THE failure on the part of private equity (PE) firms and promoters to reach a consensus on valuations has led to the signing of more ratchet private equity deals which have provisions built in to provide greater protection to investors.
After the slowdown of 2008-09, plain vanilla private equity investments and debt-equity deals are gradually making way for ‘safety-net structures’ that protect investors from fluctuating returns and underperformance of portfolio companies. One such structure in vogue now is ratchet investments.
A ratchet is a contractual agreement between a PE fund and the promoter of a company that in the event of a reduction in targeted growth (or in the case of fresh equity issue) or a decline in performance, the PE fund could increase its stake in the company without infusing fresh capital. In other words, a ratchet gives PE funds an option to increase its holding (without paying for the additional stake) if the company fails to achieve pre-set targets.
The equity allocation may vary, depending on the performance of the company and the PE fund’s expected rate of return. According to industry officials, the ceiling (the level up to which a PE fund can raise its stake in case of underperformance) could be in the 20-60% range from the floor-level (stake diluted at the first instance). There have been instances where private equity investors have scaled their investments up to 75% to gain more management control, these officials said.
“Ratchet structures are usually done by early-stage investors. These structures give them an adequate protection in times of a bad business environment. We have seen several ratchet deals happening in unlisted companies where exit options are limited,” said CG Srividya, partner of Grant Thornton. Ratchet deals start cracking when markets (and valuations) are trading at higher levels. It is in these times when promoters and PE investors fail to reach a mid-path on valuations. A large number of ratchet deals were recorded in 2006 and 2007. “PE firms are not left with many options when promoters are insistent on valuations that are 4-6 times the net revenue of a company. We do ratchets in companies that will be able to hold ground in bad times,” said a private equity fund manager, adding, “Even if a company underperforms for a brief while, we’ll be able to increase our holdings and still be invested in a company that has good growth prospects.”
Ironically, promoters of companies which had agreed to execute ratchet deals in 2006 and 2007 were not able to meet performance targets in 2008. This led to several PE funds increasing their stakes in companies where they have a ratchet contract.
“Ratchet structures are common in highgrowth economies where growth expectations are high. The pricing of the deal is done by considering the future growth of a company,” said Pankaj Dhandharia, partner of Ernst & Young.
“Apart from underperformance, ratchet deals come handy for PE funds when a company is going in for a fresh issue of shares (for example, a bonus issue),” Mr Dhandharia added. In the event of a fresh issue of shares, the overall stakeholding of a PE fund will be protected (from dilution). The fund will be allotted fresh shares (to match earlier stakeholding) free of cost or at a discounted price.