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Private equity and venture capital funds that entered a decade ago are looking for an exit route

All aflutter
They came, they saw, they invested. Believing in the India story, especially its entrepreneurial energy, private equity (PE), venture capital (VC) funds and angel investors opened their wallets and handed out money to let a hundred flowers bloom. Some companies, which desperately needed capital for their growth phase, succeeded. Some failed, some are floundering because of the inevitable shakeout that comes when too many players jostle for the same space. This is the time private equity/venture capital is looking for an exit — whereas angel investors, who typically stay invested for 20 years, will stay the course.

The first half of the past decade was marked by exuberance, while the second half was that of disappointment. In 2014, PE/VC funds have entered a challenging ‘logjam’ phase in which they are sitting on Rs 85,000 crore capital invested more than six years before, and are looking for a means to exit. The promise of a stable government and renewed activity on Dalal Street have brought back ‘structured optimism’ in the market. That’s another way of saying they are discerning, cautious, mature.

“The past 10 years were very relevant for PE in India. The volume of investment, the number of investors that participated and the increased number of sectors they funded make the past 10 years more relevant. They also have seen a full cycle of ups and downs in these 10 years,” said Apurva Patel, director, IDFC Private Equity.

Overwhelmed by the India’s growth and consumption story, private equity funds were queuing up to grab a pie of the market between 2004 and 2009. Between 1999 and 2003, private equity and venture capital firms have been investing around Rs 3,000 crore every year in Indian companies.

The investment jumped to Rs 9,000 crore in 2004, according to the analysis on PE/VC exits in India in the past decade by management consultancy and analytics group Avalon Consulting on the data provided by research firm Venture Intelligence. The investment multiplied to Rs 32,000 crore in 2006 and peaked at Rs 62,000 crore in 2007. GDP growth, close to nine per cent, was in alignment with the ‘India growth story’.

In the period of ‘exuberance’, the exits also were rewarding. PE firms that had made investments to the tune of Rs 32,000 crore made exits in the five years between 2004 and 2009. Most of the funds exited in less than three years of investment and the internal return rates were 30-60 per cent.

Among the major exits, investors General Atlantic Partners and UTI Ventures had an IRR (internal return rate) of 106 per cent in the 2004 initial public offering of software company Patni. In the Suzlon Energy IPO in 2005, Citicorp’s IRR was 306 per cent.

Foreign funds, which accounted for major part of the investments, also benefited from the appreciation of the rupee against the US dollar. Between 1999 and 2003, 74 per cent of the investments were made by foreign funds. Investments which were made in 2002-03 when a dollar was bought for Rs 48, exited in 2007 when rupee was at 39.5. Appreciation of the rupee itself generated around 18-19 per cent returns.

“New funds were enticed by the huge returns some of the firms that had invested in the early 2000s raked in during this period. Many new PE/VC firms set up shop in India. At high valuations they picked up whatever they could grab from the market. Limited partners (LPs) who provide money to these funds also were upbeat about the India growth story,’ said Sanjeev Krishnan, leader – private equity, PwC India.

The average size of PE deals, which used to be Rs 26 crore in 2000, shot up to Rs 84 crore in 2004 and it peaked at Rs 116 crore in 2007.

“The last decade started with very high bullishness and it remained till 2008. Investments were growing in this period, which also saw the peak investments in any year in India — Rs 62,000 crore in 2007,” said Sridhar Venkiteswaran, partner, Avalon Consulting.

IT and ITeS, energy, banking and financial services and manufacturing were among the top sectors that have been attracting private equity interest during these years. “Unlike their usual practice of investing in technology companies, in India these funds were investing in non-technology sectors like real estate and infrastructure. Seeing the supply-demand situation in infrastructure, they felt they could make technology-type returns from these non-technology sectors,” said Srini Udayagiri, investment director and partner at Peepul Capital. The spread of investments across multiple sectors also increased.

In 2005, infrastructure space could grab only one PE investment worth $21 million. This went up to $2,363 million across 22 investments in 2007. By 2013 investments came down to $306 million in five deals.

