CCI Out, DCF In: Will PE Deals Get Too Costly?

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Few days ago the government changed the foreign direct investment (FDI) pricing guidelines for unlisted companies. Earlier foreign investments in unlisted companies were to be made a minimum floor price at a valuation determined by the Controller of Capital Issues (CCI) guidelines. Now effective late last month the valuation will have to be done at a discounted cash flow method.

Will this change end up raising minimum floor price or the entire valuation to a prohibitive level?

In an interview with CNBC-TV18, Luis Miranda, President and CEO of IDFC Private Equity and the Interim Head of the India Private Equity and Venture Capital Association and Abizer Diwanji, ED at KPMG, spoke about the new FDI guidelines for private investors and its ramifications going forward.

Below is a verbatim transcript of the interview. Also watch the video.

Q: I hear that the private equity and venture capital industry very agitated with this change in the pricing guidelines. Is this going to make investments a lot more difficult?

Miranda: This was something surprising; it's not something that we expected and so we started a discussion with the Reserve Bank of India (RBI) to understand why this happened and what can be done about this. The RBI feels that the old guidelines were dated and therefore needed to bring in something which was more contemporary based on how investors look at it. But the moot point is whether this will actually impact deal flow.

Remember, any deal done for an investment is between two consenting adults and therefore there is a price at which the seller is comfortable selling at and there price at which the buyers are comfortable buying at. What happened so far is that under the current guidelines deals happened because the seller was comfortable selling at that price. So sellers were not comfortable and wanted and change in this and I failed to see what the problem was because they were willing to do deals with the earlier level at any way and if they feel that the prices going to go higher than what they got earlier then the buyers would not be buying so its going to come to somewhere which is workable.

But also bear in mind that the regulations do not specify and I am going to read back what it says is that - it will be on a fair valuation basis done by a registered category, one merchant banker or a chartered accountant as per the discounted free cash flow method. There are no definitions as to what discount rate to you, what growth rates, number of years of cash flow etc. So it's very possible that this is not necessarily going to drive the pricing of deals, it's going to determined by based on negotiation that the buyer is willing to buy at and frankly people are not comfortable of the valuation basis come out to be too high, no deals will happen in anyway.

There is some element of flexibility in this whole thing because of the fact that the valuation parameters haven't been defined. It does obviously whenever there is any change cause uncertainty and is something with which we have taken with the central bank and hope to get some conclusions soon.

Q: Most of the private equity players that I was talking to or have been in the course of the last ten days ever since this change in Foreign Exchange Management Act (FEMA) regulations came about, many of them said that we are already entering India and Indian companies at premium valuations because promoters are not willing to sell at anything less than premium. So even of the minimum floor price does move up its not going to dramatically impact us. But the sense that I got was that it's more likely to hurt the venture capital industry because that is where you are putting in money at a very early stage and it's very unlikely that venture capital investors would want to bring in money at a premium at that early stage of an enterprise in that sense. So is that something you would agree that this will probably be more prohibitive for venture capital than private equity notwithstanding all the points that you make that these are deals between two consenting adults why do we need RBI to dictate transaction prices and yet discounted cash flow (DCF) gives you some discretion of flexibility and so it may not mean the end of the world for you?

Miranda: It's a question of us figuring out will this have an impact. It is a change for what we accustom to and its useful if therefore there is dialogue before such a change happens and you are right today the valuation which promoters want are high so its any way difficult to close deals. This is not going to have an impact.

But will it impact venture capitals? Not necessarily and it all depends on how the DCF valuation is done and how it certified. So we are in talks with the RBI, we will be sending them a note on this from India Venture Capital Association (IVCA) and what is more important is that the central bank is willing to have a discussion on this.