The economic slowdown of 2008-09 is now a distant memory. Markets across product categories are booming, and the hunger for capital is back – just the right playground for private equity. But ChrysCapital, one of the largest players in the private equity space (it manages $2.25 billion across five funds), has returned $300 million to its investors. This has cut the size of its fifth from $1.25 billion to $900 million. Ashish Dhawan, co-founder of ChrysCapital Investment Advisors and senior managing director, discusses with Bhupesh Bhandari the emerging scenario for private equity in the country. Dhawan received an MBA with distinction from the Harvard Business School and studied applied mathematics and economics with magna cum laude honors from Yale University.
How does the private equity landscape look?
If you look at private equity, the volumes have fluctuated a lot in the last four to five years. By nature, this is a cyclical industry not just in India but the world over. During the peak years of 2006-07, we had $15 billion of private equity coming into the country. We hit a trough of $3 billion last year. And that includes some real estate as well. The big reason was the disconnection between the valuation that the entrepreneur had in their mind and the valuation that private equity was willing to offer. A lot of it had to with the public markets coming down. When public markets adjust, it typically takes an entrepreneur 12 or maybe even 18 months to adjust his valuation downward. If someone doesn’t really need capital but is raising money only because valuation is high, then that opportunity completely goes away. But most of them need capital. They can defer the need for one or two years, depending on the strength of their balance sheet.
In India, the downturn was short-lived, the economic downturn as well as the stock market downturn. So that mental adjustment process was just starting to happen. The one sector where the adjustment did happen was real estate. People were over-leveraged and therefore desperate. They accepted the new world order quickly and raised money at a lower valuation. In the second half of 2009, because the bounce back was so quick and the (stock market) indices doubled in three months, you had the reverse phenomenon. Entrepreneurs were ready to raise money, but private equity had come to believe that the growth was not sustainable, was stimulus-driven and would eventually die away. Entrepreneurs found that the public markets were very receptive. So, a disproportionate amount of capital was raised there.
This year is different. The public markets have become more discerning. In many sectors, for instance, there is a huge glut of paper. Real estate and power is a classic example. Not every company can raised money from the public market because the markets get tired of too many IPOs (initial public offers) from a single sector. But there a big need for capital because of the huge investments needed in infrastructure. Also, there is a pent-up demand. Companies did not for long raise capital. Private equity will get its share because the public markets cannot absorb all this or don’t want to absorb all this. Also, private equity is now willing to pay up. The gap between bid and ask has gone down. I expect $8 billion to $10 billion of private equity to get deployed this year. It will be back to a slightly better than a normal year. Valuations are rich because if you look at the average private company that raises money in India, the benchmark valuation is actually higher than a public company. That gives you a clear indication that people are paying up in the private equity world. The reason is that there is a huge overhang of capital and there is a paucity of good-quality private assets. There are 10-12 people chasing the same company, so they are willing to bid the asset price up.
Valuations will remain high because public markets are at a high level – 22 times trailing earnings and 16 or 17 times forward earnings. And these forward earnings are highly contingent on commodity companies. So these are risky forward earnings. Therefore, I only look at trailing earnings. Who knows the future? On a trailing basis, we are 20-25 per cent above than the historic price-earnings (multiple) for India over a 10- to 15-year period of time. Even the private equity deals that get done into public companies, in my sense, will be at a 20-ish price-earnings multiple, which is high valuation. So, we have a market where volumes are high but valuations are also high. Funnily enough, the two always co-exist. When valuations are low, entrepreneurs turn off the tap. Private equity is therefore a pro-cyclical asset – you get to deploy oodles of money precisely at the time when valuations are high, which is not a great place to be.
What is the overhang of private equity?
It’s hard to put an exact number. Unlike in the US, where most of the capital deployed is dedicated capital, there is a lot of swing capital in India. But there can be some rough estimates. Out of the top 20 global private equity funds, about 16 have offices in India with a clear intent to put capital at work. All of these have between $8 billion and $20 billion of funds. Let’s assume they want to put 5 to 6 per cent in India over a three-year window. That would be roughly $15 billion. Then you have got five to ten multi-billion-dollar Pan-Asia funds where the India allocation is 20-25 per cent. That probably is another $3-5 billion. So, there is about $20 billion of global capital sitting on the sidelines. Then if you look at India-only funds, there would probably be another $8-10 billion. So, $30 billion is the capital available to the corporate world. If it is investing $8 billion in a year, we have capital for the next three or four years. This money will get absorbed – don’t get me wrong. But the benchmark will always be the public market. If the public market valuations are high, which they are, then clearly these deals will get done at high valuations, especially because there is a large pool of capital providers. If you look at a deal with a ticket size of $50 million or more, five years ago there were probably four or five private equity funds that could write a cheque of that size; today, there are probably 20 or 25 people who can do that. I see 25 to 30 per cent premium being paid for private companies, relative to the public market benchmark.
