private Equity: The Strategy and Where the Return Comes From

Private equity buys whole companies or large stakes in companies that are not listed, holds them for years, changes how they are run, and sells them. The return is the gap between what the fund paid and what a later buyer paid. In Nilgiri Growth Partners Fund II, invented, one holding of nine produced 46.3 per cent of everything realised to the record date at Year 9 Quarter 2.

Private equity rests on one structural fact, and it is worth sitting with before any arithmetic arrives. An unlisted company has no price. There is no screen, no last traded figure, no closing level in tomorrow's paper and no buyer standing ready at any chosen hour. There is no price for a private equity fund to be right about, so the fund cannot make money by being right about a price that already exists. The fund makes money, or loses it, by negotiating one number at the start, doing something to the business for several years, and negotiating a second number at the end. The absence of a price is why governance matters here in a way it never matters to somebody holding a listed share, and it is why the honest answer to where the return came from is simply not available until the position has been sold to somebody.

What does a private equity fund actually buy, and why does nobody know the price?

Consider a shop on an ordinary street. Somebody built it up over fifteen years, and everybody in the neighbourhood has an opinion about what it is worth. None of those opinions is a price. The shopkeeper learns the value of the shop on exactly one day: the day somebody sits across a table, makes an offer, and the two of them either shake hands or do not. Until that day there is no number. The number is not hidden, not lagging, and not being got wrong by anybody. Nobody has made it yet.

Private equityBuying and holding companies whose shares are not traded on an exchange. is that situation at a much larger scale, run purposefully, by a pooled vehicle with other people's money in it. The fund buys whole companies, or stakes large enough to shape what those companies do, and every one of them is a company nobody could buy this afternoon on any exchange. Each company the fund has invested in is called a portfolio companyA company a private equity fund has invested in and now holds., and the collection of them is what the fund actually is.

Nilgiri Growth Partners Fund II, an invented fund, is managed by Nilgiri Alternatives Advisors Private Limited, sponsored by Nilgiri Financial Holdings Private Limited, and settled as a trust whose trustee is Nilgiri Trusteeship Services Private Limited. The fund is registered as an Alternative Investment Fund with the Securities and Exchange Board of India. Twelve investors and the manager itself committed Rs 5,00,00,00,000 between them. The fund bought nine companies. Its record date is the end of its Year 9 Quarter 2, 8.50 years after its final close. By that date four of those nine have been sold in full, one has been written off, one has been part sold, and five are still held. One fund over one stated period settles nothing about what private equity does generally.

How does the money go round, from a commitment to a company and back again?

How Private Equity Funds Work

The whole circuit runs in six steps, and three of them are then taken more slowly. Investors promise money rather than handing it over, so Rs 5,00,00,00,000 of commitments sat as promises at the start. The manager called that money in pieces as it found companies to buy: seventeen separate calls, adding to Rs 4,80,00,00,000, being 96.0 per cent of what was promised. Of that, Rs 4,00,00,00,000 went into nine companies and Rs 80,00,00,000 went on the management fee and the fund's own expenses. The nine were held, in total, for 45.50 holding-years to the record date. Positions then left: four sold outright, one part sold, one written off. Cash went back to investors in four payments adding to Rs 4,38,00,00,000, and Rs 2,82,00,00,000 of value is still sitting inside five companies nobody has bought.

Three of those six steps belong to the vehicle rather than to the strategy, and are covered separately. The commitment, the capital call, what the management fee is charged on and how its basis steps down, the preferred return, the carried interest, and the order in which money is paid back to investors before the manager sees anything, are all settled separately and taken here as they stand. The strategy itself is what is left: a fund with money available looking at a company that cannot be bought on an exchange, and the same company sold to somebody else years later.

What changes when the share is not quoted anywhere?

Four things change, and it is worth stating them separately because a reader who has only ever held listed shares carries the wrong instinct into all four. Take them one at a time.

The fourth row is the one to hold lightly for now. Control, in this fund's documents, means more than half the votes, and where the fund has it the fund can appoint and remove the board. Where it does not, the fund can still stop those seven things and can compel none of them. The difference between what a holder can carry and what a holder can stop is the whole of the difference between a control position and a minority one, and it is covered separately. Only the existence of that row matters here. A list of things the fund can stop is the reason a private fund can do anything at all to a business between the day it buys and the day it sells.

