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Perspectives on Private Equity in India

with G. Sabarinathan, Associate Professor; Mukul Gulati, MD,Zephyr Peacock India & Hoshedur Patel,Principal at ICICI Venture

Characteristics of Deals

GS: Most of the PE deals in India are minority deals. In recent years, there have been a few instances of majority buyouts. In terms of leverage, the buyout entity itself does not carry extra leverage; whatever leverage that comes with the company being bought is usually the leverage found. There exist differences in the buyout deals that happen in the West and here. Not all buyout deals here involve a management change whereas in the West, the buyout deal is usually associated with a management change. The team that is running the business might continue to remain, in which case it might be a ‘management led buyout’. If the team goes out, it is a ‘management buy in (MBI)’. This kind of sophistication or finer distinction is not seen here yet. It is still pretty much a financial investment, and not the kind of buyout one can see elsewhere.

MG: In India, promoters are unwilling to cede control. Furthermore, the pool of human capital is limited in India, rendering buyouts where you need to replace management difficult. Minority transactions are a natural and logical extension of this situation.

HP: Transactions with a controlling stake or a significant minority stake are generally more preferred. This allows company to wield more influence, and provides better exit at higher IRRs. Most firms have been set up recently, and are still nascent. ICICI has been investing since early 2000, and we have a lot experience in interacting with promoters. Our early fund was minority based, and we noticed that majority deals gave us higher returns. In addition, most firms have small teams of 4-5 people looking at investments. ICICI has 20-25 investment professionals allowing us to focus on buyouts. Any buyout needs to have buy in of either the promoters or the management. We are able to give comfort that we will be the majority shareholder, but we are not looking to get involved in the work. We ask promoters to speak with companies that we have invested in, and also exited from, to understand our working style. Despite this, promoters are not always keen to give control upfront. In this case, we may start with 20-25% stake and depending on performance, we can increase our investment. Being an Indian PE firm also certainly helps.

All the three of them believe that lack of human capital resources, unwillingness to run businesses and difficulty in extracting stakes from promoters are the key reasons for limited buyouts in India.

GS: The deals are mostly in mature companies. It has to be viewed in the context of the economy. We are an emerging economy, and there is nothing like a mature industry here. Companies might have cash flows, they might have reached levels of growth etc. but they still have a lot of untapped potential, for example, in terms of addressing export markets. So, given the emerging nature of the economy, one can describe these as established companies, but not mature companies. When you talk about mature companies, you usually associate them with flattening growth rates which is very rare in India.

HP: We prefer unlisted companies since we want to make it IPO ready and professional. Our portfolio consists primarily of mid-cap companies which are not stable in their growth. They experience challenges involved in scaling up, and doing so profitably. This requires HR planning, correct costing and system building measures.

It is agreed that Indian PE deals are dominantly growth capital investments due to the nature of our emerging economy.

GS: The distinction between passive and active is not very sharp anywhere in the world, but on average you would expect that an active investor would at least be involved at the board level in terms of strategy setting, and would be more actively engaged in receiving and processing information at the board level. Sometimes, it can get more involved than that, for instance, they might be pretty closely involved in setting up a 100 day plan etc. In terms of what we see in India, not much information is available in the public domain, but from the available information, one understands that the investors do take board decisions, however they pretty much leave it to the incumbent management or the new management to run the business. They don’t do the kind of things that private equity players like KKR or Carlyle do with their investments in the US or Europe. So, it seems to be more of a passive approach.

MG: We are not in the valuation arbitrage game. We do not ‘pick stocks’ and wait by the sidelines. We ask whether the CEO is willing to make changes, and make an agreement with him in writing.

HP: Partly, the value addition is driven by the nature of the company. If the management is strong, we work on strategy based on looking at inorganic growth or new markets and customer segments. If it is a founder owned and operated firm, we work at the grassroots level to implement systems which professionalize the company.

There is a sense that a lot of PE players in India, by taking minority stakes, often in listed companies, are passive investors. Most firms object to this generalization.

GS: Information is never available in the public. But it would be very fair to say that most private equity investors, especially those who make minority investments would generally seek fairly strong minority protection, particularly in the case of private companies (unlisted companies). In the case of listed companies, they cannot get any protection beyond what is available to them as a normal shareholder under the ‘Companies Act’, because SEBI regulations require that all shareholders be treated equally. So, there is no additional protection available to private equity investors in listed companies. In unlisted companies, they have fairly strong minority protection which is well beyond what the ‘Companies Act’ provides. I would imagine that the private equity investors whether majority or minority players, would seek protection whenever they make an investment in a private company. In a buyout, of course where they are in a majority position, they obviously control the company and don’t need any extra protection.

