Is private equity (PE) in India a disappointment or an unproven success? That is the question in the minds of many investors, as they decide on their allocations to emerging market funds. The comparisons with China are stark. While many Chinese funds boast of healthy realisations and returns, Indian funds talk about delayed exits and longer investment horizons. Allocations towards Chinese funds are holding steady or increasing, but allocations to Indian funds are on the decline.
So, the question worth examining today is: Has Indian PE delivered the Indian growth story to investors in the last decade? Consider the facts.
As India’s gross domestic product (GDP) grew from $460 billion in 2000 to $1.8 trillion in 2011, per capita gross national product (GNP) rose from $400 in 2000 to $1,400 in 2010.
The Sensex had a phenomenal rise and the trade grew 15 per cent compound annual rate. Investors put in $92 billion via foreign direct investment in the past three years. This points to a decade of strong growth.
Close to $40 billion has been raised by India-focused funds since 2005 (excluding allocated capital from global funds to India); the industry has grown from a handful of institutional PE firms to over 300 or 500 firms. About $50 billion has been invested to date since 2004. Managers have been charging standard terms of two per cent management fee and 20 per cent carried interest. They have not been compromised in economics.
The evolution of the PE market against the backdrop of the strong growth in the economy should translate into strong returns for investors.
The twist in the tale is that many investors have generated single-digit net returns from the India portfolio. The 2004, 2005 and 2006 vintages that should have delivered outstanding returns have, in fact, had patchy returns at best. While funds have gone on to raise their second and even third funds, investors and returns are languishing.
The root of this problem lies in the fact that the understanding between PE and the businesses was set incorrectly in 2004. PE was regarded by businesses as just another source of financing, alongside the public markets and bank debt. The PE industry did not correct this understanding. With capital rushing into PE in India and immature teams being set up to capitalise on the capital flow, a number of mistakes have been made by an immature start-up industry. These included compromising on the quality of opportunities, price-value balance, governance attitude of potential partners and evaluation of exit options.
Will PE in India survive and flourish another decade? Let us examine the backdrop against which this question is posed.
PE, typically a high-risk, high-returns asset class, is a low-returns game in India today. Investors are nervous and are approaching this segment very cautiously and selectively. Fund-raising, as I am sure some of you have already discovered, is challenging. Track records that should have been created are yet to come.
While the efforts of the government to regulate this industry are laudable, they are also resulting in fear and confusion for investors and making the industry vulnerable.
Against this backdrop, the General Anti-Avoidance Rule or GAAR (now deferred by a year) and the uncertainty of retrospective taxation can prove to be seriously harmful to the industry. Investors cannot and should not face regulatory uncertainty. Given the high dependence on this asset class for the supply of risk capital in the country, a slowdown would severely affect private capital formation and development of entrepreneurship.
All of this makes Indian PE sound a grim destination, one that few investors want to make a journey to. If the government provides clarity and stops changing regulations in an uneven manner, I believe natural market forces will have a chance to take over, streamline and focus the industry over the next few years.
The good news is that the industry has a chance to survive and flourish over the next decade. However, it is unlikely to do so in the current form. There will be consolidation and only the best investors will survive.
Competition must be reduced and reliance on intermediation stopped. This is also the time to act urgently and educate the government about this asset class in India that has a long way to go. This is also the time to break away from the old PE rules and form some new ones.
Managing Director (Asia), CDC