India exits: Sticking point

When asked to name her biggest achievement while leading ICICI Venture Funds Management, Renuka Ramnath doesn't deliberate for long: exiting Fund I within the agreed timeframe.

"For the Indian private equity industry as a whole, exits are not something we can be proud of," says Ramnath, who departed ICICI three years ago to set up Multiples Alternative Asset Management. "But if you haven't got a lot of experience and people keep telling you the price will go up further, it's difficult to sell."

Series I of ICICI Venture's India Advantage Fund, a 2001 vintage vehicle that received commitments totaling INR11 billion ($200 million), delivered an IRR of more than 70%. The success of this and other early entrants to India's private equity market set the scene for what followed: a massive influx of capital in the mid to late 2000s that vastly overstated both the market capacity at the time and companies' growth prospects. Valuations rocketed.

Five years on, fund managers are dealing with the consequences. Portfolios accumulated during the boom years are maturing yet stuttering capital markets mean expected exits have not been forthcoming. LPs that allocated to Indian managers are agitating for returns and wary about deploying any more capital unless they receive some very convincing answers.

The next 18 months will be crucial, in terms of how they manage investor expectations and how they manage exits.

"The capital markets are an obstacle, but the other obstacle is people holding back on investments made at the peak of the market in 2006-2007," says Vikram Utamsingh, head of transactions and restructuring services at KPMG India. "Some of these investments are underwater and might not generate the returns people were expecting, so rather than exit quickly they hold on and hope things will turn for the better in the next 12 months. I would have thought they can't hold on for more than one year."

Waving or drowning?

Private equity exits in 2012 amount to $4.2 billion, a level matched only once in the last six years. However, nearly half of that sum was open market sales, dominated by the divestment of minority stakes in financial services companies that were initially purchased through PIPE or pre-IPO deals between 2006 and 2008. And $1.1 billion alone came from The Carlyle Group completing its exit from Housing Development Finance Corp. (HDFC).

During the same period, India saw $36 billion in private equity investment, more than half of it in growth transactions, and exits over the following four years amount to just $12.8 billion. A large portion of that investment came from regional- or India-focused funds. More than $24.2 billion entered these vehicles between 2006 and 2008, six times the amount raised over the preceding three years.

The bulk of funds dating from this phase were in the $100-200 million range. They might have 1-2 portfolio companies that have performed well; not fully exited but on course for a money multiple of 2-4x. At the other end of the scale, another 1-2 are marked at cost or below cost and the capital invested is likely to be completely written-off. The rest of the portfolio, 7-8 companies, could go either way, but the GP would do well to generate a 2x return over a five-year holding period.

"Most managers from the 2006-2007 vintage have already burned through their capital - they finished deploying two years ago and with the exception of a few GPs, many are now struggling to raise capital," says Praneet Garg, an investment director with Asia Alternatives. "We are at a crossroads from a fundraising point of view.

Industry participants expect a number of first-timers who launched $200-250 million growth capital funds during the boom period to re-enter the market in the next 12-18 months, including Baer Capital Partners, Gaja Capital and Samara Capital. The latter has already unveiled its plans. Samara has set a hard cap of $300 million for its second fund - 20% larger than its predecessor - and started soft marketing with LPs last month.

The response will vary from investor to investor, depending on how strictly they treat managers with little or nothing to show in terms of exits. According to Mukul Gulati, co-founder and managing director of Zephyr Peacock India Management, which is currently seeking $150 million for its second institutional fund, the market is divided between those who, out of principle, refuse to commit to managers with no track record of exits and those who see it as a preferred, but not an absolute, requirement.

Zephyr has yet to record any exits from its previous fund, which closed in late 2009, but Gulati argues that the portfolio, though unrealized, is compelling. Revenues and earnings are strong, several companies are waiting for the opportunity to go public, and strategic investors are expressing an interest in M&A opportunities.

"There is strong evidence that we could exit our companies if wanted to exit - and probably at pretty good prices - but I don't want to exit right now," he says. "If you have a company with an EBITDA that is growing 30% per year and someone offers 6.5x EBITDA, then you might want to hold on for six months because the price will go up 30%. We already have a sales pipeline we might as well wait."

Gulati adds that Zephyr's sweet spot is the low- to mid-market where the competition is relatively sparse compared to the space populated by funds upwards of $250 million. Still, not everyone is convinced. "You really need 1-2 exits if you are going to raise a follow-on fund," says Doug Coulter, a partner at LGT Capital Partners.

Flight to quality

So far this year, 25 India-focused vehicles have received $1.8 billion in commitments from LPs, the lowest level since 2004. Two thirds of the capital went into just four vehicles: ChrysCapital Partners's $510 million sixth fund and the second funds of three VC players, Helion Venture Partners, Nexus Venture Partners and Kalaari Capital (formerly known as IndoUS Ventures).