A growing domestic consumption and India’s competitiveness vis-à-vis China were attracting investments in manufacturing. In healthcare and energy, there are significant supply gaps and a relatively under-developed financial sector also witnessed high PE/VC interest.

However, both the global and the national economy went through a rough patch by the end of 2008 with the global meltdown. In the Indian context, significant time delays in infrastructure projects and attention-diverting corruption scandals slowed the economy. Foreign funds that had invested in 2007 when rupee was at the 40 level lost more than 30 per cent by 2013 due to the depreciating currency itself.

From 2009 onwards, the exit situation became very discouraging. PE funds, which had invested almost Rs 52,000 crore of capital, were on the lookout for exits. At an average, exits were slower and the funds were stuck with the investments for more than four years in the absence of suitable buyers. The IPO market was dull and the strategic investors were out of the market. Those who exited through secondary sale also were able to earn an IRR of only 10-15 per cent.

Consequently, investments dropped from Rs 62,000 crore in 2007 to Rs 20,000 crore in 2009.

“Post the 2008 debacle, from 2009 to 2013, PE funds were selective and invested about Rs 2,00,000 crore – which we would call moderate growth — over the previous five years,” said Venkiteswaran.

“During this phase, funds stayed away from sectors in which there was some sort of government interference or environmental concerns. They kept infrastructure, coal, power and roads at an arm’s length. IT and ITeS too were hit by the global meltdown and the uncertain rupee-dollar movement,” said Krishnan.

Though the funds were upbeat about consumer-related sectors earlier, questions were raised about corporate governance and the due diligence processes done by some of the bad apples in retail like Subhiksha, Lilliput and Gini and Jony.

This was a learning phase for the PE/VC funds. Most of them were under pressure to do deals in the phase of exuberance. With capital in hand, fund managers often found themselves having to bid aggressively just to be counted.

“Funds acknowledge that they made mistakes. They say they were blinded by the Indian consumption story and made some bad choices,” said Krishnan.

Inability to factor in rupee depreciation was another big flaw. Funds that enjoyed the fruits of rupee appreciation post 2004, never thought that the currency could just as well swing the other way.

“With dollar-denominated capital, limited partners (those who commit capital to the PE funds) were looking for dollar-denominated returns and with the rupee taking a downward spiral between 2008 and 2013, most funds are sitting on negative returns,” he added.

In a hurry to invest and to receive investment, there was a disconnect between the funds and the promoters. The funds could not clearly communicate what they were expecting from promoters and not fully understand what the promoters’ objectives were.

In 2014, PE funds have entered a most challenging phase in terms of exits. Almost Rs 85,000 crore of capital is waiting for exits and most of the investment is six years old. However, the new government, which is expected to be more investor-friendly, and stability at the Centre may turn things in favour of the funds. “In 2005-06, the exuberance was led by the global increase in liquidity. This time it is not exuberance but optimism which is quite India-specific,” said Apurva Patel.

The stock markets too are recouping from their slump. “The performance of the stock markets has a great impact on the exit scenario. For one, it offers a good opportunity for PIPE (private investment in public equity) investments to find an exit. Secondly, it also indicates a possible revival of the IPO market which is a major exit route for investments. Overall, the situation does look more positive for the next 3-5 years,” said Venkiteswaran.

Securities Exchange Board of India (Sebi) has recently eased the offer for sale (OFS) norms so that top 200 companies in terms of market capitalisation can now use the mechanism. Earlier OFS was allowed for only the top 100 companies. As per the norms, any non-promoter shareholder, who holds more than 10 per cent stake in a firm would be eligible to use OFS to sell stake. This will help the PE/VC funds exit the company even without an IPO. Of this, 10 per cent of the issue size will have to be reserved for retail investors.

“PE investments largely happen in companies which are in the growth stage. So, the OFS mechanism will be more useful now with the extension to top 200 companies. But if there is no appetite for an IPO, chances of a successful OFS are even lower. It gives the investors another option when the markets are buoyant,” said Dinesh Tiwari, investment director, Multiples.

According to PwC, the new political situation will also see the influx of strategic investors, who were out for some time due to policy issues. It expects half the exits to happen with the help of strategic investors. Secondary sale will be the next major option and there will also be a revival of IPOs.

