Can India’s Economy Return to High Growth?

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Gaurav Dalmia, chairman of Dalmia Group Holdings, talks about the Indian economy, private equity, and his leadership journey.

While India’s GDP has fallen to a six-year low, the country’s economy has some areas of strength. Gaurav Dalmia, chairman of Dalmia Group Holdings, a holding company for business and financial assets, believes that if India can take hard decisions, “there is no reason why we can’t grow at 10%.”

Dalmia has invested significantly in private equity and real estate, including sponsoring some top quartile funds. He was chosen as a Global Leader for Tomorrow by the World Economic Forum in 2000. In a conversation with Knowledge@Wharton during a visit to the Penn campus, Dalmia spoke about the Indian economy, opportunities and risks in private equity, and his own leadership journey.

An edited transcript of the conversation appears below.

Knowledge@Wharton: The Financial Times recently noted that India’s GDP is in the fifth consecutive quarter of deceleration and has now fallen to a six-year low. Why is the economy faltering?

Gaurav Dalmia: India is going through what you would call two big Schumpeterian shocks. In November 2016, we had demonetization. And then shortly thereafter, we had the goods and services tax regime. Both changed the world significantly for Indian businesses — more so for the small and medium enterprise sector.

If you look at the investment rate, it is slowing down. Bank funding is slowing down because of the banking crisis that is going on. It’s a cumulative problem of the last few decades. Then there is over-leverage in the system, in the commodity companies, infrastructure sector, and so forth. There is risk aversion in the minds of businessmen because of the changes that are going on. And, more importantly, there is a secular decline in savings rate. This will feed into a lower investment rate and will subdue economic growth.

Knowledge@Wharton: Why is India’s savings rate coming down?

Dalmia: It was [always] lower than countries like China to begin with, which had a savings rate of 40% plus during its peak growth years. That’s a cultural aspect. Then there is consumerism, and rural distress. Indian household savings have declined from over 23% to below 17% in the past six years. This is not an insignificant trend.

Knowledge@Wharton: What do you think needs to be done to get the economy back on track, especially along the three dimensions of lack of jobs, drop in consumption, and income squeeze in rural areas?

Dalmia: The single biggest challenge in the economy is job creation. We need about a million jobs a month, net job creation, in India. We’re nowhere near that. Let’s go more granular. India’s labor force participation of youth, ages 15-24 years, is some 26%. In China, it is 57%, Indonesia is 47%, and Brazil is at 40%. If you look at women, India is about 24%. Bangladesh is 36%. Malaysia is over 50%. Vietnam, which is a real outlier, is 73%. So hidden below the aggregate jobs data are even more worrying trends.

Agricultural income has plateaued because we’ve been trying to control inflation. Not enough non-agricultural income has been generated at the same time, so that’s a challenge. But now we have been able to control inflation, which has traditionally been a challenge in most emerging economies including India. That’s the good news.

I believe that in the short term, India’s economic vitality is determined by oil and monsoons. In the long term, it is determined by demographics and geography. Oil has been reasonably okay. Monsoon this year has been pretty good. So in the near-term, there is no macro-shock expected.

In the long term, our demographics are pretty decent. We have a working-age population coming in. We have a good coastline, so our geography is pretty good, though our population density is high.

Think of the operating leverage of the consumer. We have millions of Indians who have been crossing that threshold where nominal incomes grow at 9%, real incomes are growing at 5%, but disposable incomes have been growing at 20% — which is why mature industries in markets, automotive as an example, have been growing very rapidly.

Counter to this is a view that most of India’s consumption is based on a very small foundation: a market of only about 150 million people. Whereas, to truly create a robust economy which has 1.3 billion people, you need this base to be 400 million people. The next 250 million have not yet been added in this consumer economy the way they ought to have been. That makes India somewhat vulnerable. As India goes through a period of financial inclusion, this should change.

“India is going through what you would call two big Schumpeterian shocks.”

But there are some good pieces of news as well. We recently had a big holiday buying season in India. The two biggest online retailers, Flipkart and Amazon, both reported sales of $2.5 billion during this period. Zomato, the food delivery company, has grown at 3x in the last year. You may say this is a niche business, but it’s indicative. Look at health insurance company Max Bupa. Its aggregate growth in revenue in terms of gross written premium over 2014 to 2019 was 25% per year. If you look at the largest mortgage provider in India, HDFC, it has been growing at 23.5% over the last five years.