Future earnings of companies will depend on interest rates and commodity prices. What impact will the volatility in interest rates and commodity prices have on earnings?
The bigger risk is commodity prices because commodity earnings make a very significant chunk of the overall market capitalization – roughly 30 per cent. If we have a global slowdown, and already there are some signs of prices cooling off, and have a 30 to 40 per cent drop in commodity prices, we could have in one year where earnings growth is zero. A third of earnings could show significant decline, where the other two-thirds still grows at 10-15 per cent. That’s a big risk. Interest rates are a factor as well. They are bound to harden as we go along, and that could clip earnings growth by another 5 to 10 percentage points. But I think the bigger risk is commodity because it can completely wipe out earnings growth for one year and then establish a different pace altogether.
Since private equity competes with the public markets, how does the outlook for the primary market look, especially in the context of the government’s disinvestment programme?
When the government announced its ambitious disinvestment programme, it was a very smart view. From the government’s standpoint, it should reduce its holding (in public sector units) precisely when the markets are above their normal valuations. But it clearly has a crowding-out effect. The pool of dollars allocated to India could go up as more high-quality companies, particularly large public sector units, look to raise capital. But there is some substitution effect as well. I think that the large supply made sure that the bullish run we had petered out a little bit. There is also a potentially large supply waiting on the sidelines. What it means for the private companies in the IPO market is that the bar will be raised. Quality standards will therefore need to be higher, and the size will have to be larger for companies to sail through. Since there will be many companies from one sector to raise money, the market can afford to pick and choose. It will bring in better quality, and will keep the market focused on better-quality companies.
The third risk factor the world over is the government’s finances, especially after launching all the stimulus programmes. Won’t large public deficits fuel interest rates?
Interest rates are slightly lower risk than commodities. There is a higher probability that there could be a global slowdown as the stimulus gets withdrawn. On interest rates, there is the potential to harden as the short end of the curve moves up. Clearly, the banks have a lot of 1-year deposits. The average tenure of their deposits is one or one-and-a-half years. So, it is clearly linked to the short-term rates. As short-term rates go up, the long-term yield curve may not see a crazy spike in rates, but the 10-year G-Sec is already telling us that the lending rate for corporations could be 100-150 basis points higher. So I am assuming that the (government’s) fiscal deficit will be lower, but what I worry about is the some of the revenue streams are one-time in nature. You will not have 3G (spectrum) or BWA (broadband wireless spectrum) auction every year. I don’t think the fiscal deficit from a normalized viewpoint will come down by as much as is required for us to have a structurally low interest rate environment.
In the last couple of years, low-cost has become the new buzzword in India. From automobiles to healthcare, housing and hospitality, this is being built into all Indian business models. How much is real, how much is hype?
Low-cost is real. Our low-cost is relative to the rest of the world. A low-cost airline for us means a no-frill airline, relative to a full-service airline which is the norm in the West. Low-cost has emerged for the low-income segment there, which is like the upper middle class in India. The sweet spot in the market for consumer discretionary services will always undertake low-cost services, whether airlines or any other service. That’s very much here to stay, because those are the price points that an average Indian can buy.
Is private equity ready to pay a premium for a low-cost business model?
I think it is. Let’s take housing, for instance. My belief is that the sweet spot of the market has not been exploited in a significant way. Yes, we have a lot of supply. Take Delhi NCR (national capital region), for example. In the Rs 4,000-5,000 per sq ft range, there is a lot of supply. But if you want to open a whole new market, you need houses at Rs 1,500 to Rs 2,000 per sq ft. Then you get a whole new segment of buyers. The EMI (equated monthly installment) on such a house of 600 or 700 sq ft will be around Rs 1 lakh a year, which then means that somebody who makes around Rs 5 lakh in a year suddenly becomes a customer. Today, the effective threshold is that unless you have an income of at least Rs 12 lakh, you cannot become a home owner because that product is not available. If you look at Shanghai, on an annual basis some 250,000 apartments are sold there. That is probably five to six times of what gets done in NCR. This year, we might see 75,000 or 80,000 units sold in NCR because there is a huge development at Noida. Still, Shanghai is more than three times our size, though the population of the two cities is not very different. And we have more pent up demand. More than half the market in Shanghai is priced at below $50 (Rs 2,300) per sq ft. That too when its per capita GDP is three times that of NCR. If you could sell at $40 (Rs 1,840), you could probably sell another 60,000 or 70,000 apartments in NCR. When the market is nascent, like it is today, and someone can prove that he has the technology – this is an execution play where you need industrial-size delivery to bring costs down – I think people would pay a higher valuation.
