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IL&FS Investment Managers: A Business on a Treadmill

I first heard about IL&FS Investment Managers (IIML) when Prof. Sanjay Bakshi mentioned it in his interview with Safal Niveshak.

Since then, I have wanted to analyze the business, but could not do so until March this year, when a “back-of the envelope” analysis led me to buy a few units of the stock at almost the current price.

But then, I lost that envelope 🙂 and decided to do a re-analysis of the company, which I present here.

Before I begin, please know that this analysis is just to cheer you up on a hot Friday afternoon and remind you that the weekend is here. 🙂

My mind generally goes off to sleep as the weekend approaches (though my entire week is like a weekend), so be very careful of whatever conclusions you draw from what you read below.

Let me start with…

What’s the business about?
IIML is a private equity company promoted by IL&FS, and currently has around US$ 2.2 billion under management.

Its primary income stream is from “management fees”, which is a fixed percentage – typically 1.5-2% – of the funds under its management. This is like a fixed annuity for the company over the life of the funds, which is around 6-10 years, and this is what helps it cover its costs of operations.

Apart from this, the company is also entitled to a 20% share in the profits a fund generates. This share of profits is known as “carry”.

The carry typically accrues to IIML at the end of the tenure of the funds – when it gives the funds back to the original investors.

However, the company earns a carry “only” if it is able to earn more than 8-10% annual return on its funds over their lifetime. Anything less than this, and there’s no carry to be earned at the time of returning funds to investors.

Here’s a simple explanation of IIML’s business…


I have analyzed IIML’s business looking at its good and bad sides. Here is the output.

The Good
1. Good past track record: IIML’s track record has been good. The company has been fairly successful in managing the funds, generating 20%+ returns on most of the funds in the past for its investors. It’s another matter that a large part of these returns have been generated courtesy the real estate and stock market bubble prior to 2008.

Anyways, led by rising AUM in the past and profitable exits that helped it earned the “carry”, IIML has grown its revenue and profits at average annual rates of 40% apiece over the past eight years.

Here is how some of its investments have performed…


Source: IIML’s Presentation

2. Asset light business model: You just need a small office space and a few computers to run a profitable private equity business. And this is what IIML has been doing.

In other words, the company does not require a constant infusion of new capital to run its business. It definitely requires new fund inflows to earn its income – asset management fee – but its own operations are light on assets.

This is what has helped the company earn a high return on equity in the past – average of around 40% over the past nine years – and also generate positive free cash flows.

The Bad
1. A business on a treadmill: As I see it, IIML’s business looks to be on a treadmill that never stops, or it will throw the company off it.


This is given that since the company is in the business of fund management, its income depends significantly on the size of funds under its management. In order to continue to grow its income, the company has to continue growing its funds under management.


As the various funds under its management are close-ended, the company needs to set up new funds at regular intervals. The setting up of new funds in turn is not only dependent on the performance of the portfolio of investments under the company’s management but it is also dependent on the overall economic environment and the capital markets.

Of course, there is also a “carry” element to the business, but that is a big “unknown” given that it depends entirely on how its investments perform. This is turn depend on whether IIML is able to invest at reasonable valuations, which have already spiralled upwards given the buoyancy in the capital and real estate markets.

2. Investment targets in doldrums: Around US$ 2 billion of IIML’s current AUM is invested in the real estate industry. Another US$ 0.7 billion is in infrastructure. These industries, especially real estate, are in doldrums as far as investors are concerned.

Now, a case can be made of a reversal in the fortunes of the real estate industry that can benefit IIML. But it’s important to note that despite the wealth destruction that real estate has caused investors over the past 4-5 years, realty valuations still remain expensive.

Just visit a developer or a real estate agent and you would know it!

In such an environment, earning even the hurdle rate seems a tough ask for IIML, which would impact its future carry and thus new fund inflows.

What is more, it takes around 2-3 yearns for private equity companies like IIML to raise money for a specific fund. Given the cyclical nature of its investments (real estate and infrastructure) and the long cycle of fund raising, the situation can worsen going forward.

3. Resting on past laurels: As I mentioned above, IIML has had a great track record in the past of earning more than 20% annual return in a lot of its investments.

But a large part of these returns have been earned almost 5-6 years back, before the onslaught of the financial crisis.

You did not have to be a genius to earn such returns in the pre-2008 era, and IIML’s past success seems more of a product of the pre-2008 bull market in real estate than anything else.