So while there is bad news, there are also pockets of good news. I would call it “mixed news.” So, a big challenge is the mood. You must restart the investment cycle, which means bring real interest rates down, restart a consumer boom. This requires a lot of effort and energy.

Knowledge@Wharton: If you consider the auto sector, why did it get into so much trouble? And what can be done now? Are there any lessons from the kind of government bailouts that were necessary in the U.S. in the aftermath of the Great Recession? Do you think such a bailout is required for the auto sector in India?

Dalmia: As the auto sector is a big proxy for the manufacturing sector in India, let me start with manufacturing in general. Manufacturing is slightly more than 15% of GDP in India, and this was the same 10 years ago. China’s manufacturing as a percentage of GDP at 29% is almost twice that of India’s. Indonesia is 20%. Malaysia is 22%.

The auto sector is almost 45% of manufacturing in India. Auto and auto-related businesses are almost 7% of industry GDP. Traditionally, the auto sector was growing at about 12%. Now there’s a natural plateauing, which I had mentioned earlier, and it’s happening faster than we thought. Also, almost two-thirds of the automotive sector sales are financed. Currently there is a big asset liability mismatch in the financial companies that is holding back lending, and this is pulling back demand. Things such as new insurance norms, road tax increases and so on are also stretching the consumer wallet.

Knowledge@Wharton: In September, the government of India announced a $20 billion tax cut. Do you think such solutions are helpful? If not, what can be done to bring the next 250 million people into the consumer economy?

Dalmia: I think the benefits of such moves are more limited than we think. It also depends on what our aspirations are. Is our aspiration 7% to 7.5% economic growth, which is our natural fighting weight? Is our aspiration 10% economic growth, which is emulating what China did? The solutions for these may be different.

For 7.5% growth, there is plenty of low hanging fruit like removing the financial sector liquidity issues and the asset liability mismatch that is going on in the financial sector. You’ve got to plug the delays in the GST system. Working capital for SMEs has bloated. You’ve got to rectify agricultural support prices to revive the rural economy. You’ve got to lower interest rates. We’ve got perhaps the highest real interest rates in the world. These are relatively technical things that need to be done.

Furthermore, there is this despondency in India. Author Aravind Adiga captures it well: “In the old days, we were scared of the corrupt politician. These days, we are scared of the honest politician.” I think this needs to change.

To get to 10% growth requires an Olympic-type regimen and training. It won’t happen with incrementalism. For example, we will need more free trade agreements in our favor. We have to make hard decisions regarding labor and land reform. Investment in education and health care has to increase substantially, to get a Vietnam style productivity boost.

We have to strengthen our institutions. India’s regulators often play catch up with market realities. India’s best decisions often happen in the backdrop of a crisis. India’s story is of brilliant individuals standing out in a mediocre structural framework. This is not the path to scale. And we have conflicting demands on institutions. All this needs to fit in with the new aspirations.

In the mid-70s, China’s Deng Xiaoping famously said, “To get rich is glorious.” If we think this is crass, we are not going to create our 10% growth. If we collectively think this is what we need as a society, then we have a shot at growing at 10%. We’ve got to find our “to get rich is glorious” moment.

A growth of 10% requires a long gestation period, stamina and political will. It’s not just a government which has to deliver. Businesses and society have to be able to deliver. If we make hard decisions, there is no reason why we can’t grow at 10%.

Knowledge@Wharton: How do you look at poverty and inequality in India?

Dalmia: Through our philanthropic activities, we see poverty up-close. We do a lot of work in rural water conservation and in girls’ education. I believe there is a lot of opportunity to do more but not because things are very bad. India has taken a lot of people out of poverty, just like China has. But though things are better, we could be a lot better. So it’s a positive case, not a negative case.

I come from Hans Rosling’s school of thought. Policymakers needs to read his book Factfulness. Rosling was a Swedish doctor and a public policy expert. His basic point is that we miss the small steps in progress. These small steps are cumulative, and that’s what produces good results.

