India: Private equity treads new ground

Just days after Private Equity International sat down in Mumbai with our Roundtable participants, Blackstone gave India its unequivocal stamp of approval, announcing its largest local acquisition yet.

The global fund manager is acquiring Bangalore-based information technology provider Mphasis from Hewlitt Packard Enterprise for a cool $825 million. The total could rise to $1.1 billion following a mandatory tender offer.

The panel, as yet unaware of this vote of confidence, describes a market slowly coming of age.

“LPs need to take a fresh look at India,” says King & Wood Mallesons international funds partner Ajay Pathak.

Some legacy issues still remain, he says, referencing high valuations that will have an impact on the returns of funds raised immediately post-crisis and a challenging exit environment, but, “I think the landscape has actually changed and you can say that we are now seeing version 2.0 of the private equity industry in India.”

General partners are “much more experienced, more hands on, and increasingly putting in place mechanisms so that they can get involved with their portfolio companies at the operational level”.

Companies are also more receptive to private equity buyers “and in some cases they almost see it as a sort of kudos that they are able to sell part of the business to private equity. It’s a reflection of success”, Pathak says.

“Quality and success,” qualifies Pavan A Gupte, Samena Capital’s managing director for its India Credit business. However, not all the excesses in ’08 and ’09 have flushed through the system. A large number of managers, which ballooned to 350-plus at the peak of the market, are still around. “Typical fund lives of 10-12 years have kept many of these alive.”

Of the large number of GPs operating in the Indian market, going forward “we feel many of them would consolidate or begin to rejig their business model”, says Krishna Kumar, senior managing partner, IL&FS Investment Managers Limited, who oversees its infrastructure investments.


Pathak, Gupte and Kumar are veterans of a local private equity industry that is no stranger to volatility, buffeted as it is by domestic, emerging market and international economic cycles. However, two years on from the election of Prime Minister Narendra Modi, there are signs of stability.

“In the last two years, investors have taken a lot of comfort with a single party government at the centre, the first time in 28 years,” says Kumar.

Its strict fiscal policy has reduced inflation, which now stands at around 5.7 percent – down from the highs of 10.9 percent in 2013 – although a drop in prices has hit domestic company earnings and slowed nominal GDP growth. Real GDP growth is forecast by the World Bank at 7.8 percent for 2016.

At the macro level, the fall in commodities prices, especially crude, has helped the country. “The savings in lower crude prices have been used by the government to address the issue of fiscal deficit,” says Kumar.

As a result, the industry is also expecting an interest rate cut, to the benefit of earnings and industries with high capital expenditure, such as manufacturing.

The Reserve Bank of India has also instigated a clean out of non-performing loans from the banking system, a policy that has been in circulation for years. It is an example of an acceleration in decision-making and a willingness to act.

“There were two specific issues that repeatedly came up in the discussions [prior to the election],” says Pathak. “The first was concern over government inaction. On that, the Modi government has made some strides. There has been a push to streamline regulatory and other approvals and a general move toward greater transparency and accountability. The central government seems to also be actively encouraging healthy competition among the various states. This has led to the state governments looking at ways in which they can improve the ease of doing business in their respective states.”

The other issue? “Tax uncertainty.”

Since the government began its pursuit of hundreds of millions of dollars in back-taxes from Vodafone connected to the use of offshore structures and an outsourcing arm based in India, there has been continued uncertainty among managers and LPs regarding the direction of the anti-tax avoidance regime.

The tax cases involving Vodafone are well publicised, but they are not alone as a number of other similar claims make their way through the courts, Pathak notes. “The concern is to what extent the authorities will revisit transactions that have already taken place. And, going forward, how widely will the general anti-avoidance rules be interpreted? The government finds itself in a difficult position to some extent. It recognises tax uncertainty is an issue for investors, but it doesn’t want to be seen interfering with ongoing judicial proceedings.”

For investors looking at India, ambiguity about the future direction of the tax regime is matched by tainted memories of past performance.

Although Pathak says LPs are more willing to discuss India than they were five years ago, past disappointment still hangs over decision making. “From an LP perspective, particularly if you have already made allocations to India historically, you can’t get away from the fact that performance hasn’t been as great as you might have expected and there haven’t been as many exits as well. But then on the flip side, at a global macro level, if you are an LP looking at making allocations to emerging markets, you cannot ignore the fact that the growth story is in India.”

Gupte agrees that LP motivations depend not only on a fund’s track record but, more importantly, on their own experiences and current portfolio constructions.

“Did they invest in the late 90s? Did they succeed or did they burn their fingers? What’s their maturity horizon? What’s their existing-to-proposed exposure? Which structures and/or advisors do they use to access investments? Are they fresh investors or are they older? What is their liability profile? How is their asset profile constructed broadly and specifically with regards to the EM [emerging market] exposure and, within that, India. All these complex and multifarious factors play into a decision to invest.”

Crucially, though, the global flood of capital into alternatives powered by record distributions will have to find its way to India. “The wall of capital is exploding,” Gupte says.

