What the Polaris Virtusa deal means

The recent transaction between Polaris and Nasdaq-listed Virtusa is a benchmark in many ways for mid-tier, promoter-driven IT companies. This is the second time (after the Iflex-Oracle transaction in mid-2006) a controlling stake was sold by the promoter in a prominent Indian-listed entity to a Nasdaq-listed entity. The valuations at eight to nine times one year forward EBITDA (earnings before interest, taxes, depreciation and amortisation) and 1.2 times revenue were very attractive (the IT majors are between 10x and 13x EBITDA multiples). This is more so as all the valuable assets were transferred to Intellect Design Arena (the company hived off from Polaris last year and which holds the product IPRs, land, etc ).

The value creation for investors in the pre-deal-making stage has been significant over the past one year as the combined valuation of Polaris and Intellect shot up by 300 per cent to ₹4,500 crore over its normalised trend line of a  three-year average market capitalisation of  ₹1500 crore. For Virtusa it provides a vehicle for a crucial, though significantly delayed, India entry through a highly skilled, focused talent pool and Citigroup-backed revenue contracts. So, from all viewpoints, it’s a great deal, but then Arun Jain has always been a skilled negotiator with sharp acumen for driving great commercial and contractual bargains.

From where I stand, and with in-depth understanding  of  the company from my days as group CFO and permanent invitee to the board of Polaris,  and also knowing what Arun personally stands for, I view this deal as having far deeper implications for the industry as a whole. Arun Jain is a visionary and is credited for coining the term BFSI (Banking, Financial Services and Insurance) in 1989 much before it entered the vocabulary of the IT industry. His remaining focused on BFSI attracted some of the best domain specialists to Polaris and helped create a brand with high visibility among the largest financial institutions globally. He stuck to his conviction that products was the way to go; this is what kept Intellect going despite guzzling huge amounts of cash over the last 15-odd  years.

During my time with the company almost a decade ago, Intellect was recognised by many large global banks as a product with significant differentiating features and huge potential.  I am sure it must have come a long way since then.

There are some reasons why it did not quite attain global success despite its potential.Polaris suffered from copybook issues faced by a product venture embedded in a larger  company, and that too a services company with a completely different outlook, skill set, management practices and approach. Various examples abound of such failures including Sasken (though compounded also by poor leadership post-IPO), Mindtree (course correction to focus fully on services led to a remarkable turnaround recently), and 3i Infotech (technically bankrupt today).

Most services companies either developed small reusable components or inherited products via acquisitions and tinkered with them under the illusion of transforming themselves into a Microsoft. Due to various reasons primarily linked to inadequate focus and funding, these products soon got outdated (older architecture, incompatibility with newer technologies and platforms such as cloud and mobile) and died a natural death. Finacle from Infosys is a clear exception; it continues to prove its robustness even though it contributes only a small portion of the company’s revenues.

The additional issue for Intellect was a common set of PE investors for both the services and the products business. They looked upon the products business as unnecessary diversification and distraction from the “main” services business which brought in the cash.

Linking revenues to funding needs for a product business is essentially a shortsighted goal typical of investors in a services business: this resulted in the curtailment of upfront funding needs so necessary for getting a complete product off the ground with a clear long-term strategy, a defined roadmap encompassing investments, rollouts, business development, life cycle management, R&D, and so on.

In the context of a strain on investments, and the conflict of philosophy with investors, the greatest impediment to the product effort was the necessity to persevere with a services business sales force in the highly developed global markets resulting in  a thinly differentiated sales strategy for the products business.

All this is about to change now that Arun has generated a ₹700-crore cash chest through the Virtusa transaction and thus has full freedom to invest in building the products business and truly “live his dream”, at one time the catchy Polaris tagline!  Newer revenue models are now possible based on new cloud architectures and offer immense potential in terms of platform choices and different delivery models (PaaS, IaaS and SaaS) beyond the typical user-based licence models provided, of course, additional cash-flow requirements are met by the investors.

Being a listed entity, Intellect Design Arena now has a  fresh set of investors who truly believe in the product strategy and will thus be patient about their capital investments. Further, being the only serious listed entity in the IT products space, the valuation models are amenable to paradigms yet to be set in the Indian stock markets and will borrow heavily from those crazy ones at Nasdaq. If initial performance can be demonstrated by Intellect, then, literally, the sky is the limit for the stock as has been proven (though I am exaggerating to prove a point) by Apple, Microsoft and Google in the global markets. The potential “currency” value of the Intellect scrip by itself can be enough to fund its product ambitions as it expands its global footprint.

Product businesses are completely different and can only succeed with appropriate business and technology models (revenue models, performance models, continuous innovation programmes, changing product architecture to align with newer technologies, etc) tailored for the product and its customer base, domain/technology thought leadership and continuous research. All this requires upfront funding and, very importantly, a determination to stay the course over the long haul.

Arun has shown this trait in the past amidst significant adversity. He now has the means, potentially the currency, and the platform to demonstrate it, freed from all past encumbrances, and live his dream to build a world class product company out of India.

Industry is going to watch this metamorphosis with interest. If IT services built India’s brand recognition, a product company will be its vehicle for garnering self-respect in the technology universe. To my mind, this opportunity to build a listed, world class, pure play product company out of India is the most significant implication of the Polaris Virtusa deal.

A Sloan Fellow from the London Business School and chartered accountant, the writer presently manages a PE fund

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