How India’s PE and VC industry evolves in the months and years ahead will be determined through ongoing shifts in attitudes and behaviours of PE fund managers, limited partners (LPs) who invest with them and promoters whose companies accept PE financing. How the firms approach new fund-raising, identify and structure deals, manage their portfolios and navigate the paths to exit will shape the industry’s future. When looking for direction in any of these activities, context is critical. The economic and regulatory environment in which those attitudes and behaviours are shaped will exert a powerful influence on the tempo of PE’s change.
Judged by industry participants’ actions in the early months of 2011, their outlook can be described as ‘reasonably optimistic.’ Based on responses we received to our recent survey of industry leaders’ opinions, PE insiders are influenced more by India’s strong growth prospects than by the shadows hovering on the horizon. They recognise that inflation pressures are building and are acutely aware that they can lead to a significant bump up in interest rates and disrupt investment activity. Likewise, they are taking note of the volatile equity markets. But the numbers they are watching most closely are for GDP growth to continue strong over the next 12 months, so the belief in the India long-term growth story remains intact.
PE insiders appear to be willing to write off the other signs of market nervousness as temporary. Indeed, the PE experts we surveyed see current conditions as quite favourable to PE’s continued growth and express the belief that alternative investments could increase in importance given the prevailing high interest rates in the debt markets and volatile public equity markets.
Judging from our analysis of the latest PE deal data and overlaying the insights derived from the survey and interviews, it appears that attitudes of both PE investors and promoters are beginning to shift. As we will see in the following review of PE insiders’ expectations along the four key dimensions of fund-raising, deal making, portfolio management and exits, the industry continues to mature, incrementally but steadily.
Today’s baseline: More capital than opportunities to invest. As the growing number of PE funds that focus on India attract the attention of more and more institutional and wealthy individual investors from around the world, the amount of capital looking to be placed with promising Indian companies continues to grow. In proportion to the size of India’s PE and VC market, today’s capital overhang is huge. Industry watchers estimate the total amount of committed but uncalled ‘dry powder’ to be at least $20 billion. To put that estimate in perspective, that amount is more than the value of all PE and VC investments made during the peak of 2007, and it is more than sufficient to fund all activity at 2010 levels for the next two years.
Even at those levels, the capital earmarked for investment in India represents only a portion of the full potential investor interest. Nearly 80 per cent of the money committed to India during the past two years has originated from foreign sources, which is in line with what respondents we surveyed for our 2010 report expected. With the exception of investments targeted towards infrastructure, regulations do not permit conventional sources of PE capital like insurance companies and pension funds in India to participate in PE, VC or other alternative investment classes. Domestic PE firms are limited to raising funds from affluent individual investors and non-financial institutions. They are also restricted in how they can put the funds they raise to work, being barred from investing in select sectors like non-banking finance companies.
Longer-Term Prospects For 2011 And Beyond: Demonstrating A Strong Performance Track Record Will Be More Important Than Ever
With fund-raising continuing to outstrip deal activity as in the big developed and hot emerging markets, the backlog of dry powder will take time to work through. Investors’ appetite for more Indian exposure remains strong to date, and PE firms are eager to nourish it. In interviews, most PE fund general partners (GPs) told us that they have not faced pressures from LPs to return committed capital their funds had yet to invest.
According to Preqin, the PE research firm, some 120 PE funds seeking to raise approximately $34 billion in 2011 are currently on the road in India. Although there is plenty of capital looking to invest in India, not all of these funds will succeed in raising capital. One LP Bain interviewed said, “Over time, high-quality GPs have emerged in India, and we now have a better understanding of which ones should be at the top of our list.” Forward-looking GPs that aim to continue hitting their fund-raising targets are preparing now for a time when LPs will be more circumspect about who they invest with. GPs are organising their firms to differentiate their investment approach by, for example, targeting select industries, such as education, healthcare or infrastructure, with the potential to generate superior growth and returns or by focusing on specific investment themes such as increasing consumer spending.
Adding reasons for fund-raising firms to refine and focus their approaches is the emergence and continued growth of well-connected domestic spin-off funds. Led by experienced managing directors who have broken away from global PE firms to set up their own boutique shops, the spin-offs capitalise on their intimate knowledge of the local markets and strong networks of relationships with LPs, promoters and regulators. The emergence of the spin-off funds gives LPs more choices to invest their capital directly with India-domiciled funds.
Even as more domestic firms compete in the PE asset class, the bulk of new capital will continue to come from offshore because those firms face fewer restrictions investing across sectors and are somewhat freer from complex tax and legal burdens (see figure below). Our survey found that in the coming two years almost 80 per cent of funds will be sourced through foreign institutional investment, foreign direct investment and foreign venture capital investment. If anything, respondents have said they expect the share of new capital originating from domestic investors to decrease slightly over the next two years. Among the domestic sources, respondents see the proportion coming from Indian institutional investors to hold steady at just under 50 per cent. Overall, the fund allocation picture for India will remain bright, and GPs will have to work overtime to claim a bigger share of the deal pie.
Today’s baseline: Broad-based strength across sectors but deal size remains small. With the number of deals completed in 2010 increasing by 75 per cent to 380 from 2009 levels, India was the most active PE and VC market in Asia. But that whirlwind activity does not capture the immense effort that PE investors made to bring deals to completion. For each deal that ultimately came to fruition, PE funds submitted formal initial expressions of their interest through 100 information memoranda (IM) to potential target companies, of which just two resulted in the fund conducting a detailed due diligence.
Deal making in 2010 was strong across nearly every sector of India’s economy. Particularly active industries for PE and VC included energy (33 deals, $2.2 billion), banking and financial services (43 deals, $1.1 billion) and telecom (8 deals, $900 million) — all of which saw their investment values more than double in 2010 from 2009.
The 55 investments in real estate last year continued to make that sector one of PE’s favourites, although real estate began to cool in the year’s second half following a surge in 2009 and the first half of 2010. Likewise, investments in information technology (IT) and IT-enabled services, long mainstays of India’s growth and PE interest, ended 2010 somewhat lower than they had been historically.
(Excerpts from Bain India Private Equity Report. This report was prepared by Sri Rajan, managing director and head of the Private Equity practice with Bain & Company India; Gopal Sarma, a partner who leads Bain’s Infrastructure practice in India and a team led by Madhur Singhal, a manager in Bain’s New Delhi office.)