Just two years ago, after the global financial crisis, Indian Private Equity ranked high in global investors' interest. In fact many investors saw Indian Private Equity providing opportunities on par with China, echoing the talk of "Chindia" from other parts of the political and economic discourse. INSEAD's joint study with Axa Private Equity on Asian Private Equity from that time confirmed the prevalent sentiment, with more than 70 per cent of Limited Partners (LPs) polled planning to substantially expand their allocation to India over the coming years.
Yet talk to global LPs these days and India has become merely an afterthought well behind China, emerging Asia, Brazil and even other Latin American countries. So why have perceptions changed so drastically in such a short time frame?
Michael Prahl
While surely many factors contributed to the decline in perceived attractiveness it is mainly investors' disappointment with returns from I
ndian Private Equity that has brought about this change. Not only have returns fallen short of expectations, they are lagging far behind those of China and Brazil. Generally returns in private equity depend on the following drivers: the price paid at the time of investment, the price achieved at exit, and of course company performance during time of ownership (Leverage, the fourth theoretical component, is not a meaningful contributor in most emerging markets given the prevalent investment strategies as well as legal and factual restrictions to the use of debt).
The investment side Indian Private Equity is characterised by relative smaller investment size in the vast majority of cases for (often small) minority stakes. At the same time for certain segments, especially growth investment and the occasional control transaction, competition is intense driving prices up.
Even in less competitive situations the price in the seller's mind is often anchored by public market valuations. So by not achieving a significant illiquidity discount (sometimes private transactions are actually happening at a premium to public trading comparables) private equity firms in India are at a distinct disadvantage to their competitors in the rest of the world: they are not able to benefit from the often inbuilt multiple arbitrage in private equity transactions, while taking on all the corporate governance and illiquidity risk of a minority shareholder in a private company.
This leaves many private equity funds tempted to invest in public companies in the form of PIPE deals ("private investments in public companies") While certain characteristics of the listed markets in India (companies listing earlier in India than in most markets and low liquidity in shares of many listed companies) make PIPE deals more of a private equity play than in more developed capital markets it has to be noted that by doing so the PE fund takes on general public market risk (and very visible for that matter) in its investments. Again operational influence of the PE investor tends to be often times limited by the minority investment structure making PIPEs look like a (sophisticated) stock picking strategy however, with a private equity fee structure.
The exit sideTo form a view on the exit opportunities and prevalent strategies in India a comparison with China, the success story for Private Equity in Asia, is helpful. To that end INSEAD joined resources with LGT Capital Partners and undertook a study of exits for private equity backed companies in both markets over the last ten years (until end of 2010).
Chinese Private Equity investments are predominately (about 2/3rd) exited via public markets both domestically and overseas. In India it is the reverse the dominant exit route being via sale to a trade buyer or other financial investor. Now it is no surprise that IPOs yield on average the higher returns especially for the type of growth investing prevalent in both markets. Add the aggressive timing of Chinese private equity backed companies for their listings, strongly correlating with the recent bull markets (up to 2007 and again after Q2 of 2009) and you get an additional boost to Chinese Private Equity returns that were missing in Indian Private Equity investments, which were exited at a steadier rate mostly via M&A.
Consequently a large inventory of pre-2007 deals has built up in the Indian Private Equity industry, waiting to be exited and in turn depressing IRRs (but not necessarily money multiples). It remains to be seen how this overhang will play out, as funds are coming to an end of their life cycle, right as we enter an environment of macroeconomic uncertainty and depressed public valuations.
In our study we also looked at detailed transaction data from our Asian LP panel which is heavily geared towards the more established and well known firms. For India the sample included 67 (full or almost full) exits with a median return of 1.8x invested capital. The dollar weighted return stood at a strong 3.9x invested capital highlighting that some of the lower yielding exits were part of the "work-out" from the tech investing phase from the beginning of the decade when smaller (mostly venture) investments were executed. Again the exits in this sample deals are dominated by M&A with the few IPOs delivering the highest average returns.
While these returns are not fund level returns but purely individual exited transactions (typically the more successful deals with the lesser ones still in the portfolios) it is still worth considering why these returns are so much higher than that of the average Indian Private Equity fund. Anecdotally, several factors seem to play a role: longer and better understanding of the industry translating into better company selection, greater pricing discipline and more operational value-add. Bringing real strategic and operational value-add will also often be the best way of influencing the promoter despite only holding a minority stake.
Building better companiesFor a private equity investor to support a company successfully throughout its ownership period, thorough preparation prior to the investment is necessary. Building up industry expertise and establishing contacts with promoters & executives takes time, a focused investment strategy and a diverse and well-qualified team complemented by a strong bench of outside experts. It appears however that too many Indian private equity firms follow a rather undifferentiated and reactive investment strategy. Few of them have team members with an operational background in their ranks and are therefore heavily biased towards company selection and transaction execution rather than working with the companies post investment.
The acquired industry expertise has to filter into the due diligence process. Contrary to public perception due diligence is not only undertaken to detect and avoid major problems but also to apply the private equity firm's broader knowledge of industry and strategic developments on the company level. This is the stage where a refined understanding of value drivers is developed and then discussed with management and promoters to arrive at the investment thesis. This discussion not only helps with price finding but also the development of a long term strategic approach, commonly known as the "100 day plan" for the portfolio company. Now it appears that the high competition for targets in India has frequently led to rather short and superficial due diligence processes, an approach that not only increases the investment risk of the transaction, but makes it specifically harder to develop a strategic roadmap. In addition, it makes it harder to gain the promoters buy-in for the strategy (or to detect and avoid getting into situations where the promoter is unlikely/ unwilling to cooperate later).
OutlookWe have discussed a few of the inherent problems in the structure of the Indian Private Equity industry and how they have contributed to a change in perception among global institutional investors. India does certainly offer a large number of excellent opportunities for private equity investors, especially considering its attractive demographic profile. Nevertheless, for the asset class overall to regain its former lustre, certain changes in the industry will be required.
Large pools of un-deployed capital, a queue of investments waiting to be exited, a plethora of undifferentiated first time firms on the road to raise funds and a private equity strategy geared heavily towards public market investing make institutional investors cautious about the short term outlook.
Add in the macro-economic headwinds (both globally and at home), a persistent inflation problem and a weakening rupee (adding foreign exchange risk for USD based investors), a net withdrawal of about USD4 billion from Indian equity funds and uncertainty around taxation (capital gains tax in general and robustness of Indo-Mauritius structures specifically) and Private Equity funds might be forgiven for approaching the new year cautiously.
Now as often in investing when general risk appetite decreases the remaining actors will be able to find the opportunities needed to deliver exceptional fund vintages. The renewed interest among global investors will then in turn allow Indian Private Equity not only to realise its potential but to support a fast growing economy by channelling much needed funds to worthwhile business ventures.
Claudia Zeisberger, Affiliate Professor of Entrepreneurship & Family Enterprise; Academic Co-Director GPEI at INSEAD and Michael Prahl, Head of Research INSEAD's Global Private Equity Initiative (GPEI)
Claudia Zeisberger 
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