November 11, 2012

For the patient investor: ILFS investment managers

About
IL&FS investment managers is a private equity/ fund management company promoted by ILFS (50.5% ownership). The company is in the business of raising funds from investors (institutional – both in India and abroad) in the form of individual fund offerings.

These funds have their individual mandates such private equity investments, infrastructure or real estate type investments. The company is responsible for investing the funds, managing the risks of individual investments and then finally working out exits from these investments. The company has been fairly successfull in managing the funds, generating 20%+ returns on most of the funds in the past for the fund investors.

The main source of revenue for the company is the fixed 2% management fee on these funds and an override on the returns over a threshold (a percentage of the gains made, above a threshold)

Financials
The company has delivered a 35% growth per annum over the last 8 years. The company earned around 225 Crs in 2012.

The company has grown the net profits at around 40% over the same period and made around 74 Crs in 2012. The main cost for the company is compensation for the employees and overhead expenses incurred on launching and operating the funds. The company has been able to maintain net margins in excess of 30% in the last 10 years.

Finally, the company has been able to maintain a high ROE of 30%+ and if one excludes the excess cash on the balance sheet, the ROE would be in excess of 50%.

Positives
The business requires minimal incremental capital to grow. The main assets of the company are the brand, its relationships with clients and the skills/knowledge of its employees.

The company needs very little capital to grow (some extra office space and maybe a few computers) and hence the entire profit is truly free cash flow. The company has consistently maintained a high dividend payout ratio in the past (over 50%) and used the excess capital to acquire a new fund (saffron) in 2010.

The company has a long operating history in raising and investing funds in various opportunities in India with good results (returns in excess of 20%). As a result the company has a good reputation with current and potential investors which should help the company raise additional funds from the clients in the future.

Risks
The company operates in a very competitive environment with minimal entry barriers. The company now faces stiff competition from a large number of Indian and international competitors such as hedge funds and other private equity funds. This has resulted in higher competition for raising India specific funds and investing the same in attractive opportunities (businesses) in India. This could result in lower returns for the fund investors and hence lower income for the company in the future.

The slowdown in the investment cycle, recent actions by the government such as the GAAR fiasco and other global macro-economic factors have made it difficult for the company to raise new funds. In addition the exit timelines for the fund investments have increased due to weak stock markets, resulting in lower returns for the fund investors. All this has impacted the revenue of the company which depends on the volume of funds managed (AUM) and the carry (excess returns over a threshold). It is unlikely that the investment cycle will turn around quickly, due to which the company may face a longer period of low revenue growth or even de-growth over the next few quarters.

Management quality checklist
Management compensation: fairly high at 25% of revenue. However this kind of compensation is typical of the industry.
Capital allocation record: extremely good. The company has maintained a very high dividend payout ratio and has indicated that they will dividend out almost the entire profits to the shareholders.
Shareholder communication: Quite good. The company provides adequate details of the business in its annual reports and conducts quarterly conference calls to keep the shareholders updated on progress.
Accounting practice: conservative
Conflict of interest: none

Valuation
The company is currently selling at a PE of around 7 which is on the lower side of the past PE range of the company (6-23). A company earning an ROE of around 30% and with a 15%+ growth prospects can easily support a PE of 15 or more. The company thus appears undervalued by most objective measures.

Conclusion
The company has performed extremely well in the past and has rewarded the shareholders well. The period from 2003-2008 was a bull market for private equity and stock markets resulting in high returns for the company’s funds. This resulted in good profits and high growth for the company.

The markets have slowed down considerably since the 2008 financial crisis and the Indian government has made it worse in the last few years. As a result, the company has struggled to raise new funds which is needed to drive the topline and profits for the company. It is likely that the company will take a few more quarters before it can raise and deploy new funds and a result the topline and profits could stagnate for some time.

The long term prospects of the company are good, though it will take time for the company to start growing again. This would test the patience of most investors.

Disclosure: No position in the stock as of writing this post
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog

18 comments:

Vikas said...

Hi Rohit,
Thanks for the timely post, as I was loosing my patience on IL&FS inv. managers.

I came to know about it from Parag Parikh from PPFAS. I think he is second best in behavioural finance after Prof. Sanajy Bakshi in India.
Others are just noise.

I had bought it around 50 and was fortunate to sell without loss.
Then again bought it when it fell to 30 and now my average is 26. Holding patiently since 1 yr.

