India losing game to China in private equity space

By Tanuj Khosla

Not very long ago, India’s 330-million-strong consumerist middle class, the need for massive investments in infrastructure, healthcare and education, and its role as a hedge against export-oriented China, comprised a compelling story for private equity (PE) investors around the globe.

Not anymore. The industry is facing challenges, both internal and external, and is going through some very interesting trends. Here are some of them.

Indian PE: No longer the darling of global institutional investors

India clearly seems to have lost its place in Asia to China and Indonesia as far as preference from PE investors goes. There are a variety of reasons for the same. Some of the major ones are:

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1. Competition from renminbi-denominated PE funds from China: There has been a rapid transformation of the PE market in China, from one that is dominated by foreign PE firms to a market in which domestic renminbi (RMB)-denominated funds are being launched thick and fast. The latter have few ownership restrictions, strong government support and less regulatory oversight as China aggressively tries to internationalise the RMB.

It is not surprising then that global bigwigs like Carlyle Group, Blackstone and TPG have rushed into joint ventures with Chinese state-owned enterprises and municipal governments to launch local currency-denominated PE funds. For the global investors of these PE firms it is a double bonanza - exposure to the RMB and the explosively growing Chinese economy at the same time. As if marketing these funds wasn’t easy enough, government backing to them gives additional comfort to the investors. It is no surprise then that China is beating India hands down when it comes to attracting capital from global LPs (Limited partners, or investors).

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2. Lack of exits in Indian PE space: Owing to a volatile (and mostly downward trending) stock market for the better part of this year, exits via IPOs or even sale in the secondary market (PIPE - private investment in public equity) have been few and far between and, most importantly, haven’t generated the kind of returns investors had hoped for. The Indian stock market, as everybody knows, is driven by foreign institutional investor (FII) inflows, which have been quick to leave the country due to global macroeconomic events (read : fears of US recession and sovereign debt crisis in Europe).

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China’s stock markets, in contrast, are largely driven by domestic investors and thus it is easier to exit positions in Chinese private equity space.

3. Mind-set of Indian GPs: A large number of investors are not happy with the mind-set of Indian general partners (GPs, or the fund managers) and, rightfully so, in my opinion. According to them, Indian GPs are more focused on deal making and don’t concentrate enough on adding value to the company, which is what a GP is paid for. Consequently many of them fail to generate an internal rate of return (IRR) of 15-17 percent, which is the expectation of global investors from India after adding country risk premium.

Regulations: Sebi’s draft rules are not very encouraging

The Securities and Exchange Board of India (Sebi) came out with a concept paper on the regulation of Alternative Investment Funds in August 2011. Frankly, the timing of the move surprised me as India, which runs a current account deficit, needs to do all it can to encourage foreign inflows in the country to finance the same. However, I guess that the regulators have a different thought process from mine.

Many of the proposed regulations in the concept paper are questionable, and a few are listed below:

1. Sebi (Alternative Investment Funds) Regulations: It would be mandatory for all private pools of capital or investment funds to be registered with Sebi in one of the nine categories provided by them. Three of these categories are Pipe Funds, PE funds, and infrastructure equity funds.

This would be nothing but a cost and logistical burden for PE funds in India as they have to do multiple registrations in order to execute the investment strategies they have stated in their Investor Memoranda.

For example, a PE fund that wants to do invest in unlisted companies as well as do Pipe deals will have to register in both categories. If it is an infrastructure sector-focused PE fund (and there are many around owing to the tremendous promise held by the infrastructure sector in the country), it will have to get registered in three categories out of the nine!

2. Fund Structure: The sponsor of the fund shall contribute from its own account an amount of investment equal to at least 5 percent of the fund and this shall be locked in till the redemption by the last investor in the fund.

General partners having skin in the game isn’t a new phenomenon in the PE industry. However, putting a floor on their investment is certainly not very common. While the intent here seems to be right (that of ensuring that the GPs take care of investor interests), this regulation effectively means that start-up fund managers can’t raise large enough funds even if they have the capability to do so as they will have put forward 5 percent of the assets under management from their own sources. Hence we can reasonably expect large PE funds in India to be run by the likes of Blackstone, Carlyle and others of their ilk who have deep pockets.

The recent changes in foreign direct investment (FDI) policy will also have a negative impact on the PE industry in India. The government said in its recent policy that FDI cannot come in with a put or call option. The Department of Industrial Policy and Promotion said that if any equity instrument, like compulsory or mandatory convertible debentures, or fully compulsory and mandatory convertible preference shares, are attached with any option, then that will not be considered FDI, but an external commercial borrowing (ECB).

