Unquoted Funds and Their Evaluation

Unquoted Funds and Their Evaluation

Unquoted funds used to be one of the popular private equity vehicles during the boom years prior to 2008. They really earned unbelievable yields when times were good. Many real estate funds in the Middle-east did, in fact, redeemed much before scheduled redemption date with very attractive returns to investors and this increased their appeal. However, onset of the economic decline took the shine away from these funds.

But in recent times, we are seeing a revival of such unquoted funds. The attractive valuation of assets and huge requirement of capital (with traditional lenders not too willing to lend) is the reason for renewed interest in unquoted funds

Any target investor before taking up participation should consider the following main factors:

1.       Investment strategy of the fund, investment period and tenor of the fund: This is the first step in evaluation of a fund and is based on the Private Placement Memorandum (PPM) provided by the promoters of the fund. It is important to satisfy that the investment strategy is in-line with the objectives of the investor. Investment period (which is separate from tenor of the fund) which states up to which period investments will be done is another critical decision input as this is the period up to which an investor needs to remain committed (incidentally many of these funds are commitment based which does not require the investor to part with entire funds upfront but require him to meet the commitments as and when called upon by the fund manager). Tenor of the fund (which is generally extendable) is another critical decision input. A careful evaluation of these should be the first step for any prospective investor.

2.       Yield and Exit: The proposed yield – both the hurdle rate and anticipated yield should be subjected to a critical evaluation. This evaluation should take into account the return available on any comparable sovereign issues for similar periods, returns available from other avenues such as corporate bonds, bank deposits. After determining what is the reasonable yield available from an alternative and safer investment will provide, one needs to add risk premium – based on tenor and illiquidity factor, nature of proposed investments, and geographical and currency risks proposed to be taken. Another important factor is the estimating what one would earn if investment is made in liquid equities in the same region where the fund proposes to invest. The proposed exit strategies of the fund manager – how does he manage his exist in each of the investment i.e., is he entering into buy-back agreement with majority partner in investee company, is he planning to push for IPOs, are there many takers for minority stakes and such other factors.

3.       Risk factors and their mitigation: Generally the PPM does mention the risk factors but what is not generally mentioned is how these risk factors are proposed to be mitigated. The main risk factors are risk associated with exit from the investments made by the fund, regulatory constraints and foreign exchange risk. Risk management methodology, therefore, should receive careful consideration of the prospective investor.

4.       Information flow: Availability of information and flow of information from the fund manager after launching of the fund is the important decision input. Most of the time, investors remain information takers – receiving NAV and other information only when the same is published by the fund manager. Many a times, PPM remains vague on NAV methodology and periodicity and other information parameters. This requires a careful consideration from prospective investors.

Unquoted funds though appear to be investments with high risk perception, the right kind of evaluation will facilitate identification of funds which suit investor’s risk appetite. They are attractive because of the returns which these funds offer and are convenient for those investors who lack the wherewithal to explore investments in uncharted areas.