The practitioners chose to not answer this question directly because deal structuring can be a source of competitive advantage in this industry. Typical deals have milestones that may or may not be part of the term sheet.

GS: Most of the time, they don’t exit at IPO. If at all they do exit, they make a partial exit. Firstly, investors believe that the value will appreciate substantially in the aftermarket, and they would rather ride the upside. Secondly, if the incumbent shareholders sell, there is a risk that the market might perceive that the incumbent investors don’t see any upside, and that could send wrong signals to the prospective shareholders. So, investment bankers would be reluctant to let them do it. The third reason is that PE investors sometimes hold as high as 20-30% of the equity of the company before it goes public. If they were to offload all of it at the time of the IPO, there is a risk that there will be too much paper in the market and that can affect the pricing. So, for a variety of such reasons, private equity investors are generally happy to sell a part of their share at IPO.

MG: We reserve the right to a strategic sale when we want to realize an investment. Since most strategic buyers are interested in a majority stake, this requires the explicit agreement of the promoter.

HP: In cases where we have significant stake, IPO is not feasible. When selling large stake, aside from pricing, there are also trading and market depth issues. So, we might take a staggered approach to divesting in the public markets. Of course, the ideal situation is to sell to a strategic financial investor who can take the company to the next level of growth because of the control premium. The downside there is that potential buyers may not exist, and if the buyer is aware that there is no competition, you may not get full realization of value.

The consensus is that full exit at IPO may not be possible because of market depth, pricing and signaling issues.

MG: In India, a typical venture capital deal size is traditionally US$1-2mn. In a PE transaction, company has existing customers, proven business models and a proven product, whereas a VC dealInte is one where a product or technology risk is taken.

HP: When ICICI Venture had initially started, it was a principal fund. During the dot-com phase when biotech, pharma and IT were very hot, a majority of our investments were all early-stage investments. The model in VC firms, small investments in large number of companies underscores the high failure rate of these ventures. Inevitably, 60% of deals will never bear fruit, and the hope is that the 30 – 40% which will do well will be multi-baggers with very high returns. Now, the focus is entirely on private equity, where there is a growth risk certainly, but the company has a track record and little risk from product perspective.

Impact on Management and Governance

GS: They certainly do both. They would invariably bring out changes in the organizational structure. Having said that, if you were to take the example of the transaction involving the ‘Gokaldas Images’, the Hindujas continued to run, and not many significant changes were made in the management of the company. So, a lot of things, which are very common in private equity transactions, don’t necessarily take place here. In the West, almost always, changes in management and organizational structure happen. In fact, that is the fundamental premise around which the transaction takes place. Here, it is the other way around. The fundamental premise behind many transactions is that the investors like the management. Hence, they don’t make changes. But, they might bring out changes in the structure because of business restructuring. Incentive compensation is perhaps one significant similarity between practices in the West and here. They would certainly insist on providing shareholding to key managers, key employees to align their interests with that of the shareholder.

MG: Indian entrepreneurs are hard working but are not good delegators, a prerequisite for scaling businesses. They are handling the finance function, the sales function etc., and as a result the business suffers. Often promoters are looking for us to drive changes as they don’t have the capability of making organizational changes. We map out the current organization structure, switch people if required, and look at augmenting the missing pieces by hiring. This is consistently done across portfolio companies.

While sweeping changes in the management are not usually done for a variety of cultural and business reasons, PE firms believe that part of their value proposition is in recruiting for senior level positions.

GS: The first and the most important strategic implication is that PE investors are mostly financial investors, and they work with finite time horizons. Sometimes, you can have a strategic investor who by definition does not have a finite time horizon, taking a stake in the company. For example, if an IBM or an Oracle buys into i-flex, they are not buying it to sell it eventually. Similarly, a General Atlantic partner operates with mainly proprietary capital, and they don’t invest through funds .Now, if the investor does not have the constraint of a limited life fund, he would not work with a limited time horizon. The downstream application of investors working with a limited time horizon is that they will want to exit their investment at some point of time, which essentially means that another change in the ownership of the company is pretty much imminent. In terms of whether they actually influence strategy, they atleast claim to do so. The investor in some transactions will be very active, very deeply engaged, and very effective; in some others, he may not. Again, in the press, there has been a lot of coverage about some big shot transactions in the last 6 months. This clearly seems to indicate that somewhere, some things did not work out alright.