You have nicely covered all the positive and negative of it. But I think, missed one imp. part.

They have done big equity dilution( in last 5 yrs) by issuing huge ESOPs to themselves. This I simply hate.

Whats your thought on this.

Regards,
Vikas

Anonymous said...

Since this is a PE firm, the valuation needs to be based on FCFs in 2 scenarios.

1. Years when there is no profit share earned by the PE fund on liquidated investments. In such years, the only revenues of the firm will be (a) management fees, which are typically 1.5%-2% of "funds under management" and (b) dividends if any from investee companies.

2. Years when (in addition to he above) there is profit share earned by the PE fund on liquidated investments. In such years, the addnl revenues will be about 20% of the net portfolio profits of the fund being liquidated. Note this is not 20% of the profits of any liquidated investment, but on the total portfolio, because some investments in any PE fund are loss making.

If you can provide some detail on the above lines, it will be much appreciated.

To start with, pl. share there exact total AUM, and their exact "fund management fees" being earned annual for the next 2-3 years.

Also do not put any premium on their past performance, because PE fund performance can vary wildly.

Anil Kumar Tulsiram said...

Good one Rohit. Yes, it is indeed one the cases which falls under "Heads I win (a lot may be...) and Tails I do not loose much"

Couple of weeks back a posted review of IL&FS investmanagers here http://www.valuepickr.com/forum/untested-worth-a-look/641352814.

Rohit Chauhan said...

Hi vikas
any stock related to infrastructure or investments (other than consumption related) has done badly in the last two years as the investment cycle has stagnated. so ILFS is not alone.

yes, they have been diluting at the rate of around 1.5% per annum due to esops. unfortunately in this business you cannot avoid that ...they run the company with around 57 employees and the high contributors would not be more than 40. other than compensation there is no other expense and to keep these folks around you have to pay well.
so i would just consider that as the cost of business and include it in my calculation of intrinsic value. also it is less bad than an IT company ESOP where value created by each employee is not as high as what is given out via ESOP (i know that :) ..i benefited that way )

rgds
rohit

Rohit Chauhan said...

Hi anon
i dont think ILFS gets any dividend from investee company directly. that goes to the fund ...it is similar to the 2-20 system of hedge funds.2% management fee and 20% or x% of the fund returns above a threshold (for the fund as a whole and not individual investments)

they had 3.2 Bn under management, but the actually earning assets were somewhere around 2.5-2.8 if i recall. the company does share the exact break down of the fees earned, but in 2012 and current year they have made only the management fee (confirmed in a conf call)

rgds
rohit

Rohit Chauhan said...

Hi anil
read your analysis and it is well written and covers the main points well.

i only differ on one point - the future cash flow is not a given as the company does not enjoy repeat sale like an FMCG company. it has to raise new funds to grow. if the company does not raise funds, the company will degrow as the investment exits from the funds means that the AUM is shrinking and hence the management fee is coming down. there may be some benefit from the carry, but it depends on whether the exits are profitable

also the company was planning to close a fund in the H1 of 2013 and as per latest conf call, that has got delayed. so we are talking of a few quarters of pain here

rgds
rohit

Anil Kumar Tulsiram said...

Thanks Rohit

Generally I use DCF only for reverse engineering purpose. One can never use it as a base case. What I want to demonstrate using DCF is that market is factoring a worse case scenario that AUMs will decline by 50% within next four years and then will grow at a very nominal rate. In other words assumed no new funds till next four years (by then all funds redeemed) and then assume that company will be able to raise only 50% of current AUM. So one can buy share if he thinks over long term company will do better than this.

Dev said...

This stock is for those who believe in power of doing nothing in stock markets (i.e. Buy & Hold)
Some other stocks which can be bought for similar reasons are Noida Toll Bridge, Balmer Lawrie & Clariant Chemicals.

Anonymous said...

Hi Rohit

I work in this industry and there are a couple of things that you shd keep in mind while investing in this co:
1. This business is highly cyclical and can be very frustrating even if you have a reasonably long investment horizon of 2-3 year (it takes 2-3 yrs to just raise funds!)
2. IL&FS has most of its funds in the RE segment. This segment has been hit quite badly.
3. IL&FS does not have a great trackrecord on both PE and RE side. Most of their gr8 investment are pre-2005 and post that they havent done anything gr8. Infact they have earned bad name by investing in shady company like Karuturi, DB Realty etc.
4. Share of carry which is given to employees is very high at 70%. This is in addition to a large chunk that the top guys make in ESOP and fat salary.
5. The top guys are very powerful, politically connected and least interested in building anything other than their wealth (this may be a little harsh but fairly close to realty). Hence IL&FS is not the 'go to destination' for young talent.