There is a fifth thing, and it is less a change than a consequence. Because the price exists on two days only, everything said about the value of the position on every other day is an estimate somebody produced. At the record date, Rs 2,82,00,00,000 of this fund's stated value is exactly that. The manager has marked that value and Palani Valuation Advisors LLP, an invented limited liability partnership, has valued it, and not one rupee of it has been paid by any buyer. How that mark is made, and what an investor's own statement shows, are covered separately. A mark is not a receipt, and the difference matters wherever the figure is quoted.

Where does the return come from, if there is no price to be right about?

From two negotiations and whatever happened in between. Two negotiations and the interval between them are the entire mechanism, and the mechanism is refreshingly unglamorous once it is written out. The fund negotiates a number at entry. The fund then holds the company for several years, during which the business does whatever it does and the fund does whatever it does about that. At the end somebody else negotiates a number to take the company off the fund's hands. The return is the second number less the first, less what the fund spent getting there.

Notice what this rules out. Somebody holding a listed share can be right about a price other people got wrong, and be paid for that inside a week. There is no crowd to be wrong, so a private fund has no such route. The only way the second number comes out larger than the first is that the business, or what a buyer will pay for a business like it, actually changed over the years in between. The need for a real change in the business is why the work in this subject is operational and contractual rather than analytical alone, and it is also why the whole thing takes years rather than quarters.

One more distinction has to come before the worked case. Without it, no private transaction reads correctly. Money paid at entry goes to one of exactly two places. Either it buys existing shares from people who already hold them, in which case the money goes to those shareholders and not one rupee reaches the company, or it subscribes for newly issued shares, in which case all of it reaches the company and no shareholder receives any of it. Nilgiri Growth Partners Fund II has both. Holding 1's Rs 55,00,00,000 bought existing shares from the founding shareholders of Sahyadri Diagnostics Private Limited, invented, and Sahyadri Diagnostics received none of it. Holding 4's Rs 50,00,00,000 was subscribed for new shares in Bhavani Speciality Chemicals Private Limited, invented, and the whole of it went into the company. Same fund, same manager, adjacent years, opposite destinations.

What happened to holding 1, from Rs 70,00,00,000 to Rs 2,03,00,00,000?

Holding 1 of Nilgiri Growth Partners Fund II, invented, is Sahyadri Diagnostics Private Limited, invented. Sahyadri Diagnostics is the largest single thing that ever happened to this fund, and its whole life fits into three dated transactions and a long stretch of nothing much between them.

The fund entered in Fund II's Year 1 Q3, paying Rs 55,00,00,000 for existing shares held by the founding shareholders. The entry cheque was the primary investmentThe fund's first investment into a company it did not previously hold., meaning the first cheque into a company the fund did not previously hold. In Year 4 Q1, exactly 2.50 years later, it put in a further Rs 15,00,00,000 as a follow-on investmentMore money into a company the fund already holds.. The Rs 15,00,00,000 took the cost of the holding to Rs 70,00,00,000, of which the follow-on is 21.4 per cent. In Year 7 Q2 the position was sold in full for Rs 2,03,00,00,000. The holding period was 5.75 years, the multiple on costTotal value divided by what was paid for the holding. was 2.90 times, and the profit was Rs 1,33,00,00,000.

Sit with the shape of that for a second. The shape belongs to almost every private position and to no listed one. Two payments out, one payment in, and 5.75 years in which nothing whatsoever arrived. Across that span the fund received 69 monthly information packs and sat at 23 board meetings, and not one of those 92 events produced a rupee of cash. Everything the position ever paid arrived on a single day in Year 7 Q2.

How much of that Rs 1,33,00,00,000 can this record actually attribute?

The answer is: some of it, and much less than a reader wants.

