India and China Offer Attractive Private Equity Opportunities, but Without Majority Control

Despite the recent wave of corporate scandals, severe declines in local stock markets from their peaks and a challenging regulatory environment, strong fundamentals in China and India continue to offer some highly attractive opportunities for prudent private equity (PE) investors. But to succeed, PE investments must be carefully planned and fully supported with a regional presence in order to identify attractive potential opportunities and understand competitive threats to Western companies. To learn more about PE investment in this region, members of Wharton’s Private Equity Club (WPEC) recently interviewed Dalip Pathak of Warburg Pincus and Alastair Gibbons of Bridgepoint Capital about their views on PE investing in today’s transformed environment. Dalip Pathak heads Warburg Pincus’ London office and is responsible for the firm’s investment activities in Europe and India. Pathak is also a member of the Advisory Council of the Emerging Markets Private Equity Association in Washington, D.C. Alastair Gibbons is a partner at Bridgepoint Capital. He led Bridgepoint’s United Kingdom business until 2001 and then its German business until 2006. He now focuses on Bridgepoint’s business development and cross-border investments.

An edited transcript of the interview appears below.

WPEC: Following the recent scandals in emerging markets, such as Satyam in India, have PE firms re-evaluated their approaches to developing markets?

Dalip Pathak: The Satyam scandal in India is obviously very unfortunate. It was shocking both in terms of the fraud committed and equally in the length of time it took for the situation to be detected. It was also one of India’s companies which was more exposed to international business and capital markets; hence, one would have expected higher standards of corporate behavior. This occurrence has obviously made investors more cautious and will make them more demanding in terms of transparency, which in any case is good. 

However, one should remember that Satyam is not representative of Indian companies at large. With regard to India, since the opening of the economy in 1991, the country has seen huge improvements in both capital markets regulation and in corporate governance. In fact, based on my 10 years’ experience in the Far East and six years’ experience in Europe, I am convinced that the top-tier companies in India pursue high standards of corporate governance, judged by international benchmarks. Even some medium-size companies in India compare favorably with similar companies in industrialized countries. The reason for this is very simple: Medium-size companies in India need to access capital markets because of the traditional shortage of private capital, whereas in other parts of the world, similar size companies are often privately or bank-funded and can get away with being less transparent.

The capital markets impose higher standards of governance on these Indian listed companies. Furthermore, Indian capital markets regulation today is of a high standard. However, while the regulations per se are of a high standard, enforcement has the potential to improve further. Despite this, Satyam and other scandals have happened. But incidents such as Enron, Madoff and Parmalat prove that scandals of this sort happen not just in Asia. Rational and long-term investors should no more shy away from Asia as a whole and India in particular due to Satyam than they should from the U.S. due to Enron or Madoff. It is understandable if they are more cautious, and that is only appropriate. But the inability to put the situation in perspective will be unfortunate both for India and for investors.

WPEC: Given the dramatic decline in Asian stock markets and in GDP across the region, how have you adapted your investment strategy? Have valuations and management styles adjusted to those new levels of growth?

Pathak: The decline in Asian stock markets has been sharper than that in the U.S. or the UK. These markets are inherently more volatile because they are not broad and deep, and their perceived risk is higher. That said, even at the peak of the current crisis it has been difficult to identify high-quality companies in India which one would consider “cheap buys.” Whilst GDP growth in Asia is currently lower than in the past, in countries such as India and China, growth rates are still substantially positive, unlike the GDP contraction that we see in Europe. 

My suspicion is that the decline in valuations goes beyond a mere reflection of the earnings potential of the corporate sector in Asia. Liquidity has been sucked out of Asian markets due to redemption pressures in industrialized economies, and in most cases, this has penalized valuations disproportionately to the earnings potential or prospects of companies. From a capital markets (as opposed to an economic) perspective, emerging market equities have historically been more volatile than developed economies’ markets because the marginal dollar (i.e., the dollar which drives near-term volatility) is typically “high-velocity” capital. That is, investors who are seeking “growth at reasonable value” will reallocate capital to emerging markets when reasonable values are not achievable in the developed markets, which is what happened in the late 1990s and in the mid 2000s.

As emerging markets begin to correct, this capital can go back home quite abruptly, leaving the emerging markets without a bid. This is a typical “flight” cycle. What happened this time around is that volatility in developed markets exceeded any precedent experience, resulting not just in risk capital going back home, but in its total capital destruction. So the redemption and margin wave that struck hedge funds and most high-beta capital after Lehman’s bankruptcy had a much more dramatic effect than during prior cycles. In fact, these precipitous declines in emerging market equities took place despite the underlying and relatively favorable fundamental performance of the economies, financial system and individual companies in the respective markets.

