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Private equity player Baring Asia's plans to acquire a majority stake in Hexaware has two distinctive takeaways for the Indian IT-services sector. One, the $108-billion IT industry continues to retain its global competitive edge even when the economy is going through a difficult phase - the deal is one of the largest in the IT sector in India; and two, valuations are shrinking for existing investors. For US private equity firm General Atlantic, which will sell its 14.1 per cent stake to Baring, the exit will yield far less money than was made by other private equity firms from similar deals in other IT companies in India.
In 2006, General Atlantic had invested around $67.6 million in Hexaware and as it exits, its share will go up to $88 million, only a 30 per cent increase in seven years. In contrast, when Blackstone exited business process outsourcing firm Intelenet in 2011, it got a return of over 60 per cent on its investment in four years.
The lower valuations are partly because of the downturn which has also slowed private equity investments in the country. In the first six months of 2013, $3,351 million was invested in 163 deals across sectors compared to $4,143 million in 238 deals in the corresponding period last year, according to a report by Venture Intelligence.
"If you look at the top five funds in India, they have seen a serious erosion of wealth. Majority of these players have invested in mid-sized IT players," says Milan Seth, lead (technology sector), Ernst & Young.
What then explains the Baring-Hexaware deal? Baring Private Equity Asia, subject to regulatory approval, will acquire a controlling 68 per cent stake in the company. It will buy the 27.7 per cent stake held by Hexaware founder Atul Nishar's family and another 14.1 per cent from General Atlantic. In all, it will pay $465 million to acquire about 41.8 per cent stake in the company. It will also make an open offer to acquire 26 per cent stake from Hexware's public shareholders at Rs 135 a share, a 11.8 per cent premium on the closing price of Rs 120.75 on the day of the deal.
Experts say Baring's incentive is simple: though the near-term prospects don't look too bright, the Indian IT story continues to look good and there are still some profits to be made. "If you look at the top five or six funds, you will see they have at least one investment in the IT/ITeS space. A depreciating rupee has made the companies more attractive as it means more profits for IT-services companies which earn in dollars," says Ajay Garg, founder, Equirus Capital.
The other reason for the interest is that promoters, unlike earlier, are much more willing to exit. "India has always been a growth market, private equity players have had very few opportunities for control buyouts," says Sanjeev Krishnan, leader (private equity), PricewaterhouseCoopers.
Foreign investors are also attracted by Indian IT-services companies' good cash reserves and professionally-run teams. "Hexaware, with its diverse services offerings, strong customer relationships, experienced management team and consistent financial performance provides a compelling value proposition for Baring," says Pramod Kumar, managing director, Barclays India.
Other than Hexaware, the recent years have seen private equity interest in MphasiS, an Hewlett Packard company, and Chennai-based Polaris Financial Technologies. However, all these companies are in the mid-cap segment and for them to unleash their growth potential, they need to acquire scale.
"Premium for these companies will be paid only if they have a differentiated story," says an analyst of a leading brokerage firm. Unlike the large-cap companies, which have an end-to-end offering, mid-cap companies in India have preferred to stay focussed on a few segments alone.
For instance, in case of Hexaware, most of the growth comes from its enterprise application services (EAS), which forms close to 30 per cent of its revenue pie. Strong traction in PeopleSoft 9.1 upgradation makes up for 66 per cent of the EAS revenue. However, the Hexaware management in recent years has been reevaluating the company's position when it comes to chasing deals. Since P R Chandrasekar (an ex-Wipro executive) joined Hexaware as CEO in 2008, there has been a steady increase in the inflow of large deals. This has also been reflected in the company's revenue in the past two years. From $262.7 million in 2008, the revenue has increased to $364.4 million in 2012. Chandasekar has also helped the company improve key metrics such as profit margins and the quality of large deals.
This deal flow has largely been driven by higher mining of Hexware's existing customers. For the new owner, Baring, maintaining a steady flow of deals from these clients will be a key challenge. Baring will also have to work hard on adding further scale to the company in order to exit well. Generally, private equity players stay in a company for 6-7 years after which they look for an exit option either by listing on the bourses or through merger and acquisition opportunity. In the near future, brokerages are not expecting any significant upside in the stock. Their advise to existing investors has been to use the open offer as an opportunity to exit the company.
"Due to higher contribution from discretionary spends and weaker deal closures, we expect revenue momentum for Hexaware to remain anaemic in high single digit in CY13. Moreover, the company has stretched margin levers to push the profit margin ahead of peers," says Shashi Bhusan, analyst at Prabhudas Liladher.
Having a private equity player on board with a majority stake in the company would definitely be a plus for Hexaware. It would provide Hexaware an opportunity to tap into Baring's portfolio firms and add them to its own client's list. That is exactly what happened when Blackstone acquired Intelenet in 2007. Blackstone had invested around $200 million in the company, almost three times the revenue of Intelenet then. But by the time Blackstone exited in 2011, it had made about 60 per cent on its investment. Intelenet, on the other hand, managed to get about 60 per cent of its business from Blackstone's investee companies. In a weak macro environment, doing a Blackstone on Hexaware won't be easy for Baring.
However, as Seth puts it: "In case of Hexaware, the good news is that in the last two to two-and a-half years, the company managed to turnaround its business."
