Manna? Not quite

Do you beat your wife?” The answer to that is pretty much similar to what you can expect if you were to ask someone in the Indian private equity (PE) industry, “Are your investments doing well?” No prizes for guessing how many general partners (GPs) in the Indian PE industry admit to beating their wives!

The $24-billion Dell mega deal is a welcome sign for the global PE industry, especially the buyout industry, but what about India, where buyouts are largely non-existent for regulatory and structural reasons, and which is almost completely a growth market? The Indian PE industry version 1.0 has been in existence for the past 10-15 years and has been a tremendously mixed bag, a few spectacular successes and a multitude of also-rans and failures. It is led by some of the finest and brightest minds of India, who have a genuine passion to grow India Inc, but is also home to a handful of shady dealmakers, who want to get rich quick, breaking every law in the book in the process.

The single biggest structural flaw, which has been exploited by both, unscrupulous entrepreneurs and their willing partners-in-crime aka GPs, is the famous “2/20” model, where the 2% annual management fee appears to be the incentive for many to do so. Given the perverse incentive structure, since the 2% is on the amount of committed capital in the initial five years of a fund’s life, there is tremendous pressure to “put money to work”. In other words, doing deals becomes much more important than doing “good deals”. One must not forget that a management fee of $4 million on a $200 million fund goes a very long way in India and skews the incentive structure a great deal. The attendant question is, are global PE funds diluting their standards of governance when it comes to deploying capital in India?

Instead, limited partners (LPs) should explore a model where GPs — other than the top quartile ones — are paid a higher fixed compensation, reimbursement of actual office expenses and a higher carry, and perhaps do away with management fees altogether. This may not be the most popular suggestion for most GPs, but this is one way of separating the men from the boys.

Second, the Indian PE industry is competing with a Sensex that is on fire. It has moved to the 20,000 mark (up from 14,000 just five years ago) and frontline stocks are delivering high double-digit returns to public investors. Most entrepreneurs, despite Sebi’s reasonably stringent disclosure norms, prefer the public markets, in part to eschew valuation tangles, which are the hallmark of many a failed PE negotiation in India. 

Third, if getting into “good deals” is hard in India, getting out of them seems even harder, with a lot of money chasing a few “good” deals — and thereby also pushing up valuations of companies. The Indian PE industry is in the grip of a severe exit phobia and recent liquidity has been discerning. Venture Intelligence reports that private equity firms obtained exit routes for their investments in 98 transactions during 2012 (including five via IPOs, 67 via M&A and the rest through public market sales). The volume of exits in 2012 was up almost 17% compared with 2011, thanks largely to a surge in the number of strategic M&A exits (up 71%)and secondary sales (up 60%). If Indian GPs are not returning capital and significant returns to their principals, the chances are bleak that India-focused funds or carve-outs will happen at all in Indian PE version 2.0.

Fourth, there are reported and many anecdotal cases of corruption and “kickbacks” or “Day One Carry”, as one of the brightest Indian PE partners calls it. Of late, apart from Sebi, the Central Bureau of Investigation, Enforcement Directorate, Serious Frauds Office and the Intelligence Bureau have come across and are actively monitoring instances of high-end corruption, money laundering and violations of the US Foreign Corrupt Practices Act and the UK Bribery Act, which involve some of the best-known global PE funds, and are under active investigation today. The day the government issues formal notices to top PE honchos, and if it leads to convictions and arrest, it will be a rude wake-up call for the industry as a whole. I believe this should be welcomed, for this would, at a very early stage in the industry’s life cycle, stem the rot and expose those who receive kickbacks while deploying capital. 

Opportunities galore

India is today a $1.5 trillion economy and growing at around 5-6% in real terms. Capital-starved companies abound and there is a significant need for private capital. Which industries and sectors can PE legitimately hope to invest in and make money from? It is fashionable for many an investor to argue that they would like to avoid highly-regulated industries, often forgetting that the biggest discontinuities and, therefore, the biggest scope for rewards are also in such industries. What follows is an illustrative, not an exhaustive list.