Not to mention that the company also invested in bad businesses like Karuturi Global and DB Realty, but then how many investors would highlight their mistakes!

4. It’s all about the jockey: IIML’s business is entirely dependent on its top management and fund management team, which I see as a great risk.

Peter Lynch says, “Go for a business that any idiot can run – because sooner or later, any idiot is probably going to run it.”

I would be scared if that happens with IIML because when you give an idiot a lot of money to invest in real estate, you can imagine the repercussions. 🙂

Plus, I would attribute the pre-2008 boom period to be a bigger factor in IIML’s past performance than its fund management quality, which has been tested severely during the latest crisis.

5. Competition is getting tougher: Till a few years back, IIML was the only big private equity (PE) investor in India. Now, the Indian PE space is witnessing increasing activity levels with a large number of foreign private equity players raising or allocating significant India centric funds.

Plus, this is in a period when new funds entering India are drying up like puddles on a sunny day (though it’s not so sunny out there!)

As IIML’s management mentioned in its latest conference call, India was the lowest receiver of new PE funds in 2012. While China raised US$ 18 billion, Brazil raised US$ 12 billion, India was the lowest at about US$ 2 billion (which also included some direct FDI investments).

It’s clear that the environment has gotten challenging for the company as far as fund raising is concerned. What is more, because of the sectors that IIML has a large exposure to (real estate, infrastructure), it is very important what foreign investors think of the company’s capability to earn the hurdle rate of return. I’m sure things are difficult here as well.

In a desperate effort, the company acquired Saffron Asset Advisors in 2010, which increased its AUM by over US$ 400 million. The important part is that IIML paid 8.75% of Saffron’s AUM as consideration for this buyout, which is expensive considering that the industry average is around 5% of AUM.

How to value the stock?
If you were to go by IIML’s price-to-earnings of 5.7x and price-to-book value of 1.5x, and dividend yield of 7%, the stock looks a great value buy. In fact, this seems like a classic Ben Graham play.

But if I were to assess the stock’s price-to-reality, I would doubt this conclusion.

Despite a consistent stream of free cash flow in the past, I find it extremely difficult to value IIML given that I have no idea where its future cash flows are headed – as they largely depend on the AMC and carry, which are dependent on how the AUM grows and whether the company is able to make profitable exits.

IIML is not a company that sells a product that is regularly in demand. Plus, as I mentioned above, it has to continue raising new funds just to ensure its existence after 5-6 years.

So the probability of any intrinsic value calculation going for a toss is very high.

Also, while the company has a healthy dividend yield – dividend payout has been great in the past – a high dividend yield can be a value trap if the dividend can’t be sustained, which looks difficult in IIML’s case given its drying AUM that will impact its free cash flows.

So, what to do?
Now, after all my rant that seemingly goes against the company, let me tell you again that I bought a very small quantity of IIML in December 2012 purely for the sake of earning a high dividend yield and benefit from the stock’s cheapness.

Plus, I bought these shares using my “sin money” – money that takes care of my speculative instincts, and is capped at 4-5% of my portfolio.

I continue to hold on to the stock given its extremely cheap valuations and high yield, and to benefit from any possible return of madness in the real estate market (a positive black swan).

But I don’t see this stock as part of my “core” investment portfolio.

Here is a company whose fortunes depend on a bull market, and that too in a shady industry like real estate, plus there are no meaningful entry barriers for new players to come in a spoil the market even further.

Thus, I believe that treating this stock as a “long term” investment will be like playing with fire.

So sin at your own peril! 🙂

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Has the company given out fund-wise details of how much was raised in each fund, when and what was the return ?
    Yes these are risky models because they are in a niche category and a large part of the portfolio in real estate makes it prone to opacity.

  2. Akshay Jain says:

    Now for some positives – What I like about IL&FS is the way the business model is structured. The top management has the perfect incentive to deliver, as a major part of their payments come from performance improvements resulting in better exits. Also since they have been focused on real estate and infra, one can assume a certain amount of expertise over a period of time. And finally I have heard that the conditions in which the deals happen, make it very favorable for them. For example, am assuming DB realty and Karuturi will not find it possible to raise funds in a normal way (due to their track record and management reputation). So the deal is in high favor of the PE player, since he can some what dictate terms and also protect his downside

  3. StableBoy says:

    Just to mention one positive trigger in next few months, their India Leverage Fund exits going to be completed by Sep this year, This fund is eligible for Carry so we may see some boost in quarterly earnings of one of Q this year.

