Private Equity in India: Knocking on Heaven’s Door

 

Several PE firms have cropped up in India over the past decade, each seeking to carve out its own strategy for generating returns in the unique Indian context. The operative word here is “unique” – India is unique because LBOs are not possible given government regulations around leverage. Despite lobbying, rules around leverage don’t look like they will change anytime in the foreseeable future. Since leverage is not an option, Private Equity in India remains a Growth Equity play.

Smorgasbord of Financing Options

India is also unique given the wide range of opportunities available for companies to raise money. The IPO market is very active, and since the listing rules are relatively lax, this makes it easy for companies to raise money through IPO as an alternative to PE. However the downside here is that the company needs to be able to perform well otherwise it will be penalized by the market if it tries to raise money in the future (NSR shared with us a statistic that 70% of Indian companies are trading at a discount to their IPO price). Debt is also readily accessible for companies. External commercial borrowings are available since investors don’t mind Indian debt since it represents a relatively risk free investment for a high coupon payment. Finally, once public, companies have various other alternatives available for raising funds – such as QIPs, rights issues and follow-on preferential allotments.

The Holy Trinity of Investing in India

Interestingly, the holy grail of investing in India seemed to be consistent across all the firms we met. ICICI Venture, Actis, Blackstone and others all mentioned the same 3 themes driving their investments:

1.          Consumption

2.          Infrastructure

3.          Outsourcing

1.       Personal consumption includes areas such as hospitals and education, and is mainly driven by the fact that GDP per capita is expected to multiply at least 3 times in the next 12 years. We heard that the city of Bombay alone will be the 11th largest GDP in the world by 2016. Not only is this important, but it’s encouraging to see that the wealth is percolating to B & C towns and villages. Opportunities in education specifically seem limited to either foreign universities coming to India or professional training institutions such as NIIT emerging. These make sense because they have the ability to scale, and in the case of NIIT, have a process-driven curriculum. K-12 is a tougher area since it’s regulated, and in the case of Pre-K it’s not regulated but it’s not a very scalable model since it tends to be more person-driven.

2.       The infrastructure story is pretty obvious when one looks around at the amount of construction happening across cities such as Bombay and Delhi. Infrastructure includes everything from roads to ports to power to telecom. The key driver of the need for road projects has been from traffic, which has been growing at a CAGR over 10%. However many challenges remain – IDFC spoke of the challenge of getting skilled labor; there is little incentive for contractors to skill their labor when they go to competitors, for instance. Power is another area where tremendous growth is expected – currently India has an energy shortage of 9.6% and a peak shortage of 12.6%.The government has an ambitious goal of getting the country to add 100,000MW between 2008-2012, requiring an investment of $155b; last year 15,000MW was added. IDFC spoke of money interesting opportunities across power generation, equipment manufacturing and transmission, however ICICI Venture warned of more distressed power companies emerging in 2-3 years since they have been built on forecasts of much higher prices that what they will get. Khazanah also noted how setting up the plants was the easy part, but challenges arise in execution – for instance getting land, coal, power grid access, etc. Telecom has seen explosive levels of growth at every level. At this point there are 11-12 major players and a lot of experts expect to see a lot of consolidation in the area in the coming years.

3.       Outsourcing not only includes services like BPO, but also includes manufacturing such as auto components, as well as more research & development which have recently been emerging.  Outsourcing is getting fairly commoditized now, particularly in the services domain. There is huge growth and a lot of scope for further manufacturing of auto components – even though this may be bad news for the western auto manufacturers. R&D is another area where India has a lot of technical talent that can be utilized at a much more attractive cost than the west, if companies know how to properly tap into this talent. (Effectively what PK Clean has been doing through our team in Pune).

Real Estate: Out of Vogue

Saying “real estate” to anyone in Private Equity in India is almost like saying a dirty word. We consistently heard from every firm about how out of favor Real Estate was right now. Basically if you invested before 2005 you’re in good shape, but if you invested post-2006 you’re probably in some serious pain right now (to put it mildly). A challenge for cities such as Bombay is the very limited supply of “good” real estate currently. We heard that office space in Ceejay House, which houses many investment firms in Worli, goes for $180/sq ft, which is more expensive than Midtown Manhattan. These exorbitant prices represent a challenge for any sectors which rely heavily on real estate, such as hotels and retail. For instance, it’s hard to justify expensive brands since not only is real estate expensive, but luxury demand is limited too. The more attractive businesses appear to be those using real estate in Tier 2 cities where there is still growth ahead, and where demand is stemming from the emerging classes.

Bribery: A Tax You Pay to “Save Time”

Another topic that came up in our discussion with firms was the relationship with government. For some firms, government appeared a bed partner of sorts. IDFC was one example where the firm maintains close ties with government and policy makers. It was not surprising when they spoke about having been “coincidentally” correct on many government calls in their investments. Although the government plays less of a role in IDFC now (in 1997 the government had a 40% stake) – the government’s equity ownership still represents 18-19% of the company.

Views on government were mixed – some felt that the general governance of the country was deteriorating. On the topic of corruption, it was unfortunate to hear from one major fund that it’s getting worse rather than better. While the funds would never engage in making bribes themselves, it was generally accepted that most portfolio companies would be making bribes to conduct business. Without some level of bribery things take too long – and one fund manager noted that the key challenge for companies wasn’t Return on Investment but ‘Return on Time’. Some interesting euphemisms we heard for this type of corruption included “it’s a facilitation payment” or “it’s a tax you pay to save time”.

Show me the Money

So given this landscape for PE players, where is the money to be made? Broadly speaking, we know that PE can make money three ways: (i) leverage, (ii) multiple arbitrage, and (iii) fixing businesses. Leverage is not possible in the Indian context, multiple arbitrage is just taking a bet on market movements, and fixing businesses is difficult if funds don’t have a controlling stake.

To get around this, different funds are adopting varied approaches. Carlyle has adopted the approach of focusing on high growth rate companies with low ROE where they can gradually increase leverage across several years. This could mean, for instance, industrial sectors which are capital intensive such as manufacturing and family-owned businesses. Actis meanwhile prefers to make investments in the $50m-$300m range where it can take a controlling stake in the company – the fund noted that 50% of its transactions have been control transactions. IVFA also generally takes a majority or controlling stake of companies, and essentially takes over and runs a portfolio company. While it may not always be easy to take a controlling stake, others such as Blackstone, Khazanah and New Silk Route spoke of how their relationship with promoters and CEOs is the most key thing when making an investment since they don’t have the luxury of being able to make hiring and firing decisions. At least the solid relationship ensures that even though they may only have a minority stake in the company, they still feel a certain level of control over and comfort in management to fix the business as needed. It will be interesting to see how each of these slightly varied strategies plays out for these firms.