MG: Our auto parts company, Maxop earned 80% of its revenues domestically before our investment. The company didn’t fully understand profitability on customer basis, and on a per unit basis. Once it became clear that it was not breaking even on domestic customers, we refocused its strategy by looking at Europe and USA, and eliminating domestic unprofitable customers. Last year, 85% of revenues came from exports.

Most PE firms implicitly endorse the management’s business plan when making an investment. Therefore, huge deviations from strategy are rarely seen post investment. Certainly, PE backing can provide the impetus and encouragement needed for companies to go through with strategic transformations that require changes in organizational behavior, difficult conversations with customers and a degree of internal turmoil.

GS: The widely held premise is that the private equity investors affect the quality of governance, and they affect it positively. There is no empirical evidence for this, and one has to therefore go by anecdotal examples. Personal suspicion is that they might not have done anything serious to the quality of governance. By definition, one would expect that they would strive to do that. Their intention would be to improve the quality of governance because it is in their interest to do so. After all, as an external stakeholder, positive governance helps them by improving the valuation of the firm. The effectiveness however depends on whether the owner managers are willing to play ball, and whether the PE investor is able to figure out what is positive governance for the company, and there are doubts on both these counts. Hence, it is difficult to say whether they have made a positive difference or not, but by definition they are bound to work towards positive governance.

HP: Corporate governance is the key. Even if we end up selling to another strategic or financial investor, a well reputed and recognized board is essential. Statutory and internal auditors provide comfort, not just to me but also for potential investors. Therefore, we always get one of the Big Four. The number of independent directors is also greater than minimum required by the regulator.

MG: Since the promoter has control, the board composition does not matter greatly. While minority shareholders, we have consent rights in critical decisions. We use our relationship and trust with promoters to establish a deal structure that aligns with our interests.

The principal of a well known venture firm believes that he has been able to improve corporate governance by having more independent directors, and having one of the Big Four auditors. Academicians don’t think that it automatically translates into better governance. This is reflected in the Professor’s reply where he is not sure as to whether there has been a positive improvement in the governance.

Impact on Value

GS: They claim to contribute to relationship networks. But if you were to ask the investee companies, their opinions might differ, and it is not just an Indian experience. There is empirical evidence based on serious academic research in the West, where the opinion of the investee company management differs in a statically significant sense from the perception of the investor in terms of how much they contribute to relationship networks. M & A is one of the areas where PE investors play a major role. They bring expertise, leads and offer ideas. If nothing else, the investment contract gives them a right to veto acquisition proposals. By virtue of that, they have a major say in the M & A activity. They claim to help in identifying better investment opportunities. They have a right to do so under the contract, but it is difficult to say whether they make a positive contribution. It must be remembered that in all these things, the answer is slightly grey.

MG: PE firms especially those with a global presence are able to extract value for their portfolio companies by making introductions with potential clients, suggesting business partners overseas, engaging high quality service providers such as consultants and investment bankers and also looking for synergistic mergers between portfolio companies.

HP: Because we have ICICI brand behind us, we have contacts across multiple organizations in India. This means we ensure the right auditors are in place. Some of our banking clients can be natural customers, so it is possible to make inroads into them. We can also work with them on fundraising to ensure adequate capitalization.”

The professionals believe they contribute significantly to a company’s relationship network, but this has been critiqued by academic research. In areas such as M&A, however, there is evidence that the PE firms have created opportunities for their portfolio companies.

Profiles

G. Sabarinathan is an Associate Professor in the Finance & Control area at IIM Bangalore. He has served as a director on the board of the Indian subsidiary of CDC Capital Partners, now known as Actis. His research areas include topics like the evolution and regulation of securities market in India. He holds a Ph.D. from the National Law School of India University and a Post Graduate Diploma in Management from IIM Bangalore.

Mukul Gulati is the Managing Director for Zephyr Peacock India, the India arm of Zephyr Management LP, an emerging markets focused PE firm with US$1.4bn assets under management globally. Over the last ten years he has held responsibilities in areas such as investment research, product development and general management. Mr. Gulati received an MBA with honors from Columbia University Graduate School of Business. He is also a cum laude graduate of the University of Maryland, where he was a Dean’s Scholar at the Department of Economics.

Hoshedur Patel is a principal at ICICI Venture, one of India’s oldest and most renowned domestic PE firms. He has over eight years of experience, which spans across banking and industry. Mr. Patel holds a Bachelor's Degree in Commerce from R.A. Podar College, Mumbai and has an MBA from the Indian Institute of Management, Bangalore.