The private equity industry in India has evolved over the past two decades from nascent levels to a size and sophistication that global investors find attractive. PE investors in the country also find it encouraging that more teams of professional managers are available than earlier to run the businesses they target. Outcomes at those companies are decidedly better when those managers have some equity skin in the game.
Yet, India’s PE industry faces hurdles such as the absence of a well-developed capital market that would allow firms to leverage their equity with borrowings and thus put more money to work in the businesses they target. Regulatory obstacles and sudden changes to government policies are also common, and PE investors have learned to anticipate those. They also have the occasional brush with opacity or integrity issues with the existing managements at some of their target firms. A panel of executives heading the Indian arms of global of PE investment firms discussed those and other trends at the Wharton India Economic Forum held in early January in Mumbai, adding that they shared those views in their personal capacity, and not on behalf of their companies.
“The PE industry in India is maturing, but there is still plenty of room to grow,” said Vinay Nair, founder and chairman of 55ip, an investment services firm that counsels financial advisors and wealth managers on asset allocation strategies. Nair, who moderated the panel discussion, is also a visiting professor at Wharton and at the MIT Sloan School of Management, and an advisor to venture capital funds and fintech companies. He said that in 2004, when he started teaching a private equity class at Wharton, PE investments in India were under $2 billion annually, but have since grown to about $30 billion currently.
Over the last two decades, the PE industry in India has evolved to granular levels where investments can be segregated as seed capital, venture capital, growth private equity or buyouts, according to Shweta Jalan, managing director overseeing the India operations of Boston-based PE investment firm Advent International. As a “fast-growing emerging economy, India offers big opportunities for PE investments,” she noted. The market niche for buyouts of entire firms, in particular, has expanded in the last five-six years, with “control transactions,” where investors want to have a say in the management of their target firms, she said.
Amit Dixit, senior managing director and head of private equity at Blackstone India, identified three broad trends in India’s PE industry. One, deal sizes are getting bigger, he said, while acknowledging that he might be biased because his New York-headquartered firm tends to focus on relatively large transactions. “When we started in India 12 to 13 years back, it was rare to find a deal of $100 dollars or more,” he said. However, today, deals of $100 million each account for more than 70% of the total value of transactions, and 25% of those by volume, he added.
Second, Dixit saw a surge in India in control-oriented transactions, and noted they account for about a fifth of the total market by value. “What’s driving that is many of the founders of businesses, or first-generation families, don’t have succession plans in place, or their children are not willing or capable to take over the businesses,” he said. That setting opens up opportunities for professional owner-managers to buy those businesses.
Alongside, Indian companies have faced significant pressure in recent years to deliver decent returns on equity and reduce debt overhang, forcing them to shed non-core assets. “Even the largest conglomerates in India are focusing on the core and divesting non-core assets,” Dixit said. “That makes private equity the logical owner of the non-core assets they want to shed. Those two underlying drivers are making the market quite active for control transactions.”
The third trend in India’s PE industry is that while it is not as competitive as, say, the U.S. or China, it is “a well-discovered market,” Dixit noted. “It’s rare now that you would buy low or sell high. You may get lucky once in a while, but chances are you may have to buy somewhat at a reasonable price and sell also somewhat at a reasonable price.” He noted that prior to 2007, India was “a classic stock pickers market,” and that the price-to-earnings ratio was below 10 for many listed companies. “Now you rarely see that.”
A Growing Community
That narrower price arbitrage window — thanks to more developed PE investing markets — could mean smaller returns for investors, unless they are able to significantly boost profits with better performance. “You have to have capability as a private equity firm to improve the profit performance of the company,” said Dixit. In order to achieve that, PE investors look to recruit people with the relevant operating backgrounds — not just investing backgrounds — to improve the EBITDA (earnings before interest, tax, depreciation and amortization) or the profit of the company.
“You are seeing a lot of operating talent now working with private equity firms, either at their companies or as operating partners or as executives-in-residence,” he added. “A huge community of private equity operators is emerging. We ourselves have a community of about 60 such operators whom we rely on when we take ownership of a company.”
Without doubt, PE investors place strong emphasis on the quality of the management teams they deploy to run the businesses in which they invest. “When we find professional teams who have entrepreneurial desire and the passion to build a business, we view it more as a partnership,” said Vishal Mahadevia, managing director of Warburg Pincus India.
“The hope is if the business does well, and we all do well, the team should make a ton of money,” said Mahadevia. “That is how we structure our deals with startups, with teams, and go out and buy businesses. We see so many more teams willing to do that in India than 10-15 years ago, when you wouldn’t even find a professional team willing to join a private equity-backed company because they figure it wouldn’t be in business very long.”
