The Hindu Business Line : PE deal space in India could benefit from sub-prime crisis

The grapevine in the Indian market today is that there are many more transactions being shown to the PE community, given that the IPO market and the FCCB market have become more difficult to raise funding,

— MR VIKRAM UTAMSINGH, EXECUTIVE DIRECTOR AND HEAD — PRIVATE EQUITY GROUP, KPMG

FedEx, Apple, Cisco, Genentech and Microsoft are not just household names, they share a common lineage: That of private equity (PE) funding. Little-known companies then, these entrepreneurs wanted to raise capital but found no support.

But on the way came across the ‘gentlemen’ who obliged. In exchange, a stake was all that was asked for. The rest, as they say, is history. But that was years ago. Today, the situation is a bit different, especially with the sub-prime contagion that has taken out some of the well-known firms across Wall Street. Liquidity is clearly not as easy as it used to be.

Will Indian companies and their promoters have a torrid time in searching for the ‘deal’ that could possibly change things? Not likely, if you go by numbers, says Mr Vikram Utamsingh, Executive Director and Head — Private Equity Group, KPMG. “The grapevine in the Indian market today is that there are many more transactions being shown to the PE community, given that the IPO market and the FCCB market have become more difficult to raise funding,” Mr Singh revealed to Business Line in an exclusive e-mail interview. More deals are being shown to PEs in India as a fallout of the global credit crisis currently. He adds meat to his rationale when he points out that in India debt has not been a crucial method of funding PE deals.

Read on to know how India is closing the gap with China as a PE investment destination, why Indian promoters not ready to sell out completely still end up stitching deals with PE funds and much more...

Excerpts from the interview:

Are there any regulatory restrictions placed on private equity in India?

India has witnessed gradual relaxation in its foreign investment regime as sectors have been opened to foreign investment. Private equity funds can largely invest in all sectors opened up for foreign investment up to the permissible limits except in a few sectors like retail. Hence they are largely treated on par with strategic investors making investments in India.

The regulatory restrictions placed on PE in India are limited and are less than in other emerging markets such as China. However, one of the key concerns is the delay in getting Foreign Venture Capital Investor (FVCI) registration for PE funds. Currently, about 60 funds are awaiting approval.

The key advantages of FVCI registration are that FVCIs can freely remit funds to India for investments in domestic companies and domestic venture capital funds and FVCIs are exempt from entry and exit pricing regulations that otherwise apply to foreign investors.

Are PE funds, then, better off in China when they attempt to strike a deal?

China, India’s main competitor in the emerging markets for PE investments, has recently seen a tightening of the regulatory environment which could impact PE investments. China issued Provisions on Acquisition of Domestic Enterprises by Foreign Investors to regulate foreign M&A activities in the country.

The Anti-Monopoly Law which will come into force from August 1, 2008, requires any major foreign M&A deal to be examined and supervised for national economic and industrial security reasons by relevant government bodies. This law will be important to private equity investors, as it may have an impact on their investment activities, as well as the activities of companies operating in China in which they hold an interest.

State Administration of Foreign Exchange (SAFE) in China has also recently ruled that offshore special purpose vehicles (SPVs) investing in China disclose their assets to SAFE and proceeds from sale of shares by the SPVs must also be returned to China within 180 days of the transaction.

That could be controversial. In India too, we have had our share. Take for example, Blackstone-Ushodaya Enterprises. In spite of repeated recommendations from the Foreign Investment Promotion Board for its proposal to invest in Ushodaya Enterprises, nothing concrete has come off for Blackstone. Does it discourage PE funds?

There were more than 250 PE transactions that were successfully consummated in 2007 and so one specific transaction that was not consummated, will not discourage the PE industry, in general.

Why is the hit rate of PE deals reaching completion in India so low?

KPMG in India conducted a survey in late 2007 of the Indian Private Equity (PE) industry titled “Private Equity Investing in India”. One of the key findings of our survey indicated that only 2 per cent of the deals seen by a fund lead to closure. The reasons for this could be several.

More recently valuations have been stretched and so it has been more difficult to consummate deals.

Another key reason is that the seller is not adequately prepared for a PE investment. For example, the business plan may not be adequately robust or there could be corporate governance issues. PE funds like to invest in organisations which have professional management which is distinct from the owners and in some opportunities the layer of professional management may not be established. It is important to appreciate that funds view their association with a company as a partnership which ultimately benefits both parties and so the structure of the transaction and its commercial basis needs to reflect this.

Many say that PE deals need to be country-specific. Can the same criteria for deals followed by PE funds in US be applicable to India or any other developing country?

The conceptual mechanics of PE funding is generally consistent across the world, wherein investments are made in companies to create value for the owners and the PE firm.

However, PE investments are guided by the specific regulatory and financial environment of a country. In India, PE investments are largely in the form of expansion capital for domestic or global expansion.

In countries such as the US, there could be other reasons. For example, PE funds acquiring companies which are undervalued or underperforming or where their break up value is larger, than their combined value.

Debt is a crucial method of funding private equity. Will the sub-prime and ensuing global fallout have no impact on the availability on PE funding, especially the debt part?