“During the international LP meetings held in the beginning of 2013, India was looked upon as a “bad world” for investments. But in the past three to six months, interest in the Indian market is coming back. Apart from the government change, lack of alternative markets too is making them look at India again,” said Udayagiri.

The Indian economy may have slowed down to 5-6 per cent levels, but it is still better than many other markets. LPs also want to catch India at the beginning of the next phase of growth when the valuations are at a lower level.

Even during the difficult years between 2009 and 2013, there were some successful exits. When the average IRR was at 10-15 per cent, a few investments in different sectors provided multiple returns.

ChrysCapital sold a major portion of its stake in Shriram Transport Finance in 2009, a return 10 times that of the investment. Ashish Dhawan, who was earlier with ChrysCapital, finds that the company had “rock-solid” processes in place. Similarly, Warburg Pincus exited Max Healthcare at a four times multiple and in this case the PE fund brought in the domain expertise from its global experience to grow the company, according to Mohit Talwar, deputy MD of Max India. Seedfund’s collaborative effort saw the returns multiplying several times in its investments in Carwale and Redbus.

These exits prove that there are many things an investor and investee can do to grow an enterprise despite the ups and downs in the market or the economy. Many PE/VC funds have realised this and have also effected changes in the way they operate.

Stable funds that have completed their first investment cycle in India have a general sense that the experience gained from it will help navigate the next one better.

“Learnings are critical as they went through a market that was not so buoyant. They have learned the requirement of due diligence, evaluation of plan and forecast of outcome,” said Tiwari.

Funds have increased their emphasis on diligence today as never before. The diligence has become intensive with much focus on getting to know the sector well, which means speaking to other operators in the industry, point of view discussions and learning from previous experience of investors in the sector. They tend to spend a lot of time with proposed investees as well.

“LPs too have become more discerning. They question the PE funds about the viability of the investments. In the pre-2008 period this had used to be available as easy money. The PE funds in turn are asking tougher questions to the investees about the viability of their business model,” said Udayagiri.

Once the deal is done, the fund managers are also spending time to engage in the operations of the investee companies. They are more involved in hiring key talent in the companies and also monitor progress closely and participate in strategic decisions. “The 90-day plan or the 100-day plan is part of the agenda today. A ‘100-day plan’ is the key changes that are made in the company in the first 100 days of investment in terms of recruitment, strategy and operations,” said Udayagiri.

Planning on exits start even before investment deals happen. “With the capital markets taking a complete u-turn, investors have realised that there is much homework to be done on achieving exits. This means that the funds need to foresee their investees’ anticipated financial condition at the end of the 3-5-7 year period,” said Krishnan.

“Earlier, IPOs were taken as an automatic route of exit. Now discussions of multiple options of exits are being discussed at the time of investment itself. Funds want to understand whether the promoter is open to strategic sale or merger and acquisition if IPO does not happen,” said Udayagiri.

They also expect the promoters to have less reluctance or resistance to engage and be more open to ideas in the next decade. “The funds will have to build the relationship and trust and establish their credibility so that the promoters find their involvement in the company worthy,’ he added.

The optimism and the better learning of the market might bring back the quantum of investments to the 2007 levels. But it is not going to happen immediately. “In the current scenario of a stable government, the exit scenario is expected to improve. There could be a bit of a lag, maybe one or two years, in the investment scenario picking up, but they certainly will,” said Venkiteswaran.

Tiwari finds that there is a pent up demand for funds in the market as companies have not been expanding much in the past four-five years. The supply also was limited. He thinks the optimism will pick up much faster. “I will positively surprised to see the pace of activity picking up. Even in infrastructure the investments will pick up as we have seen Canadian pension fund investing Rs 1,000 crore into L&T IDPL. In India there is a huge demand for infrastructure and people’s propensity to pay for better infrastructure is also increasing. The sector had suffered due to some government policies and actions. But now things are changing,” said Tiwari.

PwC even thinks that if things move positively, PE investments can grow to a level where it can touch Rs 2.36 lakh crore by 2025.


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