Smart money in India rides on small firms

ANALYST'S VIEW

Predicting the Sensex, India's key equity index, is an activity best left to day traders, chartists and talking heads on 24-hour news channels.

For those wanting to benefit from India's rapid economic transformation, it might be far more rewarding to invest in 10 unknown companies and see one of them make it to the benchmark in 10 years.

Why should smart money focus on the 30 mature companies represented in the Sensex, when there are cheaper options to take bets on everything from shortage of teachers and electric power to the newly acquired taste for wine?

This isn't to say that the large companies should be writen off. They are all growing fast in the home market and have managements capable of executing ambitious cross-border takeovers. The extent to which the prospective acquisitions will enrich investors is a different matter altogether.

As for unlocking value through restructuring, the wealth created by the division of Dhirubhai Ambani's empire would remain the touchstone for a long time to come.

Meanwhile, the Sensex, which rose to a record 18,658 yesterday, is now quoting at a 19 per cent premium to its 18-year average price-to-earnings multiple.

It may be time for investors in India to discover the next set of winners. And that means combing the universe of 22,000 for-profit organizations "" companies, partnerships and family- owned businesses "" out of which at least 5,500 are "diamonds in the rough,'' said Alok Aggarwal, chairman of Evalueserve, a business-research company that has analysts in India, China and Chile.

The computer software industry was such a rough diamond, in the 1990s. Arisaig Partners, which buys chunks of small companies in Asian emerging markets, was an early investor in Bangalore-based Infosys Technologies in 1993, when it had a market value of $5 million. Today, the company's shares are worth $31 billion.

Arisaig's current picks include Educomp Solutions, which creates digital lessons for the understaffed state-funded schools. The money manager also owns a stake in Champagne, which controls 70 per cent of India's growing wine market.

"One of the most exciting aspects of the domestic stock market is the way in which new businesses appear from nowhere and become multibillion-dollar activities in a flicker,'' Arisaig, which has $2 billion in Asian assets, said in a June 2007 note to investors.

Discovering these gems and polishing them, is not for everyone. Most of these aren't publicly traded. Research costs could be high at as much as $50,000 a company, justifiable only if one has at least $10 million to invest. In most instances, it means assembling a buyout fund, with rich individuals and institutional investors as limited partners.

The private-equity format is already a hit in India.

According to Evalueserve's research, India received $7.5 billion last year from more than 300 such funds that have been put together by venture capitalists and buyout specialists.

An additional 69 funds have either already raised or are currently raising money to invest in India. Citigroup is joining Blackstone Group and Infrastructure Development Finance in a $5 billion fund to invest in India's roads, ports and power utilities. ICICI Bank is seeking $2 billion for a similar fund. Jon Moulton, managing partner of London- based Alchemy Partners, is raising $100 million for investing in India.

Buyout deals this year, including two in three months by Blackstone, may add up to $13.5 billion, surpassing the 2006 total in China, an economy 2 1/2 times India's size, said Evalueserve. The researcher estimates the annual private-equity investment in India to reach $20 billion by 2010, a 1,000-fold jump over the 1996 level.

The current buyout frenzy in India stems, partly, from some notable successes in the past few years.

New York-based Warburg Pincus took home $1.6 billion on its $290 million investment in a startup mobile-phone network from 1999 to 2001. Bharti Airtel is now valued at more than $50 billion.

Another 1999 deal that struck gold was the $1 million investment by ICICI Venture, a unit of India's second-biggest commercial lender, in Pantaloon Retail, a Mumbai-based company that ran five clothing stores.

ICICI Venture sold its stake in 2003, recouping five times its investment. Today, Pantaloon is India's biggest publicly traded retailer, valued at more than $2 billion.

The probability of discovering the next Bharti or Pantaloon is much smaller for any investor than the odds of guessing the movement "" up or down "" of any of the 30 Sensex stocks in the next week and getting it right. Yet, spotting a dark horse and seeing it win the Derby has a thrill to it. And it's that lure of a large payoff that makes private equity such an exciting game in India right now.