Business Standard

Exploiting institutional voids

Business Standard  |  New Delhi 

Companies eyeing growth and scale in have no choice but to engage deeply with these economies and serve the large and growing middle class. In their new book, Winning in Emerging Markets, Professors Tarun Khanna and Krishna Palepu outline a practical framework for developing emerging market strategies. The framework describes how understanding ‘institutional voids’ — the absence of intermediaries that facilitate the functioning of the market — can help companies build a competitive advantage. The following extract from the book shows how private equity firm Capital tapped institutional voids as business opportunities in India.

The growth and potential of the Indian economy, and the companies emerging within it, attracted investment firms of all stripes to set up shop in the country in the early 2000s — from Silicon Valley-based venture capitalists to global private equity behemoths to local entrepreneurial start-ups. While chasing the next Infosys or Bharti Airtel, these firms were also filling voids in India’s capital markets. India-dedicated private equity firm Capital was established in 2005 as this flood of foreign investors and financial services firms clamoured to enter or step up their presence in the booming market.

differentiated itself from this competition by targeting a segment it identified as an underserved niche: Middle-market businesses established and still managed by families or entrepreneurs. Shallow coverage of companies by research analysts narrowed the pool of companies targeted by foreign private equity firms looking for more known quantities — even at a premium — as they raced into a market that was relatively unfamiliar to them.

Blue River avoided this competition by targeting companies not covered by analysts, including private companies and public firms that were not actively traded or widely covered. Blue River also pursued investments in businesses outside the sectors typically pursued by global venture capital and private equity firms. Sectors in which Blue River invested — such as textile, packaging, and auto components — might be considered mundane and not particularly high-growth prospects in the United States, for example, but could become big businesses in an emerging market like India.

Blue River sought out high-potential, low-risk companies within a segment deemed risky by many investors because they were not prescreened and could be difficult to assess. As with other firms operating in emerging markets, intermediaries need different capabilities to target different segments. Blue River exploited institutional voids directly as sources of investment opportunity by targeting a segment containing more institutional voids (see table ‘Segmentation for Blue River Capital’) — but where it could exploit the relative advantage of its local knowledge. “If it were easy, then it wouldn’t be an opportunity” a company executive said. “Because of all the complications, because of all the challenges, that creates the opportunity for the folks who are able to manage through that.”

Providers of risk capital such as Blue River are important market intermediaries in any economy. Venture capital and private equity firms provide seed funding for start-ups and growth capital for companies looking to expand. The value proposition of these firms is particularly strong in having other institutional voids in their capital markets. Service-oriented businesses, for example, often lack hard assets sufficient to serve as collateral for bank loans in markets without well-developed cash-flow lending facilities. In the taxonomy of market intermediaries, these firms serve primarily as aggregators and distributors of capital. As the first professional investor in portfolio companies, Blue River was an active investor, providing capital but also working closely with portfolio companies on strategy and a range of business issues and thereby serving several other intermediary functions (see table ‘Institutional voids filled by Blue River Capital’).

Identifying and executing investments in Blue River’s target segment were difficult, resource-intensive processes. The firm sourced deals through the research of its own staff and leads from local investment banks, accountants, law firms, and deal brokers. In 2006, the firm reviewed 207 potential deals, issued ten term sheets, and conducted formal due diligence for three deals, all of which were completed. “Historically, you can say that India has this problem of a lot of tainted entrepreneurs or family businesses, and you do need local expertise to be able to identify who to partner with and who not to partner with,” said one Blue River executive. Blue River built its business on the relative advantages of its local knowledge — helped by its strategic partnership with Edelweiss Capital, a middle-market-focused investment bank — and its willingness to invest the time and resources to work with companies that would be outside the comfort zone of most foreign investors in terms of corporate governance.

The absence of information intermediaries and background check services complicated due diligence for Blue River. The firm sought to minimise these risks by investing in firms that had track records long enough to assess meaningfully. Blue River began its due diligence with background checks on the of prospective investments — a process that often concludes due diligence in the United States and other developed markets — even before evaluating the company in terms of its operations. To do so, Blue River needed to fill an institutional void; background investigation firms and the databases that provide raw data for such firms are undeveloped in India (although KPMG International recently started a background check service in the country). Blue River exploited its network and other sources to make inquiries about the of potential portfolio companies.

Blue River explicitly sought out companies that needed to revamp financial reporting and corporate governance or needed help with other issues. By working with portfolio companies on these issues, Blue River served as a credibility enhancer. One of Blue River’s portfolio companies, for example, did not differentiate between payables and receivables from one company with which it was both customer and vendor, essentially saying, “Let’s net it off,” according to one Blue River executive. But he also noted, “Family business does not mean a lack of professionalism.” Blue River looked for promising businesses with established track records that needed only to change business practices (and polish their organisations) to unlock and monetise their potential.

Blue River’s model required significant “handholding,” one company executive said, even before the firm committed capital to portfolio companies. After completing deals, Blue River developed templates for new portfolio companies that were establishing plans for organisational and other changes; the protocols covered the first six months after the investment. With each investment, Blue River insisted on changing statutory auditors, financial controls, and accounting practices; identified related-party transactions; and put the entrepreneurs and any family members working for portfolio companies on employment contracts. “Be more conservative in how you represent yourselves to the outside world,” Blue River told portfolio companies.

Blue River has also worked with portfolio companies to develop boards of independent directors — including identifying candidates through its network — a practice that can add value to the firms beyond simply increasing governance credibility. ‘“You should want something from your board,’” Blue River tells portfolio companies, according to one Blue River executive. “We say that these are people who will stay with you much longer than we will.”

Blue River exploited a provision in Indian law under which contracts can supersede minority shareholder rights to demand rights above those that would be afforded conventionally, including seats on the boards of portfolio companies and approval over some business decisions, such as annual budgets, capital-raising initiatives, changes to senior management, and compensation. The firm knew that it would face resistance from portfolio companies to the organisational changes it sought to implement once they were in its investment portfolio. Blue River dealt with this challenge by investing in only those companies that were amenable to organisational changes. Still, managing the internal dynamics of portfolio company organisations, particularly those run by families, was a challenge. “Sometimes it’s like swimming in a sea of glue,” said one of Blue River’s operating advisers.

To limit resistance, Blue River sought out companies undergoing transitions, particularly family-run firms in which a younger generation of family members was assuming management responsibility. More fundamentally, Blue River’s model required its willingness and ability to empathise with portfolio companies. “Arrogance here doesn’t work at all,” a Blue River executive reflected. “We tell them that we’re doing this for your benefit, and they respect us for it. You have to give people that sense of comfort that you’re not taking away business flexibility from them.”

Intense competition from a range of players compelled Blue River to seek out a market segment where many potential rivals feared to tread, in large part because of institutional voids. The firm exploited its local knowledge and willingness to invest resources in corporate governance and organisational issues. Any investment firm fills a void by providing capital to businesses; Blue River differentiated itself by offering additional intermediary functions to a segment in which institutional voids served as both obstacles and opportunities. Like many successful intermediation businesses, Blue River developed a unique value proposition to an underserved segment.

Tarun Khanna is Jorge Paulo Lemann Professor at Krishna G Palepu is Ross Graham Walker Professor of Business Administration and Senior Associate Dean for International Development at

Winning in Emerging Markets: A Road Map For Strategy And Execution

AUTHORS: Tarun Khanna and Krishna G Palepu
PUBLISHER: Harvard Business Press 

Price: Rs 695  
ISBN: 9781422166956.

First Published: Mon, May 24 2010. 00:39 IST