For long-term foreign investors, Indian assets’ recent allure presents the problems of volatility and high valuation. In the last two years, India has received more foreign capital than most other Asian markets. From January 2009 to the second half of 2010, US$66.6 billion flooded into Indian markets, according to data from the Asian Development Bank. Hong Kong, by comparison, received US$66.1 billion, South Korea US$36 billion, Taiwan US$21 billion, and Indonesia US$8.9 billion.

The flows into India have not been smooth. According to the Reserve Bank of India, foreign institutions invested a net US$16.44 billion in 2007-2008. In 2008-2009, net outflows were US$9.84 billion.

It may explain why India’s equity market has been stormy lately. In 2008 and 2009, volatility measured by the standard deviation of daily returns on the BSE Sensex was 2.8%. That was much higher than the previous year’s 1.93%.

The only other time volatility exceeded 2% in the last 15 years was in 1997-1998, when it touched 2.3%. By comparison, the FTSE 100’s volatility in 1997 was 1% and in 2008, it was 2.4%.

Prakash Ramaseshan, principal investment manager at Kotak Mahindra, observes that most of the flows into India went to large-capitalisation listed equities. After all, 125 to 150 companies out of 6,500 listed firms account for 75% to 80% of India’s total market capitalisation.

Prakash estimates that average price-earnings multiples in India were 20 to 22 times late last month. PE ratios on the Bombay Stock Exchange range from Jay Energy’s 12,565 times of thetrailing 12 months’ earnings, to 0.12 times for Kutch Salt & Allied Industries.

“Where’s the discount?” he says. “You will need a three- to five-year time frame to invest profitably in India at this time. The risk-return from Indian assets was best at the end of 2008 or 2009.”

He says it requires more patience than before to find an asset with returns on capital of 20% to 25% priced at 10 to 12 times earnings.

For long-term institutional investors such as family offices and sovereign funds, there is a way to harness the volatility and immense diversity of Indian-listed equities, Prakash suggests. While managing a multi-family office based in Dubai before joining Kotak Mahindra, he used a private equity structure to invest in listed Indian equities.

His “quasi-private equity” approach, now replicated at Kotak Mahindra, is a closed-end fund with a five-year lock-up period. Capital is invested over two years to avoid being forced to buy at high valuations. It’s the equivalent of a proper vintage diversification.

The fund has zero leverage and prefers companies with little gearing. Both Prakash and Kotak Mahindra co-invest with the rest of the investors. The fund also takes an activist role to help the 15 to 20 small- to mid-cap portfolio companies improve their productivity, internal processes, global expansion and so on. But Prakash would not take a board seat because it would cost a premium.

“We found that family offices in particular resonated well with this approach because family offices are usually backed by an entrepreneur or a family business thinking along similar lines,” he says.

Investors in his current US$86 million fund, the Kotak India Focus Fund I, include family offices worldwide and insurance companies. One of the largest investors is a Norwegian family office of an oil and gas business that is now working with one of the fund’s portfolio companies, which provides engineering services to the oil and gas industry.

“By using highly skilled Indian engineers, our Norwegian investor managed to lower their cost structure and is saving US$3-$5 million annually. In addition, the family office can make gains from the fund,” Prakash remarks.

The fund, which began investing in August 2007, has gained 35% to 40% in rupee terms, he estimates.”Having come through the financial tsunami, I can say the old-fashioned way works.”

The global economy has remaining risks and “the triggers will be in the currency and bond markets. Bond issuance is too large to sustain economic growth in the developed markets,” he says. But Indian companies with significant domestic markets will likely be spared the next quake in the global economy, he reflects. “When global companies face challenging situations, Indian companies can benefit because they offer the lowest cost and highest quality,”he explains.

One of the fund’s portfolio companies, Aurobindo Pharma, for example, appears to be benefiting from the intense pace of drug patent expirations in the next few years. Pfizer, without a suitable cost structure to address the generics market, has licensed Aurobindo to supply dozens of generic drugs.

There are more such companies in India, Prakash says. In fact, he is now raising a second quasi-private equity fund and is hoping to close with US$90-$120 million at the end of 2010. Several Asian and European family offices have committed US$50 million as of late October, to co-invest with Ramaseshan and Kotak Mahindra. •