The year 2011 has certainly been a difficult period for the private equity industry as it has been challenged from all sides. Those out in the market to raise their first-time or follow-on funds have been pushed to a desperation point by a difficult fundraising environment. Those who are veteran players and loaded with dry powder are putting monies to work in an environment that is beset with intense competition while expensive entry valuation continues to frustrate. And those who raised billions of dollars in the benign years of 2006-07 and deployed much of it are exhibiting returns now, but the environment is no longer as healthy. As financial crisis rocks the global economy and also affects the country, industry participants have had to wrestle with significant new realities. It is now clear that PE firms need to reassess how they can continue to deliver superior returns when the traditional drivers of the past years – GDP growth, multiple expansions, readily available capital – no longer provide the lift they once did. VCCircle spots 10 dominant trends which have buffeted PE/VC markets in 2011 and will continue to shape them in 2012.

PE Fundraising Gets More Difficult

As many as 60 India-based private equity firms are out on road to raise money for their first or follow-up funds, expecting to mop up over $13 billion, according to VCCedge, the financial research platform of VCCircle. Indeed, the number of funds seems substantial and it will be interesting to see whether the Limited Partners (LPs) are going to digest it all. However, these investors with money bags (read LPs) have become increasingly demanding and vocal. "There is a meaningful reduction in the appetite of LPs towards Indian funds," said Jason Sambanju, managing director and co-head (Asia) of Paul Capital, a global alternative investment firm managing $4 billion in so-called secondary investments or second-hand LP interests.

This just goes to show that there is going to be a decline in the number of re-ups or new General Partner (GP) relationships due to disappointing performances, team changes, ‘me-too’ funds, expensive entry valuations, investment strategy overlap with other GPs, generational issues and relationship fatigue. With LPs facing their own capital constraints, the fundraising environment is expected to be choppy in 2012.

Early-stage Investing Becomes Hot

The year 2011 will go down as a record year for early-stage or VC investing as there has been a noticeable uptick in terms of quantity and quality. According to VCCedge, a total of 197 investments amounted to $879 million, compared to 147 deals in 2010 worth $650 million. Clearly, the euphoria around e-commerce deals was high and large cheque sizes were seen for companies operating across mobile, Internet and related verticals. For instance, while InMobi, a Bangalore-based mobile ad network, raised $200 million from Softbank Corp, e-commerce plays like Fashionandyou and Snapdeal raised up to $40 million each. That venture investing is finally taking off is also shown by way of exits – SAIF Partner’s multibagger exit from MakeMyTrip is being touted as the poster deal for the domestic venture industry. With the likes of JustDial, One97 Communications and others lining up over the coming months, there will be clearly more data points a year from now. On the non-tech front, companies like MedPlus and Orient Green are examples of recent successes for investors and entrepreneurs. Such momentum of early-stage investing is expected to continue in 2012 as well.

PE Action In Real Estate Still Lagging

During 2011, the real estate sector has gone through extreme challenging times. There has been a slowdown in new home sales across the country due to higher cost of borrowing and a sharp rise in property prices. As a result, real estate companies have been hammered and they continue to pile up debts. While the poor performances of a few large-listed firms have essentially meant that IPOs are not a meaningful way to raise money for realty players due to the lack of investor interest, PE funding as an alternate capital-raising option also appears to be dimming. Of course, there have been a few large deals by Blackstone this year, but overall, the number of deals has come down to 30 investments worth $1.07 billion, from 35 investments worth $1.09 billion in 2010. Given that most of the PE deals in real estate sector are structured transactions, there has been a sizeable number of exits post the mandatory lock-in period of three years and this trend has continued over the past few years. According to a report by Jones Lang LaSalle, there have been exits to the tune of $3 billion in the sector in the past four years. And as much as 83 per cent of those have come in the past two years alone. Going forward, the industry is expected to face the $3 billion exit mark again for 2012, it adds. This implies that the real estate sector will continue to see net outflow of PE money. Needless to say, fundraising for real estate-focused PE funds has been extremely difficult with only five such funds being able to mop up a paltry $372.5 million.

PE Firms Evolving Into Full-service Financial Services Cos

Motivations of private equity firms to provide debt finance to corporate houses have continued to grow. For instance, CX Partners, a Delhi-based private equity firm founded in 2009 by former Citigroup Venture Capital International (CVCI) managing director Ajay Relan, is floating a $500 million (hard cap) India-specific Intermediate Capital Fund focused on Special Situations. KKR, one of the world’s largest private equity firms, has also completed four debt transactions worth around Rs 2,800 crore through its non-banking financial company (NBFC) KKR India Financial Services Pvt Ltd. Incidentally, such endeavours are undertaken to cater to all the investment needs of a promoter – both debt and equity. In March 2011, three PE firms – the private equity arm of Goldman Sachs Group Plc., Everstone Capital and Beacon India Private Equity – set up an NBFC called Indostar Capital Finance Ltd. These three PE firms will also hold a majority stake in Indostar. In 2010, private equity major 3i Group also forayed into debt funding in India and it now plans to lend to tier II and tier III corporate houses in India.

