As India’s economy booms, many foreign investors are focusing on big, internationally known firms like Wipro Technologies, an IT services firm, and Tata Steel. But equally attractive investment opportunities exist among the country’s small and midsize enterprises (SMEs), according to the organizers of Motilal Oswal Venture Capital Advisors Private Limited (MOVCAPL), a subsidiary of Mumbai-based Motilal Oswal Financial Services. The private equity fund recently raised $42 million of a proposed $100 million to invest in promising SMEs. It’s partnering with the asset-management arm of Stone & Youngberg, an investment bank in San Francisco, and aims to gather another $40 million from U.S. investors, with the remainder coming from investors in India and elsewhere.

MOVCAPL is the investment manager of the jointly sponsored fund, called the S&Y India Fund. Last month, Vishal Tulsyan, CEO of MOVCAPL, and Anantkumar Kulkarni, a director, visited the United States to meet potential investors in S&Y India. India Knowledge at Wharton spoke with them and Nick Ellis, a Stone & Youngberg vice president, to better understand the fund and its strategy as well as the size and risks of the Indian SME sector. Excerpts of the conversation follow.

India Knowledge at Wharton: How did your firms pair up for this fund?

Ellis: At Stone & Youngberg, we specialize in underwriting economic development programs for local communities. We underwrite municipal bonds to finance public infrastructure. About a year and a half ago, we added an asset-management business, and part of the charter was to originate new investment products. My partner Sohail Bengali, managing director of S&Y, was interested in launching an India fund. That’s how he came to meet Vishal and Anant and to talk about launching a private equity fund focused on small and medium enterprises in India.

India Knowledge at Wharton: Vishal, could you tell us about your firm?

Tulsyan: Our holding company, Motilal Oswal Financial Services, was started 20 years ago by Raamdeo Agrawal and Motilal Oswal. In April of last year, two large private equity funds out of the U.S. — Bessemer Venture Partners and New Vernon — picked up a 9.3% stake in the company, and it has recently filed its IPO document with the Securities & Exchange Board of India. Motilal Oswal Venture Capital Advisors is one of four subsidiaries of our parent company. We launched the private equity fund in August 2006 and did our first closing in December and early January at $42 million. About 60% of that is from domestic investors, and the remaining 40% is from foreign investors.

India Knowledge at Wharton: What’s your investment strategy?

Tulsyan: We strongly believe that, in an economy that has grown at an average of more than 7.5% for the last four years, the biggest beneficiaries have to be small to midsize enterprises. If the economy were to grow at that rate going forward, these SMEs would continue to be its nerve centers.

India Knowledge at Wharton: Why are small and midsize Indian firms are growing so fast?

Tulsyan: [India] has always had a strong culture of entrepreneurship cutting across all regions. It’s just that capital was a bottleneck, but now capital is easily available to many corporations. Let’s take an example. If the four-wheeler industry expects to grow at 15% annually, some [suppliers] serving Maruti [India’s biggest carmaker] would grow at probably 30%.

Kulkarni: The second scenario is the rising purchasing power of many Indians and the opportunities thrown up by the changing demographics. A case in point is the retail boom triggered by increased consumerism.

India Knowledge at Wharton: What are your fund’s objectives?

Tulsyan: We will make 15 to 20 investments, averaging $5 million to $6 million each. We’ll wait three to five years for each company to attain a particular size and then take them to the IPO market.

India Knowledge at Wharton: How will you pick your investments??

Kulkarni: Broadly, one can see growth from two aspects. One is businesses that leverage India’s key competitive strengths — its highly skilled English-speaking manpower and the opportunities for cost arbitrage. In the first phase of [economic] liberalization, we saw more of outsourcing low-end jobs. Now that Indians have established their track record, Western companies are more comfortable outsourcing high-end work.

Tulsyan: One of the companies we are talking to provides high-level engineering design services. In a tie-up with a fairly good-sized U.S. company, it has designed an unmanned kiosk for immigration [checkpoints].

Kulkarni: The second part [of our strategy] is to build upon the appeal of India itself. Today everyone wants to have a share of Indian consumer spending. With India’s rising income levels and demographics — 60% of its population is below the age of 30 — a lot of opportunities are thrown up. These could be leisure and lifestyle, media and entertainment, or retail and infrastructure.

Tough Competition for Deals

India Knowledge at Wharton: Lots of people are investing in India and competing for deals. How will you ensure that you get the best ones?

Tulsyan: The sector we are targeting — SMEs — was the target for many private equity funds of Indian origin between 2001 and 2005. Most of these funds seem to have raised large amounts of capital over the past two years, and many of them are managing anywhere between half a billion dollars and $2 billion. They are no longer interested in, say, a $6 million transaction. That puts us in a unique position. Second, to be successful in India, it is very important to have a deep penetration into the market. We [through parent company Motilal Oswal] have a thousand outlets all over India. We service more than 200,000 retail customers, many of whom are high net-worth individuals and owners of SMEs. Our own distribution network will be an excellent base for sourcing investment opportunities.

India Knowledge at Wharton: What size companies will you invest in?

Tulsyan: We are not going to do startups. We are going to invest in companies that have been in existence for five to seven years and have proven their credentials in terms of generating revenues and executing their business plan but are at an inflection point where they have an investment requirement of $10 million to $20 million. We would like to fund a part of that with outside equity.

