South Asia: Indian satellites

When the Indian embassy in Nepal hosted the country’s first private equity event in March, most industry observers expected it to be essentially a matchmaking affair between Indian investors and Nepalese entrepreneurs. It didn’t work out quite like that.

The 20 investors participating in Connect-IN, which included the likes of Tata Capital Private Equity, were Nepalese by a margin of two to one. Out of a field of about 250 predominantly consumer services companies, five investments were made, mostly with local money going to local entrepreneurs. In one unexpected reversal, an Indian company was actually backed by a Nepal-based investor. 

“There’s a lot of commonality that we can build upon between India and Nepal, and that’s the reason we wanted to create that ecosystem, but cross-border is not a prerequisite for Nepal companies,” says Kapidhwaja Pratap Singh, second secretary for commerce at the embassy. “Even if there were no Indian investors at our event, it would have been a success, because there is a big existing appetite in Kathmandu to invest in local start-ups.”

If the big shiny prize of India attracts everyone like moths to a flame, that’s fantastic for us because we’ll get a cleaner run at the other markets

The outcome shines a new light on the conventional wisdom that South Asia’s smaller countries are subordinate to India – especially since Nepal arguably represents the most India-dependent economy in the region. While small South Asian markets will by no means be self-sufficient in funding their own development, private equity investors may do well to note that this process will be far from an exercise in Indian piggybacking. 

Ripple effect

Perhaps the most fundamental observation to be made about India is that it’s an important long-term opportunity but with short-term challenges that result in a lot of wreckage on the road to modernity. Historically, the sheer size of the market has largely been able to offset a lot of hesitations around struggling private equity programs and undependable exit markets.

According to AVCJ Research, PE investment in the country topped $131 billion for the 10 years ended 2017. The flow has by no means been consistent, but it is more than 50 times the amount invested in the rest of South Asia during the same period. Foreign direct investment (FDI) is a healthy 2% of Indian GDP, compared to only 1% in Sri Lanka, probably the second-most developed economy in the region.  

An interesting side effect of this influx of capital is that it has given the smaller countries around the subcontinent a chance to study the plethora of experiments in the Indian company building landscape. The ability to act on these indicators is often muted, however, by a lack of local resources, intellectual property security concerns, and geographic restrictions, particularly in the landlocked markets of Nepal and Bhutan.

Meanwhile, the dissemination of Indian business expertise has been sporadic. Cross-border expansion in the region by Indian companies has been slowed by a combination of the ongoing competitive appeal of India’s various local sub-markets, bureaucratic difficulties in neighboring regulatory environments, and political and cultural tensions, especially in the case of Pakistan. AVCJ challenged a number of industry participants to name one Indian branded company with a presence in Pakistan to no avail.

Countries in India’s shadow, however, are seen as more manageably sized markets with advantages around greater capacity to establish a competitive footprint and quickly achieve profitability. As less compelling destinations for direct investment from development financial institutions, these countries have also been obliged to provide a more attractive operating environment for international private equity players such as SEAF.

“We’re seeing more IT, agri-processing, and fintech businesses,” says Altaf Uz-Zaman, a managing director at SEAF Bangladesh Ventures, noting a Bangladeshi edge versus India regarding tax, company valuations, and labor costs for IT talent. “New investors are looking to invest in smart businesses, so that’s leading us in that direction, and less in areas like transportation.”

Uz-Zaman says his firm has experienced significant traction in Bangladesh since setting up shop in 2010. Several new LPs have signed up in recent years, driving demand for larger ticket opportunities in the small and medium-sized enterprise (SME) space. Economic growth in the country at around 6-7% a year during this period has supported more diverse deal targeting and value-add programs. One of SEAF's early investments in the burgeoning technology space, Solar International, was even able to expand into regional markets, including India.   

Bangladesh is also said to benefit from the long-term consumer potential of its 160 million population as well as a relative disconnect from the often-turbulent undulations of the Indian economy. Cross-border business, mostly in low-tech industries, is driven by trade agreements with the US and Europe.

Modernization in Bangladesh has been slightly slower than in India, however, with only about 30% smart phone penetration. Meanwhile, some investors in the region such as Frontier Digital Ventures have balked at the country, citing difficult similarities with India in terms of an unsophisticated business culture and poor potential for establishing a gainful commercial presence.