Knowledge@Wharton: You have significant investments in residential real estate. There have been media reports about hundreds of thousands of housing units that are being sold, but which developers have been unable to complete. What needs to be done to deal with such problems?

“If we follow an Olympic training type regimen, we can have a growth spurt at 10%.”

Dalmia: Real estate is among the largest sectors globally in any economy, including in India. McKinsey had a study recently which said that construction needs to move from 4.7% of GDP to 12% to 12.5% if India is to really reach its true potential. If you look at the Asian experience, in Thailand, Indonesia, Japan, and China, real estate has been a very big contributor of wealth.

In India, unfortunately, real estate is a very inefficient sector. You have to deal with a lot of local regulations. And, unlike in the developed markets you can’t give a fixed price construction contract because most contractors don’t have the balance sheets to offer a guaranteed price contract. Therefore, you’re taking that risk on yourself.

If you were to break up the real estate value chain into land consolidation, licensing, and construction and development, the bulk of the value-add comes from land consolidation and licensing, which are inevitably political in nature. The development part is a 15% internal rate of return business. So your returns are skewed towards things that are not really businesslike. This attracts the wrong kind of people. Plus, because of misplaced ambition and lack of regulations in the past, developers take money from customers for project A and divert that money into project B. If project B gets stuck, inevitably there is a cascading effect. Unfortunately, a lot of this has been funded by high-yield debt. So, on one end, customer trust in developers is broken because of cash diversion and deliveries have been very weak. And then there is pressure from high-yield debt, and there’s a cash crunch, which just gets artificially postponed.

But on a selective basis you can still invest in real estate, and we’re continuing to do that. In some cases, regulators will have to step in, create a bad bank-type of environment, take away some assets, cleanse them and sell them. You can’t leave it to the developers because the stakes of the consumers in this case are way too high. For investors, who can deal with these moving parts, returns can be extraordinary. But this is not for the average-Joe financial company, which is itself levered.

Knowledge@Wharton: Do you see any evidence of outright fraud involved in any of these instances, or is this just bad economics?

Dalmia: I would say in some cases — let’s say 15% of the cases — there may be fraud. As I mentioned, real estate sometimes invites a different breed of entrepreneurs. However, in majority of the cases, it is over-ambition. But unfortunately, it’s very difficult to distinguish where there was fraud and where there’s over-ambition.

I subscribe to the approach of selectively working with people who we have histories with, or who have been caught in a cash flow bind — their projects are good, everything else is good. You don’t put in high-yield money, but put in preference equity or even pure equity, and give them the runway to perform. This could be a possible solution. We have found that on an asset backed basis this has given us equity-type returns. But people used to air-conditioned offices need not apply.

Knowledge@Wharton: How do you view the private equity market in India? Where do you see the most promising opportunities?

Dalmia: The private equity wave started in India with the tech boom of 2000. Many private equity players made a lot of money in the first phase. Some of the best known domestic private equity firms such as True North or Chrys Capital were built in this period. International players such as Carlyle, Blackstone, KKR, Sequoia, etc. started coming in after that.

 “Overall, as an asset class, private equity has done well and there are lessons for all of us.”

At present, the industry has five or six segments. For example, players like Blackstone and True North have done a phenomenal job of buying controlling stakes in businesses. Another segment is growth capital. There are several players here and the most recent spectacular success is a fund called Kedaara Capital.

A third area of investment is technology firms. This is a specialized business. The Sequoias and the Lightspeeds of the world are backing the tech unicorns in India. Some of the hedge funds — and people like Carlyle, Chrys Capital — are doing a lot of private investment in public equities. That’s again a separate segment. To hedge against inflation, but to get some amount of fixed income, firms like Brookfield are doing annuities. Apollo and Goldman are doing high-yield investments in India.

Overall, as an asset class, private equity has done well and there are lessons for all of us. First, people who have made decisions locally have done better than people who have stuck with their core competence but made decisions from London or New York. The first example of this was Warburg Pincus. They opened shop in India and had local decision-making.

Second, unlike developed markets, most private equity in India is growth capital. It’s not leveraged buyouts of a cash cow business. Therefore, investment timelines are longer than what people are used to in more developed markets.

Third, mistakes have been made where people focused on assets like a good brand or a good footprint and paid less attention to management quality. A lot of the private equity stress is explained by this.

