Private equity funds now have to work harder for everything

Roughly 15 years after the first private equity (PE) dollars started trickling into India, PE funds find themselves in a rather tight spot. In the next 12-18 months, one bunch of firms, mostly the newer ones, will desperately try to close the funds they have just set out to raise. Another bunch, slightly older ones, will be equally desperate to deploy about $20 billion-$30 billion they have already raised.

A third bunch will also face their moment of reckoning. They had raised $15 billion-$ 16 billion by 2006-07 and deployed much of it. Now, these will need to be returned and redistributed to investors, hopefully yielding good returns.

As the next 12-18 months run their course, multiple sources in the PE industry are bracing themselves for the worst nightmare to be played out – failures on all three counts. “In a year to 18 months there will be closure, mergers or sales of PE funds,” says Markus Ableitinger, a director with Switzerland-based Capital Dynamics, an assets management firm, with investments in private equity.

“Returns have been disappointing and there is nothing to be done but accept this new reality.” Adds Anil Ahuja, Asia head of 3i: “In 2012-13, the industry could face another fierce round of consolidation.” The PE fund has over $1.2 billion invested in India.

Ahuja estimates there are 400 PE funds in the market and another 400 firms in the form of NBFCs, family offices and so on who also want a bite of this market. “In this overcrowded market, Limited Partners (the investors who back PE funds) are asking a lot of tough questions.” They are warily watching their investments from New York, London and Singapore and beginning to get increasingly agitated.

“India has been a very challenging market... exits have been low,” concedes Ahuja.

The PE industry finds itself in a pressure cooker situation which is at least partially, its own making. It is now hard to raise funds. It is harder to find companies to invest in. And where PE funds do strike deals, working with promoters is more difficult than before. Many cases of PE-promoter conflict are emerging.

The economic environment is also making it harder for PE funds to fulfill their primary competence – build value in the companies they have invested in. And finally, exiting these investments is turning out to be the hardest. With stock markets in a freefall, IPOs – private equity’s most preferred exit route in India – has slammed shut.

Subbu Subramaniam, who has seen the evolution of private equity in India first hand, first with Barings and then with his own unit called MCap, sums it all up bluntly: “PE in India has not delivered the returns expected.”

The pressure is telling. The impending consolidation will take many forms, say experts. LPs could downsize the number of firms they invest in, take longer to invest and commit smaller amounts to each fund. Many funds are likely to fail to deliver expected returns; some may even have to ask for more time to exit investments and return the money to LPs.

Raising Money

In September 2006, PE firm Everstone Capital raised its first $425 million fund in barely 90 days. But it spent a year closing its second $550 million fund in March this year, according to Sameer Sain, managing director, Everstone. This time, Sain says, investors spent time meeting all their employees, doing multiple reference checks with portfolio companies and verifying their credentials.

In 2008 (see table) PE funds raised over $5 billion in funds for India; this has fallen to just over $3.5 billion up to November 2011, according to data from Venture Intelligence, a Chennai-based tracker of venture capital and PE deals.

“The world view of LPs has changed ... liquidity is a major concern today,” says Subramaniam. “While an average manager or above-average private equity manager can still raise money in China, it’s not the case in India now,” says Doug Coulter, a Principal with Switzerlandbased LGT Capital Partners, which has over $21 billion in funds under management. “There are some Indian managers, which claim that their funds are oversubscribed and they’re telling LPs that there is no allocation available.

This seems to be the exception, rather than the norm,” adds Coulter, who has backed PE funds in India.

There are at least a dozen or more new funds in the market to raise $100 million or more. Industry experts such as Subramaniam of MCap think very few of them will be successful — especially if they are in the generic growth capital space, with little differentiation. Several of them will scale down plans or simply fade away.

Finding Deals

“India is not an easy market for private equity,” says Ableitinger. “It is not easy to acquire a stake in a company at favourable prices... competition is relatively fierce in India, with different fund types competing for quality deals.” LPs say entrepreneurs are in no hurry to sign term sheets, a nonbinding agreement to finalise investments.

“Entrepreneurs in India have not been too keen to work with private equity funds, as it is perceived as an expensive source of funding and they don't clearly see the value in many Indian private equity firms,” says Capital Dynamics’ Ableitinger. Dry powder – industry lingo for money raised but lying un-invested – is a concern. According to multiple estimates there is $20-30 billion in dry powder in the India, with few viable targets to invest in.

Engaging Promoters

Too much money chasing too few deals is one reason behind recent conflict between PE and promoters. Several cases illustrate the sign of stress between the two sides. Most visibly, kidswear maker Liliput and investors TPG and Bain are engaged in a public spat centered on valuations, alleged financial irregularities and differences over long-term goals.