  4. Thanks Vishal, I agree with your decision – indeed the risk reward ratio is not favourable, and I’ve concluded my analysis (I may have got biased by your post in concluding, but honestly, that’s where I was inclining…although my original thoughts were to not expose my portfolio too much to the revival of macroeconomics…)

    People can read my analysis here.

  5. Puneet Oberoi says:

    In a private negotiated sale of such fund, it would sell for no more than 4-5% of aum, giving it a value of no more than 500c for 2bn fund, which is close to the market cap. As management pays itself very generous salaries, real value for minority shareholders would be much less.

  6. I agree with the overall views of Vishal, but let me admit that despite working in the real estate finance space in the past I have a slight aversion to this space. Moreover, I may also lack circle of competence to understand how real estate and PE firms work. Thanks Sunny for sharing your views – its an interesting read.
    Going by typical valuation ratios it looks like a super bargain until you get in to the details.
    What concerns me again is the up and down trend in annual profits which is languishing around the 70-75 crore range for last three years. In FY 13 earnings were 76.6 crore. So we cannot expect growth unless the company make huge profits in their sale of assets/investments in their funds. Successful exits from the PE funds might bring in the spikes or gains, but normally its like an annuity business (fixed earnings).

    The other concern which is interesting is the company’s borrowings or debt in the last two years. In FY11 and 12 they seem to have taken debt and one needs to watch this closely. If debt goes up to 25% of equity or if DE moves above 0.25x I would be concerned.

    I am concerned about real estate industry and this company is focused on real estate and infrastructure, both having challenges in current environment.

    Dividend Yield: I was impressed by this initially.

    All said and done I’m not pessimistic about this stock, but personally I wont pick this as I’ve my plate full already and I want to avoid experimenting in real estate/infra side.
    However, for others I think its good to restrict this as one of the investments not exceeding 5% of your portfolio.
    If you are still building a portfolio this might be a good addition, but if your are fully invested already you can wait until you have enough cash to pick this.

  7. The dividend yield of 7% or more seems like a good bargain but the company has been paying Rs.1.5 per share as dividend since last four years. But still the yield is good right? Yes and No because the DPS is constant for last 4 years, and since the price might have fallen it appears as if the dividend is high. The stock price has been falling ever since the year 2011 – from a high of 51-52 it is down to Rs.21. Statistically it appears attractive, but it might become a trading pick as people would start selling once the company or sector recovers – so it shares some features of cyclical stock too.

  8. Thanks Vishal . I have a different view . Investing works when you invest in area of core competence . For ILFS group Real estate and infrastructure is area of core competence ( ILFS Transportation , Noida Toll and IILFS group per say )

    Today Most commercial real estate is being sold at rates that are much cheaper than residential properties in similar localities . Hence building a strong portfolio at right location can be game changer . Plus doing with OPM ( other people money and collecting Yearly tax ) is an additional bonus . Plus getting management which interacts with investors and shares view as transparently as IIM is added advantage

    I think if you are in game for 3 – 4 years , This might a turnout to be real good investment . I have started investment in this stock by taking up position only below Rs 20 .

    • Thanks Shailesh. Agree to you views on competence and collecting tax. Just that I think, given the space they are in, their past has largely being driven by the luck factor and not skill as the last five years suggest. But yeah, purely given the price, things might turn out well for investors over the next 4-5 years. Regards.

  9. Have you checked their management salaries and generous doles of stock options every year? The CEO is one of the highest pay collectors in India.
    This compensation numbers are horrible. Its not a shareholder friendly management and never will be,
    They are no different than the Blackstones and KKRs who are listed in the US. The person who benefits most from a PE fund listing is management, not shareholders.
    I am surprised you even decided to review this stock.

  10. Hello A124. I agree compensations are higher for management, but consider the amount of funds they’re managing – here’s what I wrote in my analysis, while I agree it’s not a great business, but P/E funds tend to have high management compensation compared to profits. Take any mutual fund, and their management fees is arouns 1.5-2%, and in that comparison, IL&FS is not too bad.