“If you look at all the high-profile internet companies that have had investments in India, you have to look long and hard to find a profitable outlook for many of them,” says Shaun Di Gregorio, Frontier’s CEO and founder. “But there are some really good markets in the region that haven’t had the same attention and where you can carve out a better position faster than you can in India.”

Category kings

Frontier, which focuses on developing online classifieds businesses, has backed property portals in Sri Lanka and Pakistan, and an online automotive platform in Pakistan. Part of its thesis is to invest in South Asia outside of India as a means of avoiding competition and improving the odds of achieving category dominance. This is particularly important in digital segments where the number-two and number-three players can be all but invisible economically.

“If the big shiny prize of India attracts everyone like moths to a flame, that’s fantastic for us because we’ll get a cleaner run at other markets that might not be as big but are far more winnable,” Di Gregorio adds. “In many of the technology business models, you need to be the market leader to be profitable. The premium of market leadership is enormous.”

Due to these factors, Di Gregorio regards Pakistan as a more conservative play than India despite the country’s security issues. He also sees almost no potential for expanding Frontier’s Pakistan businesses into India – a culturally and economically compatible neighbor separated by a bitter political divide. Most trade between the two countries is brokered through third parties in hubs such as Dubai. 

As a result, Pakistan-India trade is said to be worth less than $5 billion a year compared to a potential $45 billion. This underperformance is particularly frustrating for private equity investors since about 80% of Pakistan’s GDP is driven by household consumer driven industries that play neatly to the strengths of the asset class. Healthcare has traditionally been one of the biggest opportunity sets, although recent regulatory pressure is said to be dampening cross-border pharmaceutical deal flows.

JS Private Equity (JSPE), one of the first GPs to operate in Pakistan, remains optimistic that business with India will improve, but sees even more upside in the growing presence of China. The One Belt One Road infrastructure agenda has materialized here in the form of the China-Pakistan Economic Corridor (CPEC), prompting massive road and rail construction down the spine of the country, as well as new port developments at both Karachi and Gwadar.

“I can’t overstate the importance of what’s been happening in the past five years between Pakistan and China with CPEC,” says Steve Smith, a partner at JSPE. “We genuinely view this as a once in a lifetime opportunity for Pakistan, and there are going to be short, medium and long-term economic dividends coming to the country. Our job is to find the right way to invest around those themes in order to deliver returns to investors.”

JSPE has responded by focusing on growth-stage development work in basic industries such as building materials and fuel. Smith says Pakistan’s cement industry is too mature to present much opportunity for PE, but his firm is committed to two local vehicle component suppliers and looking into an oil marketing play. Pakistan-India cross-border warehousing and supply chain investments are still on the long-term wish list but considered less realistic versus the China-driven opportunity.

The China factor

The theme of increased Chinese investment in South Asia has further challenged the notion that India sets the economic climate for the smaller countries. For private equity, Chinese gravity in the region has been felt recently in markets as inconspicuous as the Maldives, where Bain Capital Private Equity and two Chinese partners teamed up to acquire a China-geared tourism business for about $500 million.

Meanwhile, industry professionals have cited growing Chinese interest in the Himalayas as a major economic shift that is supporting new private equity market development. In Bhutan, where investor attention spurred by a smoldering China-India rivalry is expected to keep the economy growing at more than 7%, an impact firm known as GNH Partners is setting up the country’s first private equity fund with a target of $100 million.

In Nepal, where a blockade on the Indian border in 2015 dramatically punctuated a trend toward more Chinese trade, two new VCs have emerged: OneToWatch, which has recently launched a EUR20 million ($24 million) fund in partnership with local PE consultant True North Associates; and B02, an SME-focused manager that received $7.3 million last year from the International Finance Corporation.

The country’s first private equity investor, Dolma Impact Fund, has flagged Chinese participation in the critically underdeveloped power sector as an encouraging sign for further proliferation of private investment. It is currently closing a $37 million top-up fund on its first vehicle with $37 million in commitments, largely from European institutions.

“There are a lot of businesses that can’t compete with imports because of the cost of managing power backups,” says Tim Gocher, founder and CEO of Dolma, which has invested two hydroelectric operations and is considering a third. “We’re trying to make the economy more sustainable by creating an institutional track record for investing in infrastructure that puts the perceived risk from abroad more in line with the risk we see.  International investors sometimes view Nepal as highly risky, but the government has never defaulted on a power payment.”

