Wealthy Indians, Ratan Tata and global hedge funds, all seem to be quite convinced about one thing. The start-up and private equity space in India has far more exciting investment opportunities than the listed space. But if you want a slice of this action and are a novice to venture capital, you first have to navigate all the jargon that the industry likes to throw at you. Here’s a primer.

Strategies: Seed to PIPE If a private equity fund is knocking at your door for capital, the first thing you would need to check on is its strategy. While all private equity funds are designed to invest in unlisted ventures, when and how the fund invests in a business decides its risk profile and returns. The options are:

Seed funding: This involves investing in ventures where the entrepreneur has just had a bright, workable-sounding idea and is seeking capital to convert it into a business.

Given that many bright ideas may not really translate into a scalable business, seed funding carries a high failure rate and is the most risky class of venture funding. Typically, large venture firms do not undertake seed funding and leave it to angel investors.

Early-stage funding: Once a venture has demonstrated proof-of-concept (an idea that works as a business proposition), has a management team in place, and can demonstrate that there is a market for its product or service, it needs capital to further develop its product, build a brand or establish a marketing network. This is where early-stage funding comes in. This also goes by the moniker of ‘Series A’ funding. Early stage funding isn’t as risky as seed funding, but there can be failures, as the venture is still young enough to lose out in the rat race.

Late-stage funding: Once a business manages some traction in its revenues, it may need more capital to invest in more production facilities or expand its distribution network. This is late-stage funding, also called Series B or Series C funding.

Late-stage funding is less risky, but soaks up higher amounts of capital. Exit for the PE fund is usually through an IPO.

PIPE: In a raging bull market, bargains in the unlisted space may be hard to come by. Funds may compromise by investing in listed companies. This goes by the appellation of PIPE (private investments in public equity). In PIPE, the growth potential may be moderate, but liquidity is a certainty. Investors in private equity are generally leery of such investments as they end up paying private equity-type fees for a public investment.

Mode of funding Having decided on their basic strategy, private equity funds home in on the kind of deals they are most comfortable with. There are three options:

Growth equity: The fund buys a minority equity stake in an established high-growth venture to help it scale up its offerings or market presence.

Buyouts: The fund gains management control over a firm by buying a majority equity stake in it. It then gets its operating partners on board and takes an active role in restructuring the firm’s operations, strategy and capital for long-term payoffs. Leveraged buyout (LBO), a strategy which earned much notoriety in the developed markets (they rarely happen in India), involves gaining control over a distressed firm by taking on tonnes of debt. The fund then reshapes it to drive up revenues and profits.

Lenders are paid off from the firm’s cash flows and the fund bids goodbye by selling its stake at a hefty premium.

Mezzanine funding: Fondly called mezz funding, the private equity fund subscribes to high-interest bonds or bonds with warrants attached, in a business that needs short-term cash. These bonds serve as a stop-gap arrangement for the firm until it finds a new set of long-term investors. In India, quite a few private equity funds specialise in mezzanine funding to cash-strapped real estate developers and rake in stellar yields on these bonds.

Know thy costs Once you’ve short-listed the strategy and type of private equity firm you like, you will need to deep dive into its offer document or information document to gauge the likely costs and returns. Be sure to know your way around the following.

Management fee: Just like a mutual fund, a private equity fund is a pass-through entity which pools money from investors, deploys it in portfolio companies and then funnels back any dividends or capital gains from them to its investors. Well, it doesn’t do this for free. The usual management fee for running the fund is 1.5 to 2 per cent of the fund value.

Hurdle rate: If that looks to be a bargain, the management fee is not the only fee that your private equity fund charges you. Usually it is also entitled to a share of the profits you make. A common fee structure in private equity is the 2-and-20 structure.

That is, you pay a 2 per cent management fee irrespective of how the fund performs and a 20 per cent performance fee on any gains that the fund makes over and above a ‘hurdle rate’. The hurdle is set based on the minimum return that an investor would expect to earn. It is usually 10, 12 or 15 per cent in India.

Carried interest: Simply called ‘carry’, this is the profit share that the fund demands, as its share of the spoils. In the above instance, the carry is 20 per cent.

Transaction and monitoring fees: Beware! The management fee and carry may not be the only fees that private equity managers are charging you.

They could also be charging their portfolio firms with consultancy fees, sitting fees and reimbursement.

These get reported as ‘transaction and monitoring fees’. Global private equity fund disclosures have shown that the transaction and monitoring fees can be at a multiple to the disclosed management fee. Ultimately, all private equity investors dream of finding Unicorns. Wondering what they are?

The hunt for unicorns “Unicorn” is the moniker given to start-ups which get rapidly to a billion-dollar valuation, thus enriching their initial investors.

The Indian e-commerce industry has already had many entries into the Unicorn club — Flipkart, Snapdeal, Ola Cabs, Mu Sigma, Paytm and Zomato. Note that to transform into a Unicorn, a firm does not have to go public.

This valuation is measured based on the latest round of funding received by the start-up. Deca-corns are unicorns ten times over — their market valuation is at $10 billion or more.

And super-unicorns, you guessed it, are those venture firms which get to the holy grail of private equity investing — a $100 billion valuation.

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