The fund's own record of the sale holds two bids. A strategic buyerA buyer already operating in the same industry as the company being sold., meaning a buyer already operating in the same industry, bid Rs 2,03,00,00,000 and won. The highest financial buyerA buyer with no existing operation to combine the company with., meaning a bidder with no existing operation to combine the business with, bid Rs 1,75,00,00,000. Against the Rs 70,00,00,000 of cost the lower bid would have produced Rs 1,05,00,00,000 of profit. The lower bid's Rs 1,05,00,00,000 is 78.9 per cent of what was actually made. The Rs 28,00,00,000 between the two bids is the remaining 21.1 per cent, and it is 16.0 per cent on top of the lower bid. Rs 1,05,00,00,000 plus Rs 28,00,00,000 is Rs 1,33,00,00,000 exactly.

The Rs 28,00,00,000 gap between the two bids is the only component of the profit this fund's record attributes to anything, and the record states the reason as a reason rather than as a rule. The buyer already in the industry expected to remove Rs 4,20,00,000 a year of cost that would be duplicated once the two operations sat together. On the multiple that buyer was paying, the saving was worth about Rs 29,00,00,000. Dividing the Rs 29,00,00,000 by the Rs 4,20,00,000 gives about 6.9, and the 6.9 is arithmetic on two locked figures in this invented record rather than a multiple anybody stated. A bidder with nothing to combine the business with had nothing to remove, so it could not pay for a saving it would never make. Rs 29,00,00,000 and Rs 28,00,00,000 are close, and they are not the same number. A strategic buyer does not always pay more, and any claim otherwise would be false.

Why is the other Rs 1,05,00,00,000 left unsplit?

Because splitting it would mean inventing three numbers, and inventing three numbers that happen to add to Rs 1,05,00,00,000 is not analysis. Such a split is a picture that looks like analysis.

There is a real and well established way of decomposing a private equity return. The decomposition separates what the earnings of the business did, what a buyer was willing to pay for each rupee of those earnings, and what any borrowing inside the transaction contributed. The arithmetic is genuine and it is worth learning. But it needs the earnings at entry, the earnings at exit, the multiple paid at each end and the debt outstanding at each end, and this fund's record of holding 1 contains not one of those six figures. The return arithmetic on a purchase funded partly with borrowed money is covered separately.

The silence about those three components earns its place rather than being pedantry. A chart with three invented components would be indistinguishable, to any reader, from a chart with three real ones. Such a chart would read as a claim about how private equity returns are made, and this record supports no such claim. A visible gap teaches more than a picture that is complete and made up. So the honest sentence is the short one: Rs 28,00,00,000 of this profit is attributed, Rs 1,05,00,00,000 of it is what the business and the price it commanded did across 5.75 years, and nobody has broken that further in a way this record supports.

What does a follow-on ask that a first cheque does not?

Primary Investment vs Follow-On Investment

Consider a cousin who opened a small printing business two years ago, and an early backer who put money in at the start. Now he is back, asking for more. A stranger being asked for the first time is looking at a business he has never seen. The early backer is looking at a business watched for two years, whose books have been read every month, and whose first plan that backer personally believed. The backer knows more than the stranger does. Part of that knowledge is whether the backer's own earlier judgement was any good, and that is the uncomfortable half.

The backer's own earlier judgement is the whole difference, and it is why the second decision is harder rather than easier. A first cheque asks one question: is this company worth holding at this price? A follow-on asks a different one: is more money into a company already held worth more than the same money into a company not yet held? The second question carries information the first cannot have, and it carries a pull the first cannot have either.

Look at what the fund knew each time, with holding 1 as the case. Before the first cheque, the manager had done what it does before every entry. Across the five-year investment period it reviewed 412 opportunities, signed 31 confidentiality undertakings, issued 14 non-binding offers, went to exclusivity on 11 and completed 9. Two of those eleven fell away in diligence, one on a finding in the operational workstream and one because a second bidder paid more. Nine completed out of 412 reviewed is 2.2 per cent, and that is the shape of the work rather than a virtue or a fault. Before the follow-on, in Year 4 Q1, the fund had held Sahyadri Diagnostics for 2.50 years. At this fund's contracted cadence that is 30 monthly information packs and 10 board meetings. The fund was not looking at a stranger.

And there is a pull worth naming. The fund's own governance list holds a conflict about exactly this, and it runs the opposite way to the obvious one. Putting more money into a struggling holding postpones marking a loss, and that is the temptation. Nilgiri Growth Partners Fund II answers it with a rule rather than with good intentions, requiring the investor advisory committee's consent on any follow-on above a size the fund's documents fix. Both of this fund's follow-ons happened to go into holdings that were above cost at the time. A follow-on is never on its own evidence that the original decision was right.