Going Solo Still Fashionable

The PE industry has continued to witness a huge churn with top executives quitting their well-established companies and going solo. Manish Kejriwal, till recently heading India, Africa and the Middle East operations at Temasek Holdings (the Singapore government-owned sovereign wealth fund), and Sunish Sharma, managing director at General Atlantic India, left their respective companies to form their own private equity firm – Kedaara Capital Advisors. These spin-offs essentially capitalise on their intimate knowledge of local markets and strong networks with LPs, promoters and regulators. The emergence of spin-off funds gives LPs more choices to invest their capital directly with India-domiciled funds. Other PE executives who have left their jobs in 2011 to set up their own ventures include Ranjeet Nabha, former MD & CEO of WL Ross & Co (India operations), and PR Srinivasan, former MD & India region head of Citigroup Venture Capital International (CVCI). Earlier, Ajay Relan (another ex-CVCI executive) started his investment firm CX Partners while Renuka Ramnath (ex-head, ICICI Venture) started Multiples.

Lack of Corporate Governance, Misaligned Interests

Suboptimal corporate governance and an inclination on the part of some entrepreneurs not to be fully forthcoming with their PE partners are also emerging to be a big worry when it comes to PE investors’ relationship with promoters, particularly those of small-to-mid-size companies. In one of the biggest such cases in recent times, the promoters of Lilliput Kidswear Ltd have started looking for new investor(s) after a bitter legal spat with their existing high profile PE investors TPG and Bain Capital. Lilliput Kidswear, KS Oils, Subhiksha and Biotor are a few examples where PE investors have fallen out with the promoters because of alleged poor governance practices. Building trust is going to be a valid concern even in 2012 as promoters value PE investors who understand their requirements and are willing to discuss upfront how to align the interests of both. Going forward, promoters will be keen to work with PE firms who act their trusted advisors.

PIPEs Continue To Drive Action

Investors have increased their activity in PIPE deals as the choppy capital markets in 2011 have presented attractive opportunities for PE funds. For instance, in one of the largest deals this year, private equity giant Kohlberg Kravis Roberts & Co. L.P. (KKR), along with International Finance Corporation (IFC), invested Rs 440 crore ($100 million) in Kolkata-based non-banking finance company Magma Fincorp to support its growth plans. Also, Apollo Management LP put $290 million into Welspun Corp. In other words, PIPEs vastly expand the PE deal universe and it is now difficult to ignore them. "We will spend more time in public markets," affirmed Naveen Wadhera, country head of TA Associates, during an earlier interview. The recent departure of four managing directors from Sequoia Capital India, to form Westbridge Capital – an independent fund that will focus on PIPE deals and raise $500 million in a short span of three months – also points to the fact that PIPEs are here to stay. Incidentally, Pulak Prasad’s Nalanda Capital was also successful in raising money for the second time.

PE Exits Low, Focus On Putting House In Order

Generating quality exits and returns has always been critical for private equity investors, but their overall significance is now more crucial as holding periods have been stretched. Against the backdrop of a difficult public market, PE exit volume fell 38 per cent to 109 deals while value fell 55 per cent to $2.5 billion (we kept tabs till Dec 10, 2011). This is in sharp contrast to 2010 when exits hit a record and there were 175 exit transactions worth $4.54 billion – of course, against the backdrop of robust capital markets. In fact, private equity portfolios are now demanding more attention as the environment has become more challenging and unpredictable. Consequently, PE firms have to ensure a deeper operational engagement for empowering their portfolio companies to beat the downturn and create ‘saleable businesses.’ "We are spending a lot of time on portfolio management than before," said a PE investor on conditions of anonymity.

Mezzanine Deals, Safe Structures Emerge

Instead of pure equity, private equity investors are seen to be fast migrating to convertible structures and thus ensuring downside protection while doing deals. A few investors are also resorting to keeping some components of the total deal amount as debt, rather than all equity. This is seen more as a response to the cyclical nature of the economy and provision for a hedge against that trend. "Private equity investors are seen pushing for mezzanine structures," said Ravinder Pai, MD of Century Real Estate, in an earlier interview to VCCircle, pointing to the structured kind of transaction or debt-style protection that the PE investors are increasingly seeking.

Mid-market M&A Deal-making Continues To Be The Sweet Spot

Despite the headwinds, crossborder, inbound M&A has continued to be reasonably strong, especially in the mid-market segment and across a wide range of industries. According to VCCedge, there have been around 291 deals worth $3363.97 million, with average deal size in the range of $50 million. "It just goes to show that strategic investors were able to displace PE investors as more attractive options for entrepreneurs, particularly the ones who were less fussy about control," said C Venkat Subramanyam, founder-director of Veda Corporate Advisors. Private equity has a long tail and the trend of small funds selling to a larger fund and those selling to strategic investors in return, will continue in 2012.

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