Premium Pursuits Of PE Investors: Shifting Focus Towards Control Deals

The landscape of private equity (PE) investments in India is undergoing a notable shift, as PE investors, known for their proclivity to lean on investments that have the potential to generate impressive returns, have increasingly shifted their leaning towards control deals. In these transactions, PE investors seek a majority stake in target companies, allowing them to exert more influence over strategic decisions and operations. However, this strategic move usually comes at a cost – the control premium – which reflects the extra value that PE investors are willing to pay for the benefits of control. This article delves into the reasons behind the growing preference for ‘control deals’ by PE investors in India and examines the implications around payment of control premium.

Changing Landscape Of Private Equity Investments 

Historically, PE investors have favoured investments involving minority stake with a robust package of economic and corporate governance rights. Such investments have been geared towards acquiring a non-controlling stake with enough fetters on the promoters and the target company from being able to erode the value of the investor’s investment. This approach allowed them to benefit from the target's growth potential while minimising their involvement in day-to-day operations. However, this landscape has evolved, which has witnessed PE firms now setting their sights on control deals as their preferred investment strategy.

One of the primary reasons behind this paradigm shift has been the informed desire for greater influence over the business operations of target entity(ies). A trend is being seen in PE investors acquiring a majority stake (51 per cent or more) with a view to obtain substantial decision-making power. This control enables them to implement strategic changes, drive operational improvements, and guide the target company's growth trajectory, in alignment with the target’s management team.

Further, India’s economy has grown remarkably over the past decade, leading to opening of more investment avenues. This is also complemented by the emergence of a new generation of entrepreneurs and professionally-managed companies, who are more open to accepting investment. Moreover, succession issues in promoter-run businesses, particularly as their second and third generations take charge, open doors for external investments. Many such businesses, having reached growth saturation, now seek professional management to propel them forward. Also, a shift in the traditional mindset of promoters, who once hesitated to dilute control, is noticeable due to societal changes and increasing pressures to divest less profitable assets. This transformation underscores the gradual rise of control deals in India.

The Control Premium Phenomenon 

As PE investors pursue control deals, they often find themselves having to confront the control premium conundrum – an additional cost over and above the fair market value of the target company. The control premium serves as compensation for the seller’s willingness to relinquish control and the buyer’s expectation of greater value creation under its ownership.

Why pay a control premium?

The justification for paying a control premium lies in the belief that having control allows PE investors to unlock greater value within the target. This value creation potential becomes a central argument in favour of the premium, as PE investors anticipate that the benefits of control and the potential will far outweigh the additional cost, as also enabling them to exercise authority to implement operational improvements, cost-saving measures, and strategic initiatives that can lead to a substantial increase in the target's value.

In many cases, control deals involve competitive bidding processes, where multiple PE firms vie for a target company. This competition can drive up the price, resulting in a control premium. As per Bain & Company’s India Private Equity Report 2023, as the Indian economy continues to rebound, PE firms are actively pursuing quality assets, leading to competitive bidding scenarios. PE investors are often willing to pay a premium to secure the deal, as they believe they can extract more value through control.

Moreover, investors are increasingly gravitating towards control deals given the inherent ability to exercise greater oversight on the target company and to be able to mitigate risks associated with potential cash burn, inflation of revenues, overspending, siphoning off of funds and other fraudulent activities by promoters and employees, as has been seen in some Indian portfolio companies recently. Gaining control (which includes control over operations and financial management of the target) not only allows for more effective implementation of operational improvements but also acts as a safeguard against potential malpractices of the kind described above. The hands-on approach in control deals empowers investors to closely monitor the financial activities of the company, and also to retain confidence in the management. 

Further, control deals often come with a long-term vision for the target company. PE investors are willing to pay a premium because they plan to hold the investment for an extended period, allowing them to realise the benefits of their strategic initiatives over time. This also carries the potential of being beneficial for the investee company, as PE firms can bring to bear global best practices and insights from other such successful investments.

Key implications for investors

While paying a control premium can be a strategic move for PE investors, it also comes with certain implications and considerations.

One of the foremost challenges in control deals is the risk associated with execution. If investors fail to execute their strategic plans and effectively manage the target company, the anticipated value creation may not materialise. This failure can turn a seemingly lucrative investment into a sub-optimal one, emphasising the critical role of post-acquisition management. Investors also need to contemplate whether the existing promoters and management should continue post the deal, or whether they require wholesale changes to the management team by way of onboarding professional managers. 

Further, control premiums can significantly increase the valuation of the target company. This can be a double-edged sword for PE investors. While it may lead to greater potential returns if the company performs well under their ownership, it also increases the financial risk associated with the investment.

Also, acquiring a majority stake often involves navigating complex integration processes, especially when merging the target company with other portfolio companies or implementing substantial changes. Combining distinct entities involves harmonising diverse corporate cultures, management structures, and operational processes, creating a complex landscape. Successfully managing these integration challenges is crucial in order to realise the intended benefits of control. 

Another challenge that PE investors face in taking control of a company is regarding increased scrutiny from various stakeholders, including regulators, employees and the public. For instance, investors who acquire or agree to acquire shares, voting rights, or control of a listed company are required to make an open offer under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, which the PE investor may not have an appetite for. Further, acquiring control of a target company can expose investors to the risk of their nominee directors being considered an “officer-in-Default” for the day-to-day operations of a company, and therefore liable for violations as mentioned under the Companies Act, 2013 and other social welfare and environmental legislations. Moreover, PE investors also have to make peace with being classified as “promoters” in case the company goes for an IPO. For instance, the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 provide that promoters to the issue must contribute at least 20 per cent of the post issue paid up share capital, and this minimum contribution capital is subject to a lock in of three years from the date of allotment. This adversely impacts the marketability of the investment and might discourage investors looking for a quick exit. Further, other portfolio companies of the promoter-investor and the investor’s own fund structure(s) also come under a heightened degree of scrutiny by the regulators, which is often not desirable.

That said, with a view to ring-fence the liabilities of directors who form part of the senior management of the investor’s ecosystem, the investor can always consider appointing unrelated persons as directors to the board of directors of the investee entity. This is to ensure that any ensuing liabilities from non-compliance with applicable laws vest with such individuals. Another mode of ensuring ring-fencing is to separate management from ownership, which would firstly, enable easier hiring of top-quality talent to professionalise the investee entity, and secondly ensure better risk allocation and compliance responsibilities amongst the owners and the management.

Moreover, investors in control deals often commit to a longer investment horizon. While this aligns with the strategy of realising value over the long term, it also limits the flexibility of exit options. Investors may find themselves bound to the investment for an extended period, unable to capitalise on early exit opportunities that might be available in minority investments.

Conclusion

In today's dynamic M&A landscape, it appears that the trend of shelling out control premiums by investors is likely to be on the rise. As PE investors continue to seek opportunities for value creation and strategic influence, the balance between the premium paid and the returns generated while being open to greater amounts of scrutiny and regulatory interface, will be a key consideration in their investment decisions. The future will reveal how successful these investments ultimately prove to be and whether control deals continue to shape the PE industry's landscape.