A key question now, since developed markets are still in significant disarray, is whether emerging markets (especially China and India, which both have different, but very attractive underpinnings for growth) can develop more advanced sources of capital, perhaps even internally. This is important because liquidity from foreign flows might be slower to return this time, yet there is a significant need for non-domestic savings, at least in India, to support the high levels of growth in the recent past. Management teams were slow to recognize the oncoming economic tsunami that hit in 2008. For example, there was a sense in India that the country was somewhat immune from the world crisis. Furthermore, the severity of the global crisis was underestimated. However, by November 2008, most Indian businessmen had recognized that India would not go untouched, and subsequently have been quick to reduce costs or take other measures appropriate to the situation.

WPEC: Do you think there will be a distressed cycle in Asia that mirrors the U.S.? What factors limit PE firms’ ability to execute LBOs [leveraged buyouts] in Asia, and how will those evolve?

Pathak: LBOs in much of Asia are rare events. The reasons for this, particularly in India, are fairly straightforward. Most Indian banks, relative to international banks, have small balance sheets. There are strict central bank regulations restricting how much Indian banks can lend to any one company, and this ultimately controls the amount of debt that any one company can have on its balance sheet, making the whole concept of LBOs in India quite alien. Furthermore, Indian companies are typically founder-family owned or controlled, and Indian families are disinclined to forego control for financial gain, even if the company is not performing well, or if they can achieve “super-normal” gains by divesting.

In Asia, this is very much a cultural factor, and unless this attitude changes, it will be difficult for LBOs to thrive. In addition, most of Asia does not have the kind of bankruptcy laws that exist in the U.S. For this and for other cultural reasons, you do not come across Indian banks foreclosing on companies or assets. They are more inclined to try and reach settlement with borrowers. If this were not the case, we would probably see the kind of disposals and distressed asset sales that we see in the West.

As Asian economies, including India, develop, we are likely to see the emergence of bankruptcy laws, more M&A and LBOs. In fact it is believed that there is a high likelihood that post the April-May 2009 elections in India, bankruptcy laws could well be introduced. This is desirable because the current regime of regulation permits poor governance and inefficient use of capital. Worse still, it punishes the performance of well-managed, high-quality companies by keeping inefficient companies alive supported by government banks or even private banks.

The promulgation of bankruptcy laws will create a market for M&A and restructurings which currently, though not non-existent, is quite small. In conclusion, I think it is fair to say that the secular trend is for Asian economies, particularly India and China, to grow at significantly higher rates than the U.S. or economies in Europe. The road will be bumpy on occasion, because development is not a neat process. However, it is this very growth, together with occasional discontinuities, that will continue to create unusual profit opportunities.

WPEC: How relevant are developing markets, such as India and China, to PE firms traditionally focused on Europe?

Alastair Gibbons: The developing markets are becoming more relevant to PE equity firms with a European investing focus. In evaluating potential deals or portfolio company performance in Europe, it is important to understand how value is impacted by competitive threats to European companies from these markets and also the opportunities that are available in India and China from improved commercial sourcing.

A secondary opportunity to develop sales channels in those countries is also relevant, albeit much more difficult to achieve in practice. In the future, we also expect more activity from Chinese and Indian companies looking to acquire businesses in Europe. Consequently, as we consider exit opportunities, we will increasingly extend our net to Asia for prospective acquirers. As a middle-market European firm, we do not envisage setting up a local team in these countries to compete with local private equity firms for local deals in the near term. However, for the reasons mentioned above, we are likely to establish representative offices to add value to our portfolio companies.

WPEC: How have Western PE firms needed to adapt their investment styles for the Asian markets? Which specific markets are most appealing and why?

Gibbons: Western PE firms have had to accept that acquisition of majority stakes providing outright control is extremely difficult to achieve and, hence, have had to shift their strategy to holding sizable minority stakes. The degree of control afforded is necessarily less and [therefore] more time is spent on goal alignment and relationship building with the majority shareholder. The PE markets today are largely growth-capital rather than buyout oriented, and less leverage is available to be structured into deals. [This means that] a higher proportion of target returns must come from growth in earnings, either revenue-driven or cost- and efficiency-improvement-driven.

Regarding specific attractive markets, China and India are both interesting as they offer enormous scale, strong long-term growth, burgeoning development of a sizable consumer-oriented middle class, low cost and an increasingly educated labor force. Furthermore, PE markets in these countries are still relatively nascent. They also present massive challenges, not least of which are weak corporate governance regimes, unreliable judicial systems and regulatory regimes, plus widespread corruption. Overlay on to that markedly different cultures and a language barrier (for China) as well as an inadequate supply of well-trained or experienced managers, and we conclude that market entry must be carefully planned and staged.

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