The Hindu Business Line : M&A, private equity in IT-ITES

The information technology (IT) sector in India has historically been among the highly acquisitive sectors. The ITES/BPO segment, which is considerably younger, has also been among the top acquirers.

Traditionally, the IT-ITES sector primarily catered to the US market and almost the entire revenues for the IT-ITES companies came from the US.

It would be appropriate to mention that the reliance on the US economy has come down to some extent over the years as Indian IT-ITES companies have successfully started diversifying their client portfolio to Europe, West Asia, South-East Asia, and so on.

The acquisition focus continues to be in the US (over 80 per cent of the value in the first half of 2008) considering that it is still the largest market and has several mature businesses with a significant skill base.

Rationale for M&A

There have been several reasons for M&A (mergers and acquisitions) in the IT-ITES sectors. Most of the deals in the sector have been cross-border deals. Indian companies have been keen making outbound acquisitions for one or more of the following reasons:

Access to market: This has been among the foremost reasons for acquiring companies, typically in the acquirer’s key markets. These kinds of acquisitions come with existing customer contracts and relationships.

In some cases, these acquisitions have helped source businesses from specific sectors/segments that are keen to work only with local service providers.

Moving up the value chain: Overseas acquisitions in mature markets have enabled several Indian businesses enhance their skill sets based on the target company’s strengths. This has helped early maturity in their business model from pure service play to product development, high-end consulting or specific sector/domain expertise.

Better valuations: Valuations are cheaper for outbound acquisitions in several economies and profitability could be significantly increased by outsourcing work to India with lower people costs.

The key reason for inbound deals has been for tapping the large resource pool available in India at reasonable cost and, hence, improving the international acquirers’ profitability and growth.

Data reveal that M&A deal volumes have continued to show a growth between 2005 and 2007. The deal value did not grow in 2007 due to smaller deal size, which has been a result of more outbound, rather than inbound, deals in the sector.

With the slowdown in the US economy in early 2008, which started impacting several other economies in some way or the other, the Indian IT-ITES sector is adopting a wait-and-watch policy on acquisitions to evaluate its own future business strategy, client segmentation as well as value buys overseas.

Despite the decline in M&A values, the sector has contributed to the highest proportion of M&A volume for all the years — 2005, 2006 and 2007 — as well as for the first half of 2008. The value of private equity investments in the sector has started showing a decline since 2006. While the venture capital and private equity industry in India started with the core focus on the IT sector almost two decades ago, most of the funds have started diversifying their sector focus a few years back and the larger deals have moved to sectors such as telecom and real estate in the recent past.

The proportion of private equity investment value in IT and ITES has declined from 20 per cent in 2006 to less than 2 per cent in H1 2008.

While most of the investors started looking at larger deal sizes a few years back, away from the original venture capital focus, we have started seeing an encouraging sign of investors coming back to focus on early stage technology companies. Some examples of such investors are IDG ventures, Canaan Partners, Sequoia Capital and NEA Indo-US Ventures.

Way Forward

There are several reasons why deals in the IT and ITES sector are expected to pick up momentum in the next 6-12 months. Some of these are:

There is a compelling reason for consolidation within Indian companies and, hence, domestic M&A is likely to increase.

After a period of market correction and instability, we could expect much more stability in the second half of 2008. Hence, the range between the bid and ask prices is expected to narrow, enabling more deals to materialise and faster decision-making.

With the global slowdown, there is an immense possibility that Indian IT-ITES companies would acquire more US companies at highly attractive valuations with a strategy to turn them around.

Considering the decline in valuations in the stock markets in India and globally and fund raising from the stock markets becoming less attractive till the markets improve, private equity could be an attractive option for raising expansion capital.

(The author is Partner, Specialist Advisory Services, Grant Thornton. Responses to blfeedback@thehindu.co.in)

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