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BW Businessworld

Gulliver’s Travails

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Sanjeev Narula could say his fight with private equity (PE) investors Bain Capital and TPG is a Lilliput versus Gulliver saga. The managing director of Lilliput Kidswear, an apparel retailer that until recently was a success story, got into a fight with his principal investors over the veracity of the company's audited accounts that were presented at a board meeting on 28 September.

Details are scant, but what appears to be a whistleblower call about fudged accounting, just as the company was readying to file a draft red herring prospectus (DRHP) ahead of a planned initial public offering (IPO), has driven a wedge between the two parties. Narula has 55 per cent of the stake, and the PE firms, 45.
 
A re-audit was suggested, but Narula did not agree to it. Instead, he appears to have taken umbrage at the suggestion, refused to agree to a re-audit and moved the courts.

The fight prompted many resignations from the company's board: by the representatives of Bain Capital and TPG, four independent directors, and just days later, by the auditors S.R. Batliboi and Ernst & Young (Lilliput's advisors).

In an appeal filed by Lilliput in the Delhi High Court on 3 October 2011 against Bain Capital India, the company has "restrained the respondents from selling, alienating, transferring or creating third party rights in any manner dealing with their shares of petitioner (Lilliput) and hence, the respondents are restrained, directly or indirectly, from acting contrary to the minutes of the Board Meeting dated 28.09.2011 and they are further restrained from giving adverse publicity to Lilliput. The petition also restrains the respondents, its associates, affiliates, servants, and employees directly or indirectly, from interfering with and obstructing the operations of the petitioner".

After the company filed an injunction in the high court restraining its investors and related parties from exiting the company or taking matters further, no one — Narula, the PE firms, or the auditors — is willing to go public on anything. BW's attempts to talk to them were unsuccessful; they claim the matter is sub judice.

The PE investors' concerns stem from what is standard operating procedure. "In US firms, any suggestion of wrongdoing in an investee company is always reported by the managing partner to his fund," says a PE expert. "That prompts a set on questions, checks and inquiries that ultimately are taken back to the investee company's management."

The opportunities for litigation against the PE firm's general partnership make a firm very cautious. Occasionally, the general counsel gets involved. "All too often that ignores the realities on the ground in India, like very sensitive promoters," the expert adds. "That could have driven Lilliput's promoters over the edge."

We talked to more than a dozen analysts, experts and retail consultants to try and piece together some answers. None of them, however, was willing to go on record.

The Beginnings Of A Clash
"Both Bain and TPG competed fiercely to get a piece of Lilliput in 2009," says a leading investment banker. At that time, 35 per cent of the company was held by PE investor Indivision Fund (now Everstone Capital), with Narula holding about 65 per cent.

Other investment bankers say Narula was unwilling to give up control, so Everstone, which had invested in the company in late-2006, sold its stake, and Narula sold a small part of his. After the deal was completed, the company was valued at about Rs 775 crore.

S.R. Batliboi and E&Y have worked with the company for over three years, and helped conduct the due diligence necessary for the PE investors. That was followed up by another due diligence exercise by KPMG, another global consultancy, before Bain and TPG paid about $86 million to buy in, closing the deal in January 2010. Lilliput's revenues, say market observers, was then more than Rs 300 crore.

The company then embarked on a rapid expansion spree. It added four manufacturing plants to its existing six. In 2010, the company had about 225,000 sq. ft retail space; by September 2011, that had gone up to 700,000 sq. ft, with another 200,000 being fitted out. It also took on a lot of debt. "All of this cannot be done without at least the strategic approval of Bain and TPG," says another investment banker. "July to September  have been hard on retail, and such rapid growth implies huge inventory. That may have scared Bain and TPG." Perhaps, but where does the alleged fudging come in?

Invent(ory) Accounting
The Lilliput story highlights a critical issue that investors in organised retail have been facing for some time: inventory management and accounting. "Stores do not do any annual stocktaking," says one analyst. "In most cases, there is no policy for markdowns, or writing off for losses."

That, he says, leaves the door open for accounting gaps. Other analysts say that sometimes stock from existing stores is moved to new stores without accounting for them properly. But they add that a lot of it could be because of inadequate management information systems (MIS) — at the end of the year, these transactions and markdowns are ‘rounded off'. "This could have prompted the whistle-blowing," says a retail consultant.

Rapid expansion could exacerbate the effects of slack inventory accounting. Analysts say there is usually a benchmark of unaccounted inventory-to-sales ratios. "It is something that auditors are aware of, or should be," says an analyst with a brokerage firm.

"There is constant pressure on the company to show sustained growth, top-line progress and a sizeable foot-print," adds Devanghsu Dutta, CEO of Third Eyesight, a retail consultancy. Other instances have illustrated the consequences of very rapid growth before.

"With investor interest one can create turnover in ways you would not use otherwise," says Datta. "This is partly driven by stockmarket movements, by the exit window of PE investors who want sizeable returns, and by
human aspiration."

No End In Sight?
Reports say that Narula has agreed with his creditor commercial banks to allow a re-audit; he wants them to pick the auditors (something he had disagreed to earlier). This may suggest that he is confident that there is no substance to the allegations of fudged financials.

By taking the matter to court, however, Narula may have tied the hands of his PE investors. "Once things move into the legal arena, there usually is no going back to the negotiating table," says an investment banker. So chances of a settlement or understanding between the two parties have weakened.

The clash has also dented reputations: Narula's, the PE firms', the auditors', and the advisors'. When the smoke clears after the re-audit, which people estimate should be in about six months, it might well turn out that the spat was ill-advised. "If nothing else, the value that the promoter and investors would have realised (through an IPO) is unlikely now," says an investment banker. As one put it, what a tragedy of errors.

Srikanth Srinivas with Suneera Tandon

(This story was published in Businessworld Issue Dated 31-10-2011)