India IT services: The digital divide

As internet users across the developed world conduct their connected lives, most of them give little thought to the digital infrastructure that underpins the technology they use. The vast majority could not tell you where to find the servers for the site from which they bought their airline tickets, or who developed the software they use every day at their jobs.

The answer to these questions would often be India, which became the back office location of choice for assorted multinationals in the 1990s, with a number of these providers subsequently going independent. The fact that users around the world can rely on the country's IT services without ever knowing where they come from is a testament to the professionalism that has made the sector one of the most compelling investments for private equity firms.

"A few years ago this was a field in which you made pure minority growth investments, or venture investments," says Cyrus Driver, Asia head of private equity at Partners Group. "It's now a field that is conducive to leveraged buyouts and to control-oriented investors. Not only does it have relatively scaled up businesses, it is also a sector that, at least in the Indian context, has the most professional management teams."

markets move fast and so larger scale players are always on the lookout for ‘acquiring' capabilities that they may have missed out on building organically. And so what you see is not only private equity deals for control, but also a lot of M&A in this market - Prateek Dhawan

India's IT and IT-enabled services (ITES) sector has come a long way from its beginnings in business process outsourcing (BPO). With many of the traditional call centers migrating to the Philippines and other countries, the sector has moved into a new phase, with companies more willing to assert themselves in acquisitions.

However, this new direction opens up new challenges as well. PE firms that have historically supported the players in this sector will be instrumental in its continued evolution.

Overcoming the skeptics

During the first wave of Indian outsourcing, entrepreneurs faced considerable skepticism that the model could work. The idea of trusting a company's support service to outsiders - and more than that, to people in a completely different country - was novel and untrusted.

"Back in the 1990s, the first generation Indian companies were renegades going out to the developed world, pitching that they could do tech services out of India. They were selling a concept, and it had never been done before at any major scale," says Prateek Dhawan, managing director at Everstone Capital, which has held a controlling stake in customer interaction management software developer Servion Global since last year.

That alien concept has turned into global market that IT consultancy IDC - citing BPO only - estimates will be worth $220 billion by 2018, growing at a compound annual rate of 5.6%. For business analytics services alone, IDC projects expansion from $58.6 billion in 2015 to $101.9 billion in 2019. The group noted that there is greater pressure on service providers to differentiate themselves by investing in specialist talent and intellectual property, and building truly global infrastructure.

"New end market disruptions like social, mobile, analytics and cloud provide a huge market opportunity that will drive sustained growth for the Indian IT services industry for years to come," Dhawan adds.

The management teams that led that first wave have left their mark on the industry. Several PE industry professionals credit the IT sector with bringing a new, more flexible and adaptable management style to India.

The familiarity of investors with these teams is related to the fact that private equity has always been integral to the growth of India's IT services space. GPs have generally been willing to support the companies because their services are always in demand and therefore they have considerable leverage when setting the terms of their contracts.

"When we look at Indian IT service companies, these companies have a phenomenal return on capital. They generate a lot of cash, and they don't need a lot of capital to grow, so after the initial round of funding they're pretty much on autopilot. They don't need any external funding," says Gaurav Ahuja, director at ChrysCapital. The GP is one of the more active investors in ITES providers, having backed Indian companies such as Hexaware Technologies and US-based providers such as Infogain.

PE investors historically have also helped IT firms as they pursue new clients - given the asset-light nature of these businesses, capital tends to be directed towards customer acquisition. GPs can provide the needed financial support, along with advice for establishing themselves in the chosen market and presenting themselves to potential clients.

"If there is an Indian business that needs to sell in the US, they have to invest in front end infrastructure, be close to the customer, and deliver services offshore seamlessly," says Everstone's Dhawan. "This requires investment and capital to make it happen. We provide that growth capital and operational help in terms of customer connects, operational rigor, and hiring the right front end talent through our networks. That helps the companies scale up and tap into that overall market opportunity."

Target rich environment

The IT and ITES space is still congenial to PE investment. Of the top 10 private equity deals in India in the first quarter of 2015, five were for companies in IT or ITES. Additionally, data from Ernst & Young show that M&A activity in India in 2014 was led by the technology sector, including IT.

This rising tide of M&A has been fueled by increased LP investment in private equity funds, making more resources available for PE investment in general. Vikram Utamsingh, managing director with Alvarez & Marsal's transaction advisory group in Mumbai, remembers meeting with a global LP that was willing to commit additional capital for IT services transactions.

"The LP was clear on a framework of co-investing with their domestic GPs in the Indian market. This would allow the GPs to look at much larger size transactions than they're actually capable of doing on their own," says Utamsingh. "And the LP's approach was to say in some of these situations, we might even lead the investment opportunity or co-lead it with our GPs, and not just be somebody who's in the background providing the funds."

