Report on Private Equity
sandeep arora hisar...
A Report on “Private equity: way to Indian markets” Submitted by: sandeep arora 07MBA142 In partial fulfillment of the requirements of MBA program of Institute of technology and management
Submitted To: Prof Vivek Bhatia Faculty Guide
TABLE OF CONTENTS Acknowledgement …………………………………………………….....3 Abstract ..................................………..…………………………………..4 Objective ………………………………………………………………....6 Methodology……………………………………...………………………7 Understanding private equity Definition ………………………………………………………………...8 Industry size …………………………………………………………….11 Investment
Taxation issues …………………………………………………………15 Indian perspective ………………………………………………………16 SEBI’s concern …………………………………………………………17 Stages of PE investment in Indian scenario …………………………....18 Role’s played by private equity in Indian economy ……………………20 Role’s played by private equity in growth of Indian economy ……...…26 Some other roles ……………………………………………………..…27 PE capital is more than just money …………………………………….29 PE investments: Current Trends ………………………………………..31 Comparison with senior debt …………………………………………..36 Why PE firms choose India: Warburg & bharti’s case …………….…..38 References ……………………………………………………………..43
Acknowledgement I take this opportunity to express my profound and sincere gratitude to Prof. Vivek Bhatia (Faculty member) for his inputs and feedback in developing this project. His guidance, continued support, constructive criticism and suggestions helped invaluably in shaping the form and content of this report. This project I am sure will help me in understanding the global investment pattern and factors influencing it from a different dimension which is so very critical to be successful. I also acknowledge and thank with deep sense of gratitude, the staff of ITM-library for their constant support and invaluable suggestions right from the conception to the design and completion of the project.
ABSTRACT India has been witnessing dramatic shift in the size and composition of foreign investment inflows over the couple of years. Institutional investors in developed countries, for their portfolio diversification, are continuously seeking new destinations and innovative and alternative asset class. Private equity is one such investment avenue which is broadly defined as involved investment in equity linked to an asset that is not listed and therefore not publicly traded in the stock markets. At present private equity firms have invested even in listed companies, though the buyout by an investor occur through a negotiated process and these buyouts turnout to be hostile or friendly depending on whether the negotiation is with controlling interest or not. With increasing number of deals the subject becomes an important aspect of Indian economy as this could lead the Indian economy in either direction. The Bull Run by foreign companies in the private equity market has begun. The market position has revealed that there were entry barriers in this particular field because of the red tape restrictions on the ownership and other such factors which have made the entry of foreign players in the Indian market a cumbersome process. The present market scenario is transforming, as doors have been widened for foreign players to enter. Private equity investment in India first chased IT and outsourcing during their boom period, but now the opportunities are expanding in sectors such as pharmaceuticals and finance. The profits are expanding 20-30% annually drawing some big names to the industry. This situation demands a study to be conducted to figure out the success path for the firms entering and presently working in the industry and how these firms are finding and creating new economy to earn huge profits. The project would deal with understanding the role of private equity in India, analyzing their investment strategies, their particular strategies, by studying their entry strategies into Indian financial markets, regulatory norms in India and how it is beneficial of Indian companies. An attempt will also be made to understand their investment patterns. The project also includes the understanding of competitive
profile of different players in Private Equity in India and the different types of funding done by them in India like - seed funding, expansion capital, buyout financing, financing restructuring of companies and providing mezzanine capital. The project also includes the understanding of the Private Equity model of investments and analyzing the reason for investments in selective sectors. With India becoming a preferred investment destination, this heightened level of private equity activity is likely to continue for some time to come.
OBJECTIVE The objective of this project is to study the role of private equity in India, analyzing their investment strategies, their particular strategies, by studying their entry strategies into India financial markets, regulatory norms in India and how it is beneficial of Indian companies. An attempt will also be made to understand their investment patterns. The project would also deal with some of the major deals in India, this would help to understand the investment pattern and than the exit strategies of the PE firms. The project would also help to understand us what could be the scenario of the private equity investments in the near future, and comparison of the Indian scenario with rest of the world.
METHODOLOGY Study would be mainly focused on the analysis and use of secondary data. Extensive use of Cygnus, various journals, magazines and different online resources would be used to construct the investment pattern. The entry strategies of the Private Equity firms with respect to the legal structure will be understood. Various surveys and data sources would be used to figure out the current investments in the economy. Study would not be limited to the study only, but analysis of various deals and the pattern of investment would also be done. It would also include various regulatory norms for the private equity investment in India and the benefits and hazards of PE over public equity.
UNDERSTANDING PRIVATE EQUITY Definition Private equity is medium to long-term finance provided in return for an equity stake in potentially high growth unquoted companies. Some commentators use the term “private equity” to refer only to the buy-out and buy-in investment sector. Others, in Europe but not the USA, use the term “venture capital” to cover all stages, i.e. synonymous with “private equity”. In the USA “venture capital” refers only to investments in early stage and expanding companies. To avoid confusion, the term “private equity” is used throughout this Guide to describe the industry as a whole, encompassing both “venture capital” (the seed to expansion stages of investment) and management buy-outs and buy-ins.
What is private equity? Private equity provides long-term, committed share capital, to help unquoted companies grow and succeed. If you are looking to start up, expand, buy into a business, buy out a division of your parent company, turnaround or revitalize a company, private equity could help you to do this. Obtaining private equity is very different from raising debt or a loan from a lender, such as a bank. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of your success or failure. Private equity is invested in exchange for a stake in your company and, as shareholders; the investors’ returns are dependent on the growth and profitability of your business. The Private Equity sector is broadly defined as investing in a company through a negotiated process. Investments typically involve a transformational, valueadded, active management strategy. Private Equity investments can be divided into the following categories: •
Venture capital: an investment to create a new company, or expand a smaller company that has undeveloped or developing revenues
Buy-out: acquisition of a significant portion or a majority control in a more mature company. The acquisition normally entails a change of ownership
Special situation: investments in a distressed company, or a company where value can be unlocked as a result of a one-time opportunity (Changing industry trends, government regulations etc.)