So is there enough backend work being done of the kind you mentioned?
No. I haven’t seen enough happen so far. I do believe that as we see better infrastructure come in place, which I think is five years out, some of these low-cost options will become more realistic because the drag is not entrepreneurial energy but the lack of the eco-system.
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India got out of the economic slowdown in double-quick time. One would have thought that the allocations for India would go in global private equity funds.
Clearly allocations have gone up. Through this crisis, the emerging markets have demonstrated that they have de-coupled (from the developed world) from the economic standpoint and are on their own trajectory. That trajectory may get dented to some extent when the developed world slows down, but it is a trajectory that will stay its course for many years. That has got reinforced. Having seen the data, people realize that India’s worst growth was 6 per cent in two quarters. This proves there is genuine de-coupling. The vast majority of capital will still be deployed in the developed world. If you look at private equity as an asset class, most institutions have woken up to the fact that they are under-invested in the emerging world. They also realize that they cannot flick a switch and double their commitments overnight. If you do that, the valuations will kill you. I see that private equity has a five-year target to increase allocations to the emerging markets.
Earlier, people used to laugh off the suggestion that emerging markets could trade at a higher price-earnings multiple than the developed world. For a long time, the emerging world had a 10 per cent to 30 per cent discount. We are now in that phase where there is belief that growth is sustainable, companies are not dependent on the external world for finance, and big emerging countries are all insulated because their external debt to GDP ratio is very low. The risk premium is down. In the next five years, the price-earnings multiples for some components of the emerging world will be at a premium to the developed world. That’s here to stay. The 10-30 per cent discount will become a 10-30 per cent premium. Amongst the emerging countries, India and China are clearly the preferred destinations.
Have you redrawn your priorities in light of what has happened in the last couple of years?
We have not changed our priorities. We always took a top-down view and focused on sectors where growth would be higher over the long term. I still believe that is the case. From the exports side, our main focus is IT and BPO. Yes, there was a lull for a couple of years, but I still believe that is our competitive edge. It is a $1-trillion market, and the runway is long. I don’t believe we have run out of steam in that area. Manufacturing exports are on top of the domestic business. I can only see an upside there. Our penetration of global markets is so tiny that there is only an opportunity of growth. Growth can come out of six sectors: Consumer discretionary, pharmaceutical & healthcare, banking & financial services, infrastructure & real estate, engineering, and IT & BPO. We have focused on these for the last ten years.
What is the play you favour in pharmaceuticals? The results in drug discovery have been way short of expectations.
We have always focused on the domestic market. Our belief is that the generics business, while it’s a good add-on to a company, over time lends itself to commoditization. The domestic business is stable, branded, and has steady range-bound 15-20 per cent growth. As India invests in its healthcare infrastructure and health insurance takes off, we believe there will be a massive increase in the consumption of pharmaceutical products also. If you look at the pharmaceutical market, 75 per cent of the consumption comes from urban areas where 30 per cent of the population lives. Only 25 per cent comes from rural India. Penetration there is very low. That is the opportunity for the next 10 years. It is not an industry where you will see 20-25 per cent growth, though 8-9 per cent growth has accelerated to 13-15 per cent and will stay there for some years.
You have returned $300 million to your investors.
This is not an attractive private equity market. The valuations are rich. Our recommendation is that if you are looking for a lower threshold, ay 10-15 per cent return, then you can deploy money; but if you want returns of 20 per cent and more, it is very difficult. Given that we do not want to dilute our underwriting standards, we decided that we should return the money. One reason why we raised money at that time was that we were setting ourselves apart with this size. As that space has now changed and there is too much competition, we went back to our investors to return the money. We have deployed $500 million; we had to deploy another $750 million. But now we have to invest $450 million. That’s a lot less pressure. We haven’t made an investment in the last 12 months. Out fund has been focused on exits.
Haven’t your returns come down over the years? You have given up to 40 per cent in the past.
Yes, in the later funds, the returns are lower. We are telling investors that now 20-odd per cent is probably a more realistic return.