But fundraising remains tough as always. “You need to educate the LP community in terms of what the market offers, what are the different risk return characteristics of each strategy and, crucially, how a particular strategy or offering is accretive to their existing portfolio. I’ve seen some very good managers with interesting track records and yet they struggled to raise capital because of their inability to articulate how their product fitted into a LP’s portfolio.”

A rapport with international investors is key, as the domestic investor base remains shallow, constrained by allocation limits and incentives.

“Capital from domestic investors has not been very forthcoming,” Kumar says. “Due to regulations, commercial banks are unable to invest in alternative assets. Similarly, insurance companies have internal guidelines which prevent them from committing large pools of capital. While on a global fund raise, if we are able to demonstrate meaningful capital being raised from the domestic market, it helps the fund raise significantly. It’s a huge validation of domestic commitment towards funding infrastructure.”

One positive, Kumar says, is that domestic private insurance companies, which have growing asset pools, are now closely evaluating participating in alternative assets.


Perhaps because of the small domestic LP base, public scrutiny of carried interest has yet to erupt in India. But all LPs committing capital are sensitive to fees and costs.

“In order to bring down costs, LPs are splitting their commitment between the fund bucket and the co-investment bucket,” Kumar says.

However, not everyone is geared up to assess opportunities and respond quickly, Pathak adds. “As a result, there is a much greater focus from the GPs in terms of making sure that there are clearly defined parameters and timelines associated with co-investment opportunities.”

And large institutional investors who have been active in the Indian market through fund structures are now pursuing direct investments, says Kumar. “However, for a large part of the investor universe, who are yet to commit capital to India, pursuing a direct investment strategy is still some time away.”

Gupte agrees there are obstacles. “It can be very rewarding, but is quite risky if an investor doesn’t have the ability to manage risks. The challenge is that you can say you want to invest directly, but unless, like the CPPIB [Canada Pension Plan Investment Board] in India, you are setting up a team and bringing on board the right talent and skill set and aligning them correctly, it is very difficult to do it sitting elsewhere [outside India]”.

Another way for an LP to get direct access to transactions at lower costs is to enter into managed accounts with GPs. “It enables investors to have perhaps a greater say on the investments that are made, tighter investment policies and restrictions, much greater reporting, and transparency,” Kumar says. “And at much reduced fees.”

“One of the reasons some LPs are looking at separately managed accounts is because they are prepared to take a longer-term view,” Pathak says. “And although in theory they would usually have the right to terminate even earlier than under a typical closed-end fund, in reality it means they can monitor the investment and give the GP flexibility to hold onto investments for a longer period.”

This can be an interesting way to entice investors, but it’s not without its own challenges, Gupte says. “It’s very hard for a GP to be negotiating with an entrepreneur or counterpart and at the same time managing the LP, which has an effective veto on every investment decision as well,” he notes. “I’ve seen at least two examples for Indian strategies where accounts were not well thought through or structured and as a result, the LP-GP relationship has floundered.”

LPs can also tend to have rigid investment parameters that are not structured to adapt to changing market dynamics; emerging markets like India have shorter economic and business cycles relative to developed markets and need to adapt investment strategies a lot more frequently, Gupte says.

“I’ve seen an example where the team was frustrated, and said, ‘We believe the opportunity set has shifted marginally and we should now shift strategy accordingly, but our mandate doesn’t allow us to change; we’re trying to convince our LP but it’s tough for various people and portfolio reasons.’ This is compounded by the fact that for a large LP, India occupies a small part of their focus.”


However, it is at exit – not investment – that the alignment of interest been GP and LP becomes the most critical for fund managers, which are still typically minority stakeholders.

“One of the criteria to make the investment in the first place is whether or not the GP and the promoters are aligned when it comes to the exit options,” Pathak says. “There is also a recognition that just having contractual protections, such as put options, in itself is not sufficient. This is another example of a changing landscape.”

In order to carve out a successful exit, GPs need to constantly work with investee companies toward creating value, build a strong relationship with sponsors who would help support the exit and constantly evaluate multiple exit opportunities, Kumar says. 

IL&FS has achieved 22 exits in the infrastructure space with only five through capital markets and the rest via strategic sales and trade sales, he notes.

Samena Capital, a regional special situations fund, has tended to be an opportunistic investor in India and, therefore, exited mostly through the public markets “because we had the flexibility to do it”, Gupte says.

“Most of our peer group that plays only in the PE side haven’t had the best experience. The IPO window is, as in most emerging markets, a narrow one that opens and shuts very quickly. If your portfolio company is not prepared to optimise on that window it can get pretty challenging. You can’t rely on it.”

Complicating the exit decision is the dislocation between hold periods and investment maturity. “Fundamentally, the three, four, five-year holding period just doesn’t work in markets like India,” Gupte says. “There is a huge execution challenge on the ground. What you think you’ll accomplish in five years, usually takes six or seven years. In year four, five, six, there’s usually an inflexion point in terms of the growth of the company, but that’s the time when the fund structure forces you to exit. LPs need to fundamentally rethink these structures for the Indian market.”