Private equity firms generally receive a return on their investments through one of three ways: an IPO, a sale or merger of the company they control, or a recapitalization. Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool. Considerations for investing in private equity funds relative to other forms of investment include: •
Substantial entry costs, with most private equity funds requiring significant initial investment (usually upwards of $1,000,000) plus further investment for the first few years of the fund.
Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as "illiquid" investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to gain access to your money as it is lockedup in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.
If a private equity firm can't find good investment opportunities, it will not draw on an investor's commitment. Given the risks associated with private equity investments, an investor can lose all of its investment if the fund invests in failing companies. The risk of loss of capital is typically higher in venture capital funds, which invest in companies during the earliest phases of their development, and lower in mezzanine capital funds, which provide interim investments to companies which have already proven their viability but have yet to raise money from public markets.
Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.
For the above mentioned reasons, private equity fund investment is for those who can afford to have their capital locked in for long periods of time and who are able to risk losing significant amounts of money. This is balanced by the potential benefits of annual returns which range up to 30% for successful funds. Private Equity investments can be classified into: •
Seed stage Financing provided to research, assess and develop an initial concept before a business has reached the start-up phase
Start-up stage Financing for product development and initial marketing.
Expansion stage Financing for growth and expansion of a company which is breaking even or trading profitably.
Replacement capital Purchase of shares from another investor or to reduce gearing via the refinancing of debt.
The above stages can be explained by the diagram which is shown below -:
INDUSTRY SIZE Nearly $135 billion of private equity was invested globally in 2005, up a fifth on the previous year due to a rise in buyouts as market confidence and trading conditions improved. Buyouts have generated a growing portion of private equity investments by value, and increased their share of investments from a fifth to more than two-thirds between 2000 and 2005. By contrast, the share of early stage or venture capital investment has declined during this period. Private equity fund raising also surpassed prior years in 2005 and totaled $232 billion, up three-quarters on 2004. Prior to this, after reaching a peak in 2000, private equity investments and funds raised fell in the next couple of years due to the slowdown in the global economy and declines in equity markets, particularly in the technology sector. The fall in funds raised between 2001 and 2003 was also due to a large excess created by the end of 2000 of funds raised over funds invested. The biggest fund type in terms of commitments garnered was buyout, with 188 funds raising an aggregate $212 billion. So-called mega buyout funds contributed a significant proportion of this amount, with the ten largest funds of 2006 raising $101 billion alone—23% of the global total for 2006. Other strong performers included real estate funds, which grew 30% from already strong 2005 levels, raising an aggregate $63 billion globally. The only fund type to not perform so well was venture, which saw a drop of 10% from 2005 levels. The regional breakdown of private equity activity shows that in 2005, •
North America accounted for 40% of global private equity investments (down from 68% in 2000) and 52% of funds rose (down from 69%).
Between 2000 and 2005, Europe increased its share of investments (from 17% to 43%) and funds raised (from 17% to 38%).
This was largely a result of strong buyout market activity in Europe.
Asia-Pacific region’s share of investments increased from 6% to 11% during this period while its share of funds raised remained unchanged at around 8%.
The biggest fund type in terms of commitments garnered was buyout, with 188 funds raising an aggregate $212 billion. So-called mega buyout funds contributed a significant proportion of this amount, with the ten largest funds of 2006 raising $101 billion alone—23% of the global total for 2006. Other strong performers included real estate funds, which grew 30% from already strong 2005 levels, raising an aggregate $63 billion globally. The only fund type to not perform so well was venture, which saw a drop of 10% from 2005 levels. In terms of the regional split of fundraising, the majority of funds raised in 2006 were focusing on the American market, with 62% of capital raised in 2006 focusing on the US. European focused funds account for 26% of the global total, whilst funds focusing on Asia and the Rest of World account for the remaining 11%. An Interesting aspect of private equity is the Private Equity Secondary Market. The private equity secondary market (also often called private equity secondary or secondaries) refers to the buying and selling of pre-existing investor commitments to private equity and other alternative investment funds. Sellers of private equity investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds. By its nature, the private equity asset class is illiquid, intended to be a long-term investment for buy-and-hold investors. For the vast majority of private equity investments, there is no listed public market; however there is a robust and maturing secondary market available for sellers of private equity assets. Driven by strong demand for private equity exposure, a significant amount of capital has been committed to dedicated secondary market funds from investors looking to increase and diversify their private equity exposure.
INVESTMENT PATTERNS OF PRIVATE EQUITY FUNDS Private equity fundraising Private equity fundraising refers to the action of private equity firms seeking capital from investors for their funds. Typically an investor will invest in a specific fund managed by a firm, becoming a limited partner in the fund, rather than an investor in the firm itself. As a result, an investor will only benefit from investments made by a firm where the investment is made from the specific fund that they have invested in. The majority of investment into private equity funds comes from institutional investors. The most prolific investors into private equity funds in 2006 were public pension funds and banks and financial institutions, which together provided 40% of all commitments made globally according to data from London-based Private Equity Intelligence Ltd. Other prominent groups investing in private equity include corporate pension plans, insurance companies, endowments, family offices, and foundations. Another large investor group in private equity funds is so-called fund of funds, which are private equity funds that invest in other private equity funds in order to provide investors with a lower risk product through exposure to a large number of vehicles often of different type and regional focus. Fund of funds accounted for 14% of global commitments made to private equity funds in 2006 according to Private Equity Intelligence Ltd. As fundraising has grown over the past few years, so too has the number of investors in the average fund. In 2004 there were 26 investors in the average private equity fund; this figure has now grown to 42 according to Private Equity Intelligence Ltd. It is also worth noting that the managers of private equity funds themselves will also invest in their own vehicles, typically providing between 1–5% of the overall capital. Often private equity fund managers will employ the services of external fundraising teams known as placement agents in order to raise capital for their vehicles.
