India in recent months has been witnessing a surge in foreign direct investment inflows which, together with enhanced borrowing abroad by Indian firms, seems to explain the sharp rise in foreign exchange reserves. In this edition of Macroscan , C. P. Chandrasekhar and Jayati Ghosh discuss the possible source of these direct investment flows and the factors driving such investments.
C. P. Chandrasekhar
Recent months have witnessed a dramatic shift in the composition of foreign investment flows coming into the country. According to figures released by the Department of Industrial Policy and Promotion of the Ministry of Commerce and Industry (see Table), foreign direct (equity) investment inflows during the first ten months (April-January) of financial year 2006-07 touched $11.19 billion, as compared with $16.5 billion over the whole of the 1990s and an annual average of $2.2-3.2 billion during 2002-03 to 2004-05. The current surge in inflows had begun modestly in 2005-06, when FDI inflows stood at $5.5 billion.
There are two messages that are being read into these new figures. First, that post-liberalisation India, like China, is finally becoming a manufacturing hub for international firms that are making long-term productive investments in the country. Second, that India is finally moving out of the phase when it was largely the target of speculative foreign portfolio investments (via the Foreign Institutional Investor route) into the country, to one in which it is attracting productive investment flows.
There are reasons to believe that these judgments may not be warranted. It needs to be noted that the distinction between portfolio and direct investment flows is based purely on an arbitrary cut-off line defined in terms of the proportion of equity in a firm held by a single foreign investor. After liberalisation India had adopted the international (IMF) definition of foreign direct investment as any investment in which a single foreign investor acquires 10 per cent or more of the paid-up capital in a firm. If the acquisition by a single entity is less than 10 per cent, the investment is classified as a portfolio flow.
New investor class
The implication of adopting such a definition for classificatory convenience is that investors acquiring stakes of more than 10 per cent in listed or unlisted companies, irrespective of their motive, are automatically treated as direct investors with a long-term interest in the companies they invest in. But with new kinds of investors entering the Indian market, this is increasingly less true. Our concern here is with one such class of investor identified as "private equity" firms.
Portfolio diversification by financial investors in developed countries seeking new targets, higher returns and/or a hedge has over the last quarter of a century taken them into new and ostensibly "innovative" and "alternative" asset classes. One such is private equity, which, as originally and broadly defined, involved investment in equity linked to an asset that is not listed and, therefore, not publicly traded in stock markets. More recently, private equity firms have invested even in listed companies, though the buyout by the investor occurs through a negotiated process, with the buyout being friendly or hostile depending on whether the negotiation is with the controlling interest or not. In sum, private equity is acquired either through the private placement of new shares or the sale of pre-existing shares by the controlling interest or minority shareholder and, therefore, has features that characterise most takeovers.
It can be bought directly by an investor or through an intermediary such as a private equity fund that mobilises capital to finance a set of such investments. However, capital mobilised from investors is substantially enhanced by borrowing to finance acquisitions.
Range of transactions
Given the broad definition of what constitutes private equity, a range of transactions and/or assets fall under its purview, including venture capital investments, leveraged buyouts and mezzanine debt financing, where the creditor expects to gain from the appreciation in equity value by exploiting conversion features such as rights, warrants or options. Despite the entry of different kinds of investors into this area over the years, it was the raft of leveraged buyouts of the 1980s that gave private equity its fame, making it largely an activity which involved the take over of relatively large companies financed substantially with debt.
Private equity firms or funds are most often limited partnerships, with the firm as the general partner that manages the fund being paid an annual fee (calculated as a percentage of the money invested in and managed by the fund) as well as a share of the profits, if any, garnered by the fund. The investors themselves are limited partners with a right only to a share of the profits.
In recent years, private equity firms have been able to mobilise substantial sums of money from investors such as banks and pension funds that are looking for alternative avenues of investment outside of stock markets. Figures from Venture Economics suggest that between 1980 and 2000, the amount of commitments of capital to funds managed by private equity firms increased from $2.3 billion to about $177 billion, cumulatively totalling $737 billion.
However, estimates of the industry's size vary, reflecting the secrecy that shrouds it. According to estimates made by Thomson Financial, 2006 was a record year for private equity in both fundraising and investments. 684 PE funds raised a record $432 billion worldwide in 2006, led by buyout and real estate funds with $213 billion and $63 billion respectively. The total value of announced private equity buyout deals hit a record $700 billion in 2006, more than double the record set in 2005 and 20 times bigger than in 1996 (Metrics 2.0 2007).
