Sev Vettivetpillai, chief executive of Aureos, talks about how emerging markets experience underlines advantages of securing cash flow before exit.
The private equity industry may need to rethink its business model by putting more emphasis on securing cash flow from investments before exit. More focus on structuring deals using dividends or other mechanisms to realize cash from a growing business before an exit through initial public offering (IPO) would result in less volatile returns from private equity, says Vettivetpillai. This would boost the confidence of potential investors and help private equity firms to negotiate a potentially still volatile global economy in the coming years.
In order to reduce risk for fund investors, Aureos makes extensive use of geared structures or preferred instruments carrying the rights to dividends or stock redemptions that can generate cash flow while ensuring that the relevant business has all the capital it needs to pursue growth opportunities. Nearly 50% of Aureos’ investments make use of such instruments and the yield on its income-generating structures accounts for 15% of investment returns.
“There are huge opportunities in the emerging markets in which Aureos operates, but these economies also have particular investment risks that make relying on exits through IPOs an unreliable approach,” says Sev Vettivetpillai. “Emerging markets have historically been subject to rapid changes in their economic and political climate that derail short-term planning, and it can take a long time to grow an established family business to a size where IPO becomes a realistic option.”
He gives an example of some Latin American markets where the minimum viable size for a public market candidate is $200 million in market capitalisation. As a result of these features of emerging economies, Aureos has always taken the view that exits through the IPO markets cannot be its main mechanism for producing returns for fund investors.
“The last three years have more than vindicated that approach, with an almost unprecedented slowing in IPO activity across both the developed and emerging markets,” he adds. “While our cautious structuring of deals, and several successful trade sales, have meant that we have been able to continue to generate returns for investors, even in developed markets some funds have to wait indefinitely for the right moment to launch an IPO.”
He adds that with the medium term economic outlook still far from certain, private equity investors may want to look closely at how they could secure a more stable flow of cash from a business rather than depend on the magic of leverage and the return of pre-crisis IPO valuations. There is a small minority of private equity investments in start-ups where dividend payments might hamper the growth of the company, but in most of our investments, generating early cashflow, while still benefitting from the potential upside of the investment would be quite normal.
Aureos’ strong track record in delivering returns for investors, demonstrated by a nearly 20-fold increase in its assets under management since 2001, is based on close work with its portfolio companies to achieve strong earnings growth. Over 50% of Aureos’ returns can be attributed to earnings growth, with increases in the valuation multiple contributing a much smaller proportion.
Aureos has a network of more than 20 local offices covering more than 50 markets. Its combination of broad local presence and deep local knowledge, extensive experience of building small and medium-sized businesses into regional champions, and strong focus on environmental, social and governance performance as an integral part of managing risk and generating returns, is unique in the industry.