Why private equity funds prefer IPO exits the most

The corporate office of Ratnakar Bank in Lower Parel, Mumbai, has been buzzing with keyboard clicks and shifting of documents. The bank is deep in the throes of a frenzy to prepare for its initial public offering (IPO).

The echoes of this clicking and shifting can be heard a few floors above, where the offices of Aditya Birla Capital Advisors (ABCA) are brimming with cautious enthusiasm. Bharat Banka, Senior President with Aditya Birla Group, who was earlier the CEO of ABCA, says the fund plans to dilute its three per cent stake in Ratnakar Bank during the IPO. It hopes to get Rs 150 crore to Rs 225 crore for its holding, which would be a return of two to 2.5 times on the Rs 75 crore the private equity (PE) arm of the Aditya Birla Group had invested in the bank less than two years ago.

That anticipated exit from Ratnakar Bank would be in the midst of a purple patch for ABCA. Set up six years ago, it had raised Rs 1,200 crore through two funds: Aditya Birla Private Equity Fund 1 and Aditya Birla Private Equity Sunrise Fund. It invested parts of that money in Coffee Day Resort, Credit Analysis and Research (CARE), BSE, Tree House, Wonderla, City Union Bank and Indian Energy Exchange. Of those it has exited CARE, Tree House and Wonderla, making returns of two to three times.

There is one more reason for optimism as the Ratnakar Bank IPO comes along. Henderson, another PE fund, exited Sharda Cropchem in an IPO in September for a return of Rs 223 crore on its six-year-old investment of Rs 100 crore - a healthy 2.23 times.

In the many interesting ways that the PE industry reads the tea leaves, the Sharda IPO has encouraged a bunch of PE funds to egg on their investee companies to approach the market with share sale proposals. The prominent ones among these are Adlabs Entertainment, Monte Carlo Fashions and Power Mech Projects.

"With market sentiments improving, one is bound to see exits," says Vishakha Mulye, the ICICI Venture CEO. She is counting down to the IPO of Adlabs Entertainment, in which ICICI-V invested Rs 144 crore in August last year for 17.8 per cent equity.

A good exit, with good returns, is what PEs live for. Within that, the IPO exit is the most sought-after, as that is when a company gets truly valued by the market. That is not the case with sale to financial or strategic investors. A good exit during an IPO makes money for the Limited Partners (LPs), those who park their monies with PE funds, and helps funds convince more people to trust them with their monies.

"Exits through IPO look good on the fund manager's CV," says Jayanta Banerjee, Managing Partner at ASK Pravi Capital Advisors, a Mumbai-based PE fund manager. "But this route was closed for a long time."

The demand for IPOs was dormant, indeed non-existent, because investors had tuned out of the equities market - secondary (stock market deals) as well as primary (IPOs) - because of uncertainty on the domestic as well as overseas fronts. Debt, with its promise of security of investment, was by far the more popular option.

This may seem anachronistic because the Sensitive Index of the Bombay Stock Exchange (Sensex) has been for some time exploring new highs. But the rise began in February 2014 just before the Modi government came to power. Even so, the rise is selective, driven by Sensex heavyweights like Hindustan Unilever, TCS and Infosys. The wider market has only now begun to perk up on hopes of deep economic reforms by a decisive government.

But perking up it is, and that has put wind beneath the wings of IPO aspirants. And PEs are flying high, dreaming once again of the ultimate glory through IPO exits. And that brings us to PE cycles.

In India as well as overseas, PE investments move, roughly, in seven-year cycles, bookended on one side by investments and on the other by exits.

The PE era started in India with Warburg Pincus putting in $292 million in Bharti Airtel in 1999 for 18 per cent equity. It exited in 2005 with $1.6 billion, making it a landmark in every sense - timing, opportunity, and return - and triggered a raft of PE deals involving fund houses like ChrysCapital, ICICI Venture, Citi Venture Capital, IL&FS, Morgan Stanley, Temasek, Actis, General Atlantic, IDFC, Baring, etc.

Some of the investments turned out to be lucrative. ChrysCapital made 13 times returns on its Yes Bank investment over three and a half years. Henderson made 2.5 times in HT Media. ICICI Ventures four times in PVR.