According to one study, private equity assets under management are now nearing $400 billion in the US and just under $200 billion in Europe. Private equity expansion is also reportedly strong with aggregate deal value growing at 51 per cent annually from 2001 to 2005 in North America. The largest private equity firms, such as Blackstone, the Texas Pacific Group, the Carlyle group or Kohlberg Kravis Roberts & Co., each control companies with combined net revenues that exceed most US companies. And the large volumes of committed investor capital controlled by these funds and their substantial access to bank credit make them consider and execute deals that are huge and often unprecedented. One such recent deal is the Blackstone take over, after an intense battle with Vornado Realty Trust, of Equity Office Properties (the publicly traded owner of US office towers) for $39 billion. This is reportedly the largest leveraged buyout ever.
Scouring for opportunities
Being awash with liquidity, these firms have been scouring for investment opportunities, taking them increasingly to developing-country "emerging markets", including India. According to Emerging Markets Private Equity Association, fundraising for emerging market private equity surged in 2005 and 2006. Estimated at $3.4 billion and $5.8 billion in 2003 and 2004, the figure shot up to 22.1 billion in 2004 and $21.9 billion in the period to November 1 during 2006. Asia (excluding Japan, Australia and New Zealand) dominated the surge, with the figure rising from $2.2 billion and $2.8 billion in 2003 and 2004 to $15.4 billion during 2005 and $14.5 billion during the first ten months of 2006 (
EM PE Quarterly Review, Volume II, Issue 4 2006).
Deal making in the region has also gained momentum. Dealogic estimates that the value of private equity deals in Asia-Pacific, excluding Japan, more than tripled to $26 billion in 2006 from $7 billion in 2005 (Metrics 2.0). Private equity buyouts have accounted for 7 per cent of regional merger and acquisition volume this year, up from 3 per cent in 2005 but still below the global figure of 17 per cent.
India's experience is illustrative of the rush of private equity to the developing world. Observers began to take note of private equity's growing presence in India when in late 2002 Oak Hill Capital and Financial Technology Ventures resorted to a buyout deal by backing a management bid to acquire Conseco's stake in Delhi-based EXL Services. Subsequently, in September 2003, ICICI Venture bought out the Tatas' controlling stake in Tata Infomedia. Three months later, CDC Capital Partners, the UK-based private equity investor, struck a Rs 75-crore deal to buy ICI India's industrial chemicals business in Gujarat. The private equity asset class had arrived in the country.
When private equity fund Warburg Pincus LLC announced in the middle of March 2005 that it had sold a chunk of its stake in India's top cellular player, Bharti Tele-Ventures Ltd, for $560 million (the largest stock trade in India's history), it was time to sit up. Warburg Pincus had with that deal made $1.1 billion by selling off two-thirds of its 18 per cent share in Bharti, reflecting a huge payoff on a $300 million investment made in stages between 1999 and 2001.
Since then, there has been an increase in such activity with all the majors finding their way to the country. Growth has also been substantial. The total number of M&A deals struck in 2006 was estimated at 782 ($28.2 billion) compared with 467 ($18.3 million) in 2005 (
Business Line, January 7). Of these, 302 involved private equity. Private equity investments also saw substantial growth in 2006. From $1.1 billion invested in 60 deals in 2004, private equity investments rose to $2 billion in 124 deals in 2005, and a remarkable $7.9 billion in 302 deals in 2006. This remarkable 287 per cent increase in the total value of private equity during 2006, points to a growing value in each deal. There were more than 29 deals valued at over $50 million as against 10 such in 2005. The average private equity investment size increased from $16.40 million in 2005 to $26.02 million in 2006.
Some of the big deals included Kohlberg Kravis Roberts & Co's $900-million investment in Flextronics Software Systems; Providence Equity Partner's $400-million investment in Idea Cellular and Temasek Holdings Pte's $330-million investment in Tata Teleservices Ltd. Such deals are continuing in 2007 with Blackstone Group acquiring a 26 per cent stake in Ushodaya Enterprises Ltd, which publishes the Telugu newspaper
Eenaduand owns television channels under the same name.
India has been a hot destination even according to Venture Intelligence, a firm tracking this market in India. Private equity investment in India rose by over 230 per cent in 2006, to $7.46 billion, up from $2.26 billion a year earlier. And the trend seems to be continuing. Private equity investments are estimated to have doubled in the January-March quarter with firms such as Goldman Sachs and 3i investing large sums in Indian companies. Private equity firms invested $2.5 billion in the first quarter of 2007, up from $1.27 billion a year earlier, according data recently released by Venture Intelligence. Private equity investment in India is expected to touch about $10 billion in 2007, from $7.46 billion in 2006 which was more than triple of $2.26 billion invested in 2005.
What is noteworthy is that many of these deals are occurring outside the stock market, since rising valuations in a booming market have reduced the potential for substantial capital appreciation there. In the book of the DIPP and the Reserve Bank of India these get reported as foreign direct investments.