Traction on this front is expected to accelerate with the recent advent of a democratic process in Nepal and the establishment of a relatively stable government. Historically, policy hang-ups around licensing and clearances have resulted in less than 5% of FDI commitments in infrastructure actually making it to the bank.

Despite a preponderance of liberal FDI rules, regional infrastructure project success rates are consequently low. In the Himalayas in particular, regulations and a lack of professionalism around deal process diligence are considered the main deterrents to capital flows from India, which has the greatest interest in accessing the power production potential of Nepal and Bhutan’s natural hydro advantages. 

“There is a lot of negativity around repatriation of profits, and investors from cross-border have to face doubts about their exit options after 3-4 years,” says one industry participant in Nepal. “That’s especially true for private equity and venture capital. It may change this year, but for now, it’s a concern for PE.”

The rationale for Indian expansion around South Asia is strongest regarding the relative homogeneity of the region. Most of the markets that border India appear to be a natural fit socially, unlike a geography such as Southeast Asia, where national borders imply stark cultural divides, including changes of language.

Whether or not companies can make cross-border work will depend on sector targeting as much as policy navigation. Healthcare is expected to be difficult, whereas education is seen as having substantial potential for regional scaling. South Asian technology companies, meanwhile, have historically found partners outside of the region altogether, especially in Europe and the UK.

“These are not essential expansion markets from an Indian perspective, but they’re not a bad choice for Indian companies that want a safe place to test a product in a foreign market,” says Don Lambert, a principal finance specialist at the Asian Development Bank. “In particular, Sri Lanka is attractive for its potential to be an intermediary between South Asia and the outside world. It doesn’t have the historical and political legacy tied up between India, Pakistan, Bangladesh and Nepal. If it can position itself as a staging ground for business in the region, that would be an effective value proposition for PE.”

Connection point

There is skepticism, however, about Sri Lanka’s ability to fill the role of global broker. Although the country maintains strong trading connections with the Middle East, the US and Europe, it is neither formally tied to a global block like EU members nor informally credited as the junction of a loose geographical group like Singapore. 

In 2016, Sri Lanka launched a special economic zone program known as the Colombo International Financial City, but the market for another such hub between Singapore and Dubai remains in doubt. At the same time, the country ranks 111th in the World Bank’s ease of doing business index, firmly in line with its South Asian peers and far from the likes of the United Arab Emirates.

Still, Sri Lanka is often touted as possibly South Asia’s most attractive development market in its own right. This is attributed to regionally high education levels, a more pervasive consumer culture, higher smart phone penetration at around 50%, and relatively developed infrastructure, including Chinese-backed ports.

Although it must be weighed against the limited marketing scope of a small consumer base of 21 million people, red tape in Sri Lanka is seen as less of an issue, and GDP per capita is second only to the Maldives at about $13,000. High-value agriculture is recognized as a prospective export play due to a climate agreeable to upmarket crops. Business process improvement (BPI) services is another growth area – not as direct competition to the Indian market, but as a diversification play for BPI clients wary of overexposure to a single country.

Private equity interest has been diverse, with BOV Capital launching an INR1 billion Sri Lanka-focused technology fund and Zephyr Management targeting later-stage deals across BPI, textiles, agriculture, tourism infrastructure, and logistics. TPG Capital has been active in the country in both finance, with an investment in Union Bank of Colombo, and healthcare, with a turnaround of Asiri Hospital Holdings, the largest local hospital chain.

Earlier this year, Samena Capital agreed to invest up to $35 million in Softlogic Holdings, a conglomerate that operates Asiri as well as businesses in retail and financial services. The investment capped a seven-year due diligence process on the country by Samena. Although the GP has previously made this strategy work in South Asia’s smaller economies in areas such as ceramics and retail, it acknowledges that realizing cross-border ambitions in the region is not as intuitive as it seems. 

“Not everyone in India is looking to grow into Sri Lanka and Bangladesh. They’re a nice-to-have, but they come with their own challenges because, in these jurisdictions, you need the right structures, capabilities and reporting to manage that level of growth,” says Pavan Gupte, a managing director at Samena. “It sounds nice on paper, but it’s only when the business is a bit more mature that you can start thinking about these things.”  

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• South Asia
• GPs
• Consumer
• Industrials
• Infrastructure
• Technology
• India
• Pakistan
• Bangladesh
• Sri Lanka
• Asian Development Bank
• Samena Capital
• Growth capital
• Venture
• Emerging Markets