Private Equity-A pioneer for Sustainable Growth of India

Authors:Deepali Sharma & Sanchit Sawhney ,FMS

              

Introduction & History of Private Equity

The first PE fund was started way back in 1978 in USA by Kohlberg, Kravis and Roberts (KKR) which was based on the venture capital limited partnership model. The innovative PE model of western countries that was introduced to India got customized with time. The underlying logic on which the western PE model was based is the” inadequate or misallocated capital resulting in underperformance of businesses”. PE funds job is to search for such companies and to buy them with the purpose of providing cheap debt and institutional equity to the business and turn them around  by hiving off its unprofitable operations so as to resell the company to public at a higher price either directly (IPO) or indirectly (trade sale).Developing countries like India differ from the developed counterparts in terms of lacking the large, mature capital markets that not only provide PE funds their target firms, but also help them to attract foreign investors. In addition regulatory barriers in India further raised concerns for easy access to capital in scale resulting in undermined western model results. Indian businesses primarily controlled by families wherein the largest shareholders runs the firms as managers made any kind of disagreement between the two entities over the use of cash flow almost negligible forcing the PE Industry to adapt to Indian landscape by targeting unlisted firms that need capital to grow and expand.

KPMG Survey done in 2008 revealed the unique factor that differentiates India from other countries that is the requirement of overseas equity, corporate governance issues,  lower fund size, longer holding periods, above-market risk with higher expected returns. 

A Glance at the PE journey in India

Over the past decade PEs have adapted itself to Indian economy drawn by excellent growth opportunities in market-oriented environment in addition to increased number of entrepreneurs coming up constraint by lack of capital to expand their businesses as shown in the figure.

Figure above provides the snapshot of the performance of PE Industry in India.India has moved from the sixth position among the largest PE markets in the Asia-Pacific region (including Australia) in 2004 to the top spot by 2007 due to the macro fundamentals that suited the requirements of both PE investors and the Indian economy.

PE provided businesses with new source of capital, extensive network of connections and expertise in management. In return, Indian Businesses rewarded PE with exceptional returns with number of PE deals rapidly grew and reached the record levels in 2007 and 2008.The rapid takeoff of PE industry in India came to an end in second half of 2008 with the global financial crisis unfolded after US housing bubble collapsed that led to slowdown in global economy especially US and Europe. 

The 2007 Crisis & Impact

The impact of financial crisis started showing from the second half of 2008 when the euphoric results enjoyed by PEs in India have been mirrored by uncertainty in the financial world with the slowdown becoming more pronounced. As a result, PE in India witnessed a change majorly characterised by lower volumes and fewer exits due to the unwillingness of selling stakes at lower prices due to depressed market sentiments. However, India’s medium and long term potential remains intact backed by its strong domestic consumption that offers superior investment opportunity. By the second half of 2009 Indian economy bounced back. Private Equity in India has not recovered from recent financial downturn. Though fundraising fell by more than 70 percent in the first half of 2009 from its peak. Moreover, the credit crunch has made leveraging cost much more expensive. Thus, PE investors have  to play a more diligent & critical role.

Post Crisis

In 2010 Indian economy environment stabilized and price expectation become well below the peak in 2007 although comparatively high relative to developed markets, PE space regained strength in India. PE firms made 66 exits valued at US$2.1 billion in 2009 compared to 120 exits worth US$5.3 billion in 2010 according to financial research firm.Following Figure shows trends in PE investments with Deal both in terms of number & value in year 2011 signifying the rise of PE investments both in value & in number of deals from the Q4 of 2009 after the crisis.

Trends: Private Equity as a Pioneer for Sustainable growth

Sustainable Growth focuses on economic growth which is a necessary and crucial condition for poverty reduction. For growth to be sustained in the long run, it should be broad-based across sectors. Issues of structural transformation for economic diversification therefore take a front stage.  It should also be inclusive of the large part of the country’s labor force, where inclusiveness refers to equality of opportunity in terms of access to markets, resources and unbiased regulatory environment for businesses and individuals. Sustainability focuses on both the pace and pattern of growth.PE funds from around the globe are being lured by the enormous opportunities that are on offer in many sectors of the Indian economy. Factors that are boosting the inflow of PE funds:

• Sharp drop in stock market indices that have consequently resulted in a significant fall in stock offerings.

• Increase in interest rates that are making borrowings dearer, and tough Reserve Bank of India norms.

 Not surprisingly, most PE funds’ inflow into India has been in sectors that generally have a relatively long gestation period. According to IndusView, the real estate and infrastructure sectors accounted for 50 per cent of the total PE inflows in 2009.Still Private Equity has been successful in India, the main reason being dire need of their service much more than their money.  Companies in India have different reasons for wanting private capital depending on the type of company and what stage it is at, i.e. growing, seeking acquisitions, family owned, or a large corporate. For an example, first generation business builders look for private capital because they gain a considerable credibility and governance by having private equity representative on board. This in turn will help them while bidding for international contracts or attracting good talent.

