Private Equity in India Finds Opportunity in Adversity

Private equity (PE) in India is facing problems because of unclear and changing regulations, and the lack of exit routes. At the same time, many are turning to PE funds because other sources of finance have dried up. This year is expected to be one of consolidation for the industry, according to the "India Private Equity Report 2012," released in May by global management consulting firm Bain & Company. Arpan Sheth, head of Bain's India private equity practice and the main architect of the report, tells India Knowledge@Wharton that there have been developments — both positive and negative — since the report was released. But the effects of those events have largely canceled each other out, he notes, meaning the broad conclusions of the Bain report are as valid today as they were a few months ago.

"Since we published the 2012 report in the first half [of the year], it has been a mixed bag with challenges like regulatory uncertainty, including the impassioned debate over GAAR rules," says Sheth. GAAR – general anti-tax avoidance rules — were part of the Union Budget proposals this year and spooked many foreign investors. "Also, given the overall uncertainty — which has been somewhat cleared up by the recent pro-reform measures of the government — there are still some residual effects on deal volume and PE value. We do not see a rebound later this year given this scenario."

The Bain numbers on PE activity show that India and China are happening places for the sector. "Despite declines in other geographies, the value of PE investments in the Asia-Pacific region (including Australia) grew at an impressive 32% in 2011, largely due to increased investment volumes in India and China," according to the report. "India was the fastest-growing PE market in Asia in 2011."

The flip side of this story, however, is that the growth in PE in India is not entirely due to the lure of such investments. Indian entrepreneurs are going for PE funding because of "the higher cost of debt and choppy capital markets," the Bain report noted. The markets continue to be in the doghouse — according to Prime Database, which tracks public offerings, only Rs. 407 crore (US$93 million) was raised through initial public offerings (IPOs) in April-to-September 2012, compared with Rs, 9,553 crore (US$1.79 billion) in the corresponding six months of 2011. And the Reserve Bank of India continues to keep interest rates high to control inflation.

"If you look at the past few years, taking a more macro perspective, PE has proven itself to be a viable source of funding," says Sheth. "This is particularly so as the public markets were weak last year and companies were finding it hard to raise funds through IPOs. PE funds stepped in to support companies looking to fund growth and expansion. Over the past seven years, PE has developed strong credibility in India, including among a number of promoters who may have had doubts earlier about this relatively new asset class." In 2011, PE investors poured US$14.8 billion into the country, a 55% increase over 2010. The number of deals stood at 531, 40% more than the previous year.

Regulations Not Clear

So what's holding back PE from reaching even greater heights? First is the regulatory environment. "One factor impacting deals is regulatory uncertainty," Sheth notes. More importantly, exits have become difficult. Company owners cannot go for IPOs because that market has tanked. The only way out is to find another PE player who is willing to come in at a higher valuation. That's difficult because in many cases the PE investment had been made at high initial valuations. Expected growth may not have taken place because of the general economic conditions. In some cases, PE investors have had to take a haircut.

"Two-thirds of the private equity deals are yet to exit, so it is still an open story on exits," says Sheth. "The PE deals made in 2006-2007 are up for exits and LPs [limited partners] are clearly looking for returns here. There have been good returns on some deals, showing the potential for profits. Overall, the jury is still out." The Bain report notes that there was a "dramatic" decline in exits in 2011. "Only 88 investments exited PE fund portfolios in 2011, compared with 123 in 2010 — a nearly 30% decrease."

The lack of exits and allied factors have made international investors a bit wary of putting money into India. The Bain report says that about 680 funds throughout the world raised around US$270 billion in capital in 2011. Of that total, however, only US$12 billion came with the mandate to invest in India. This was down from US$18 billion in 2010, "a clear sign that LPs are becoming more selective about where they park their money".

That, by itself, is not an immediate cause for worry. PE companies in India, too, have been selective about how they invest their funds. Some have preferred not to invest at all. PE funds entered 2012 with about US$17 billion in "dry powder" — money earmarked for India but not invested. This is less than the US$20 billion they had at the start of 2011, but adequate to fund several ventures should the climate suddenly change.

VCs and PEs Blur

The report also points out one peculiarity of the Indian market — the difference between venture capital (VC) and PE has blurred. Both are operating in the same space. "The Indian market continued to see overlap in the interests of PE funds with VC investors, which is a departure from the traditional styles of these firms. While VC funds typically invest in small start-ups and in small amounts, several VC funds evaluated larger-ticket investments in India last year." Everyone is eyeing early-stage deals. According to the Bain report, "In 2011, 28% of the deals struck were with new companies founded within the last three years, up from a high of 25% in previous years."

Where to from here? The PE market in India is "a tremendous opportunity laced with a great deal of hard work," the report notes. Given the negative factors at play, isn't that being overoptimistic? No, says Sheth: "I think our report paints a realistic picture of the opportunities and challenges on the ground. Economic cycles come and go and sentiment follows. One needs to be careful of making calls based on the sentiment at any single point of time."

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