This ability to acquire equity through the private market suggests that foreign acquisitions could increase sharply in India, since it is known that there is a substantial proportion of companies in the country that are either unlisted or in which free-floating (as opposed to promoter-held) shares are a small proportion.
Forms of exit
What needs to be noted is that the acquisitions by private equity firms, even if large in terms of equity share are more in the nature of portfolio rather than direct investments. The exit from an investment by a private equity investor normally takes one of four forms:
direct saleto investors seeking a shareholding in a firm acquired by the fund;
post-purchaselisting of the company permitting sale of equity through the stock market;
"recapitalisation" byincreasing the debt outstanding and using the money to make dividend payments that the fund distributes to its limited partners; or
sale toanother private equity firm, referred to as a secondary buyout.
Realising profits through these means often requires waiting for as long as ten years or more, during which period expectations of an increase in the value of the original investment may or may not be realised. The consequent relative illiquidity of the investment implies that private equity investors expect to take in their returns over the medium or long term, unlike many investors in publicly traded equity.
Given the risks involved and the long periods for which capital is locked up, private equity investors normally expect their investments to significantly outperform investments in bond and equity markets.
This can create a problem inasmuch as the original investment is based on a purely financial calculation, while the realisation of returns implicit in that calculation requires counterpart investors looking for returns from acquiring an asset that allows engaging in a profitable non-financial activity. That is, the expectations of conventional investors in different kinds of economic activities must match, with a lag, that of pure financial investors represented by private equity firms.
Since private equity returns derive from an appreciation in the value of the acquired asset or company, private equity investments are often followed by efforts at restructuring to resuscitate loss-making companies or substantially improving the performance of profit-making ones. These efforts are aimed at adding value to the investment before private equity investors exit with a profit. Less appreciated forms of intervention by private equity firms are those in which bought-out firms are stripped of assets or are broken up so that the pieces can be sold to the highest bidder for an aggregate sale price that exceeds the purchase price.
The revival or improvement of the performance of a poorly performing company must be a prerequisite for ensuring the appreciation of an asset, excepting in cases where: (i) the company concerned was bought cheap and could therefore be sold for a profit, which would be more an aberration than the rule; (ii) the market for the company's products takes a turn for the better, which was not foreseen by the original owner but expected by the private equity firm; or (iii) the company develops a new product or technology which can be commercialised for a large profit, as does happen in the case of some venture capital investments.
While these may be the principles on the basis of which the private equity business is rationalised, in the final analysis the business rests on the fact that "valuations" are speculative. Private equity firms would like to keep their buyout prices cheap, but loaded with funds find the need to push up valuations to acquire assets. While informed by the profit potential of the target, these valuations do often imply a high degree of risk. But the very fact that such initial valuations are made, by firms led by individuals with a track record, creates an environment for future sale at a price that incorporates a profit. And the longer investors in private equity funds are willing to wait for returns, the longer would fund managers have to wait out the market in search of a profitable sale. Further, in certain circumstances, valuations in the private equity market could influence stock market prices as well, with high valuations in the former encouraging higher price earnings ratios in the latter. This could help the sale of assets through the stock market.
Valuations may also be sticky upwards in the relatively good times, or when there is liquid capital looking for investment avenues, because of a fact noted earlier: the distinction between purely financial capital and capital aiming to derive returns from production of goods or services in the long run has blurred. Increasingly, investments in production are driven by the possibility that the creation of a successful company could offer the option of selling out at a high price, delivering wealth that can be invested in financial assets. Since wealth is measured by the prevailing market value of the asset, the process can feed itself, leading to unsustainable valuations at which someone has to carry a loss. The bourgeoning of finance results in the "dematerialisation" of wealth, permitting wealth accumulation at a pace much faster than the growth of production, so long as the game of rising valuations can be sustained.
Speculative in nature
All this makes this kind of investments speculative in nature. This is a factor whose implications need to be taken into account before celebrating figures on surging FDI. Moreover, the incipient trend of transfer of ownership of productive assets from Indian to foreign owners would be aggravated by the private equity boom, which is not restrained by the extent of free-floating shares available for trading in stock markets. Private equity firms can seek out appropriate investment targets and persuade domestic firms to part with a significant share of equity using valuations that would be substantial by domestic wealth standards even when they may not be so by international standards. Since private equity expects to make its returns in the medium term, it can then wait till policies on foreign ownership are adequately relaxed and an international firm is interested in an acquisition in the area concerned.
The rapid expansion of private equity in emerging markets such as India suggests that this is the route the private equity business is seeking given the fact that the potential for such activity in the developed countries is reaching saturation levels. The dematerialisation of wealth has as its counterpart rising foreign ownership in developing countries like India.