This rule will prevent PE firms from incorporating the ’re-up’ clause which basically includes a mechanism that entitles the PE investor to a higher equity stake in future as the company’s EBITDA (earnings before interest, tax, depreciation and amortisation) grows. I don’t think any GP in India would be happy with this option being taken away from him/her.

Top honchos launching their own ‘personality’ driven funds

The trend of leaving an established PE major and starting one’s own PE fund was kick-started by Renuka Ramnath, former chief of ICICI Venture in 2009. She has been followed by a host of other well-known names in the PE space in India, with the latest one being Manish Kejriwal, head of India, Africa and Middle East operations at Temasek Holdings, the Singapore-government owned sovereign wealth fund.

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Only time will tell how successful these ventures are. The fund-raising market for Indian GPs is more difficult today than it was in 2007 and 2008. Moreover, successfully executing a PE transaction (identification, negotiation, entry, improving efficiency and earnings, and then exit) in a small start-up is a completely different ball game from doing it in big and reputed organisation which commands industry goodwill and contacts. The personality, reputation and contacts of the GP will play a critical in fund raising and deal flow here.

Story of dry powder and competition in fund-raising

According to some estimates, over US$ 20 billion is lying idle with India-focused funds waiting to be deployed as PE investment in the country. However, volatility in the stock market, combined with expensive valuations being quoted by Indian promoters, is holding the GPs back at the moment.

At the same time, over 100 India-focused funds, about 60 percent of them being first timers, are hitting the road to raise assets. According to a recent Bain & Company study, these PE funds seek approximately US$ 34 billion. Clearly not all of them will be able to close their funds. Pedigree of the GPs, relationships in the industry, terms, and the model and strategy of the PE fund will all be closely scrutinised by investors who will be spoilt for choice in India-focused PE funds.

I have been meeting investors at various conferences and my suggestion to these funds would be to look beyond the US and UK for fund raising. Pension funds in Europe, sovereign wealth funds in the Middle East and family offices in Asia might prove to be a better bet in the current environment. Also, wealthy investors in countries like Norway and Switzerland might be more open than investors in New York and San Francisco who are in flight-to-quality mode - i.e. away from emerging markets. Another good source of assets can be PE fund-of funds like the UK Government-backed CDC Group.

Raising assets from domestic investors in India also holds promise but with Sebi looking to set a floor on the amount that can be invested, there will be many funds competing for a relatively small pool of investors. The ones that end up getting a cheque in their name will do so not on account of their terms or strategy but due to the personal relationships between the GP and the investors, most of whom will be rich businessmen or bankers with whom the GP (or a hot shot relative of the GP) has interacted in the past.

Getting an anchor LP can be another good option for first-time funds, but GPs should be mindful of not letting the investor agreement with the anchor become too restrictive and thereby lose control of the fund.

The real juice lies in public equity space

At over 5,000, India has the largest number of listed companies in the world. The main reason behind this ‘record’ is that the country never had (and still doesn’t have) an established bond market while PE is a fairly recent phenomenon. Consequently, companies had no choice but to tap the capital market to raise funds. However, beyond the top 300 companies, the coverage of the rest is quite poor. There are hundreds of small and mid-cap healthy companies listed in India that are undervalued as they are not adequately researched. Typically, the promoter holding in such companies is around 60-70 percent.

Some private equity firms have a business model consisting of the following steps:-

1. Identify healthy and promising but under-researched listed companies.

2. Take a minority stake (typically between 2-7 percent) in them.

3. Work with the management of the company to improve efficiency and increase earnings.

4. At the same time, the PE firm also works with research houses and sell-side analysts to increase awareness about the company, especially among global institutional investors. This improves the daily trading volumes of the free float and leads to a drastic rise (sometimes more than twice) in the stock price over a few months.

5. Exit the company by selling shares in the secondary market.

Many PE firms are generating stellar returns using the above mentioned strategy but I feel that there is room for a few more. This is not the typical PE model; in fact the strategy almost borders on those being used by long-only equity hedge funds but it is quite lucrative in the Indian market and, at the end of the day, that is what the investors care about.

In conclusion, these are not the best of times for the PE space in India. Lack of returns, billions of dollars in dry powder and competition for assets among various India-focused funds as well from China and Indonesia are major challenges that the industry faces.

The regulators don’t seem to be making life any easier. At the same time, investment in public equity in India holds a lot of promise. Some of top honchos at PE firms have realised this and have quit to start their own ventures that will deal in the PE space. Their success will attract more players which will be nothing but good news for India that needs to have a large capital account surplus to finance its burgeoning current account deficit.

Watch this space.

(Tanuj Khosla is currently working as a research analyst at an asset management firm in Singapore. He can be followed on Twitter @Tanuj_Khosla. Alternatively he can be reached at khosla.tanuj@gmail.com. Views expressed are personal.)