All these things make me shy away from this stock despite attractive valuation and gr8 cash flows
Happy investing

Anonymous said...

@Anonymous
your points actually reinforce why one should be buying it..
1)you say it takes 2-3 years just to raise funds,this company has around 9 bn in management in a span of 9 yrs.
This fact is infact kindda "moat" for the business where you need "seemless web of trust" to raise and maintain funds.
2)Its because they are badly hit you are getting things at such cheap price!
Tempelton says-don't tell me whr the outlook is the best,tell me whr it is worst..
3)Read the analyst call the MD says for an infrastucture fund investment they require govt approval and its been 6 months!
I am not sure what would be the fate of such fund without that kindda political connection.
4)Employee earning large part of carry may be bad,but i think if u put a carrot infront of a donkey,it would run faster(its not the same situation as a trader whr they can "leverage" and bust the whole process)

regards,
Queen

Anonymous said...

Prof Bakshi, if I recall right had the opinion that this company was run for the benefit of its employees more than anything else. While the payout may be high, the costs will never go down. There was a Dubai cost center added in the last 2 years, a questionable acquisition (supposedly growth prospects in Middle East/Europe), poor investment track record, 70-80% of investment profits being distributed to employees, continuous & compounded equity dilution ,etc. This company performed awesomely only when the going was good. (pre 2006-07, little to no PE competition)
If I were a pension fund, I would not invest with this company for its track record. Why should I invest in its stock then ?

Rohit Chauhan said...

Hi anil
i agree , from a reverse engineering standpoint it makes sense.

Hi dev
i have published the analysis but not invested as i am not still comfortable with the business or the management yet. i would not put it in the league of balmer which has performed across biz cycles and really dont compensate themselves as much (being a psu could be the reason)

rgds
rohit

Rohit Chauhan said...

Hi anon
i am not too concerned with points 4 and 5. people in the PE and investment banking are known for seeking high compensation and getting it. its the name of the game - its like saying that cigarette companies sell a harmful product.

now one may not invest due to this reason, but it is not hidden

my bigger concern is the point 1-3 ...is the company a product of a bull run and will they able to replicate the sucess of the 2003-2008 years. almost anyone did well in the stock market and in the PE industry during that period, but will they be able to do well in the future ?

maybe they would as then next commenter says ...i personally dont know and cannot evaluate it and hence have not invested a single paise in the stock.

rgds
rohit

Rohit Chauhan said...

Hi anon
i am not making a case for investment. i have only published my analysis.
i am not concerned that the max value is taken away by the employees. that is the name of the game in this biz. these guys through esop, carry and high compensation are taking 80% of the gains.
at the same time 20% of a large number is better than 100% of a very small number.

my concern as you point out is whether these guys were just lucky or capable. i dont know and hence i have not invested in the stock

rgds
rohit

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dissident said...

I wouldnt buy right now when the insiders have been selling in a big way..

http://www.bseindia.com/corporates/Insider_Trading.aspx?scripcd=511208

ASHOK SHAH said...

Dear All,

I have been tracking this Co when it was operated from Bangalore.
As per my observation I was bullish in this Co around 2002-04 period when No major profit was coming but one year they started allotting shares in large quantity to board members at low price as if they were owner and they were not governed by SEBI,BSE and NSE.
This institution has only decreased small investor in INDIA in last 10-12 years only.They are just to collect fine from all king of market.
I exited when splitt was completed at Rs.50-55 price inspite of good future of Co but with new partner in profit at low stock price.
New partner has certified that there is no charm in business then are there any reason to invest at such a high price like SENSEX in 15000-18000 and Real estate at 10 times compared to last 10 year old bottom price in INDIA.
As they are in business they are compelled to do business to draw salary and low price shares only.

Thanks

ASHOK

Ishaan Gupta said...

Rohit: You might like my article on IL&FS too: http://www.igvalue.com/2014/04/il-investment-managers-no-sales.html

Feedback and comments would be appreciated.