The end of the Indian summer

Private equity investment has taken off in India over the last few years. Indian companies raised more than US$14bn (excluding real estate deals) though private equity in 2007, up from US$7.5bn in 2006 and US$2.3bn the year before, according to Venture Intelligence, an Indian research company. The amounts raised through private equity far outpaced those raised via public offerings. And the number of PE deals – 396 in 2007 – was the highest in Asia.

Rapid economic growth, booming stock markets and an increasingly confident corporate sector looking for expansion have fuelled private equity activity. And while markets seemed to be going in just one direction, everyone did well. But even as PE firms unanimously declare their commitment to the Indian market, a cautious note is creeping in. The global slowdown and recent stock market volatility has taken the shine off deals, and many predict that the party is over, at least for now.

“The one-way bull market has spoilt things,” says Rahul Bhasin, managing partner at Barings Private Equity Partners India. “Private equity has underpriced risk. We are likely to see a correction and it’s not going to be fun.” If PE firms have slipped up on their due diligence, the test is going to come in coming months, as they seek exits for investments made in headier times at high valuations. But while the industry could be adversely affected in the short term, the prospects look bright over the longer term. The macroeconomic fundamentals, together with the oft-cited “soft” attributes of a democratic government, the availability of English-speaking professionals, a long history of entrepreneurship – will all continue to make India an attractive investment destination.

However, all the players in the area may not survive the short term, say industry insiders. Depending on your classification of private equity and your source of information, there could be more than 300 private equity investors in the country. There are all the global heavyweights including Warburg Pincus, Blackstone, General Atlantic, the Carlyle Group, TPG Newbridge, Provident Equity, Barings, and Temasek Holdings, with Chryscapital and ICICI Ventures on the domestic front. But while it is unlikely that any of the big players will have to withdraw from the game, many of the smaller ones may find the environment hostile in the coming months. “What many in the PE space have forgotten is that not everyone can make money in every market,” says Varun Sood, Managing Partner at Capvent, a Zurich-based private equity investment group focused on India.

To start with, while the numbers bandied about are impressive, what actually constitutes private equity in India is a bit hazy. Although some estimates put the private equity portion of total FDI at over 60%, such numbers are to be viewed with scepticism. “PE is not classified in the traditional way in the Indian context,” says Abhay Havaldar, Managing Director of General Atlantic in Mumbai. “There are all kinds of players investing here. Some companies use their treasury and call it private equity. High net worth individuals do the same. So the numbers can be misleading.” Rahul Bhasin echoes this view: “When you’re competing with hedge funds and FIIs for deals, it’s hard to know what the PE component actually is.”

Private equity players – the ones who are in it for the long term – differentiate themselves on process. They usually take a substantial minority position in a growth-oriented unlisted or listed company (in what are known as PIPE, or Private Investment in Public Enterprises, transactions), and work with management on investment decisions, governance and routes toward greater profitability. Most investments in unlisted companies are late stage. Ideally, the PE firm gets to monitor its investments through a board seat, although this is not always an option in companies controlled by families.

In the context of the family-dominated business, where promoters want to pass it on to the next generation, buyouts are thin on the ground. Some foresee more opportunities for PE firms as families running diversified conglomerates spin off non-core businesses. But it is unlikely to happen in a meaningful way, unless there is a truly sharp correction, says Sri Rajan, head of Bain & Co’s private equity practice in India. “If you look at what happened in Korea in the late 1990s when the chaebols got into trouble and started hiving off businesses, that could conceivably happen here if there’s a sharp enough downturn, though it’s not very likely.”

Nonetheless, buyouts are on the rise. Last year, Goldman Sachs paid US$172m for a majority stake in Sigma Electric, a manufacturer of cast metal parts. And Blackstone bought back-office company Intelenet Global Services, and Gokaldas Exports, one of India’s largest garment manufacturers. Leveraged buyouts are another story. Firstly, LBOs are suited to more mature markets. Secondly, they are difficult to execute, largely because of Reserve Bank of India regulations curtailing the raising of debt in India by a foreign entity for investment in an Indian company. A few LBOs have been done through structures that get around this rule – Kohlberg Kravis Robert’s US$900m leveraged buyout of Flextronics Software Systems in 2006 was the biggest of all – but not many PE firms have chosen to go down this route.

Because most private equity investments constitute minority holdings in mid-market companies, the amounts invested remain modest – the average deal size in 2007 was US$45m, according to Bain & Co, although that was almost double the US$26m in 2005. Some big ticket deals have grabbed the headlines, and while they have been the exception, at least they prove that it can be done. At the end of 2007, Goldman Sachs, Temasek Holdings and others made a US$1bn investment in mobile operator Bharti Airtel’s tower subsidiary Bharti Infratel, which was followed by an additional US$250m fund injection by KKR. The year before, several private equity funds, including Providence Equity Partners, ChrysCapital and Citigroup took a US$950m stake in Idea Cellular, India’s fifth-largest wireless operator.