This first cycle of PE investments in India ended in 2004-06, with ChrysCapital making a successful exit from Gammon India, Citi from I-Flex, and others.

The successes in the first cycle created more interest among global funds in the India story. Blackstone, Carlyle, KKR, TPG, Advent, Goldman Sachs set up shop in the country. Some home-grown funds took shape: ASK Pravi, Motilal Oswal, Banyan Tree, Lighthouse, CX Partners. With a spring in their step, they braced up for the next cycle. That was when it all went down.

As with so many of the best-laid plans, the Indian PE story, too, was undone by the global financial meltdown that officially set in with Lehman Brothers going under in September 2008. The story since then has been one of drudgery and misery, with only sporadic bright sparks.

"India has been a tough story. Unlike the first cycle, in which there was less competition and abnormal returns, the second cycle has been pretty sad," says Aluri Rao, Managing Director at Morgan Stanley Private Equity Asia.

Numbers bear her out. The first round saw PE investments of $5 billion to $6 billion, on which the funds reaped an Internal Rate of Return of 25 to 26 per cent as the Sensex rose from around 3,000 in 2002 to about 9,000 in 2005.

This fervour carried over into the next cycle, with $35 billion worth of PE investments coming in between 2006 and 2008, when the Sensex rose from 9,000 to 21,000. The sins of those days - euphoric deals made at high valuations - are still being atoned for.

About two-thirds of the money invested in that period is still stuck, as the exit options slammed shut. According to market grapevine, funds like Clearwater were forced to make exits at returns of 0.6 to 0.8 times as the life of the fund ended and money had to be returned to LPs. Rajesh Khanna, who left his position as Managing Director at Warburg to start his own fund, Arka Capital, could not raise money and shut shop. Steer Capital, set up by Neeraj Bhargava, who left WNS, and Harsha Raghavan, who left Candover India, met the same fate.

Part of the struggle is to find good companies to invest in. That has led some PEs to shed the core character of a PE, which is to invest in companies that have not yet gone public, and go after listed companies. Advent India PE Advisors, a PE fund, opened its India office five years ago but has invested directly only in two companies. Says Shweta Jalan, the Managing Director: "In India large deals will be fewer."

Many see that dreadful second cycle as having come to an end. They believe the third has begun, with renewed hope and promises of IPO exits. In July this year Morgan Stanley raised $1.7 billion for its fourth Asia Fund, which would focus on Korea, China and India. "We have been among the few people to have returned more than what we took from investors," says Rao, who had raised $2.6 billion from investors and given $3.6 billion back to them. No wonder, he says: "This current cycle is better than the second." However, in the same breath, he adds: "But it has to be seen if it is better than the first."

The answer will depend on the exits on the anvil. Without good exits, the funds will not find LPs. "There are no second chances," says M.K. Sinha, CEO at IDFC Alternatives, a PE fund. "Investors expect you to generate 22 to 25 per cent returns. They understand the environment, but still won't accept lower returns. If you can't make money, you have no option but to shut shop."

That brings up the prospect of a shakeout. But that would mean bloodshed, because consolidation in the PE industry is always an unlikely event, given the lifecycle of funds. That is why IDFC Alternative's Sinha and Aditya Birla's Banka have pinned their hopes on exits.

"In the next six months I would like to exit four to five companies, of which some will be sold to strategic investors, and at least one to a financial investor. Another exit may come through an IPO," says Sinha, as he prepares to set up a fourth PE fund. "I want to go to investors with my performance and therefore the focus is on exit."

That performance, he admits, may be a mixed bag. "My second fund will be subdued, but the third will deliver decent returns. I will do better than my peers. At least, I give capital back to my investors."

The tempering of ambition is clear in Sinha's statement. But even the tempered target must be achieved in a finite period.

"The window of exits will be open for another three to six months as the mood will continue to remain buoyant on hopes of reform," says Rabindra Jhunjhunwala, who looks after the PE practice at Mumbai-based law firm Khaitan & Co.

When a lawyer talks like that, you know you have to pay attention.