    ‘According to Annual Report FY2011-12, the salary of director is Rs. 2.62 crores. The non-executing directors are paid between Rs 20 lacs and Rs 4 lacs. According to P&L statement, the total expense on salaries and allowance for FY2011-12 is Rs 23.2 crores. Understandably, for a PE fund, most of the expenses are employee salaries and benefits, as also evident from P&L statements. Notably, director’s compensation is ~10% of total employee compensation, and about 6% of PAT for the year. This is certainly not small, however, we should note that it is P/E fund, and hence such values are also not unreasonably high. Considering that the “team” manages an AUM of $3.2 billion (as of FY2011-12), the salaries for the “team” is Rs 232 million, which is 0.15% of AUM, which indicates a very low “management fees” if this company is treated as a mutual fund.

    The company also has policy of ESOPs and encourages to provide performance based bonuses. In this case, director’s compensation of Rs 2.62 crores includes Rs 1 crore as performance related pay.’

    • Shiv Kumar says:

      Sunny,

      A few more points I notice after reading up on the concalls. Management fees of 2 per cent is under pressure. In one of the concalls, CEO said new clients are bargaining heavily, so the company is not getting fees of 2 per cent. It is around 1.5 per cent when the new funds are raised.

      Also as the old funds wind down, this fixed income will disappear. In the last concall, Arpit Ranka of Tactica Capital (Sanjay Bakshi’s company) who was the only person attending asked this question which set me thinking on these lines. Now if the exits are at good profit then investors will get a good share of the carry. As of now, the company is exiting some of the investments. A fund it operates along with Milestone is exiting the 24X7 business park at Vikhroli. Talks are on with Blackstone and the value of the investment has more than doubled in 4 years.

      The management is still setting up sector specific funds and conducting roadshows. It has tied up with foreign banks to mobilize funds to invest in the middle east.

      The risk is that if the new funds do not materialize on time, the management fees will come down since the existing funds will get liquidated. If the liquidation happens with low returns then the carry will get hit.

      Potential for upside is huge if the economy recovers sharply in the next couple of years when majority of the exits happen. Then carry will be huge and the bullishnes will bring in more funds. But if the slowdow is prolonged it will be a double whammy for the company.

      • Indeed Shiv, agree, and hence I decided it is pretty speculative, since we bet on strong economic revival in next 2 years

  11. Hi,

    Very good analysis. However, would like potential investor to keep in mind following peculiarities of PE business. Carried Interest, in most case is an illusion. Secondly, the hurdle rate mentioned of 8 – 10% can in true sense would be much more than that due to following reasons:-

    1) Difference in amount raised and amount actually deployed… For e.g. You raise Rs 100 from Investor and invest only Rs 80 (Difference of Rs 20 being for incurring expenses (management fees etc.) and working capital requirements). Say, Hurdle rate agreed with Investor is 10 per cent. So in essence, the investment made need to provide at least return of 12.5% (on Rs 80 invested) and much more (trust me) to even meet hurdle rate. (10% on Rs 100)

    2) Timing difference between the money raised from the Investor and money being deployed. Which again pushes the investment made to generate higher return to meet the hurdle rate.

    3) Hurdle rate in most cases would be agreed on compound basis – So compounding adds the pressure on the investment made to generate enough returns to meet hurdle rate (ever increasing due to compounding)

    The point being, to completely ignore carried interest in computing the value to wish to pay for the stock.

  12. Vishal-ji,

    Have you ever looked at eClerx. IT services company in the data analytics domain (KPO) available at a PE of 12.

    Regards

  13. Your decision to buy few stocks is a brave move. However your statement is worth mentioning here….
    “..Plus, I bought these shares using my “sin money” – money that takes care of my speculative instincts, and is capped at 4-5% of my portfolio….”

    I have observed that over a period of longer time, it is able to give higher than expected returns. All the best.

  14. Hi, thanks for the write-up.
    Have you ever looked into calculating the liquidation value which Prof. Bakshi mentioned as the price where you could hardly do wrong?

    Thank you.

    Best
    Robert

  15. Dear Vishal
    How do you see the valuations of R.S.Software a software company with 70 cr cash an manages payments of VISA accross world. EPS of 32 with PE of 3 – 3.5.

  16. Does IL&FS need to pay back in dollars? If 10% is the hurdle rate, is that calculated in dollars or in rupees? The rupee depreciation will reduce the rate of return for investors.

  17. Hey Vishal …why have IL&FS investment managers been consistently diluting their equity???

  18. Hi Vishal, Others,
    I am curious. What did you you guys do with this stock or with this sin money? Stock has rallied a fair bit when I purchased at lows of what I thought was below liquidation value.

    In two minds.

    Regards,
    Ashish

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