The world was a different place in early 2008. The mood was bullish in India — over 2005-08, private equity (PE) investments in India had grown 10 times. Nearly $50 billion was raised during this period for investment in India, of which $20 billion was yet to be invested at the end of 2009, as the global recession took hold and investment activity froze. PE investments had delivered attractive returns in the previous cycle (1998 to 2004), but is unlikely to replicate those successes in the current cycle.
So, what went wrong?
In the past, the PE industry relied on earnings growth led by strong revenue expansion and multiple arbitrage to deliver returns. After the financial crisis, the earnings growth has declined and multiple arbitrage (between entry and exit multiple) has vanished. In fact, in many deals done before the financial crisis, the arbitrage is likely to be negative.
What should we expect in the future?
Earnings growth: While revenue growth may not match up to the last cycle, we expect it to be two to three times the GDP growth rate in the fast-growing sectors PE funds focuse on. However, 15 per cent revenue growth is unlikely to deliver a 25 per cent internal rate of return. Consequently, there has been a fundamental shift in the industry towards operational improvements to enhance value. A number of PE funds now have in-house operational partners, supported by a network of industry advisors. These industry specialists are working with the management teams of portfolio companies to expand margins by streamlining operations and optimising costs.
Multiple arbitrage: Un-deployed capital (dry powder) raised before the financial crisis has substantially reduced over 2010 and 2011, as more capital has been invested than raised. According to a recent Bain study, there was $17 billion dry powder in early 2012, against a backdrop of $15 billion invested in 2011. This is 12-18 months’ supply, taking into account $8-9 billion being raised every year over 2010 and 2011.
The demand is from growth capital (new money) and secondary money required to provide exits to private equity investors, who had invested in the previous cycle and are nearing the end of fund lives.
Growth capital: Even six to seven per cent GDP growth will drive demand for growth capital increasing at 20 per cent every year. In fact, growth capital invested in 2011 was triple that invested in 2009.
Secondary capital: The $40 billion invested over 2005-2008 is ripe for exit and many of these deals are already in the market, boosting demand for capital.
As initial public offerings (IPOs) remain unfavourable, PE funds are likely to be the dominant source of capital.
The imminent consumption of dry powder and the likelihood of capital markets remaining unviable should dictate receding valuations, as demand for capital outstrips supply. In fact, valuations have corrected since the last cycle and might correct further. Multiple arbitrage in this cycle will be neutral if not positive.
In summary, this cycle should bring back credibility to the Indian PE industry.
JM Trivedi
Partner and Head of South Asia, Actis