“The quality of the management team is the single biggest judgment call you have to make on the investment,” said Dixit. “Also, with the competition model, the same individual behaves very differently when they are a manager versus an owner. The owner behavior is what you want to drive and not the manager behavior. And the way you drive owner behavior is making them your partner and sharing your equity with them, which is a fundamental difference between a family ownership and a private equity ownership.”
According to Dixit, PE investors have created new sets of opportunities for talented managers that wouldn’t have existed in the earlier environment. “Value creation has been happening in India for the last 50 years by talented professionals, but they were working for families and had no equity in the game,” he said. “What’s changing now is we have come into the game. The talented management teams are not working for families; they would prefer to work for a professional owner who’s not only paying them a salary, but also sharing in the wealth created.”
In fact, the “most dramatic” change in India’s PE setting in the past decade has to do with “the quality of the entrepreneur,” said Mahadevia. He saw the emergence of “the professional entrepreneur,” who is typically “someone who’s been a professional manager in a conglomerate for many years and wants to go out, buy a business, or create and own a company,” but doesn’t have his or her own capital. “Private equity would back them, help them buy something, improve it, turn it around and then create a better company which is hopefully more valuable,” he said.
Mahadevia recalled that two decades ago, when private equity was in its inception in India, the public market was the only source of capital for entrepreneurs, and so most companies tended to be publicly listed. “For the first decade, we were investing in a private-equity type of transaction in an illiquid public company.” The evolution of the PE environment since then has led to larger-scale transactions and more control transactions. Going forward, he said the PE industry in India “needs a new ecosystem of entrepreneurs and managers whom we are able to back.”
The other big change has to do with “the value that we as investors ascribe to quality of governance, quality of entrepreneurs and the kind of people we partner with,” said Manas Tandon, managing director and head of India operations at Partners Group, a global private equity investment firm based in Baar, Switzerland. “Almost invariably, you see high-quality businesses and high-quality entrepreneurs being funded now.”
Nair noted that those trends “are largely consistent with the maturity of an evolving private equity industry.” In addition to PE investors executing more transactions where they gain management control of their target firms, there has also been a dispersion in the size of deals, making room beyond large deals for smaller deals, he said.
Uniquely Indian Challenges
Jalan added a note of caution to Tandon’s enthusiastic assessment of management quality at Indian PE targets. “It is a given that the governance is good, and integrity is high,” she said. “The one thing that is taken for granted in many other parts of the world is integrity of your partner, the promoter or the management team. In India, that is something you just have to double-check the day you sign the deal.”
It helps that private equity investors bring in safeguards with forensic auditors “who not only look at the numbers but even the quality of partners, their history, their history of partnerships, dealings with vendors, customers and their track record,” said Jalan. “We’ve had a bunch of very difficult learning experiences where companies have gone belly up or there have been huge integrity issues, which have resulted in loss of capital for the industry as a whole.”
At the same time, PE investors in the country face “structural constraints” such as the inability to raise debt and thereby boost the total amount of money they could deploy in their target firms, said Jalan. “Leverage is not available in India as it is in the West. We don’t get that advantage, so our money has to work doubly hard to make returns similar to what our peers do in the U.S.”
India’s regulatory mechanisms are among the structural challenges PE investors face, said Jalan. She referred to a 2006 deal where her firm Advent International and Temasek Holdings of Singapore, another private equity investor, bought a 34.37% equity stake in Crompton Greaves Consumer Electricals Ltd., a prominent Indian maker of fans, lights, pumps and other home appliances. They had bought that stake for Rs. 2,000 crores ($300 million) from Avantha Group, which belongs to the promoter group of Crompton Greaves, the Thapar family.
In the Crompton deal, Jalan said the investors had to secure approval from eight regulatory bodies. They included the Competition Commission of India, the Reserve Bank of India (India’s central bank), the Securities and Exchange Board of India (India’s capital markets regulator), the National Stock Exchange, and the courts, because it involved a demerger proposal at the parent company’s end. “You still have to navigate a lot of those hoops to get to do good transactions in India. It takes a long time for you to be able to get to the end game.”
Jalan saw imperfections also in price discovery in India. “At every point in time you feel valuations are high, and that is definitely a big challenge in the industry,” she said, although she acknowledged that such issues are common across geographies. Unrealistically high valuations happen to be a more acute challenge with respect to consumer goods companies, an area in which Advent International specializes, she added.
In addition to regulatory challenges, Tandon pointed to a Murphy’s Law type of a situation that PE investors have to face in India. He recalled saying to a colleague, “Anything that can go wrong will go wrong,” and his colleague’s response: “Twice.”
Tandon offered several examples. In October 2010, government restrictions crippled the microfinance industry and all but shut it down. Back then, microfinance had become controversial when several suicides in India’s Andhra Pradesh state were attributed to the difficulties borrowers faced in repaying high-interest loans.