The Indian Scenario-Inducing Sustainability

·   Aid the budding Entrepreneurs & act as partners than just fund providers:-In India where the situation is characterised by family-owned companies, 8000 companies listed on the stock exchanges, abundantly available capital, and yet a relative lack of liquidity in the market means that private equity companies will need to position themselves as partners than just fund providers if they are to become the preferred source of investment capital. These companies expect private equity firms to be able to add value, as required, in strategic, operational and human capital matters in addition to their financial contribution.

·    Labour Diligence:-Another issue addressed by private equity firms is due diligence. Much of the time spent on “demand diligence” is mostly irrelevant as companies already know there is enough demand and important question is whether the management can actually deliver or not. And to find out the answer they need to spend time on the shop floor for what can be called “labour diligence”. Most of the family-owned businesses have boards consisted almost exclusively of family members and friends. Private equity firms recognise the importance of finding outside directors who can provide the knowledge, environmental local expertise and experience necessary to help steer a company   through its next stage of growth or towards a public offering. For many companies, the board meeting is purely about compliance and the real debate and decision-making happens outside the meeting. Adjusting to a more rigorous style of board meeting can be extremely difficult for such companies. Private equity firms often play a strong influencing role in helping companies attract talent, commissioning search activity, and helping promoters to interview and assess talent & leadership.

·   Infrastructure/Real Estate & SEZ’z:-The Planning Commission estimates that India needs an additional $500bn over the next five years itself to finance infrastructure. Under the growing power and effect of global capitalists over third world nations like India, where the state has become an easy tool to facilitate these activities - huge investment for both industrial and non-industrial purpose from national and foreign investors are allowed. Land acquisitions are one aspect that draws a lot of controversial aspects related with question of national interest versus community interest. One of the decisive factors of fast growth of corporate sector is the impact of economic policies of liberalisation that have undergone a sea change in the two decades, starting from 1991. The underlying theory is to have a minimal reliability on state and more on market forces. PE has contributed by investing in such sectors & making them economically feasible in the interest of the nation. PE plays a key role critical growth driving sectors of the economy, As per Delloite Report the various sector wise requirements from PE are as follows:

Road ahead :

The Securities & Exchange Board of India(SEBI)  proposed new takeover rules that will make acquisitions by Indian companies easy and scrap the non-compete fee. The minimum holding requirement to trigger an offer to minority holders has been increased to 25% from 15% for a company. Once that level is reached, the acquirer must offer to buy 26% up from 20% now.

Implications-This move by the SEBI is in the right direction as it will lead to more participation from PE players both in terms of value and size of the deals and will also give the opportunity to increase their stakes in existing portfolio companies. This draft, if implemented, will also ease the difficulties faced by the listed companies due to 15% barrier for open offer. In Japan, the trigger for an open offer is 33.3 per cent, while in Hong Kong it is 30 per cent and in Singapore it is 29.99 per cent. In all three, the trigger requires an acquirer to make an offer for the entire company. The Achuthan Committee on Takeover Regulations had recommended that an open offer ought to be for all the shares (100 per cent) of the target company to ensure equality of opportunity and fair treatment of all shareholders no matter if they are big and small.On SEBI abolishing non-compete fees, companies woul d split the total pricing consideration (deal size) into a non-compete fee portion too so that the acquirer spent less on the total transaction cost. The fact is very often people with a considerable stake in a company signify some extra value for the acquirer ,that person could be a technology innovator, a progressive leader and/or manager with in depth understanding of the business and the environment, etc. A control premium/non-compete fee is often recognition of this reality. With non-compete fees abolished, what is likely to happen is that promoters may look to issue different classes of shares a practice that is legal in India, but almost never followed – to ensure a premium.The reduction of open offer size from 100 per cent to 26 per cent and scrapping of non-compete fees is a welcome balancing act.

Conclusion

Private Equity provides a unique edge so as to result in sustainable development of India. As per  Delloite survey various parameters that make PE a reliable companion for funding are shown :

To conclude the discussion, PE investments are not only a source of funds but also play the bigger role of the partner in taking the India’s companies to next level in terms of good governance, building capable executive teams, improving organisational capability, enhancing evaluations, creating liquidity and global competence. Private equity is developing into a major player in the Indian economy and there is a growing perception among Indian companies that private equity firms can add value on several fronts. With more and more companies setting up local offices and teams which work at the ground level, this industry will continue to be successful in the years to come.