Fourth, everybody in India talks about adding value to their portfolio companies. I would say less than 25% of the private equity shops are able to bring value. But those who do can have a USP.

Fifth, people have to marry the top-down and bottom-up view to investing. A top-down view may be that South and Western India are growing faster than North and Eastern India. So if you’re an insurance company, for instance, you could decide to focus on South and West. A bottom-up view may be: What’s your return on capital employed? How are you creating a barrier to entry? Many private equity investors get seduced by the top-down view and don’t pay enough attention to the bottom-up view, which then hurts returns. And lastly, it’s not a financial modeling business. It’s a growth-type of business in India with implementation being the driver. People who are doing only financial modeling are inevitably disappointed because the numbers don’t play out just like that.

There’s a wide dispersion of returns. Indian private equity’s median returns are not that attractive. But if you look at people in the top quartile, people will salivate. Blackstone’s best deals in the world today are happening out of India. So you’ve got to try not to be a median player where you are just mimicking the index or beating the index by a small amount, but actually create alpha.

“I think the long-term play in a growing economy like India is equity.”

Knowledge@Wharton: Where would you invest in today’s business environment in India?

Dalmia: One, we do public markets. We think public markets and private equity are interchangeable on a relative value basis. We don’t have a top-down asset allocation. History shows Indian index returns have been about 10% in dollars over decades, and across cycles. The whole hedge fund industry in the U.S. was built on this 10% return. In India, passive investing, by buying the stock market index, and tightening your seat belt to ride turbulence, can get you that kind of return.

There are many companies that are seeing their operating leverage playing out. With business volume going up, the fixed costs are amortized over a longer or a bigger base. Many investors do not fully appreciate the upside of capital-work-in-progress. A lot of companies which made capex a few years ago are seeing the results of those investments now. So there may be a lot of opportunities in public markets, and similarly in private equity.

Thomas Russo is a well-known investor in the U.S., and he invests only in consumer companies. He has a statement, which is, “Be a farmer, not a hunter.” This statement applies well to India. People who have tried to “hunt” in India have not done very well, but people who have tried to do “farming” in India, have tended to do a lot better.

We do a lot of real estate-related structured credit. We have done a few things in distressed and we think in the next five to seven years this will be a great play. We tend to play mostly in private equity and structured credit. And we like to build businesses.

Warren Buffett said that it’s difficult for people to copy him because they don’t want to get rich slowly. If you have a 15-year view you can do things which are very sensible yet very attractive financially. Look at the Forbes billionaires. They have all created wealth out of building businesses over long periods of time. I believe an equity-linked mindset is a very good way to play in India.

Knowledge@Wharton: What are the biggest risks that you see as a private equity investor? Are there areas that you try to keep away from?

Dalmia: One, we tend to be very bottom-up. We’ve concentrated in niche-consumer and consumer proxies. We’ve done a whole bunch of financials — consumer-related financials, SME-related financials. We’ve stayed away from wholesale financials because leveraged play on wholesale lending in India has not been that attractive.

Two, we keep risks low. We do what we understand: primarily equity, a mix of private and public, together with structured credit. Technology is very attractive, but [it has] too much adrenaline and is outside our core competence, so we’re more a limited partner in funds. Infrastructure development used to be a flavor of the month. For us, there was too much flavor, so we stayed away. On the other side, we’ve played with infra-annuities and some rental yield to keep ourselves safe, yet inflation protected.

Three, the Rothschild family had a mantra: buy to the sound of canons, sell to the sound of violins. We have learned to be independent minded and counter-cyclical.

Knowledge@Wharton: You come from one of the well-known business families in India. When you think back on your leadership journey, what are some of the most enduring lessons you learned from your family at a young age that have stayed with you over time?

Dalmia: My grandfather moved from a small town called Chirawa, in the western state of Rajasthan, to Delhi to do business. That’s akin to me moving today from Delhi to San Francisco. These are the kinds of risks people took. At that time, people were not rough-elbowed. Everyone would work together. They would co-operate. The lessons we have learned are that there’s enough for everyone and it is up to you to make your future whether it’s relocating from Chirawa to Delhi or from Delhi to San Francisco. You are your own boss in that sense. It’s an intense sense of agency.