The use of placement agents has grown over the past few years, with 40% of funds closed in 2006 employing their services according to Private Equity Intelligence Ltd. Placement agents will approach potential investors on behalf of the fund manager, and will typically take a fee of around 1% of the commitments that they are able to garner. The amount of time that a private equity firm spends raising capital varies depending on the level of interest amongst investors for the fund, which is defined by current market conditions and also the track record of previous funds raised by the firm in question. Firms can spend as little as one or two months raising capital where they are able to reach the target that they set for their funds relatively easily, often through gaining commitments from existing investors in their previous funds, or where strong past performance leads to strong levels of investor interest. Other managers may find fundraising taking considerably longer, with managers of less popular fund types (such as European venture fund managers in the current climate) finding the fundraising process more tough. It is not unheard of for funds to spend as long as two years on the road seeking capital, although the majority of fund managers will complete fundraising within nine months to fifteen months. Once a fund has reached its fundraising target, it will have a final close. After this point it is not normally possible for a new investor to invest in the fund, unless they were to purchase an interest in the fund on the secondaries market.
TAXATION ISSUES The most contentious issue is that of taxing these Private equity Funds. Private equity funds and hedge funds are private investment vehicles used to pool investment capital, generally for a small group of large institutional or wealthy individual investors. They are subject to favorable regulatory treatment in the United States, which allows them to engage in financial activities that are off-limits for more regulated companies. Both types of companies also take advantage of generally applicable rules in the U.S. Internal Revenue Code to minimize the tax burden on their investors, as well as on the fund managers. As media coverage increases in the United States regarding the growing influence of hedge funds and private equity, these tax rules are increasingly under scrutiny by members of Congress. Private equity and hedge funds choose their structure depending on the individual circumstances of the investors the fund is designed to attract, as discussed below:
Basic Structure: U.S. Domestic Fund A private equity or hedge fund located in the United States will typically be structured as a limited partnership, due to the lack of an entity-level tax on partnerships and other flow-through entities under the U.S. tax system. The limited partners will be the institutional and individual investors. The general partner will be an affiliate of the manager of the fund. Typically, the manager of the hedge fund is compensated with a fee based on 2% of the gross assets of the fund, and a profits interest entitling the manager (or, more typically, its affiliated general partner) to 20% of the fund's return (subject to minimum guaranteed returns for the limited partners).
PRIVATE EQUITY INVESTMENTS IN INDIA- A PERSPECTIVE The Indian stock markets witnessed tumultuous times during the years 1999-2000. There was continuous surge in the stock markets and in 2001, the king pin of these surges, Ketan Parekh was arrested and put out of action by SEBI. Back then, there were over 20 companies that had either planned or made allotment of shares during this period through modes such as preferential and private placements of equity. While preferential allotment was seen in companies where the promoters' stake is low, the private placement was made to companies (in the form of strategic investment), mutual funds, FIIs, or high net worth individuals. Between 1999 and 2000, when the market was in its infancy, around Rs 6,000 crores were raised by private placement of equities. Some of the big deals during these periods were: •
HFCL (Rs 735 crores at Rs 1,050 per share and Rs 1,039 crores at Rs 1,450 per share),
Zee Telefilms (Rs 800 crores at Rs 1,000 per share),
Pentasoft Technologies (Rs 798 crores at Rs 798 per share)
Trigyn Technologies (Rs 606.38 crores at Rs 825 per share).
SEBI Concerns: Between the years 2000 and 2007, a lot of water has flown under the bridge and there have been many calls to call in for greater regulation of these funds and their target companies in India because: •
The securities issued by companies through the private placement route get listed and traded on the stock exchanges after allotment, just like a public issues.
In turn, they are bought by all kind of investors, including the retail, through the secondary market. Therefore, this way the transaction in them is at par with the securities issued through the public issue. 16
The difference between the two is on the disclosure. In the case of public issue, the disclosure is broad and the companies are mandated to inform their shareholders through public announcement and annual reports about the utilization of the funds raised. In the case of private placement, the disclosure is bare minimum. For instance, the companies are not required to inform the utilization of funds raised through the private placement.
India and Private Equity Investments India has been on the radar for many Private Equity firms(also known as PE firms in common parlance). Primary factors attracting these funds in India being a vibrant market and democracy which fosters entrepreneurship as well as new firms. It is these new firms which know the target market very well who form the basis for new investment by all Private Equity Firms across the words. PE(Private Equity) has come a long way from providing fuel (funds) to the fiery growth of India Inc. It helps investor companies with a whole host of activities — from forging strategic alliances to assisting in corporate governance, from providing management advice to budgeting.To gauge the activities of these firms as well as their investment patterns in India, the following study has been undertaken by me: Analyze the performance of companies receiving PE funding. I did this by tracking deals concluded before January ’07, since it’s too early to comment on companies that received money in ’07. I am in the process of analyzing data for approximately 100 listed companies, spread across sectors like gems and jewellery, tea, shipping, aviation, edible oil and garments, to name a few. I intend to compare the performance of companies receiving PE funds with those of their peers in the corresponding Economic Times sectoral indices that did not get any such funds. On an average, a preliminary analysis of the Private Equity funding in new, virgin indutrsies and companies concludes some basic, yet vital and important points: It is observed that by and large, companies which received funding seemed to do much better than their peers on the following parameters — profitability, cash profits, sales and investor returns. There were some intangible benefits too, such as greater recognition and increased media attention.
