The international investor is worried about the amounts realised from exits that have happened versus the quantum of capital that has been invested in the last three-odd years. And if investors are expecting an exit from those investments, there certainly is a problem. While there is an investment strategy for private equity capital, most of the investments were actually a bet on pre-IPO and the structures going around then was linked to IPOs and exits. Last 12 months, the market was really bad and hence exits were just not possible. Even in today’s context, there are exits but not to the extent that investors feel very comfortable. In the recent past, the lines between private equity investing (five-year investment horizon) and hedge fund (one-year horizon) investing blurred.
Is IPO exit good for the PE industry?
It is, but investors want to see all forms of exit. When we sit down and negotiate the exit clauses with issuers of capital, the least preferred is a buy-back option. The most preferred is a trade sale deal, while IPO and merger and acquisitions fall somewhere in between. The reason investors choose trade sale over everything else is because the company (in the same line of business) will generally tend to pay a higher price for the business as compared with a financial investor. However, one good thing I have seen in the last 12-odd years is that regulations have become much more structured as compared with what they used to be before. In 1997, when ING set up private equity business, they chose to be in Delhi because a clarification was required from ministry of finance (FIPB) on the permissibility of foreign investment in the sector. All that has changed now as policies have been laid out very clearly and the regulation has been very supportive and clear.
We have 100% FDI permitted in some industries on an automatic basis; we have 10% limits on FDI in banking, 26% for insurance, 51% for some other sectors, 74% in others and finally, until recently, no investment was permitted in certain formats of retail stores.
Having said that, a few issues have arisen with respect to the taxability of divestment proceeds like the pass-through benefits for funds, which is currently being taken up by the Venture capital Association of India, which I currently chair. While everything else looks pretty good for the PE industry, the concern on exit remains.
What is your outlook on the M&A scene in India? Which sectors can expect to see good activity?
We can’t predict anything in that space at all. What is happening or triggering M&As varies from time to time. Somebody starts a business because they got a licence and later figured it is not their core competence, while someone built a business around a particular activity a few others stepped into to cash in on the opportunity and later sold it realising it wasn’t their cup of tea. Thus, M&A will be driven by different things wherein consolidation and shedding of one’s non-core businesses is just one of the criteria.
Secondly, there is international interest coming into some sectors, like for instance the auto components industry, as we speak today. If auto fortunes revive globally, some of them would want to come back and source components, take strategic stakes etc. With respect to sectors, it doesn’t matter much as long as it gives an exit to a private equity investor — something people like me would be concerned about. An essential for M&A activity to flourish in India will be the orientation of Indian promoters to be wiling to sell their stakes.
What kind of returns do PE firms expect when making an exit?
Private equity investors usually have two benchmarks —- one is the IRR (internal rate of return) that the investment generates and the other is the ‘times money’ where the investments compound for a longer time even though at a lesser rate of return (say 2, 3 or 4 times the original investments). A portfolio manager balances these two parameters. For the most part, I’d say it is the ability to deliver higher risk-adjusted returns that is sought as a service from the investment advisors. Thus, investments in infrastructure can be expected to yield 18-20% IRR, whereas the expectations can be over 25% for investments perceived to have higher risks.
Do you think funds operating in India would have managed to reach this threshold?
I don’t think so. There are about a handful of them that have managed and just a select few who have exceeded it. The weak players with a 12-month horizon for their capital have shut shop and are gone already. I’d say those who are still around and doing their third fund would have achieved or are expected to achieve and exceed the threshold; else they wouldn’t be able to raise their third fund.
What’s your take on the fund-raising scene?
There is a lot of challenge in fund-raising today, especially because the biggest source market of capital (US) is absorbing it now. There is almost no capital available from the US for India. While some like the growth potential that India provides, they do not necessarily feel comfortable with the prevailing market valuation. The fact is, they don’t have the money to invest, which is the key reason they are not investing.
As far as fund-raising goes, most international players have already placed their bet on India. All the thought leaders (like foundations, pension funds, etc) with the appetite and inclination have placed their ‘bets’ and are waiting to see demonstrated quality exits. My understanding and assessment of the Indian market is that people want to see more exits before new capital can make its way into the country. There is some capital in the Middle East and adequate capital in India. If somebody is raising a fund in the next 12 months, I think it will make tremendous sense to start raising capital in India, which gives the ability to access and execute transactions, and based on the built-up portfolio, look at sourcing money from the international markets.
What in your opinion are things that PE funds did right or otherwise?
I think PE funds went gung-ho and paid for future ‘growth’ in terms of share price. In many a case, the growth has not come through. Because of the auction situation that prevailed in 2007, some of them have gone overboard and have compromised on the conditions as well, as in investing without a board seat etc.
What changes do you see in the investment ideologies now?
Classic private equity is supposed to be based on solid cash-flow-backed investing, which has not changed. It is the adaptations and innovations people have tried in between that have changed.
What about the LP-GP relationship?
A Limited Partner (LP) - General Partner (GP) relationship is generally inked in an agreement, which is the formal side of it. The unwritten portion is the equation that each of them build with their fund managers. This involves visiting portfolio companies, knowing the CEO, etc. During difficult times, the LP wants to have adequate information to be able to predict the possible lower returns. At least, LP would like to know the challenges that the investment advisor is facing, whether the investment will blow up ahead of the event. It gives them (LP) a lot more comfort to know ahead than suddenly knowing that they have lost money on a particular investment. Thus, the information and interaction time requirement have gone up significantly. They (LPs) are of the opinion that once the information is there, they will be in a position to construct/ understand what returns they can get or whether there is a possibility of any return at all. Thus, information disclosure, interaction and related transparency norms have becomemore stringent.
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