India’s high GDP growth rate in recent years has made it appear to be an obvious market to achieve success private equity investments. But private equity investment in India is still a recent phenomenon in India and most investors would not view it as a success so far.

 “India has faced a lot of economic headwinds and there have been challenges for private equity that are a function of the amount of capital raised in a very short time period between 2006 and 2008/09 when the global financial crisis really arrived on India’s door step,” says Simon Faure, private equity investment director of PPM Managers. “A lot of capital was being invested during a very difficult economic period, and in unlevered investments, as private equity in Indian generally is, this has made it difficult to generate attractive returns”.

Russell Steenberg, head of private equity at BlackRock, concurs: “A lot of money has been raised with a lot of players but I am not sure we have seen strong results come out of it yet. As a result, I, like many others would see India as oversupplied by private equity and we have not seen the type of returns that we would need on a risk reward basis.”

The consequence of this has been that over the last few years, India has seen little new private equity investment raised and instead attention has shifted to other “hot” emerging markets such as Brazil, Indonesia and Turkey, which have all seen the recent launch of large dedicated private equity funds. Yet private equity in India is here to stay and for those investors who do not follow the crowd and adopt a thoughtful and patient approach, this may just be the beginning of private equity’s role in helping to transform India’s economy.

Case study

India is a case study in emerging market private equity investment. It exhibits all the features that can make private equity an attractive opportunity, and also those that can make it very unattractive. But accessing the market requires an appreciation of both the opportunities within it, and the challenges that private equity firms need to overcome.

The value and the role of private equity within the Indian economy still require a lot of education for both entrepreneurs and investors. What has attracted private equity investment to India, like China, is the strong growth in the economy. But both countries are open and closed to private equity investment in different ways.

India is seen as more open and more transparent with more information available at the SME level, Faure says. “It has always been the case that the level of intermediation in India has been surprisingly high for a developing market. Promoters seem to be extremely aware of shopping deals around.”

That, combined with the fact that in contrast to China, India’s capital markets are well developed and very deep has often led to what Faure sees as unrealistic valuations for private equity investments, particularly during bull markets for listed equities: “In the period leading to 2007/08, when the Sensex was booming, comparisons with listed markets created high floors to pricing”.

Private equity fund of funds may have also had a negative impact on the evolution of India’s private equity industry, argues one industry investor: “Fund of fund investors have to offer their LPs niche strategies since in today’s world, institutional investors are well positioned to access vanilla products themselves. What it means is that fund of funds raise large funds for strategies that are seen to be in favour at any one time so the market is already predisposed to invest, whether in Brazil or India. If a fund of funds raises capital for India, they might have to invest in 20 funds, but of the 20, we would only see three or four as worthwhile investments. This creates ‘excess capital’ in the market. Three or four years later, the returns that are posted publicly by those investors under FOIA may look terrible, discouraging other investors.”

Key issues

There are a number of key issues for private equity investment in India. Private equity for any company is always an expensive source of capital. Private equity firms will want the maximum returns for the minimum amount of capital put in with as strong a set of minority rights as they can argue for.

Entrepreneurs therefore need to understand that what makes private equity valuable from their viewpoint is the added value a private equity firm can bring and a comparison with an IPO is misleading; the fund structure can be less than ideal for a company as the pressure to achieve results within a defined timescale may not be conducive to the optimum timing for exits; there have also been a number of examples where private equity has been less patient and destroyed value in the process.

Yet the opportunity for private equity firms to add value to companies, particularly at the smaller sub $10m size is tremendous as one investor describes: “Small firms of this size may be seeing tremendous growth, but they often have little idea of how to run a business. Basic ideas such as where is the cash, how much profit is being made are often poorly understood. A restaurant chain with six outlets wanting to double the number may have little idea of the implications in terms of cashflow. Sometimes they undertake an IPO too quickly and then find they cannot raise more capital from their shareholders in the capital markets.”