The Stages of PE Investment in Indian Scenario 1996-1997 - Beginning of PE activity in India: The Indian private equity (PE) market roughly started in 1996-1997 and it scaled new heights in 2000 primarily because of the success demonstrated by India in assisting with Y2K related issues as well as the overall boom in the Information Technology (IT), Telecom and the Internet sectors, which allowed global business interactions to become much easier. In fact, the total value of such deals done in India in 2000 was $1.16 billion and the average deal size was approximately US $4.14 million. 2001-2003 - PE becomes risk averse and activity declines: Not surprisingly, the investing in India came “crashing down” when NASDAQ lost 60% of its value during the second quarter of 2000 and other public markets (including those in India) also declined substantially. Consequently, during 2001-2003, the PEs started investing less money and in more mature companies in an effort to minimize the risks. For example: (a) The average deal size more than doubled from $4.14 million in 2000 to $8.52 million in 2001 (b) The number of early-stage deals fell sharply from 142 in 2000 to 36 in 2001 (c) Late-stage deals and Private Investments in Public Equity (PIPEs) declined from 138 in 2000 to 74 in 2001, and (d) Investments in Internet-related companies fell from $576 million in 2000 to $49 million in 2001.This decline broadly continued until 2003. 2004 onwards - Renewed investor interest and activity: Since India’s economy has been growing at 7%-8% a year, and since some sectors, including the services sector and the high-end manufacturing sector, have been growing at 12%-14% a year, investors renewed their interest and started investing again in 2004. As Figure 1
shows, the number of deals and the total dollars invested in India has been increasing substantially. For example, US $1.65 billion in investments were made in 2004 surpassing the $1.16 billion in 2000 by almost 42%. These investments reached US $2.2 billion in 2005, and during the first half of 2006, PE firms have already invested $3.48 billion (excluding debt financing). We forecast that the total investment in 2006 is likely to be $6.3 billion, a number that is more than five times the amount invested in 2000. PE investment expands beyond IT and ITES: A very important feature of the resurgence in the PE activity in India since 2004 has been that the PEs are no longer focusing only on the IT and the ITES (IT Enabled Services, commonly known as “Business Process Outsourcing” or BPO) sectors. This is partly because the growth in the Indian economy is no longer limited to the IT sector but is now spreading more evenly to sectors such as bio-technology and pharmaceuticals; healthcare and medical tourism; auto-components; travel and tourism; retail; textiles; real estate and infrastructure; entertainment and media; and gems and jewellery. Figure 2 shows the division across various sectors with respect to the number of deals in India in 2000, 2003 and the first half of 2006. Percentage of the number of deals by PEs in various sectors Sectors IT & ITES Financial Services Manufacturing Medical & Healthcare Others Total
2000 65.5 3.13 3.0 2. 25.2 100
2003 49.1 12.3 1.8 7.0 29.8 100
2006(Q1&Q2) 23.18 9.7 19.3 8.3 37.9 100
Important roles played by PE in the growth of Indian Economy “Private Equity in India: Adding Human Capital to the Value-Creation “ If you are a global company and India is not part of your plan, then you have missed the bus…..said by - Dr. Manmohan Singh, Prime Minister of India In the days before economic liberalization, it was just established industrial houses such as Tata or Birla which had easy access to the capital markets and money resources largely on the basis of their pedigree. The investment environment has radically changed since then. A whole new breed of entrepreneurs now occupies front ranking positions in their respective fields. Many of the old business houses which had the foresight to embrace change, have restructured, re-focused and have flourished. The rest have withered into insignificance. And in their stead, many have emerged who could become future stars in manufacturing, technology or knowledge-based services. Indeed the investment environment is so attractive that investors are flocking to scores of funds, domestic and international, taking a heavy exposure on the future of these companies. Besides foreign institutional investors and mutual funds, private equity funds are also taking concentrated bets across companies and segments. Many India-dedicated funds have, and are, being set up to finance and to provide resources to the organizations as they know the potential of these organizations. And allocations in existing ones are being ramped up for corporate in south Asia, India and China. Draper Fisher recently announced plans for setting up a $200 million fund for startups. Timothy Draper, founder of Draper Fisher Jurveston, a Silicon Valley venture fund, on his first exploratory visit to the country in October went on record to say that he was adopting a contrarian approach. "Now that everyone's crowding in China I have to go someplace different. And that place is India." Draper is also contemplating to set up an office in India. Draper is well known for funding Sabeer Bhatia of Hotmail, the free internet e-mail service which was subsequently sold to Microsoft for over $400 million. There are several other PEs which are rushing to India. Unlike Draper, they are not contrarians but are willing to bet on the India growth story. Among them is west Bridge Capital Partners, a Mauritius based
company focusing on IT and BPO businesses and having offices in Silicon Valley and Bangalore. It recently procured subscriptions to its second India VC fund of $200 million. “One major draw in favour of India is the diversity of enterprises which span over virtually all sectors,” says Dhananjay Mungale a financial expert, who quit his high-profile job at DSP Merrill Lynch to set up his own advisory venture. The breadth of opportunity in India is much higher than places like Indonesia, Malaysia or Taiwan, he says. Many of the private equity funds tend to seek a place on the board and participate actively in laying down the policy framework to ensure quicker rise of the enterprise. This is especially helpful in case of new economy businesses where traditional assessment by investors may not get the same valuation as may be received from a private equity investor. Again this is helpful in case of an unlisted company. India’s private equity sector is moving to the big league. Fund sizes have increased dramatically from US $10 to US $25 million just a few years ago, to between US $400 million and US $1 billion today. The minimum deals now start at around US $25 million, eclipsing the average deal size of US $8 million in 2002. With the strong global interest in the Indian market continuing, the challenge is no longer about raising private equity funds, but how to extract value from the portfolio investments, turning the focus from ﬁnancial capital to human capital. During the ﬁrst half of ﬁscal year 2005-06, US$7.96 billion of foreign direct investment (FDI) poured into India — more than triple the FDI in the corresponding period a year before. This is set to explode further, with sweeping reforms by the Indian government to loosen restrictions on FDI across various sectors, which will lead to more international corporations and ﬁnancial investors entering the Indian market. Examples include the retail sector, where 51 percent FDI is now allowed in single brand products; the telecoms services sector, where the FDI limit has been raised from 49 percent to 74 percent; and selected infrastructure sectors, such as the development of new airports, laying of natural gas pipelines, petroleum infrastructure, captive mining of coal and lignite, mining of diamonds and precious stones, as well as the development of townships where complete foreign ownership is now welcome.
Role of Private Equity players Provides Fund irrespective of market conditions for – Expansion Capital
Acquisition Capital/Change of control Restructuring Businesses MBOs, Divestments, Consolidation Restructuring B/S Shoring up Promoter stakes Privatisation (Public to private)
To enable entrepreneurs achieve success that may otherwise have been beyond reach by providing resources over and above money. Money can be availed through any other form of funding. But, money alone can not catalyse the working of your organisation, thus along with the resources PE players also provides risk management tools ensuring high degree of success to the organisation. PE players also facilitate and promote building businesses and teams ensuring high standard of corporate governance. Success of PE Fund is dependent on success of the venture. PE funds make sure that their star entrepreneur are helped with all the resources and learning which can be mustered by the fund to help him realise his dream. The different major roles played by Private Equity players in the economy are as follows • Financial – Equity – Quasi Equity – Shareholder’s Loans – Guarantees • Managerial – Board inputs: Industry specialist Independent Directors – Investment professionals with experience & knowledge of building businesses • Networking – Global access to valuable group of people and skills • Fast track partnership.
