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.
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.
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! 🙂