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PRIVATE EQUITY, INDIAN MODEL

A lot of foreign and domestic capital can be mobilised and invested in India, provided the industry can evolve a successful model over the next few years.

Private and venture capital in India is not new, with a venture capital fund called the Technology Development and Information Company of India Ltd promoted by ICICI and UTI 30 years ago. Foreign fund houses like Warburg Pincus helped in the development of the then-nascent Indian telecom industry in the 1990s. The growth in private equity investments slowed during the dot-com bubble before rebounding.
While investing in a private company is the more natural thing to do, it is the number of exits, which show how sustainable the model is for the future. High returns for investors will encourage further investments into the country.

Tailoring PE for India

The past decade since the financial crisis has given much experience to the PE industry in dealing with the Indian ways of doing business and the industry is maturing. The western model of Private Equity is being rethought and PE investment models more suitable for the Indian ground realities are being developed.
• Firstly, the SME and unlisted sectors of the economy are dominated by family-owned businesses which are managed traditionally by family members. Indian society itself is relationship based and not contract based. Most promoters may not be inclined to bind themselves to rigid western-style corporate governance rules. The relationship within the promoter family and influence centres is a determinant of the success of an investment. This makes exits by IPO that much more difficult as the style of functioning and governance may not adhere to the strict scrutiny of the public market participants.

• Building business relationships over a longer term with promoters are necessary to make substantial risk capital investments. Only this will dispel the information asymmetry and give a clear picture to the fund manager about the risk profile of the enterprise and the entrepreneur. Due diligence cannot be an exercise over a few months on a new party but should be done over a period through multiple smaller business transactions. The CA firms associated with family business groups have been the sole financial advisors for groups over the years. They are often the repositories of intelligence required for maintaining the investment, not ordinarily cognizable by a due diligence. Originating deals through this vital network of CAs, and maintaining relationships, can reap good dividends. PE funds often insist on changing auditors in favour of one of the Big 4 firms, which leads to losing a vital source of intelligence the funds can obtain through the traditional CA firms.

• PE firms should avoid paying huge valuation premiums when entering into a business. Exiting from the investment after paying such high entry premiums becomes very difficult.

• The preferred mode of exits for PE funds should be from business cash flow generation. This mandates building up a fundamentally strong business model and not relying merely on a ‘valuation exit’ based on rapid revenue growth over a shorter time frame. This may entail having patient capital over a longer period. Exercising contractual control over cash flows of the business also helps.

• PE Funds should play a critical role in the management of the investee companies. In the deals in the past, PE Funds had taken minority stakes in most deals. The minority stake restricted their involvement in management and contribution by way of expertise to influence decisions to a large degree. PEs should look at investment models where they are more active than passive investors either by way of agreements or majority stakes or board voting rights.

• PEs should start working with entrepreneurs first by providing debt and mezzanine finance for smaller sums with downside protection before moving on to naked equity, if at all. Equity with debt features should be explored before building a good relationship with the management.

An analysis by the consulting firm Bain & Co says every percentage point of GDP growth will need close to $30 billion of additional capital. At the current pace of development of equity, bonds, external commercial borrowings and bank credit pools, private capital investments will have to double in order to fund the country’s growth.
The Indian banking sector has been mired with problems of excessive bad loans for a long time now, which currently stands at almost Rs. 11 trillion. This has prevented credit off take from banks. The recent Insolvency and Bankruptcy Code has armed the creditor and strengthened his position vis-à-vis the promoters. This has completely changed the model from one of ‘debtor in possession’ to one of ‘creditor in possession’. The banks have got powers to take over the responsibility of management. This presents opportunities for PE firms to invest in distressed assets at a bargain price, as the banks will look to exit within a defined time scale. This also helps banks to clean up their balance sheets by raising money from PEs.

Encouraging outlook for PEs

The outlook for the PE industry in the last few years has been very encouraging.
Global capital is looking for opportunities for deployment. This is without even considering the vast domestic pools of capital available within India with banks, pension funds, insurance companies and resident HNIs.
There are vast amounts of foreign and domestic capital that can be mobilised and successfully invested in India, provided the industry is able to evolve a successful model for returning incremental returns over benchmark to investors over the next few years. Sustainable returns by realised exits, by creating real economic value coupled with socially responsible behaviour, would determine how far this opportunity could be capitalised by the PE industry.

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