The chart below shows the different roles played by Private Equity firms –:
Reasons for Private equity players entering into India The strong interest in India has resulted in very bullish stock market conditions, with trading volumes increasing substantially. This has eased exit possibilities, with most of the early domestic and foreign entrants such as Actis Partners, Warburg Pincus, Citigroup Venture Capital, Barings and West Bridge Capital reaping significant multiples on their investments. It is little wonder that other global private equity players such as 3i, Blackstone and Goldman Sachs have been setting up shop in India, each with deep pockets. The most of the private firms in India is still in the need of capital to expand them, in spite of having the required technology, labour and knowledge they are not able to become productive to the economy. Thus the advent of private equity players has provided an opportunity for these firms to grow with the economy. Private Equity players have came to India with a research back up and thus they know the potential of these firms and thus there has been reduction in the corpus amount invested in China than in India, which definitely gives a hunch where the Indian economy is booming.
How the Indian firms will perform will largely depends on their management How successful these firms will perform in the big league of high stakes private equity plays over the long run could depend heavily on one key factor — their teams of professionals. A recent global survey by McKinsey & Company revealed that Indian business leaders are much more optimistic about the future than their international peers are. Yet Indian business leaders see the high cost and low availability of talent as the single greatest constraint on their companies — it’s a problem that worries them much more than it does their counterparts around the world. Similarly, top on the agenda of India’s private equity firms is finding the right leadership teams to drive business. To date, private equity firms have focused on different stages of a portfolio company’s evolution, entering at an early stage with venture capital funds, later for growth capital, and even after listing as a Private Investment in Public Equity (PIPE) deal players emerging in the Indian market. Firms that focus on a few narrowly defined industry sectors are better positioned to build upon and translate their expertise into value-creation potential, transaction pricing, and higher potential returns over the long run. It is therefore no longer sufficient to look primarily at the skill sets and track records of investment professionals. Firms need to ensure that their executives think and act like owners, and will take active responsibility for the proper guidance of portfolio companies. We also envisage that more private equity ﬁrms will hire operating partners who become deeply involved in the management of buy-out investments and other portfolio companies. In many cases, private equity ﬁrms retain the incumbent management, preferring not to rock the boat when buying out a company. As seasoned managers with in-depth industry or functional expertise, operating partners act as sage counselors and critical advisors on operating, ﬁnancial, and strategic issues for the portfolio companies’ management teams. With a clear mandate to add value to an investment within a ﬁxed timeframe, they can adopt a less sentimental approach
and focus unﬂinchingly on results to make fast decisions and act rapidly where necessary. An alternative to hiring operating partners is to create management buy-in teams. Here, private equity ﬁrms enter into joint investments in speciﬁc portfolio companies with a small group of seasoned professionals who are looking for a new challenge, and who have the funds for a small co-investment amount as “sweat equity”. It has been shown that running the business as an owner inevitably helps unlock value. The beneﬁt of this joint management ownership program is that it instantly puts in place highly motivated owner executives to run the company from day one.
Reasons for Private Equity players being accepted in Indian Economy are – Another practice that private equity players in India have yet to actively adopt is to supplement executive teams in portfolio companies with a talented board of directors, who not only play an active role in formulating the company’s strategies but also use their network of relationships, contacts and managerial expertise to implement various strategic initiatives for the company — whether it is to tie up a joint venture, to acquire another company, or to diversify into a new area through a greenﬁeld project. These board members are expected to devote a signiﬁcant amount of time outside board meetings to contribute to the company’s growth and value creation. The private equity industry in India is at a key injection point. Investors the world over are increasing their allocations on India. The robust economy, supportive government, and recent industrial reforms could see several hundred billion dollars channeled to the newly opened infrastructure sector alone.
Role played by PE in the growth of Indian economy Since 2004, India has witnessed a tremendous rise in Private Equity financing. Indian companies are creating partnerships with PE firms on a scale that has not been witnessed before. Is this good for the Indian economy? What kind of value does this relatively new form of financing offer to Indian entrepreneurs?
Private Equity boosts the Indian economy 25
According to the Private Equity Impact study and research findings -
quantitative comparison of Private Equity- and Venture Capital-backed companies against their non Private Equity-backed peers and relevant market indices, in terms of key economic parameters like Sales, Profitability, Exports, Wages and Research & Development.
In accordance with the research reports and findings from the study: PE-backed companies grew at a significantly higher rate compared to non Private Equity backed companies as well as market indices like the Nifty and CNX Midcap.
Comparative Annual Sales Growth (2000-2006) 25.0%
10.0% 5.0% 0.0% PE-Backed Non PE
CNX CNX Pharma Midcap
Source: ICFAI reader august 2007 Wages at Private Equity-backed companies grew at a significantly higher rate compared to their peers who are not PE-backed. About 96% of top executives at Private Equity-backed companies believe that without Private Equity financing, their companies would not have existed or would have developed slower. More than 60% of top executives at Private Equity-backed companies said that the number of employees at their companies had increased after the PE investment.
Roles played by PE in the growth of Indian economy – PEs not only provides resources of funds to the new ventures but also focuses on identifying
and upgrading both product/process innovation and
management functions in accordance to the global economy. PEs plays a critical rule in the innovation process, not only as a source of finance to innovation but through other functions that lie at the core of high tech Development. PEs bridge between sources of finance, entrepreneurs, scientists, suppliers, and customers by providing not only the required sources of funds but also an added value of technologies and requirements. PEs typically also add value to their portfolio companies through assistance in strategic decisions in the day to day management of the firms. PE capitalists with technology & entrepreneurial background generate more value added than PEs with financial background
Some other important roles are 1.) Intermediation and Market Building - The enhanced access to business and advisory/consultancy services and to knowledge/technology that PE provide will contribute to the emergence of new markets in the global economy. Moreover PEs help enterprises global product and global capital markets. This is particularly important for SMEs and clusters wanting to expand the range of markets in which they would like to operate e.g new markets for intermediate inputs which the Globalization process is opening.