Earlier retail firms Subiksha and Vishal Retail had both run aground, leaving their investors clutching straws. More recently, Morgan Stanley’s first investment in India — a producer of castor oil and its derivatives called Biotor — has also gone belly up. Expect more such conflicts to unravel as the weak economic environment puts pressure on both promoters and PE investors.

Building Value

Classic PE investing is all about building value. But this has proven to be harder than what many fund managers had imagined when they raised billions of dollars in the middle of the past decade.

"In 2005-2007, the outlook for Indian private equity was considered relatively positive among global LPs. However, on average, funds did not meet these high expectations,” says Ableitinger of Capital Dynamics.

Industry insiders say several funds made their investments during peak growth from 2006 to 2007 and now they’re unable to recoup their investments — or are having to settle for much less than they initially hoped.

According to Rahul Bhasin of Baring Capital, the venture capital industry in Silicon Valley — the barometer of profits for the sector — historically returned three or four times the money it invested. In India, he claims, the returns from PE have been negative over the past five years. “Poor contract enforce ment in India has led to this situation," he adds.

But PE executives are quick to add that poor decisions and valuations alone can not be blamed for this situation.

They argue that two economic troughs (one in 2008 and another ongoing), systemic issues around slow pace of project completion and regulatory hurdles, the current policy paralysis in terms of government indecision, corruption are all adding to the problem. “All projects have systemic delays in India ... when this happens, projects with returns over a period sees internal rate of return start dropping dramatically,” adds Bhasin.

PE money initially backed firms in IT and telecom services, which were growing at two or three times India’s GDP. But growth has tapered even in these due to a combination of growing scale and the headwinds of global economic uncertainty. Few replacements have been found — even if PE mandarins think that sectors such as logistics and healthcare can provide the impetus required.

Looking For Exits

When PE funds exited investments worth $4.55 billion in 2010, many thought 2011 will be even better. Not so.

Up to September 2011, the value of PE exits was only half of the corresponding value of last year. The global economic meltdown leading to poor appetite for stocks has been one big reason. Public listing, a key exit route for PE funds in India, has become harder to accomplish. And PE funds are often saddled with investments which are, in hindsight, too expensive.

“The PE market in India is still relatively young and there have been a limited number of portfolio company exits,” says Charles Daugherty, Managing Partner of Stanwich Advisors, a boutique investment bank based on Stamford, Connecticut. This is a concern even though many LPs view the investment opportunity in India as attractive, Daugherty adds.

But not everything can be blamed on external factors. MCap’s Subramaniam says PE funds in India have been guilty of over paying for deals and have been ineffective in using alternate exit routes.

The Silver Lining

Without doubt, more than a few PE funds will crumble under the weight of these five pressure points. But this is not the end of the road. Despite the temporary blip in the political and economic environment, there is still a lot of steam left in the long-term India growth story. That’s good enough for many.

“I am not sure there is too much money in India ... but there is plentiful supply in some pockets,” says Archana Hingorani, managing director, IL&FS Private Equity, who plans to join the growth capital scrum with a $300 million fund. Despite the intense competition in the growth capital market, she plans to focus IL&FS’ investments in emerging areas such as logistics. “The generic India growth story has been told.”

Another PE fund head who’s banking on a similar story is Raj Duggar, managing director of Fidelity Growth Partners India. He thinks that many small and midsize firms who rushed to go public earlier, will now sign up with PE funds. “Earlier you had companies with barely Rs 700-800 crore in revenues going public,” he says. “But with dozens, if not hundreds of firms languishing unnoticed on the exchanges, private equity has now become a much more viable option.”

As funds face up to the task of showing better returns, they are looking to new avenues of growth — investing earlier in the cycle, looking to the hinterland to uncover new opportunities and adding new sectors such as logistics and healthcare — to improve returns.

Sequoia Capital is just one example of a fund that is tweaking its strategy to boost growth. In June 2011, the marquee investor signed a deal with Prakash Snacks, far away from the arc lights of Mumbai and Bangalore, in the town of Indore, in Madhya Pradesh. Another PE firm, Fidelity Capital has signed a deal with Shreeram Capacitors, a closely held electrical products firm based in Sangli in Maharashtra. The journey to the hinterland isn’t a one-off trip.

Besides hunting small town India, firms like Sequoia Capital is now looking to make a larger deal in smaller firms to try to exert more control on their fate, rather than tussle for a relatively insignificant stake in a large company.

“We would prefer a 25% stake in a Rs 400 crore firm rather than a 10% stake in a Rs 3,000 crore one,” says Abhay Pandey, a managing director with Sequoia India. Then, Sequoia is also lowering its minimum deal size to as little as $40 million as it looks to enter earlier — and take more control — of promising firms.

That said, PE funds have a point to prove in the next 12-18 months — that they can indeed earn returns on the billions raised.