India, China markets aren't mature enough for PE players to thrive: Hugh H MacArthur, partner at Bain & Co

Hugh H MacArthur, partner at Bain & Co, says private equity (PE) is a cyclical industry which will go through a roller coaster like other industries. In the short term, he expects the overhang of committed money to drive multiples higher. In an interview with ET, he says that India and China are tough markets due to the absence of large base of middle market companies. Excerpts:

What's your view on the prospects of private equity industry?

The private equity industry is a growth industry, but a cyclical one. We have seen three distinct periods that are called data or market forces that have really pushed the long returns for the industry. We did an analysis that created a synthesis portfolios of US business that suggested you could have earned an 18% internal rate of interest between 2002 and 2008 by riding the credit market.

I am sure there would be a 4th cycle in the business that will drive market data. My crystal ball is as cloudy as anyone's, but right now it looks like the forces that drove the market returns to ever greater heights are not present. So, it is really going to be down to the quality of general partners' ( GPs) themselves to create alpha in order to generate returns.

So what is the way out if the industry cannot generate those super high returns of 1990s?

First, I think it is possible. Second, creating a truly differentiated investment thesis as to why you as a PE firm should be an owner of an asset vs someone else, and why you can help maximise its value. And thirdly, finding ways to partner with management teams to create a blueprint for value creation plan to really execute on that potential value.

We estimate that 30% of the funds which are currently in the market will not be able to re-raise. This is no surprise as 15 to 20% of funds couldn't re-raise post the 2001 recession.

The overhang of money that's not being utilised...That will make fund-raising even more difficult.

Yes, it is a very big issue as there are a trillion dollars worth of committed but uncalled capital which we call 'dry powder' in the market place. And $400 billion of that has been allotted for buyouts. It's the number that hasn't changed much in the past 4-5 years and there will be pressure for those who have capital, haven't invested and whose investment terms after agreement with their limited partners (LPs) are running out to put that money to work.

We anticipate that we will see more of that in coming years. It is definitely a situation in the industry which will drive prices higher. There will be a lot of competition for quality assets and that's going to drive down returns or certainly raise the bar of generating high returns in the industry.

And it is also worth noting that this is how the cyclical industry began in the 2002. There is a capital overhang. We are not worried that overhang is a problem, but there is a concern that competition would keep the multiples very high.

So capital raising will obviously be affected...

New funds in the industry have been declining since 2008. LPs fund this industry in large parts with the capital that they get from the GPs. What we are seeing now is lack of liquidity coming to LPs, particularly in the second half of 2011. So that's why the LPs did not want to commit capital to the industry unless they see their capital going back.

Look at the industry today, it is about $2.5-trillion industry, there is a trillion dollar worth of committed but uncalled capital, and there are a trillion and half dollar worth of companies that are still on the books that need to come back to the LPs. So, in such a situation, it is very difficult to write a new cheque.

It's only the likes of sovereign wealth funds which do not have liquidity demands on their assets that have the ability to write new cheques, as their cash is accumulating. We will continue to see difficulty in 2012 while raising money until some of those $1.5 trillion of portfolio investments start to flow back to the LPs.

It is clear that PE firms have an image problem. What can they do to solve it?

I think the reputation of PEs very often belies their economic importance. There is no definitive study that shows what the PE industry has done. But you will see studies that will tell you PE-backed businesses compared to their public companies have grown revenues, productivity and profitability faster, some studies have shown growth in employment.

So, overall the picture where we have data will tell you it is not a bad industry, but has been very valuable industry to fix business where no other capital is available. Its returns are attractive than the returns of public companies, the beneficiary of those are the pension funds, private pension funds and many individual investors.

India was supposed to be a big market for PE money. But it has not really developed like that. What do you think are the reasons?

In any emerging market, PE is a long-term game. PEs need companies of a certain size to buy. If you look at India and China, the mid-sized companies which PE need are missing. So, these markets are not mature enough to have that mid-sized companies that are the life blood and staple of PE firms.

So, you will see in India and China that there are lot of big-sized companies at the top and a lot of small companies at the bottom and that can be a really tough environment.

Is the issue of corporate governance haunting investors? In some high profile cases, the PE firms were board members but the management still ended up committing fraud.

I think the corporate fraud is everywhere, and PE industry is not new to fraud. But it puts the criticality of due diligence and background checks in focus but unfortunately frauds are really hard to detect. PE firms have a loss ratio of 30%, which means bad things do happen here.

So, investors know that they are going to lose money, it is another part of the risk that you take. You can try to avoid it, but there are small people and it is really hard to detect it.