With this money on the line, and with the historical profitability of the ITES sector, GPs are also pushing their investee companies to be more active in taking risks and improving their position in a crowded market.

"We like IT services companies that are a little more aggressive on that front, and are happy to use that cash, because otherwise you're creating cash reserves that are not efficient for you," says ChrysCapital's Ahuja. "If you have the ability to use that cash wisely, and create a more comprehensive set of services, or create a more global company with clients across the world, I think that is more exciting to us."

This investor pressure, combined with the previous success of the sector overall, has shifted the IT and ITES players in a new direction. Companies now seek to build a more effective platform that can generate returns more efficiently, rather than continuing straight-line organic growth.

Technological advances are another factor driving the changes in thinking among IT companies. The rise of SMAC - social, mobile, analytics and cloud - services has created an opportunity for the IT sector, which has already built up its communication infrastructure to support these new developments.

"I think the move has gone away from hiring heads, to acquiring more and more technology, and software platforms," says Gautham Radakrishnan, a partner at Tata Capital. "You hear this phrase about ‘non-linear earnings growth' the big IT companies talk about. What they're really saying is they want to buy more IP, in order to be able to generate returns which are more linked to operating leverage than to scale in terms of numbers of people."

Private equity professionals again credit the nature of the management teams in the sector for its unusual amount of M&A activity. Founders of ITES companies, dating back to the beginning of the industry in the 1990s, have tended to see their businesses as means to an end, and to view a trade sale as a normal part of business rather than a relinquishment of responsibility.

"Given the technical nature of this market, and the functional expertise that it requires, most entrepreneurs are professionals, who are more amenable to move on, sell control, take their chips off the table, and let somebody else scale to create more overall wealth rather than care about percentage ownership," says Everstone's Dhawan.

"In addition, markets move fast and so larger scale players are always on the lookout for ‘acquiring' capabilities that they may have missed out on building organically. And so what you see is not only private equity deals for control, but also a lot of M&A in this market."

The two tiers

Not all IT and ITES companies are created equal, however. Industry professionals split the market into two tiers: the top one contains the large global players, such as Tata Consultancy Services and Cognizant Technology Solutions, while the lower one contains relatively smaller operators like iGate, which received support from Apax Partners in its acquisition of India's Patni Computer Systems in 2011 and was sold to CapGemini this year.

The second tier also contains more specialized players, such as healthcare-focused Sirius Technology, or analytics firm Mu Sigma. Private equity professionals say that the danger for these more niche firms is that it is unclear what their long-term relevance will be, and so investors are reluctant to commit funds to them. In addition, their smaller size keeps them out of the range of larger funds.

"The challenge for us given our check size is, barring a handful, a lot of the companies in those niche segments today are not big enough," says Pawan Singh, managing director at Bain Capital, which paid $1 billion for a 30% stake in pioneering BPO firm Genpact in 2012. "Over time, if they are able to scale organically and inorganically, they could become more interesting."

Second-tier firms also face a disadvantage when it comes to achieving scale on the level of the biggest players. Their more specialized nature keeps them from attaining the size available to a company with a broader focus.

"It's difficult to see how a niche service line-focused or vertical-focused player will get to the scale of one of the tier-one players. You could get consolidation in the middle tier-two players to create a more scale business, even if not quite tier one," Singh adds. "But the top players continue to distance themselves from the rest of the pack, and as they get bigger they will focus on certain sectors or segments. This will create opportunities for other players to come in and be more specialized under that umbrella."

Industry participants see further potential for sector growth in international expansion. As the services offered by the IT companies become deeper, they will require deeper collaboration with outside firms, at levels beyond the technology departments. Indian players already often deal with corporate sales and marketing offices at their foreign clients. In some cases the services they provide have become so comprehensive that they have to keep a representative on site to better coordinate services.

Vikram Hosangady, head of transactions and restructuring at KPMG India, notes that the changing nature of the IT sector also plays to the strengths of India, where large teams with diverse skills can be assembled quickly.

"When you look at a data analytics company today, it's not a person who just has an engineering degree or a computer training background. These are people who come from design schools, from advertising organizations, people who have creative skills," says Hosangady. "To get a pool of those people is not easy. And India allows that, because if you're setting up a city in cities like Bangalore or Mumbai or Gurgaon, you have access to very large pools of such talent."

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• Topics
• Expansion
• Buyouts
• Technology
• South Asia
• buyout
• Growth capital
• Technology
• India
• Everstone Capital
• ChrysCapital Management
• Bain Capital Asia
• Partners Group