Private equity funds will need to explore diverse exit avenues beyond public listings for their portfolio investments
Private equity has come into its own in India over the past six years. The funds raised by corporate India from private equity investors (over Rs.250,000 crore in total) have been over 60 per cent higher than funds raised from the capital markets (around Rs.150,000 crore).
Against this backdrop, one would expect that sophisticated overseas financial investors, from the community of foreign “Limited Partners” or LPs, would be increasingly attracted to private equity investing in India.
Ironically, the last three years have witnessed significantly reduced funding for Indian private equity; substantially lower than the high point reached in 2008, just before the global financial crisis. By contrast, a similarly placed market such as China has not only recovered from the drop in funding during the financial crisis, but has roared back to historic highs in fund raising last year. Chinese private equity received incremental funding of around $25 billion in calendar 2011, a new record, while Indian private equity received closer to one-tenth of that amount in the same period. What explains the reduced interest in Indian private equity, and is this likely to change in the near future?
A key issue for LPs has been the reduced returns private equity funds have delivered in recent years. Private equity funds invested during the first-half of the 2000s were able to ride the rising wave of booming stock markets that offered excellent exit returns; a good proxy for evaluating typical returns to LPs is the performance of the Bombay Stock Exchange sensitive index, Sensex, over a four-and-a-half-year hold period that private equity funds typically tend to stay invested in companies.
Thus, funds invested in 2001 could have seen compounded returns of around 25 per cent from the Sensex in 2005; funds invested in 2002 would have fetched returns of around 40 per cent in 2006; and the 2003 vintage would have handsomely rewarded investors exiting in 2007 to the tune of 50 per cent return. But the tide turned thereafter, and returns in 2008 dropped to 15 per cent, and after climbing back to around 25 per cent in 2009, again dropped to 15 per cent in 2010, and further plunged to single digits in 2011.
LPs have, therefore, made hard-nosed decisions and opted to invest in other emerging markets such as China that have tended to reward investors better.
LPs have also been concerned about the “auction” phenomenon in India. With numerous private equity funds raised in the mid-2000s, on the back of the first wave of excitement and interest in the Indian growth story, better and more credible investment opportunities have tended to attract disproportionate interest, and private equity funds have often got into bidding wars to win such transactions; more so with funds that are nearing the end of their “commitment” period.
Savvy Indian promoters have exploited the situation, and secured a high price for the equity they are willing to part with. High entry prices automatically reduce the returns that are possible. It has also not been lost on LPs that the same phenomenon has impacted the public markets. Over 75 per cent of the equities listed in the previous three calendar years have typically been trading at below their offer prices, a reflection of the aggressive pricing adopted by promoters.
LPs have also grown increasingly impatient with the “governance deficit” they see in India. Well-publicised scandals in the Indian corporate sector apart, LPs have noted the continuing difficulty of doing business in India. The World Bank ranks India at 134 in a rating of 183 countries in its “Ease of doing business report”; even worse, India is ranked 182 out of 183 countries in terms of enforcing contracts.
The herd mentality in the mid-2000s, of LPs rushing into India to tap into the growth opportunities offered by a billion people strong economy growing at an annual GDP growth rate of around 8 per cent, has now been replaced by a much more cautious fraternity asking probing questions about the returns private equity funds have delivered.
Exits have been relatively few as compared to investments, and with low median ticket sizes, it is unclear whether there will be lucrative exit avenues for many of the portfolio investments of Indian private equity funds. With roughly four times as many private equity transactions as there have been public market listings over the last six years, private equity funds will need to explore diverse exit avenues beyond public listings for their portfolio investments, including secondary sales to other funds.
Finally, high profile movements of well regarded investment managers (‘ key persons' in private equity terminology) from established funds have tended to worry LPs who primarily buy into the teams investing their capital.
So, what can change going forward? It appears clear that across all the stages of investing, from deal sourcing to exits, private equity funds will need to demonstrate different and more refined capabilities than in the past.
Differentiated deal sourcing, with deal origination capabilities stemming from strong networks and ecosystems, will be highly valued by LPs. Better diligence and valuation discipline will become de rigueur for funds. Funds will also have to think long and hard about the strategic and operational value add they can bring to portfolio companies, moving beyond mere monitoring of financial metrics. And finally, private equity funds will need to be more innovative in charting appropriate exits for their investments, including avenues such as the proposed new SME exchanges, alternative markets, and perhaps secondary sales. Indeed, the big opportunity over the next 24 months in the Indian private equity landscape may well be secondary transactions, as funds raised between 2004 and 2007 come under pressure to liquidate their positions as they near the end of their fund lives.
DR. MUKUND GOVIND RAJAN
Managing Partner — Tata Opportunities Fund
(Views are personal)