The grapevine in the Indian market today is that there are many more transactions being shown to the PE community given that the IPO market and the FCCB market have become more difficult to raise funding.

Also, certain other form of debt-linked funding, e.g. mezzanine capital, has become more expensive. In India debt has not been a crucial method of funding PE deals. PE deals have largely been equity deals as they have been growth capital in nature.

So there is no impact whatsoever…

Where PE may be impacted is on transactions where an Indian company is backed to do a deal overseas.

On such transactions, the Indian companies have raised debt as well as PE equity to do the deals. However, as a result of the global credit crisis, Indian companies are finding it more difficult to raise overseas debt for financing such transactions.

What are the top three reasons that you attribute to for the tremendous increase in the number of private equity deals struck in the country?

The top three reasons for the large number of PE deals in India are:

Robust economic growth which is expected to continue in the foreseeable future;

Increasing allocations by Limited Partners in PE funds focused on emerging markets;

Increasing difficulty in sourcing alternative capital such as IPOs, debt, etc.

Do you see the trends continuing through 2008 and later?

As capital markets remain at levels lower than those witnessed last year, PE funds may find attractive investment opportunities. However, valuations could become an issue as Indian promoters may prefer to wait and watch, expecting the markets to go back to the high levels instead of consummating the transaction at a lower valuation.

Investment Committees of some funds will seek a higher level of comfort from the investing team on Indian opportunities as equally or more attractive opportunities could be available in other markets such as the US. So, in 2008, we predict that the number of deals will fall as there is a valuation expectation gap between buyers and sellers but PE activity should increase in 2009.

Valuation expectation gap, what’s that?

Most PE funds expect a risk adjusted 20-25 per cent internal rate of return (IRR). Private Investment in Public Equity (PIPEs) and Pre-IPOs accounted for 25 per cent of transactions in 2007. Some of these transactions, which were done when the capital markets were at their peak value, may find it challenging to achieve their benchmark returns.

Depending on the willingness of the promoter to conclude a transaction at lower valuations, some PE deals in 2008 could be at attractive prices, if the capital markets do not go back to the high levels witnessed last year.

There is a concern that PE funds always have an eye on exit. The result, many say, is that under-prepared companies come the IPO way and finally have to list themselves. While the PE funds get out with huge profits, the public at large have to buy a company that could have come some time later. What is your take on the issue?

The above statement seems unfair as the fundamental thesis of PE investments is to nurture a company to build value. Empirical studies have proven that PE funds add value by bringing in good corporate governance, global practices, and help business grow through their network of relationships.

PE funds come in early and take a larger amount of risk in supporting the company to grow and help prepare the company for an IPO. IPO pricing is driven by market conditions and by intermediaries like lead bankers. The response to an IPO is also driven by the public perception of the value of the company.

PE investments also consist of venture capital, buy-outs, special situation investments and negotiated private equity investment by financial institutions. As far as India is concerned, which ones are likely to see more number of deals and why?

Indian promoters have a different mindset whereby they are not ready to sell out completely and want to be largely independent in managing their operations. They usually seek PE funding to raise capital for domestic expansion or for funding global acquisitions. Hence, India will remain a growth capital story for some time where PEs take minority stakes in companies.

While a few buyouts were witnessed last year, they will not gain much momentum as only a few sellers may emerge.

However, venture capital investing is emerging especially in areas such as technology.

It is often said that sectors such as infrastructure, retail and consumption-related are the most favoured ones from the PE perspective. But is there too much crowd in those pockets?

Infrastructure will continue to be attractive because of the scale of investments required. Various estimates indicate that infrastructure would require about $400 billion investments in the next five years, necessitating Public Private Partnership (PPP) in funding. Thus, private sources are expected to contribute about 30-40 per cent of this requirement. Hence, the potential for infrastructure investments remains attractive.

Investment banks are a major source for PE investments/deals. Mere coincidence or conscious connection?

Indian companies, typically, do not have much experience in fund raising and need the help of an advisor who can help them prepare for both capitalising on growth opportunities as well as fund-raising. Hence, investment bankers who play this role become integral to PE transactions in India.

In a country where promoters are seen as less reluctant to let go of their business, what are the problems faced by PE funds who buy stakes in such companies? Is there interference on day-to-day issues?

The KPMG survey of the PE industry indicated that PE funds do not interfere but actually collaborate with the promoter to help grow the business. Our report showed that the most important factor (after valuation) for management when choosing an investor is the relationship with individual fund managers and that plain vanilla funding is not the single driver for PE investment. The main drivers for portfolio companies in choosing a PE investor is support with corporate governance and enhancement of market reputation and perception. However, from the PE fund manager’s perspective, the single largest issue, post-investment, is the management’s digression from the agreed plans.

Globally, PE funds are looked upon as a collection of individuals who cut jobs, pressurise workers, relax on yachts and throw big parties. What is the real situation?

We cannot think of a transaction in India where jobs have been cut. In India, there were 70 and 37 PE-backed company exits in 2007 and 2006, respectively. These exits were successful and such success typically comes with hard work.

D. MURALI

KUMAR SHANKAR ROY

www.AccountSpeak.blogspot.com

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