2.) Source of External Capabilities - PEs complement the capabilities of innovative SMEs, sometimes in those areas were entrepreneurs are less likely to be knowledgeable and capable e.g. export marketing; know whom, management, etc.
3.) Facilitating Complex Contracting - This is particularly so in relation to marketing agreements, alliances, strategic partnerships, M&A, etc—many of these critical for fast access to global product markets. A central condition for 27
success in many of these is prior experience which entrepreneurs frequently do not have. A PE sector may eventually have such capabilities and thereby have a strong impact on innovative enterprises quest to rapidly build global market share.
4.) Promoting International Links – It provides promotion and global links to the enterprise thus increasing the industry visibility of the firms to go for global expansion with the right partner.
5.) Supporting of the Global Expansion of Promising Innovative SMEs - The value roles of PE is to provide equity based (generally private) finance and support organizations could play important roles in promoting innovative SMEs and clusters in industrializing economies PE could become a pillar of the Knowledge Economy—by facilitating the provision of services to Innovative SME’s; by being a node of three overlapping networks; and because its capabilities are largely based on tacit knowledge. Moreover, by promoting SME they are promoting invention (and indirectly innovation and diffusion), self-organization and creation of new teams & tacit knowledge, and the continuous building of new markets. Interactive learning lies at the basis of these processes.
6.) Facilitate the Transition to a Learning Economy – Since the PE are learned and qualified investors, this could provide enterprise a new learning environment that constitute a key sector in the creation, diffusion and adaptation of tacit knowledge, codified knowledge and technology
Private Equity catalyzes innovation in the economy Research and Development (R&D) activity – that helps launch innovative products and services – is key to spurring economic demand. Lack of capital to invest
in R&D has long been a factor that has held back corporate India. Private Equity capital is helping address this issue. About thirty percent of top executives from Private Equity-backed companies surveyed said they utilized PE funding to invest in R&D initiatives. Private Equity-backed companies invest more in R&D activities compared to their non PE-backed counterparts. R&D investments by Private Equity-backed IT companies grew at almost twice that of CNX IT index companies.
Growth in R & D Spending 80% 60%
40% 20% 0% PE Backed IT Cos.
Source :ICFAI reader august 2007
Private Equity capital is more than just money Apart from providing capital, Private Equity investors provide strategic and operational guidance to the companies they invest in. A vast majority of top executives from the PE-backed companies felt that their Private Equity investors made far greater contributions than just provision of capital. Entrepreneurs cited strategic direction, financial advice, top management recruitment and marketing as the main areas where Private Equity fund managers add value. Private Equity firms are active investors and adopt a hands-on working relationship with their portfolio companies. Their strategic input is more than just financial monitoring. Eighty percent of the top management at PE-backed companies said they interact with their investors on a weekly or monthly basis.
Private Equity investments in 2006-2007 : Current trends Before moving to year 2006 let us see through the graph the Private Equity investment in India till 2005 -:
Private Equity Investments in India 2500
Amount (US$ Millions)
2000 1629 1500
500 20 80 0
2001 2002 2003 2004 2005
Private Equity firms invested a record $7,460 million over 299 deals in India during the 12 months ending December 2006. The amount invested during the year was over three times that during the previous year. (These figures exclude investments in real estate.)
Despite the headline grabbing mega deals, the bulk of the investments were in the sub $25 million category, with the maximum number of investments falling in the $10-25 million range.
By Industry Information Technology and IT-Enabled Services (IT & ITES) continued to remain the favorite industry among PE investors during 2006. Other industries that attracted significant PE investor attention during the year included Manufacturing, BFSI (Banking, Financial Services and Insurance), Healthcare & Life Sciences and Engineering & Construction.
By Stage Late-stage investments accounted for 36% of all deals while PIPEs (PE investments in listed companies) accounted for 22% of the deals. Early-stage investments accounted for about 20% of deals during 2006. Current Trends and Future Prospects The technology boom of 2000 and the outsourcing wave have affirmed India position as a provider of high quality products and services at highly competitive cost. A buoyant Indian economy, the change in spending patterns and rising income levels in the working population have acted as a catalyst for domestic demand. In the wake of increasing competition and slow economic growth in developed economies India,s importance is growing, not just as a low cost outsourcing destination but also as a potential market offering high growth. Key factors that have contributed to the steady inflow of investment in India are - : Growing consumer demand and India, s consequent emergence as a high demand and quickly expanding market. Growing recognition as a high quality, low cost production and Research and Development destination. Infrastructure growth and public private partnership in infrastructure projects. 32
Competitive business models focused on exports and outsourcing from small and medium sized companies. Government inclination and reforms which create an investment friendly atmosphere. A sizeable, multi-talented workforce and established management capabilities. All of the above factors have contributed to the Indian growth story, which has, apart from the traditional PE funds, attracted the attention of a cross-section of investors ranging from high net worth individuals, pension funds and universities in developed countries to propriety funds of the investment banking firms. The assets invested in emerging economies generally form bout 5-10% of their total investment corpus. Besides looking to optimize the risk-return profile, these investors also want to hedge their investments in developed economies. Business models in emerging economies, built to cater to export led demand, shift the risk back to the developed economies. This is where the large Indian market, fuelled by increasing consumerism, has provided investors with a natural hedge. Indian business models , essentially built to cater to domestic demand , have interested PE players and a larger component of PE investments are being made in this space , as PE players consider this model to be more stable. These trends are expected to continue in the short to medium term. Accordingly, while IT and ITes are still in favored sectors, healthcare, automotive ancillaries, hospitality, real estate, infrastructure, entertainment and media and services have also witnessed significant action and hold promise for a lot more. Apart from valuations issue in recent times PE players have been concerned about the slow down in the government economic reforms policy – key areas of concern include •
Opening up of sectors such as retail to foreign investments.
Providing greater operational autonomy in sectors such as telecom and media.
Facilitating smoother entry and exit norms for foreign investment.