What did the Rs 25,00,00,000 of follow-on buy, and did the cap ever bite?

Across the whole life of this fund, exactly two of the nine holdings ever received a follow-on. Rs 15,00,00,000 went into holding 1 at Year 4 Q1 and Rs 10,00,00,000 into holding 4 at Year 5 Q2. The two together are Rs 25,00,00,000 of follow-on against Rs 3,75,00,00,000 of first cheques, adding to the Rs 4,00,00,00,000 the fund invested. Follow-on money is 6.25 per cent of everything this fund invested and 5.0 per cent of the Rs 5,00,00,00,000 committed, and 22.2 per cent of the holdings, being two of nine, ever received any.

One coincidence is worth naming precisely so that nobody reads it as a pattern. Both follow-ons arrived exactly 2.50 years after their holding's entry. Holding 1 entered at 0.75 years after final close and took its follow-on at 3.25; holding 4 entered at 2.00 and took its follow-on at 4.50. The matching interval is a coincidence inside one invented fund and it is not a rhythm in anything.

Now the cap, and it must be stated together with what actually happened to it. The fund's documents cap follow-on capital called after the investment period ends at 15.0 per cent of commitments, being Rs 75,00,00,000. Both of these follow-ons fell inside the five-year investment period, at Year 4 Q1 and Year 5 Q2, so neither counts against it, and nothing at all has been called for a follow-on in Years 6 to 9. The cap exists, and it has never been engaged. A cap named without saying whether it bit implies a constraint that was never doing any work.

One last thing about a follow-on, and it is the thing nobody mentions. A follow-on does not arrive at an investor labelled as a follow-on. A follow-on arrives as a line inside a capital call notice, sitting beside the year's management fee and the year's operating expenses, and the notice does not say the words. Drawdown 9, issued for Year 4 Q1, was Rs 25,60,00,000: the Rs 15,00,00,000 follow-on into holding 1, plus Rs 9,80,00,000 of that year's management fee, plus Rs 80,00,000 of operating expenses. Drawdown 12, for Year 5 Q2, was Rs 20,60,00,000, being holding 4's Rs 10,00,00,000 follow-on plus exactly the same Rs 10,60,00,000. Both reconcile to the rupee.

What does the fund actually see from a company it holds?

How a Private Equity Portfolio Company Is Monitored

Two landlords, same building. One lives on the ground floor and walks past the shop every morning, sees which day the shutter went up late, hears what the staff are saying, and gets the accounts because he asked for them in the tenancy agreement. The other lives in another city and receives a rent receipt every quarter. Neither of them holds more of the shop than the other. One of them knows what is happening.

A private position is the first landlord. The fund contracted for a defined arrangement with every one of its nine holdings, identical across the nine, and the arrangement is written into each shareholders agreement rather than being anybody's habit. There are five items. First, a monthly information pack, due within fifteen business days of month end. The fifteen business days are this invented arrangement's own contracted term and are not standard, typical or required of anybody. Second, a board meeting each quarter, four a year. Third, audited annual accounts. Fourth, a budget approved before the year it covers begins, one of the seven reserved matters. Fifth, immediate written notice of a defined list of events that the agreement sets out.

Now put a number on what that produced. Across 45.50 holding-years to the record date, this fund received 546 monthly information packs and sat at 182 board meetings. Against that it made nine investments, took two follow-on decisions, sold four positions and wrote one off. Sixteen decisions came out of seven hundred and twenty eight arrivals of information, and that ratio is the honest shape of monitoring rather than a criticism of it. Most of what a fund receives is not a decision waiting to be taken. The packs and the meetings are the material out of which somebody might notice that a decision is needed.

If the fund is 1.80 times, how many of its nine holdings are?

Consider a caterer who takes nine wedding bookings in a year. One of them is a very large wedding that pays for the year. One household cancels and never pays. The other seven are ordinary. Saying that the caterer averaged a comfortable margin across nine bookings would be true in every sentence, and the listener would still have no idea what that year was like to live through. RealisedSold, with the cash actually received. outcomes in a private fund arrive in exactly that shape, and the ones still unrealisedStill held, carried at an estimate rather than a sale price. will too.