India's venture capital space is young and unproven, but LPs are won over by the development of a full venture ecosystem, clarity offered by leading practitioners in terms of strategy and fund size, and a few strong cash exits. Helion and Nexus were "substantially oversubscribed despite not really putting any effort into marketing," says one investor. Like ChrysCapital, these firms are generally regarded as best in class, led by experienced professionals with track records in the industry.

"ChrysCapital is proven over multiple cycles. They have shown the ability to make money in public and private markets; they have picked the right management teams; and they have taken money off the table - if they've had the chance to sell, they've taken it," says one LP, explaining why he backed the fund. "They are also sensible on fund size. You could argue that $510 million is still large for India but it's not a silly size."

It is a more modest fund for a more sober investment environment. ChrysCapital Partners VI is a little more than half the size of its predecessor, which returns $300 million to LPs in 2010, bringing its corpus down to $960 million. Several other GPs who launched funds from the middle of 2008 onwards - notably debut vehicles from spin-outs such as Multiples' Ramnath and CX Partners' Ajay Relan, as well as vehicles from Westbridge Capital and Everstone Capital - have ended up in the $400-500 million range.

More recently, India Value Fund Advisors (IVFA) decided to return $100 million, including fees, to investors in its fourth fund, which reached a final close in 2009 at approximately $700 million, more than twice the size of the PE firm's previous vehicle.

Vishal Nevatia, managing partner at IVFA, tells AVCJ that the first two years of the investment phase coincided with an economic rebound, which pushed up valuations. The firm held back, deploying only $100 million in 2010 and 2011, and it has already walked away from seven deals this year due to a gulf in price expectations.

IVFA was faced with a choice: accelerate commitments in order to burn through $625 million by 2014; extend the investment period beyond 2014; move up from its typical $30-60 million transaction size; alter its transaction type to focus on opportunistic PIPE deals; or return capital.

"Even though we were running out of time, we took the harder route of sticking by our beliefs and integrity, and walking away from deals that were either too expensive or gave us reasons beyond pricing to not close," Nevatia says.

This begs the question: What is now the optimum size for an India-focused growth capital fund?

Based on a corpus of $500 million or below, the "new" mid-market sweet-spot appears to be ticket sizes of $30-50 million, which is generally seen as commensurate with the opportunities available. One perspective is that companies of sufficient size to be of interest to a $1 billion fund are capable of an IPO or a qualified institutional placement (QIP). This effectively means private equity is in competition with other forms of capital at a time when there is no longer a rich vein of target companies on stratospheric growth paths.

"They all believed that India would generate sufficient opportunities," observes Ramnath. "A larger M&A market was contemplated with more corporate high-ball. Even among smaller companies - those raising money to make acquisitions, for example - we expected significant expansion because India is a large country."

Does it work?

No one suggests that the India growth story is dead; just that during the mid-2000s the market was hyped up to such a degree that it was unlikely to meet these expectations and capital ended up in the hands of many managers without the experience to put it to good use.

Strong, long-term fundamentals have been called into question by short-term policy crises, but the situation is not irreversible. Similarly, capital markets are cyclical and will at some point bounce back. Indeed, KPMG's Utamsingh suggests that if the government cuts interest rates in January, the markets will be spurred and this could re-open the window for IPOs.

However, for the PE industry, regaining the confidence of LPs is conditional on proving the model works and that they will see a return on their capital. As many have already concluded, it is better to service the existing portfolio before seeking to raise capital for the next.

"If a GP raised a $200 million fund and has seven portfolio companies but no exits, they are charging a 2% management fee on the capital under management and it's not getting any lower. On top of that, the rupee is down 20% against the dollar, so the GP's cash flow has gone up by 20%," says Pratima Divgi an investment director at Squadron Capital.

"We ask how they will deal with this and some don't have an answer - they just say there will be exits in the next two years. If you are getting close to full management fees do you really need to come out and raise a new fund before working out some exits?

LGT's Coulter adds that Indian private equity firms need to be more thoughtful in considering their exit options. Chinese GPs have until recently enjoyed a long period of multiples arbitrage, allowing them to invest in the knowledge that, almost regardless of the strategic positioning and operational value-add, a profitable public markets exit would come. Their Indian counterparts haven't had the same luxury: the IPO window has been shorter, exacerbating the impact of already high entry valuations.

"With India it's much more important going in to have a clear idea of the exit," Coulter says. "You shouldn't invest unless you know your exit."
Encouragingly, the exit channels are broadening. At $588 million, trade sales in 2012 are down by more than half on the previous year - arguably a function of uncertainty about foreign investment and tax regulations - but historically this has been a rich source of liquidity. Ten of the 15 largest India exits on record have been sales to strategic investors and GPs say there is considerable interest in areas such as consumer products.

There have been 22 trade sales, above median for the past decade, but the numbers appear weak due to the absence of a bumper transaction that really moves the needle, such as Actis Capital and Sequoia Capital's sale of Paras Pharmaceuticals to Reckitt Benckiser in 2010 or the Barclays-Blackstone-HDFC exit of Intelenet Global Services to Serco Group in 2011.