In terms of leadership, what we have learned is also a function of our own age and our own evolution. When I was young, I thought talent and domain knowledge was what would take me forward. At that age, it was probably correct. A few years later I asked myself: “Okay, building a team is now the new game. Your talent and your domain knowledge, that’s good enough but that’s gone. Let’s go to the next variable.” So we kept moving up the curve. Next was: Do we have strategic insight? Can we create stretch goals for our own organizations? Our next leadership challenge, as Jim Collins phrased very well: “The ultimate test of leadership is – do you have humility and, at the same time, do you have indomitable will?” These seem contradictory but are complementary. That’s where we are today. Warren Buffett says that he is a better investor because he is also a businessman, and he is a better businessman because he’s also an investor. In some ways, we are trying to emulate this.

I’ll end with a philosophical point. In the ancient Indian epic, The Mahabharata, there’s a guru called Dronacharya. His students are from the royal family. One of the lessons Dronacharya teaches his students is that they should never lie. A few weeks later, he asks his favorite student Yudhisthira if he has understood that lesson. Yudhisthira says “no.” Dronacharya looks at him and says, “It’s so simple. Don’t lie.” This goes on a few times. Every time Dronacharya asks him if he has learned the lesson, Yudhisthira says he hasn’t. Dronacharya is exasperated and asks, “Why haven’t you learned it?” Yudhisthira replies: “I’ve never been tempted to lie, so how do I know that you don’t have to lie? Only when I’m tempted and I don’t lie, that’s when I will know I have learned the lesson.” I think our leadership journey evolves as we get challenged in life. We are in that process.

Knowledge@Wharton: If you were to reflect over the course of your career, what is the biggest leadership challenge you have ever faced? How did you deal with it and what did you learn from it?

Dalmia: I’m a third-generation businessman. We’re told the odds are against us. There’s a saying, more pertinent to kings, but it could be applicable to business families also: “If you can keep your head on your shoulders for three generations, you’ll build an empire. But if you can keep your head on your shoulders for five generations, you’ll build a dynasty.” Needless to say, we all aspire not just to an empire but a dynasty.

About 15 years ago, I was having lunch with a friend, Anshu Jain, who went on to become co-CEO of Deutsche Bank. He made an observation about prominent business inheritors. He said, “The problem with you guys is that if you underperform to your potential, you’ll still do okay.” I heard that, and I said, “I don’t want to just do okay. I want to do better than okay.” We have consciously tried to minimize the risk of complacency.

We’ve had to evolve over the last 25 years. When I came into business, operating skills were the pre-determinants of success. Is your quality good? Is your brand and distribution good? Very quickly those became redundant because everybody had it. Then we had to move to strategy. Can you create barriers to entry? Are you good at capital allocation? Are you taking advantage of the financial markets? In 15 years, that edge also went away. The next game, which is our current game, is culture. Can we move fast enough? Can we create a cohesive team in a turbulent world? So, we’ve had to learn and unlearn a lot of these things. To me, that would be the greatest challenge: just staying in the game.

Knowledge@Wharton: How do you define success?

Dalmia: I think of success as a close friend. You meet him off and on. In other words, sometimes you’re successful, sometimes you are not. But he is always around. Even if you’re not successful in an endeavor, he’ll meet you again soon. That’s the philosophical approach we take to success.

You can break this up into many parts. One is material, whether it is money or market share. That’s the material aspect of success. You’ve got to be able to crack a certain level. It’s a way of keeping score. I joke with our kids: money is far more interesting than anything it buys. Second, it is character, to the extent that you believe character is destiny. Third, I think success is a dancing spirit. Somebody tweeted the other day: “I don’t know where the limits are, but I would like to go there.” If you have a dancing spirit you will test your limits and you will hopefully exceed your limits. Fourth, you’re self-actualizing. You’re meeting your higher order needs. That’s success. Fifth, I think a peer group evaluation is success. The Nobel Prize is given through peer review. You have to be able to test yourself through your peers.

And lastly, I will quote Warren Buffett. Somebody asked him: “What is success?” And he said: “Well, people you care about — if they love you back, then you’re successful.” I think this is the ultimate test, and on this one, I’ll do very well.

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