In the wake of the U.S. financial crisis, valuations of Indian firms have tumbled — something which the private equity industry has been careful to note, according to Sri Rajan, partner and head of Bain & Company’s private equity practice in India. Over the next few months, he predicts, “we’ll see a lot more deal flow with private equity firms in India.” Rajan, whose work with private equity funds includes mergers and acquisitions, post-merger integration, offshore outsourcing and assessing entry and exit risks, discussed the industry outlook with India Knowledge at Wharton at the Wharton India Economic Forum in Philadelphia.

An edited transcript of the conversation follows.

Knowledge at Wharton: Has the U.S. financial crisis affected the private equity industry and India?  

Rajan: I think that the impact [in India] is primarily because the stock market has been impacted. The private equity industry is looking at what is happening in India very closely, because valuations have come down over the last couple of months. And what [funds] are hoping is that at some point in time, these downward trends in valuations will have an impact in terms of the attractiveness of some of these assets.

We haven’t seen an increase in the amount of deal flow yet, and we haven’t seen the impact of valuations yet on Indian companies. But, my perspective is that over the course of the next two or three months, we will see that impact. And we will see a lot more deal flow with private equity firms in India. 

Knowledge at Wharton: Is that very similar to what you think might happen in other emerging markets as well, like China?

Rajan: I think that it is. The one big difference between India and other emerging markets like China is that over the last three or four years, there has been a significant amount of activity in the private equity industry in India — and that is not true for China. So, in terms of both volume and the quantity of private equity money that has been put to use in India, it has been far higher than China. I think that’s the one basic difference that will lead to increased deal flow in India, compared even to China. 

Knowledge at Wharton: What, in India, would you say are the most attractive sectors for investment at the present time?

Rajan: If you look at the trend over the course of the last three or four years: In 2004 and 2005, the most attractive sectors were the IT sectors, IT companies, BPO companies and so on. In 2007, the most attractive sectors were real estate and infrastructure. That is where the bulk of the money went in.

It’s a little difficult to predict what will happen, given what’s going on with valuations. My sense is that we will see a lot of activity across all sectors if valuations stay where they are. We’re going to see a lot more activity in manufacturing, which we haven’t seen a lot of over the course of the last few years. I think that India is becoming a manufacturing hub for a lot of subsectors. And, given that, I think there will be a lot more deals that will happen in manufacturing than what we have seen. My sense is that services will come back as well. As valuations of services companies also become more attractive, I think that you will see a lot more of deal flow over there.

Knowledge at Wharton: In making investments, or actually evaluating investments in emerging markets like India, what kinds of attributes should firms be looking for?

Rajan: The challenge with doing investments in India, especially private equity investments, is that you have to look at both the macro picture as well as the company very carefully. And, in many instances, that information is not available very readily — or not as readily as it might be in the United States, for example.

So, one of the things that private equity firms have to do is to really understand the macro picture — understand what the trends are — but more importantly, have a very good sense about the quality of the asset, the quality of the company that they are buying, both from a financial perspective and also from the quality of  management team perspective. I think that those are actually very important things and are as important as accounting diligence and legal diligence, for example, and are what a private equity firm should look for.

Knowledge at Wharton: One issue that comes up for private equity in any market is finding the right people to run things. In India, this seems like it is especially an issue. Is that issue likely to get worse, or do you think that it will get better?

Rajan: I think that it is going to get worse before it gets better. Over the course of the last couple of years, a lot of money has come to India. There are a lot of funds that are setting up shop in India. I don’t think that that’s going to calm down.

I think that we are going to see many more funds which have not yet set up an office in India, but are looking to set up a presence over there. And, I think that there is going to be a lot more difficulty in terms of getting talent, especially people who understand what the private equity landscape is like in India, and how to do deals over there. And so, my sense is that it’s probably going to get worse before it gets better.

Knowledge at Wharton: What do you think it would take to make it better?

Rajan: I’m not sure that there is a “fix,” so to speak. I think that there are a lot of people who are moving from other parts of the world to India. These are people who have experience in terms of private equity deals with offices in New York or London or Hong Kong. So, those people have the private equity experience. I think the challenge is that those same people will now need to come to India and develop the relationships that are necessary to make private equity deals happen — and that, I think, will take time. So, I’m not entirely sure that there is a quick fix. We’re going to have to wait this one out for the next year or so. 

Knowledge at Wharton: Aside from the larger market shocks that have been taking up all of the headlines, what kinds of trends do you see taking place in private equity in general?

Rajan: One of the things that the private equity industry is concerned about, apart from valuations, has been the regulatory framework within India. So far, the private equity industry has been unregulated for the most part. I think that the government has started making noises about potentially controlling flows into India. I’m not entirely sure where that will go, but that’s certainly one concern. 

The second concern really is the access to domestic debt markets. In India, it is very difficult to access domestic debt to do buy-outs, for example. And so, what a lot of private equity funds do is set up offshore vehicles in order to do that. The debt market has to be developed a lot more for private equity funds to access that. I don’t know when that will happen. I think that it’s a matter of time and it’s a question of when, not if. But, I would say that those are two of the issues that private equity firms need to think about.

Knowledge at Wharton: What sort of opportunities do you see coming up on the horizon?

Rajan: I think that the opportunities are actually very large in India. I say this because I think that the opportunities exist in almost every sector. We just heard from a panel on infrastructure that talked about the need for a trillion dollars over the course of the next ten years. I think that in terms of opportunity, there is clearly a lot that exists whether you are talking about infrastructure or you are talking about real estate, there is a lot of build-out that needs to happen in India; whether you are talking about services companies or manufacturing companies. I think that the need for capital exists.

And so, I’m not actually at all concerned about the opportunity that might exist in India. I think that what the private equity firms have to come and show to Indian companies is the value that they will bring. The value that they bring is not just capital. It has to be far more than that. It has to be expertise. It has to be the ability to increase or to improve governance practices and so on. In my mind, those are things that will really differentiate private equity firms from one another. I don’t think that there is really an issue of opportunity at all.