Healthcare and related service industries remain one of the foremost sectors to deploy capital, given that India’s spending on health is the second-lowest in the world at 0.9% of GDP (only Pakistan spends less than India, and even Sub-Saharan Africa spends more). Further, private health insurance accounts for only about 1.2% of total health expenditure and about 15-20 % of the population have some form of insurance. Of the total spend, about 58% is on in-patient care and medical tourism by itself will be a $2-3 billion per annum market by 2012-13. It is expected that about $70 billion will be spent over the next six years on about 90,000 beds and private hospitals are expected to grow at a CAGR of 15%. Above all, almost 90% of all private healthcare in India is in the unorganised sector. The challenge remains procurement of land; ramping up of bed utilisation; contingent liabilities on account of “free care” contracts if any, which are often loosely defined and deliberately so by the government; and inadequate talent acquisition due to shortage of doctors and nursing staff. Having said that, many hospitals such as Narayana Hrudayalaya and Vikram Hospital, have recently closed attractive deals with private investors. 

Specialised clinics in eyecare, dental care, fertility and geriatric care are the next big thing for the Indian PE industry to focus on. Specialty hospitals such as Confident Dental (which is also the single-largest manufacturer of the highest quality dental chairs in India and now high-end dental care), Craft IVF (whose success rates surpass even the famous Boston IVF and Bourn Clinic, which invented this life-transforming practice), and Skanray (the only US FDA-certified medical equipment manufacturer in India, which bought out the medical device arm of L&T recently) are being courted and wooed by several marquee funds in the hope of getting into the specialised side of the business at
attractive terms.

 Infrastructure desperately needs big ticket equity but faces an unpredictable regulatory environment; cost overruns; coal block issues; right of way and land acquisition issues; definition and attendant legal problems while defining total project cost for viability gap funding; siphoning off equity via gold-plating and over-estimations; all of which make it not-too attractive a sector. To invest in infrastructure, PE needs to find entrepreneurs who are thugs enough to “manage the system” but at the same time, not thugs enough vis-a-vis their own dealings with the fund. That’s like asking for a reformer and a Pope rolled into one.

Likewise, flexible power companies, speciality beverages and bottlers, several customer-facing large-volume (not necessarily large-format) plays in the retail and food space, select e-commerce ventures with good track records, IPL teams, ports/shipping services companies, select NBFCs, coal washing industry, speciality chemicals, logistics/warehousing are all excellent potential sectors for investments. Every Indian IT company is almost a mirror-image of its closest peer and the industry would see in the decade ahead some distinct verticalisation and specialisation.

A not-so-insignificant part of the problem is most first-time entrepreneurs are intimidated by PE and do not quite understand how to handle it, and the fancy financial engineering that sometimes comes with it. Further many, but not all, PE firms are unable to successfully demonstrate their value addition to a hard-nosed Indian entrepreneur. Many entrepreneurs have gone on record that they would rather walk away from a private equity deal leaving money on the table, for they find many PE investors simply do not add the value they claim to add, other than bringing capital, and instead take away a disproportionate part of the profits.

Last and most importantly, one of the biggest lessons of Indian PE 1.0 is that funds cannot outsmart the canny Indian entrepreneur and unless their interests are aligned from Day One, it is almost impossible for them to succeed. As several cases have demonstrated, the unscrupulous Indian entrepreneur can spin so many rings around the GPs that it will take them forever to free themselves. Also, there is a significant global reputational risk to the PE fund in such tangles, but not for the entrepreneur, for whom it is simply the “cost of doing business”, and the latter’s ability to live with uncertainty is far greater than that of any PE fund in the world!

In sum, Indian PE 1.0 has not quite been the manna that it has been in its global avatar in delivering value and growing businesses. It has also been tainted to some extent by a handful of unscrupulous elements that are giving the industry as a whole a bad name. As Indian PE awaits its version 2.0, LPs will be much more wary into putting money into them, and the forest fire of version 1.0 will hopefully clean up some of mess and allow for fresh growth to bloom.

These are the author’s personal views