In spite of the above, there appears to be enough momentum at this point of time to ensure that there will be no slowdown in PE activity in the near future. For example, a
large number of domestic funds are finding great value in retail business in India, both in the hope of a policy change in the future and the expected growth in the sectors in times to come. The Indian economy grew 8.9% during the first quarter of 2006-2007, which is the highest first quarter growth in six years. This growth is expected to continue in the near future – and combined with an increase in domestic demand and a friendly business environment, can be expected to ensure that PE funds remain highly focused on India. Private equity investment in India is forecast to grow rapidly over the next few years as overseas investors continue to be attracted by the country’s strong growth prospects. According to consultants Bain & Co, the value of Indian private equity investments is set to grow to $7bn a year by 2010, compared with $2.2bn in 2005. US entertainment giant Walt Disney is planning to become the first foreign media group to release original, local language programmes for the Indian children’s TV market. Disney recently acquired Hungama, an Indian children’s channel, and is working on two Hindi-languages TV series to be shown on its Disney Channel. US IT group IBM is to establish a software development centre in Calcutta, creating 3,000 jobs, while fellow US computer company Dell is to invest up to $60m to build its first manufacturing plant in India.
Comparison of private equity with alternate source of financing: A provider of debt (generally a bank) is rewarded by interest and capital repayment of the loan and it is usually secured either on business assets or your own personal assets, such as your home. As a last resort, if the company defaults on its repayments, the lender can put your business into receivership, which may lead to the liquidation of any assets. A bank may in extreme circumstances even bankrupt you, if you have given personal guarantees. Debt which is secured in this way and which has a higher priority for repayment than that of general unsecured creditors is referred to as “senior debt”. By contrast, private equity is not secured on any assets although part of the non-equity funding package provided by the private equity firm may seek some security. The private equity firm, therefore, often faces the risk of failure just like the other shareholders. The private equity firm is an equity business partner and is rewarded by
the company’s success, generally achieving its principle return through realizing a capital gain through an “exit” which may include: •
Selling their shares back to the management
Selling the shares to another investor (such as another private equity firm)
A trade sale (the sale of company shares to another)
The company achieving a stock market listing
Although private equity is generally provided as part of a financing package, to simplify comparison we compare private equity with senior debt.
Private equity compared to senior debt Private equity Medium to long-term.
Senior debt Short to long-term. Not likely to be committed if the safety of the loan is threatened. Overdrafts are
Committed until “exit”.
payable on demand; loan facilities can be payable on demand if the covenants are not met.
Provides a solid, flexible, capital base to
A useful source of finance if the debt to
meet your future growth and
equity ratio is conservatively balanced
and the company has good cash flow.
Good for cash flow, as capital repayment, dividend and interest costs (if relevant) are tailored to the company’s needs and to what it can
Requires regular good cash flow to service interest and capital repayments.
The returns to the private equity investor depend on the business’ growth and success. The more successful the company is, the better the returns all investors will receive.
Depends on the company continuing to service its interest costs and to maintain the value of the assets on which the debt is secured.
If the business fails, private equity investors will rank alongside other shareholders, after the banks and other lenders, and stand to lose their
If the business fails, the lender generally has first call on the company’s assets.
investment. If the business runs into difficulties, the private equity firm will work hard to ensure that the company is turned around.
If the business appears likely to fail, the lender could put your business into receivership in order to safeguard its loan, and could make you personally bankrupt if personal guarantees have been given.
A true business partner, sharing in your risks and rewards, with practical advice and expertise (as required) to assist your
Assistance available varies considerably.
Why Are Private Equity Firms Looking Hard at India? In March, when the international private equity firm Warburg Pincus sold a $560 million stake in Bharti Tele-Ventures, India's largest publicly traded mobile telephony company, it created a sensation both in that country and among privateequity investors around the world. The transaction, on the Bombay Stock Exchange, was the largest block trade ever on the Indian market. It was also consummated in a breathtaking 28 minutes, prompting stock market observers in India to remark on the unexpected depth and maturity of their equity markets.
Private equity investors marveled at the profitability of the investment -- in a market that was in its infancy barely a decade ago. Money from U.S. private equity investors was going to Asia back then, but it was to destinations such as Indonesia and Thailand. India did not figure in most investors' definitions of "Asia" -- or at least not in any major way. The March transaction was the largest of a series of retrenchments, over several months, that saw Warburg reduce its 18.5% stake in Bharti to about 6%. Warburg, which invested nearly $300 million in Bharti between 1999 and 2001, walked away with a profit of $800 million from selling two-thirds of its holdings. At Bharti's current share prices, Warburg's remaining 6% stake in the company is worth some $700 million, or more than twice what it originally invested. Bharti, which trails privately held Reliance Infocomm, had a sallow $100 million market capitalization when Warburg entered the scene. It now has a market capitalization of $15 billion. In 1999, Bharti had 104,000 subscribers. It now has 14 million. So is the Bharti deal the tip of the iceberg or, alas, the entire iceberg? Two Warburg veterans at the center of the firm's activities in India from its inception in 1994 are emphatic that the Indian story is no one-deal wonder. India has done well by Warburg, generating returns in "the mid-30s over 10 years," the firm's co-president, Charles R. Kaye, said during a presentation on October 11 organized by the University of Pennsylvania's Center for the Advanced Study of India. (Kaye will return to Philadelphia next month to speak at the Wharton India Economic Forum on November 17 and 18.) In turn, the firm has favored India. Warburg is the largest private equity investor in India by far, having ploughed $811 million into the country as of mid-2005. This amount is more than twice the $362 million Warburg has invested in China, according to data provided by the National Venture Capital Association in Arlington, Va.