Telecom, then, is one of the sectors seeing high-profile deals, but private equity in India is a multi-sector opportunity. The ball got rolling with PE investment in information technology and business process outsourcing – it is estimated that two-thirds of the capital for the fledgling BPO sector came from PE firms. IT and BPO companies have seen less PE investment of late as funds look away from export-oriented sectors hurt by the rupee appreciation toward those that are benefiting from the rise in domestic consumption.

Real estate has attracted a large chunk of funds. Although investments in real estate are often not classified as true private equity – “they are a different kind of asset class, with different liquidity options and investment methods”, says Arun Natarajan, founder and CEO of Venture Intelligence – the sector has seen a huge amount of interest as investors size up the prospects of a market that is slated to grow, according to Merrill Lynch, from US$12bn in 2005 to US$90bn by 2015. It is estimated that more than US$5bn of foreign capital went into real estate projects in 2007. But valuations have hit unrealistic levels and fears of an asset price bubble are giving investors pause for thought. There is little transparency in the sector, and those who’ve plunged headlong into pricey deals could find themselves badly burned.

Investment in infrastructure started off modestly but has now developed momentum as PE funds turn their sights on what is indisputably India’s most pressing need. The country requires some US$500bn in infrastructure spending in just the next five years in order to sustain its growth. The opportunities are enormous. 3i launched its “India infrastructure fund” in September 2007 to invest in power, ports, airports and roads, Australian investment bank Macquarie Group is launching a US$1bn “Macquarie India Infrastructure Opportunities Fund”, and others, such as Citigroup and Blackstone, are also contemplating dedicated infrastructure funds.

Another area that could give rise to interesting opportunities is the banking sector, once FDI restrictions are lifted and the doors are opened to foreign banks in 2009. Under current regulations, a foreign bank’s holding in an Indian private bank is limited to 5%. Indian financial institutions will have to gear up for much greater competition, and with consolidation inevitable, the sector is poised to become one of the best investment plays. Many funds are investing now in preparation. According to Venture Intelligence, the first nine months of 2007 saw 29 deals, valued at over US$3bn, in the banking, financial services and insurance sector. A prominent PIPE deal was Carlyle’s investment of US$650m and Citigroup’s investment of US$117m in Housing Development Finance Corporation (HDFC) – India’s first retail housing finance company and one of the biggest originators of housing loans.

While these sectors are creating a buzz, industry professionals point out that it is a mistake to focus just on “hot” areas, and that opportunities exist across the board for those willing to look hard enough and do their homework. Very few sectors have significantly large players, so backing a sound firm in almost any industry area offers attractive growth prospects. Manufacturing, for example, may be out of favour in India but Sri Rajan of Bain says it would be folly to overlook it – “It may look like a small percentage of the overall pie but in absolute numbers there’s still money to be made there.”

With the proliferation of private equity investments over the last three to four years, PE firms are now heading into an exit cycle. It’s the first real one since PE took off and will be a critical one. PE funds have to be able to show a convincing track record of exits if they want to continue raising money for the India story. So far, things have been fairly smooth. Rising stock markets have made public offerings the preferred route. No deal has yet matched Warburg Pincus’s spectacular sale of its stake in Bharti Airtel (see box), but buoyant market sentiment has yielded profitable exits. A few have been staggering. Citigroup made a return of over 2000% from its investment in wind energy company Suzlon when it went public in 2005. Barings’ sale to EDS of its stake in back-office services company MphasiS garnered it a 25-fold return. Successful PE-backed IPOs last year included consumer products company Jyothy Laboratories, and BPO company Genpact’s US$600m IPO on the NYSE.

So far, everyone’s made money and everyone is happy, but valuations have reached unsustainable levels in some areas, and there is a sense that PE firms have become careless about due diligence. As Varun Sood says, a number of the firms have come in fairly recently, at a time when there “hasn’t been much critical examination of the PE space. They haven’t seen a full cycle of private equity. It could come as a rude shock when markets change.”

Other issues could come to the fore in the event of a significant downturn, such as contract enforceability. This is of particular relevance as most PE investments are in the form of minority stakes. While contract laws in India look pretty good on paper, “the legalities are not tested when things are going up. This has been the case over the last four to five years. But if you go back some way, enforceability has historically been poor,” says Rahul Bhasin.

On the positive side, pricing will become more realistic in the wake of a correction. And with access to public markets blocked for the time being, corporates are likely to turn to PE funds for capital and guidance. “There was a sentiment in the Indian corporate sector that it could achieve anything, that it did not need the kind of rigorous planning needed in more competitive economies. Now, with tightening markets, companies are starting to think they might need more help than just raising capital. And that’s where PE comes in,” says Abhay Havaldar.

