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Wednesday / March 29.

The PE Cure and the PE Trap

By Praveen Chunduru

It is nearly impossible to talk about private equity these days without mentioning Uber. From being a no-namer a little more than four years ago to being the largest unicorn (privately held company with a valuation of over $1 billion) in the world, it now has a whopping valuation of over $50 billion. It would have been unthinkable 10 years ago for a privately held company to be as valued as Uber is today.

Yet, Uber has chosen not to go public. Going public involves a lot of hassles, most notably the need to comply with increased regulatory and financial reporting requirements. Further, it requires the company to pay a lot of attention to the short and medium term to reward its shareholders. Staying private allows Uber to undertake massive expansion campaigns (with investors’ money) and scale up operations for the long-term, without being worried about quarterly results. This translates to a rapid expansion in valuation, something highly improbable if the company were listed and closely scrutinized by shareholders and analysts. Uber was valued at $18 billion in June 2014 and in July 2015 this figure grew to $51 billion. It is hard to think of any publicly listed stock that tripled in valuation in one year. So when you find yourself in a heated market as Uber does and if you are under pressure to raise funds then don’t just go public. Instead, raise PE money and enhance valuation amply before your IPO. This is ‘the PE cure’ – the relief that PE funds provide.

Of course, PE firms expect more than reasonable compensation for the risks they are taking. The conditions of investments by these PE firms, which have invested in Uber are not known but a ‘liquidation preference’ is fairly common i.e. the PE investor will get x times its money back before the founders and the management get anything in equity returns. In some circumstances PE investors successfully negotiate for a ‘participating liquidation preference’. This allows them to get back not only x times their investment but also to participate in sharing the proceeds of the remaining amount (in short, double-dipping). But this is not the ‘PE trap’- a PE firm does not have much leverage when it is a late investor in a hot company such as Uber, thus I would not imagine the terms of their investments to be too demanding.

If you’re investing at $50 billion, and you want to make 10x return in 5 years; that means Uber would have to be valued at $510 billion in 5 years’ time.

The trap I am referring to is the one that PE investors themselves may be falling into. It is common for PE investors to envisage a 10x return on their investment in 5 years. If you’re investing at $50 billion, and you want to make 10x return in 5 years; that means Uber would have to be valued at $510 billion in 5 years’ time. Only Apple today has a valuation north of $500 billion. There seems to be some sort of a ceiling for companies; one can’t just accumulate infinite value. So, it’s unreasonable to expect that Uber would continue its meteoric rise for too long. Competition inevitably sets in, competitors increase, market saturates, technology changes (what if people don’t use cars much in the coming few years), among other potential causes for a slowdown.

For the first time, probably ever, we are seeing companies receive an ‘illiquidity premium’ on their valuation, instead of a discount. This begs the question – what will be the exit for these investors? Will it still be an IPO? Will it be a controlled stake sale to smaller and smaller parties? Will it be a large M&A transaction? Or will the companies accumulate enough reserves that they actually buy back the shares they issue to the investors? My bet is the controlled stake sale to smaller parties. With further fin-tech innovations, it is not inconceivable that an individual buys 100 shares of Uber from Sequoia Capital in a secondary purchase, completely by-passing the formal stock exchange system. In short, the future may hold for us a blurring of the lines of what is private and what is public. For now though, PE investors seem to be placing very large bets without a clear exit strategy.

Praveen Chunduru is a Co-Founder of VideosForKnowledge, an NGO aimed at enhancing general awareness and good-citizen values among children in low-income schools in India. He is also an MBA Candidate in Wharton Business School (Class of 2017) with experience in private equity and credit ratings, having worked for 2.5 years each in IFC (World Bank) and prior to that, in CRISIL (S&P). He is a CFA Charterholder and an avid blogger – simplecatch.blogspot.com.