Successful private equity strategies in India have to navigate a path through not only these issues, but also the problems of competition from too many fund managers chasing too few deals in the target market a firm is centred on. The majority but not all, private equity is growth capital. Buy-outs do occur, but at the top end, private equity firms would find themselves competing with the large Pan-Asia private funds set up by the global mega funds. Yet India’s economy, dominated by family-owned conglomerates, is ripe for restructuring through buy-outs of unloved or extraneous divisions, argues Neil Harper CIO of the private equity group at Morgan Stanley Alternative Investment Partners: “There are a handful of private equity firms in India that specialise in this and we are keen on investing in this area”.

But the problem Harper finds is that like in Japan, while there is a massive theoretical potential for restructuring conglomerates through private equity financed buyouts, in practice the owners have been reluctant to do anything. “The problem here is not too many private equity investors, but the reluctance by owners to restructure businesses.”

He is however, optimistic about the future: “There is a creeping change, which does throw up a few attractive opportunities.”

Growth capital

The domination of India’s economy by a few large industrial groups does give rise to issues when it comes to growth capital. Are private equity firms just seeing the deals that large conglomerates have looked at and rejected as unattractive for further investments?

One option is to invest through a captive private equity firm that is a subsidiary of major financial and industrial groups such as Tata Capital, Kotak Private Equity, ICICI Venture and IDFC Private Equity. But as one investor argues: “As an LP you need to be very careful about the people you invest in. What is their interest in operating on a genuine arms-length basis, as against forcing through full ownership of a business by the captive’s parent at an artificial low price if it is doing well?”

Many investors have a policy of not investing in captives at all, arguing the huge potential for conflicts of interest, not only in adverse selection, but in areas of transfer pricing when it comes to dealing with group companies etc. are too difficult to address to protect outside investors. There can be exceptions to this if investors have trust that corporate governance issues can be sorted out.

The Tata group for example, has an international reputation and an unrivalled brand in India. Few would worry about the probity of their behaviour. As Amit Dev Mehta, who heads Tata Capital in Europe explains, they currently run five private equity funds, all with a target size of $1bn: a special situations fund; an ‘Innovations’ fund; a healthcare fund undertaken in conjunction with healthcare specialist HBP Partners; a growth capital fund; and, lastly and most significantly, the Tata Opportunities Fund, investing in opportunities arising from within the Tata Group and outside. During the past decade, Tata has invested $40bn and expects to invest a significant amount over the next decade, so it is no surprise to find it looking to diversify targets of funding to include an element of private equity.

Even if captives themselves are not a preferred choice, investors have to recognise the environment they are operating in. Steenberg says: “We don’t prefer captives, but we prefer firms that have strong relationships with the large industrial groups and the large industrial families – they are one and the same in many cases. India is a big country but not necessarily a big market, so the economic powers in India know each other very, very well.

“You would rather sit on their side of the table rather than across the table in any negotiations because they are the ones who know their market the best. There are also a lot of regulations that limit what you can and can’t do as a private players and ownership controls in place.”  

For India to be attractive for private equity investment, Faure argues private equity firms need to invest in companies with 30%-50% annual cashflow growth over a 3-5 year time period enabling the firm to generate a 3 to 5 times return of invested capital over the time period. “That would equate to 25%-35% annualised IRR which after a private equity firm has met its costs and covered loss making investments, may produce a portfolio return of 20% p.a. IRR. Private equity investment needs to generate that kind of return to justify the risks.”

Now that the crowd has gone away, investors such as PPM see India as a much more attractive proposition for private equity investment, says Faure. “We have been inactive in India for the past three years, but now that many investors have deserted the market, it is looking more rational. Entrepreneurs in particular, are more realistic when it comes to valuations of their companies and this has coincided with the devaluation of the rupee having run its course.”

The crowd may be focussed elsewhere, but for astute private equity investors, the real opportunities in India’s private equity marketplace may be just beginning.