At an industry meet here last month, CDC Asia’s Managing Director, Anubha Shrivastava, made a startling disclosure: Most private equity (PE) investors have only generated low, single-digit returns from their portfolios in India.
For instance, the CDC Group, the investment arm of the UK government, which invests in PE funds, has earned zero returns from India between 2004 and 2009, compared with 20-plus per cent net returns from China. The returns from Southeast Asia have been 14-16 per cent. ‘‘This is stark and disturbing,’’ said Shrivastava at the meet.
This is the biggest challenge for the PE industry in India. While PE is a high-risk, high-reward asset class, in India it has been a low-return game. As a result, fund-raising has become challenging, as PE investors have turned nervous. The money raised by India-focused PE funds has dwindled over the past 12 months.
Key issues
The returns have been low as PE players invested at high valuations. ‘‘The intense competition for a few private companies resulted in high valuations,” said Ajay Relan, founder, CX Partners, at the same meet. ‘‘The alignment of interests with owners was not thought through at the time of investing. The owner has a longer horizon. Exits create huge conflicts.”
Anil Ahuja, Asia head of UK-based 3i, said at the conclave: ‘‘Many promoters here believe that what you deserve to make is 20-25 per cent returns; the day you are making 10X, there’s resentment.” On an average, a PE firm will have five deals that generate 20-25 per cent return, two deals which deliver 10X, and three deals on which it loses money.
Over the past few years, limited partners (LPs, who invest in PE funds) have observed that returns from PE in India have been lower than those from China, both in terms of internal rates of return (IRRs) or the dollar value of exits. As India became more prominent for global investors, increased competition for deals drove valuations. “In this business, entry valuation is a key determinant of ultimate returns on a transaction,” said Darius Pandole, partner at PE firm New Silk Route Advisors.
More From This Section
With access to public markets in India easier than in China, PE valuations here have been on par with public markets. In China, the relative inability to access public markets has resulted in PE valuations prevailing at a significant discount to public markets. ‘‘The listless state of the secondary market for the better part of the last three years has resulted in the IPO (initial public offering) window not being available, as a consequence of which exits became more difficult,’’ added Pandole.
PE was regarded by businesses as just another source of financing, along with public markets and bank debt. With capital rushing into India, teams were put together quickly to capture these flows, with little focus on the team make-up, which led to mistakes. This led to compromises on the quality of opportunities, framework of engagement, governance attitude of promoters and evolution of exit opportunities, said Shrivastava.
There is hope. J M Trivedi, head of PE firm Actis, said returns in the next cycle would be better than those in the previous one (2005-09). “Valuations are high on Wednesday as there’s surplus capital chasing fewer deals. As the surplus gets consumed in 12 to 18 months, valuations will correct.”
After the financial crisis, the level of PE investments in India had come down to $3.5 billion (2009), but bounced back to $10 billion in 2011, after recovering to $6.5 billion in 2010. Trivedi estimated there’s $10-15 billion surplus capital in the market, which will get consumed in the next couple of years, and the returns will improve.
The response
There are no quick-fixes to some of these problems but urgent action is needed to ensure India does not lose in the capital allocation hierarchy with global investors, who have a choice of going elsewhere. Competition, and the industry’s reliance on intermediation, need to come down. But many said it was virtually impossible to cut deals without intermediation. “This is the time to break away from the old rules that have been set in India,” said Shrivastava.
The Indian PE market is highly intermediated. Experts say the manner in which you get a deal and the relationship with the promoter plays a crucial role in determining performance. A key differentiator for leading PE firms is to develop proprietary deal flow, which results in better relationships with investee companies, and more favourable pricing and terms. Funds like Actis are also trying to help investee companies in operational areas by roping in advisors who can add value and improve margins.
There are several things the PE industry in India can do to win back confidence. Faced with a similar problem in 2006-07, the industry in the Silicon Valley had cut their fund sizes. “Instead of coming to us (investors) and seeking an extension (for deploying capital), the funds should consider returning capital. There’s no pressure to deploy capital,” said a limited partner. The funds can organise secondaries to clear the baggage of their portfolio, without which experts feel not many people would be able to raise funds.
“The critical imperative for PE in India is to achieve more exits and return more capital to our LPs over the next one-two years. If this can be achieved with reasonable IRRs, then the floodgates of additional capital into Indian PE will open. If this does not happen, then question marks will persist over the viability of Indian PE,” said Pandole.
As the industry grapples with its problems, regulations like the proposed GAAR (the tax-avoidance plugging proposal, now deferred by a year) and retrospective taxes have created fear and uncertainty. With investors nervous, they may well find some other place to invest.