It’s too early to tell whether the value-added approach that PE firms like to offer as their USP has really paid off for Indian corporates, although anecdotal evidence suggests it does.

When Barings acquired a 10% stake in Jyothy Laboratories, for example, the PE firm expressed concern about Jyothy’s high advertising expenditures and persuaded the company to bring in outside advisors to evaluate them. The advisers identified the problem, leading to a modification of the company’s distribution channels and boosting profits. If the model works, PE firms can greatly improve the governance, and the capital and organisational structure of a company.

In the long run, India is a convincing story, and for funds with the stomach – and the pockets – to ride out the turmoil in the markets and build value in their investments, the opportunities are huge. Sri Rajan of Bain has a few words of advice for those PE firms operating in the Indian market: follow the broader economy and don’t get stuck on trends, establish your presence on the ground, get comfortable with the investment model of taking significant minority stakes in growth-companies where the family dynamic plays a large role, and have a lot of patience. The party is not over. It’s just become a lot more sober.

Putting India on the map

New York-based private equity firm Warburg Pincus is legendary in the Indian private equity space for its spectacular exit from Bharti Airtel. The PE firm took a bet on ambitious telecom entrepreneur Sunil Mittal and bought 18.5% of his company Bharti between 1999 and 2001 for just under US$300m. Having helped it grow into India’s largest private sector telecom company, Warburg Pincus fully exited by 2005, pocketing US$1.9bn along the way. The transaction served as a wake-up call for PE firms everywhere – India was a place capable of generating serious returns.

Warburg Pincus is one of the largest private equity investors in India, having put in over US$1.5bn over a 12-year period. It has invested in top tier firms across a range of sectors, from auto component manufacturer Amtek Auto to Kotak Mahindra Bank to pharmaceutical major Nicholas Piramal. The majority of its holdings are growth investments, although it has done early stage investing in Internet portal Last year, the firm did its first buyout deal in the Indian market, when it teamed up with an Indian tyre industry entrepreneur to acquire Israel-based Alliance Tire Company.

EVCJ spoke to Leo Puri, a former director of McKinsey, a managing director at Warburg Pincus in Mumbai.

Are you turning your attention to any particular sectors now?

We’ve been quite agnostic on sectors. Our approach is to back strong management teams, which has led to a combination of growth investment and some early stage investment. We support management – with governance participation – with an investment horizon of five to seven years.

With the corporate landscape dominated by business families, have you encountered resistance to your involvement in governance?

There has been a culture shift. Entrepreneurs have realised that governance helps. The initial reluctance has melted away when they’ve seen the benefits. And we, as a firm, are averse to policing management constantly. We’re looking for alignment. And we form an assessment on whether or not we can work with the management early on. Also, our initial investments have created strong references for us.

Are there too many PE firms chasing the same deals?

Yes, there is a sense that there are a lot of players around today. And they’ve all adopted similar strategies – backing growth companies by taking meaningful minority positions. In the short run, that has created a certain amount of froth in the market. It may be that players not fully embedded in India may find it’s not the right time to be active here.

We have a record of successful deals here, so we’re in the fortunate position of being able to sit it out when the market gets too frothy. Also, we don’t have an India-specific fund. It’s a global fund, so there’s no allocation requirement. This allows a good amount of flexibility.

What has been your experience with PIPE deals?

The thesis behind PIPE deals is the same. We’re looking for management we can believe in. In India, many companies have been able to access the public markets, even some that shouldn’t have. You can find companies that are nominally listed, but that still require better governance and strategic guidance. We can provide that. Also, it is sometimes the only opportunity in an attractive sector. So you have to be flexible.

After your exit from Bharti, few deals have grabbed the headlines. Are exits a problem, particularly with markets heading down?

Bharti wasn’t an outlier. There have been a number of smaller but equally profitable exits, which have not got as much media attention. We haven’t seen too many trade sales in our portfolio, but so far, exits have been possible in the public markets – there is a lot of interest in India and other institutional investors have provided us with the exits. Typically, we exit in alignment with promoters. And we’re not looking for a quick way out, so we’re not overly concerned with the stock market downturn. India will continue to throw forward good opportunities. We are optimistic and looking to expand regardless of the state of the markets.

What about buyouts?

Buyouts are of two kinds. The true LBO – which is really a function of financial engineering – is constrained here, and anyway there isn’t much need of it as this is a growth market. But controlled transactions, where entrepreneurs are exiting businesses – that’s beginning to happen. In such transactions the PE firm is in control but the deal is not highly leveraged. We did it with WNS [a business process outsourcing firm], for example. In some situations this kind of deal is the best way to build value – because it gives you more freedom.