India Knowledge at Wharton: How do you plan to secure your investments? Will you take board seats?

Kulkarni: We will do thorough due diligence. We will structure each investment in such a way that the valuation is linked to milestones to be met by the company in terms of revenue, profits and other things. In addition to that, we would like to play an active role at the strategic level by getting onto the board and also having a very well defined shareholders’ agreement that gives us specific rights to protect our investment.

India Knowledge at Wharton: What would the shareholders’ agreement include?

Kulkarni: [It] could include clauses such as who gets the first opportunity to exit if, at any point, the company’s promoters want to divest their equity for nonbusiness purposes. [The companies] will also not be able to unduly expand or diversify without our consent. Other minor aspects are, they should take us into confidence when they finalize their budgets, their accounts and so forth.

India Knowledge at Wharton: Do you plan to have a minimum stake in each company?

Tulsyan: Given the fact that we will have a shareholders’ agreement backing the investments, whether we own 10% or 15% won’t really make a difference in terms of voting rights.

India Knowledge at Wharton: If you don’t agree with specific business proposals of the companies you invest in, will you have the right to block them?

Kulkarni: Under India’s Companies Act, you need a minimum of 26% equity to block such proposals. But here, even if we do not own 26%, our contract will give us the right to do so.

Tulsyan: Such rights or covenants are available as long as the company remains private.

Looking for the Exit

India Knowledge at Wharton: What if three or five years down the line, the equity markets are not strong enough to support an IPO? Do you have other exit options?

Tulsyan: There will definitely be an opportunity for us to sell our investments to other private equity funds. There are a lot of funds eying the Indian market right now and looking for opportunities in the $25 million to $30 million range. We have seen some transactions where one private equity fund has sold off its investments to other funds. As the market matures, there will be more transactions. That is the first option. Second, many of the shareholders’ agreements will also have a clause for buyback by the promoters of the company. And there will always be consolidation plays. Say a company reaches a certain size. There would be other larger companies willing to buy it.

India Knowledge at Wharton: How much of the $42 million raised so far has been invested?

Tulsyan: We made one investment of $4.5 million in March. We are in the process of looking at four or five more opportunities and hopefully will make one more investment soon.

India Knowledge at Wharton: Could you tell us about the company you invested in?

Kulkarni: We cannot name the company. It is in the polymer-based bulk-packaging business. It makes 100- to 200-liter drums that are used to store specialty chemicals or other liquids that could be very reactive if they were stored in metal containers. It is a licensee of a $1.3 billion German company with patented packaging-products technology. The company we have invested in has a market share of more than 75% in India, revenues of about $100 million and after-tax profits of $10 million. It has diversified into businesses related to polymers and plastics.

India Knowledge at Wharton: What attracted you to it?

Kulkarni: Three things. The business itself. It is near monopolistic. It is a high technology-based business started by first-generation entrepreneurs. That fits with our investment philosophy. And the management has very high integrity and execution capability. We have known these managers over the past 10 years since they started this business.

India Knowledge at Wharton: What distinguishes you from other private-equity investors in India?

Tulsyan: Our name is one of the most respected in the equities market in India. Many of the franchisees in our vast distribution network are boutique accounting and advisory firms that service a lot of the small to midsize firms in their respective regions. That is one of our sourcing pools. I am not saying that all the transactions will come to us and that the Kotaks and Reliances — [Kotak Mahindra Financial and Reliance Capital are active private equity investors] — will not be able to get them. But the opportunities are so many that there is probably a place for everyone. And I don’t know how keen a Reliance or Kotak will be on the space we are targeting.

Rising Interest Rates

India Knowledge at Wharton: A few weeks ago, the Reserve Bank of India (India’s central bank) took steps to raise interest rates. How does that affect you?

Tulsyan: That is an opportunity for us. For a fund like ours, what is the competition? [If I’m] an entrepreneur, I have three options. One is to take money from a private equity fund. Two, I could go directly to the market and raise money. And in the last 12 to 18 months, companies with $10 million to $15 million in valuation have gotten themselves listed on stock exchanges and raised some money. But many of them are trading at a 60% to 80% discount to their IPO price. So, the IPO market is definitely not competition for us right now. The third option is, instead of taking $3 million or $5 million from us, a company could borrow from a bank. But in India, [bank loans are available for] asset-based financing, not cash flow-based funding. Also, banks insist that promoters fund 30% to 40% of the project cost with their own equity. So, clearly, I think it is a blessing in disguise for us when there is a weakness in the secondary market, and liquidity is tightened.

India Knowledge at Wharton: With higher rates, couldn’t growth slow for everyone?

Kulkarni: It will definitely hurt companies that are looking for working capital; their cost of borrowing will go up. We look for companies with positive operating cash flow. The more positive a company’s operating cash flow, the less it is dependent on banks for its working capital. But in general, the liquidity crunch will hurt all businesses. It will hurt retail credit growth. It will hurt home financing. It will affect the SME sector.

India Knowledge at Wharton: What else do you worry about? What keeps you up at night?

Kulkarni: Basically, what could go wrong in our model is our call on the management. It might be a great business and a great opportunity, but not if our call on the management is [incorrect]. Second, you make money in private equity only when you exit. If something drastically goes wrong in the IPO market, we will have to look at other options, be it third-party deals or a secondary private equity market. There, we may not get the value that we want and may end up getting a sub-optimal return.