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Brighter prospects for private equity in India, but regulatory challenges remain

The first year of recovery following the economic downturn has been a good one for private equity (PE).

April 27, 2011 12:40 IST | India Infoline News Service
Deal values in Europe and North America, the epicentres of the global credit crisis, were up 160% and 192%, respectively, from 2009 lows. Deal activity has also rebounded in India, following a brief lull in 2009. With the economy growing between 8% and 9% and the consequent increase in corporate funding requirements, transactions look set to continue strongly in the coming year. It's safe to say that PE is now an integral feature of India's business landscape.

The total value of new India PE and venture capital (VC) investments (including infrastructure and real estate) more than doubled to $9.5 billion (Rs.42,275 crore today) in 2010 from $4.5 billion the year before. Indeed, India experienced the largest increase in investment activity among major Asia-Pacific markets in 2010. Despite its growth and resilience, Indian PE retains two distinctive traits, spelt out in Bain and Co.'s India Private Equity Report 2011, produced in collaboration with the Indian Private Equity and Venture Capital Association (Ivca).

First, most Indian promoters are reluctant to cede management control. Related to this is a second long-standing characteristic of PE in India: the relatively small size of the deals. Average deal size in 2010 increased marginally to $24 million from about $21 million in 2009. In line with their small values, 60% of PE deals in 2010 were for minority ownership positions of less than 25%. Still, the prospects look good for Indian PE's continued growth and adaptability in 2011 and beyond. Riding on the back of strong underlying fundamentals, India will retain its status as a favoured investment destination among emerging markets, notwithstanding short-term nervousness that roiled the Indian capital markets earlier this year. In interviews and surveys conducted for the India Private Equity Report 2011, most investors say that the short-term uncertainty and high interest-rate environment present interesting opportunities to acquire assets at favourable prices.

About half the respondents report that they expect deal activity to increase by between 25% and 50% or more over the next three years. Almost 35% anticipate growth in the 10% to 25% range. One important barometer of a healthy pipeline in deal activity is the amount of capital looking to be placed with promising Indian firms. Industry watchers estimate that investors have committed at least $20 billion that PE funds are yet to deploy. This "dry powder" is sufficient to fund nearly all deal activity at 2010 levels for the next two years. PE funds are looking to roughly double the capital earmarked for investments in India, but limited partners (LPs) are becoming more discerning about whom they invest with. The key for PE funds is differentiation, both by demonstrating a proven track record of value creation and by following an investment philosophy grounded in clear investment themes or focused on specific sectors. Fund managers are also deepening their relationships with promoters and other intermediaries to ensure that they will be the partner of choice in the most attractive deals, well before initial term sheets are drafted.

One trend helping boost LPs' confidence in the Indian PE opportunity is the strong record of exits in 2010. PE funds unwound positions in 120 companies and took in $5.3 billion, the industry's best year so far. Industry experts are bullish about exit prospects through the end of 2011-and even more optimistic about the next three years. With the investment and exit environment likely to remain strong, where will PE funds look to do deals? Investments in information technology (IT) and IT-enabled services, long mainstays of India's growth and PE interest, decreased somewhat in 2010 from 2009 levels. But other sectors, notably energy, banking and financial services, and telecom, saw investment volumes more than double last year. In 2011, banking and financial services, healthcare, infrastructure, and consumer products are likely to attract greater interest. Whether these investments fulfil their potential depends on how promoters select a fund they are willing to work with. If getting peak valuation remains their chief criterion, the role of intermediaries that help match promoters and funds will increase.

Given this likely scenario, it is no surprise that respondents to our survey of 50 leading PE and VC funds said that the tough competitive environment is one of the industry's biggest challenges. Further fuelling the competition among PE funds and driving up valuations has been the emergence of domestic spin-off funds with experienced general partners at the helm. The new funds capitalize on their local market knowledge and strong networks of relationships. Another factor that will influence PE's future in India is the attractiveness of valuations of potential Indian investments compared with those available elsewhere in the region. For example, the double-digit multiples of pre-tax earnings a PE buyer must pay for Indian assets are higher than the singledigit multiples available in other emerging economies, including China. How can PE funds land winning deals amid increasing competition? A good majority of PE funds believe that profit growth, not multiple expansion, will be the key driver of value creation.

PE firms that bring operational expertise to the table will enjoy a clear competitive edge. When PE funds are actively involved in the operations of their portfolio companies, they strengthen corporate governance, bring rigour to business systems and processes, assist in raising new rounds of capital, provide access to their business networks, and help fill critical management roles. India has been a difficult market when it comes to collaboration between PE funds and promoters, but the fact that Indian promoters are warming to PE, albeit gradually, is a sign that the PE industry is maturing. More promoters are now beginning to see VC and PE as a credible source of capital with a distinct value proposition rather than as a funder of last resort. For their part, PE funds are reciprocating by enlisting a wider team of advisers and experts and by nurturing a more collaborative relationship with promoters. They aim to have promoters value them as a true business partner committed to their success. PE firms are seeing greater understanding among promoters about the value PE and VC offer.

Nearly four out of five are very sure that promoters' appreciation for the value PE can add will deepen in the future. PE and VC stand ready to assume a bigger role as growth enablers, but regulatory obstacles remain. For instance, PE funds are impeded by ambiguities about their treatment under Indian securities and tax laws. Regulators can begin to address these by recognizing that PE and VC are a distinct asset class, apart from promoter holdings, creditors and public investors. To attract more foreign direct investment into PE and VC funds, the government also needs to ease current disclosure rules. Ultimately, how far PE funds can go towards fulfilling their value-creation promise depends on PE investors and company owners building a stronger foundation of mutual understanding. One big step forward would be for the two sides to come into closer alignment over asset valuations. Also, while there has been some real progress in post-deal collaboration between PE investors and promoters, there is plenty of room for improvement.

As PE in India enters a new phase, its prospects are promising. Whether India realizes the full potential investors see in it as a leading destination for PE and VC capital depends on how these challenges are addressed.

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