The Andhra Pradesh government, egged on by local politicians, introduced a series of constraints, “basically telling everyone not to pay back their loans,” Tandon recalled. “[Until then], the microfinance business was on fire; it was the fastest growing in our portfolio. One day, all of a sudden, the Andhra Pradesh government came out with rules on microfinance that completely made the whole space untenable. It was the fastest mark-down we have seen.”
Six years later, another government move hurt especially small and midsized businesses with cascading effects across the economy, Tandon said. He referred to India’s demonetization of high-value currency notes in late 2016 that effectively put 86% of the currency out of circulation, severely hampering the cash economy with extensive ripple effects that are felt to this day. “Again, the industry went through the same churn and the same challenges [as with the microfinance meltdown], and many firms had trouble coming back up to speed. That is the challenge you have to live with in India. You have to believe that stuff will happen every once in a while, and really make it very hard, and you just have to be prepared.”
In the wake of the demonetization exercise, a mortgage finance company that Partners Group had invested in found itself in dire straits when its borrowers were unable to make payments. The episode also found Partners Group thinking up some creative solutions to cope with the crisis. “Many of the people we lent to were self-employed and get their revenues in cash — shopkeepers and small contractors,” Tandon said. “Our guys stood in lines with our customers, making sure that they would deposit money in the bank, so that their payments could get cleared when their EMIs (equated monthly installments) were due. So that is the level of planning you have to do when these challenges present themselves, which is reasonably frequently in India.”
India’s PE industry has a long distance to go if one compares it with its U.S. counterpart, according to the panel participants. For example, transaction velocity is much higher in the U.S. than in India, said Dixit. “[Private equity] transactions in the U.S. start and finish in 90 days, and the entire ecosystem is built around it,” he added. “There’s so much precedence that you don’t have to negotiate from first principles. It’s still not the case in India, where a lot of stuff is negotiated from first principles, and transactions take very long for a variety of issues.”
A lower degree of competition intensity is the second area where the Indian PE market is different from the U.S. market, said Dixit. Although it has improved in many ways, the PE industry in the country “is still not as productive a market [as in the U.S.] in terms of the people you deploy and the results they deliver in a given time frame.” For example, PE activity in the health care space is intense in the U.S., with some 20 firms actively investing in each of its different categories, such as health care services, pharmaceuticals, medical technology or biotechnology, and getting more granular within those sub-categories, he explained.
The source of PE capital is the third area where the Indian PE markets are different from those in, say other emerging markets like China. Nearly half the PE capital deployed in China is renminbi-denominated, but in India’s case, more than 95% of such funds are dollar-denominated, and are sourced from overseas investors, said Dixit. “The rupee capital is less than 5% of the market.”
Finding Returns Beyond the Challenges
On the positive side, the exciting aspect of doing PE deals in India is that they offer “the opportunity to grow and scale companies, taking advantage of extremely talented, world-class entrepreneurs,” said Mahadevia. He acknowledged that transaction velocity and structural deficiencies tug at the development of India’s PE industry, but he offered a piece of advice to cope with them. “One of the big differences [in India] is you need to have patience,” he said. “Everything does go wrong twice. You have to be patient through multiple cycles, as you build these companies. Over the next decade or two, private equity is going to be a fantastic asset class — for investors, for professionals, and more importantly for the folks that make us all smart, the entrepreneurs. So, I’m quite optimistic.”
Jalan agreed that PE investors who brace themselves for those hairpin bends in India’s regulatory system or other humps will do better than others. “Don’t expect it to be a smooth journey,” she said, “There will be lots of ups and downs.” She noted that her company faces similar obstacles with its fund in Latin America, another evolving PE market. “Whether it is currency demonetization or retrospective tax laws, those will be bumps along the journey, but that’s what makes it more exciting, and more fun for new entrants,” she told students and other audience members who may be considering a career in private equity in India. “In some ways, you will be building the industry from where it is to hopefully what would be a mature industry in 15 to 20 years.”
Tandon pointed to the ability to help create employment as another fulfilling aspect of doing PE deals in India. “A lot of private equity in India is about creating jobs and growing business,” he said. “They are not about [boosting] profitability by cutting costs; there is real growth. When you see businesses triple the number of employees over five or six years, it’s very gratifying, because there are very few careers that enable you to do that, and to see that from such a close distance.”
Another satisfying aspect for PE investors in India is when they leave their target firms in better shape than they were in before they made their investments. “Most businesses that we invest in don’t have the systems, the processes and the professional management necessary for growth,” Tandon said. “Just the ability to leave businesses five or six years later in much better shape, with systems, processes, and high-quality professional management teams, and say ‘I made a real difference to the way the business is run’ is gratifying, too.”