Holding 5's outcome is not somebody's fault, and it is not evidence of anything about how private funds behave. A write-offA holding valued at nothing, which leaves the portfolio without producing cash. is a position leaving the portfolio without producing cash, and that is all this record says about it. The fund had the packs, the board meetings and the reserved matters at holding 5 exactly as it had them everywhere else. Access to information is not the same thing as a decision somebody took, and a line drawn from monitoring to outcome would be untrue.

Which of the three multiples is this fund's real multiple?

All three of them, on the same day, about the same fund. Three multiples on one day is the arithmetic trap of the whole subject and it catches careful readers, so it is worth being slow.

The fund's total value at the record date is Rs 7,20,00,00,000, being Rs 4,38,00,00,000 already received in cash plus Rs 2,82,00,00,000 still carried in five holdings. The Rs 7,20,00,00,000 on top does not change. The denominator underneath does. Divided by the Rs 4,00,00,00,000 the nine holdings actually cost, it gives 1.80 times, the deal-level figure that ignores every fee and every expense. Divided by the Rs 4,80,00,00,000 the investors actually paid in, it gives 1.50 times, the figure an investor's own statement shows. Divided by the Rs 5,00,00,00,000 committed, it gives 1.44 times, a figure almost nobody quotes and worth knowing for exactly that reason.

The gap between 1.80 and 1.50 is the fee and the expenses and nothing else: Rs 70,20,00,000 of management fee and Rs 9,80,00,000 of fund expenses, being Rs 80,00,00,000 drawn on top of the Rs 4,00,00,00,000 invested. None of the three figures is wrong. A quoted multiple with no denominator attached has said almost nothing, and the fix is one question rather than any arithmetic.

What is still unknown about a fund that has not finished?

A great deal, and this is the sentence most reports do not put at the top. Of the Rs 7,20,00,00,000 this fund is said to be worth at its record date, Rs 4,38,00,00,000 is cash that a buyer actually paid and that actually reached investors. The other Rs 2,82,00,00,000, being 39.2 per cent of the total, is an estimate of five holdings nobody has bought. The Rs 4,38,00,00,000 and the Rs 2,82,00,00,000 are different kinds of number and they are printed in the same column.

The fund's contracted term ends at the end of its Year 10, so at the record date six quarters remain and five positions are still held. The unfinished state is not a fault and it is not a warning; it is the honest position of a private fund in its ninth year. The consequence is simple and strict: any sentence about this fund's outcome is a sentence about 60.8 per cent of it plus an estimate of the rest. How an unsold holding is valued, who values it and what an investor's statement shows are covered separately, and none of that changes the shape of this figure.

With one hour to spend on a private fund's report, what should be asked?

Reading a private fund's report is the practical end of the matter, and more people do it than might be assumed: somebody on an investment committee who has to approve a commitment, an analyst covering an institution that has made several, a monitoring team inside an investor, an auditor, and a student who will do one of those jobs in three years. Four questions, and every one of them is answerable from a document rather than from any judgement about the manager.

First, ask which multiple that is. A report saying a fund is 1.80 times has not said 1.80 times what, and the same fund on the same day is also 1.50 times and 1.44 times. The denominator is the single most load-bearing thing in the report and it is almost never printed next to the number. Second, ask how much of what has been realised came from how many holdings. In this invented fund one position of nine carried 46.3 per cent of everything realised, and a portfolio whose result rests on one name is a different object from one where nine names each carried a ninth of it, whatever the average says.

Third, ask how much of the stated value has actually been sold. Rs 4,38,00,00,000 of cash and Rs 2,82,00,00,000 of estimate are both real figures and only one of them has met a buyer. Fourth, read the capital calls and ask what is in them that is not investment. Drawdown 9 of this fund was Rs 25,60,00,000, of which Rs 10,60,00,000 was fee and expenses, and across the fund's whole life Rs 80,00,00,000 of the Rs 4,80,00,00,000 drawn never went into a company at all. None of those four questions needs an opinion about anybody, and three of them can be answered from the report itself in an afternoon.