Secondary sales to financial investors, meanwhile, have shown significant growth, rising from $122 million in 2009 to $1.6 billion in 2012. This trend is likely to continue. Bain Capital's $1 billion purchase of a minority stake in Genpact from General Atlantic and Oak Hill Capital is seen as a template for greater involvement by global buyout firms, most of which are raising larger regional vehicles or looking to deploy more capital in emerging markets.

"Companies need that extra round of funding but the original investor cannot do it so they look to another PE firm and the original investor has the chance to exit," says Vishal Mahadevia, managing director at Warburg Pincus India. "It is good news for larger funds. These companies have good corporate governance and management practices that have been put in place by the original investors. We have done a couple of deals like that and there will be more of them in the market as a whole."

Give and take

The challenge facing Indian GPs is one of balance. They must navigate the post-2008 capital overhang and exit their portfolios, possibly postponing new fundraising activity while they do this, but at the same time they have to retain staff. As India's volatile recruitment market shows, investment professionals can be even more impatient than LPs. Most 2006 vintage funds can opt for two one-year extensions to an initial investment and post-investment lifespan of eight years, but exits won't materialize if there is no one around to nurture the portfolio.

"Teams fall apart if they think the platform will not raise any new money," says Zephyr's Gulati. "Young professionals have never seen a carried interest check and they aren't interested in pursuing legacy portfolios."

It is a difficult balance to strike, but investors are reasonably optimistic about the prospects for the leaner but more grounded vintages of 2012 and beyond. Those managers with dry powder are arguably well positioned to invest now many of the funds raised during the boom period are exhausted and unlikely to see successor vehicles and valuations gradually falling. According to Divgi, Squadron Capital has made quite a few new commitments in the expectation of top-tier GPs performing strongly over the next three years.

"We still believe in the long-term potential of Indian private equity, but these key issues - the capital overhang and exits - must be resolved," adds Asia Alternatives' Garg. "The managers that have demonstrated singular focus on and track record of delivering cash on cash return for investors and built a sensible portfolio will continue to raise capital."

 

SIDEBAR - Uncertainty: What's bothering foreign investors?

"You have a bad finance minister; you have one set of rules. You have a good finance minister; you have a different set of rules. What has happened in the last few months is very positive for India." This was TPG Capital founder David Bonderman's verdict on India appointing P. Chidambaram as finance minister earlier this year in place of Pranab Mukherjee, who has since become president.

Foreign investors hope that the change will help eliminate concerns that the government is inconsistent on economic reform and unfriendly towards overseas capital. Foreign direct investment understandably declined in the wake of the global financial crisis, but it recovered only moderately in 2011.

For all the measures introduced by the Securities and Exchange Board of India and the Reserve Bank of India in the past 18 months to smooth the path for financial investors - ranging from cutting the trigger shareholding for a buyout of a listed company to reducing long-term capital gains tax on PE investors - uncertainty over tax treatment and FDI policy still loom large.

Opinion is divided as to the impact. "In the last five months financial institutions have re-invested in India's capital markets," says Vikram Utamsingh, head of transactions and restructuring services for KPMG India. "People are starting to get some comfort that the government will do the right thing. There is a national election in 2014 so that gives the government 18 months to continue its reform agenda."

Haigreve Khaitan, a partner at Khaitan & Co, argues that the situation is having an adverse effect on investors. "There is a complete lack of trust in government policy and the certainty of stability of government policy," he says.Other industry participants warn that, for all the good intentions espoused by the government, it remains to be seen if it stands by them.

A decision last year to permit foreign investors to acquire majority interests in domestic multi-brand retail enterprises in cities with populations of more than one million was subsequently rolled back in the face of political opposition. In September, the cabinet enacted the measure - alongside policies permitting FDI in the aviation and broadcast industries - but allowed state governments to oversee the implementation. The decision still faces legal and political challenges.

For private equity, the general anti-avoidance rules (GAAR) proposed in this year's budget are a particular concern. Implementation has been postponed pending a review, but it remains unclear how offshore structures will be treated - transactions routed through treaty jurisdictions would be presumed to have been structured to obtain tax benefits unless the taxpayer proves this is not the main objective - and whether the rules will be implemented retroactively.

Pratima Divgi, an investment director at Squadron Capital, recalls a secondary sale between two GPs taking eight months to negotiate because they had to work out the various scenarios if the GAAR negated the exemption on withholding tax payments routed through treaty jurisdictions.

The concerns extend to the taxation of transactions between overseas parties that involve India-based assets, following the government's decision to pursue Vodafone over the buyout of joint venture partner Hutchison Essar.

According to Sidharth Bhasin, counsel at Shearman & Sterling, there are ways of structuring transactions to minimize the potential fallout - using double layers and indemnities, for example - but there are no guarantees. "The GAAR is so broad that it's virtually impossible for anyone to know if they are on the right side or the wrong side," he says.

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• Topics
• Exits
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