Bears and Bulls Warburg's vote of confidence in India is not universally shared. Globetrotting financial commentator Jim Rogers has written off the country as a haven for slowmoving bureaucrats who are insensitive to the needs of business. He has predicted a gloomy future for India not only as an economy but also as a country -- predicting its breakup into smaller nation states, torn apart by ethnic and religious strife. But Rogers drove through India and sought out its most difficult political and economic terrain. Warburg has an office there. Rogers was dejected by the country's
decaying roads and bridges. Warburg investors see investment opportunity in them. Rogers hated the rickety telephone landlines he encountered in India. Warburg investors, like millions of Indians who are simply bypassing the landlines and migrating to mobile telephony, fell in love with Bharti. The Indian government reluctantly embarked upon political and economic reforms in 1991, after years of stifling government control of business and profligate spending on propping up failing state-run enterprises brought the country to the brink of bankruptcy. The reforms have continued unimpeded through four different coalition administrations with seemingly disparate economic ideologies, according to Dalip Pathak, the managing director at Warburg who spearheads the firm's strategy in India. "There may be debate about the pace of reform, but not about its direction. Indian businessmen today very rarely point to government as an obstacle," Pathak says. As for that vaunted Indian bureaucracy, he mentions that Warburg repatriated its profits in 48 hours. It's easy to take money out of India, perhaps even easier than bringing it in, he jests. What has Warburg discovered in India during the last decade? Pathak lists the developments that are exciting investors like him: Foreign institutional investment has boomed (more than $12 billion in 2003-04) as curbs on foreign investment in Indian industries have been relaxed; there is a virtually open skies approach to investment from the United States; and gross domestic product has grown at rates between 6.5% and 8% in recent years. The volatility of the Indian rupee has been curbed and inflation has declined. "There are smart people running that economy," Pathak says. Declining inflation has meant lower interest rates, and in turn has goosed the equity markets. Since October 2004, the Bombay Stock Exchange's Sensitive Index, or Sensex, of 30 blue chip stocks has added 2,500 points, to cross 8,000. "We made a big bet on interest rates coming down, and it was the right bet to make," Pathak says. He even compares India favorably with parts of Europe in one surprising aspect: "Labor issues are far more difficult in France than in India," he says.
High Confidence One of the biggest changes Pathak says he has noticed has nothing to do with numbers. "There has been a complete change in the confidence level of people in India," he says. The "tipping point" here was the contribution of Indian information
technology companies to averting a worldwide Y2K meltdown. Suddenly, India's small IT companies went global, and the government -- long accustomed to regulating big industry but unfamiliar with IT -- had nothing to do with it. Now "most people believe they will not let government get in their way," Pathak says, "and that's why we keep putting money there." There's a swagger in the step of India's business, and the country's government is showing signs it has caught the contagion, Kaye says. According to a 2003 Goldman Sachs report, "India's economy could be larger than all but the U.S. and China in 30 years." It's a prediction that doesn't appear far-fetched to Kaye and Pathak. As Warburg's substantial divestment from Bharti shows, however, the investment firm has not lost its head over India. "Bharti has reached the scale and quality level that ensures it will have a long and bright future," Kaye says. But that very milestone means it is "less appropriate from a risk-reward perspective." That's investor-speak for "there's not enough upside left" in the company. Warburg's other notable holdings in India include Rediff Communication, the country's largest consumer web portal; Gujarat Ambuja Cement; Sintex Industries, an industrial plastic-goods manufacturer with a 60% share of the market for waterstorage tanks; Kotak Mahindra, a financial services conglomerate; Nicholas Piramal India, a major pharmaceutical company, and WNS Global Services, a business process outsourcing company. As the list shows, Warburg's bets in India are hardly reckless. The firm generally sticks to the tried, true, big and stock-market listed. That is rarely a winning strategy for a private equity investor in the United States, but can be in India, where the pentup demands of a billion people leave plenty of room to grow for even the largest conglomerates. So in India, the investment firm is not spending much time seeking out early-stage companies or funky technology. In fact a couple of its forays into tech were jettisoned. They involved minor investments, under $2 million each, Pathak says. "Larger companies are less risky; listed companies are less risky," he says, citing the transparency afforded by India's capital markets. One other reason to pick big over small, in Pathak's view: Bigger Indian companies are increasingly seeking capital and acquisitions abroad, and if they play foul with Warburg, "they know they will never get investment abroad."
But success has brought competition. Several significant names in the U.S. private equity world are now operating in India, among them Intel Capital, Oak Hill Capital Management, the Carlyle Group, Citigroup Venture Capital International, General Atlantic Partners, CSFB Private Equity, and the California Public Employees Retirement System, or CalPERS. Most of them have invested only in the double digits so far -- Citigroup has invested as little as $23 million. But "we need to keep on our toes," Pathak says. Warburg is now looking to participate in India's raging real estate market, he adds. "Last year we were not." A growing number of Indian financial institutions, including Kotak, have created venture funds to tap into the sector's potential. Indian news media say fund managers expect returns of 20% to 30% a year.
Big Pool "Being smart and having a lot of money is not a differentiator anymore," Kaye says. So Warburg is working assiduously to become a recognizable brand in India. It is doing that in part by staying close to the market, operating from offices in the commercial hub of Mumbai. Unlike many private equity firms, Warburg invests through a single fund worldwide. That allows it to be nimble in adapting to change, Kaye says. Warburg has more than $10 billion under management invested in more than 100 companies in Asia, Europe and the United States. In August it raised $8 billion more -- the largest single pool of capital the firm has raised since it was set up in 1966. In India, Kaye and Pathak expect the thirst for capital will be unquenched for years to come. Just infrastructure improvements -- greater power generation, better highways and more efficient ports -- are estimated to require $20 billion to $25 billion in investments each year. For policy makers in India, Kaye says, the main social challenge is to lift 200 million people out of abject poverty. Infrastructure projects, far more than IT, have the potential to generate the large numbers of jobs needed to accomplish that task, he adds. Towards the end of their session, a seminar participant asked Kaye and Pathak to describe their "most pessimistic scenario" for India's future. Both men were silent. That silence spoke as loudly as their optimistic presentation about the possibilities India holds for investors like Warburg.
REFERENCES Websites •
• www.privateequity.com • www.indiavca.org • www.financialexpress.com • www.privateequityonline.com Books and Journals • The Economist (ICFAI Gurgaon Library) • The Fortune Business Magazine (ICFAI Gurgaon Library • Private Equity Investing – David Gladstone & Laura Gladstone. •
ICFAI Journal – ICFAI Reader (April 2005 & August 2007).
Private Equity in India – Satish Juneja.