The market is also evolving in terms of new strategies. Although controlling stakes are more prevalent, Pathak does not see a proliferation of buyout funds on the horizon.

Investment in more typical growth strategies, too, has actually fallen in the last couple of years due to competition for capital from venture capital, he notes.
Instead, more niche players have arrived on the scene. “The credit space is particularly interesting in India.”

This is exactly where Gupte focuses. “During 2008-12, companies entered into a capital structure on a set of growth assumptions that haven’t really panned out in the past cycle, he says. That is clearly the biggest opportunity set for us as mezzanine providers. Across sectors, companies need to realign their balance sheet and need more breathing room in the next few years as they do this.”

Gupte is spending time with the 2,000-plus mid-market companies which are underserved by the banking system. “There has been some consolidation in the non-bank finance space that has reduced capital supply to the market and we are stepping in there.”

Its new thrust is on the “private equity take out thesis”, he says. The firm identifies situations where minority investors and company owners no longer want to be in partnership. “We are seeing multiple situations where we are looking at lending to the company or the entrepreneur himself to buyout the private equity investors and give the business a bit of breathing space to normalise the capital structure. These situations are fully secured, fully collateralised, and offer very stable yields.”

Also outside of the scope of traditional private equity, infrastructure is alive with investment opportunities.

“Infrastructure is one of the best investment themes in India today,” Kumar says.

Moreover, the government is also taking steps to ensure there is more funding for the sector and is playing the role of a facilitator, he says.

IL&FS is currently raising $1 billion, split between a fund and matching co-investments, targeted at Indian assets. It follows previous funds it has invested with significant Indian infrastructure exposure.

Its strategy is to invest in both infrastructure platform companies and infrastructure operating companies. “We feel that there is significant opportunity to invest at the platform company level for some of the larger developers who require capital, one to deleverage, and other to grow,” Kumar says.

“Platform companies have the ability to generate higher returns over a medium to longer term, while single asset operating companies have the ability to generate stable long term returns. If one were to blend both these investment strategies toward building a portfolio of infrastructure assets, one could generate returns which are commensurate to the risk return profile of emerging markets, together with a current yield.

“Especially in the current vintage, infrastructure sector valuations look attractive to generate such returns.”

Currently, IL&FS sees a lot of acquisition opportunities in the road sector. “The discounting rates on operating toll roads hover between 15-18 percent. If you can strike some good acquisition opportunities with ticket sizes of $75 million-$100 million, from a portfolio perspective this sector could alone see $300 million-$500 million of commitments over the next one to two years.”

Looking ahead, one significant development that boosts the opportunity across the Indian private equity landscape, is that the distance between valuation expectations held by company owners and fund managers is narrowing.

This means for “the more recent vintages, the expectation is they will deliver better returns”, Pathak says. “And the exit environment is also slowly improving. If you look at where the problem lay, the funds that were pre-2005 vintage, a number of them did deliver quite attractive returns. It’s that vintage in between where the greatest challenges lie, however that is washing through now.”

While managers hold out hope for some currency management to support the fluctuating rupee, foreign exchange volatility remains one of the most significant topics in GP-LP discussions.

“One of the major factors affecting returns is the devaluation in currency,” says Krishna Kumar.

“There have been instances where GPs have clocked attractive returns in local currency terms, but have lost a good share of those returns when converted to dollars.”

The rupee has been on a rollercoaster ride in recent years, trading at 49.45 to the dollar in January 2012.

It started 2015 at 61.57 and undulated to 66.52 rupees to the dollar by the end the year, where it was still trading around this March.

“Building a constant devaluation rate in the business model helps one gauge returns in US dollar terms, and thereafter, putting in place short term hedging strategies could mitigate this risk to a large extent,” Kumar says, adding that a constant running yield in your portfolio would also help mitigate this risk.

For the manager, the declining rupee hits their own pay packet. With a hurdle typically measured in dollar returns, it can reduce or eliminate the chance of any carried interest.

There is tremendous scope for aligning LPs and GPs in India better, says Pavan A Gupte.

“International investors are effectively handing over dollar capital to a local manager who is investing in rupees with their hurdle in dollars,” he says.

“LPs don’t give the manager the ability to hedge or not. If the belief is we’re aligned, then let the manager take the call.”

Pavan A Gupte is managing director of Samena Capital’s Indian Credit business, which he joined in February. He has previously worked as chief strategy officer at CVCI Private Equity in Singapore and as co-head of Asia at Adam Street Partners London before returning to India as founder and managing partner of Bombay Central Advisors LLP. At Samena Capital he manages its India credit fund, along with private credit/direct lending solutions and co-investments alongside other stakeholders.

Krishna Kumar is a senior managing partner at Mumbai-based IL&FS Investment Managers and one of the founding members of its private equity practice, which includes growth private equity, real estate and infrastructure. He heads the infrastructure vertical in IL&FS Investment Managers. Over the past 20 years, the firm has raised $3.5 billion in third party capital and has made about 175 investments, about 90 of which it has exited.

Ajay Pathak is a London-based partner in the international funds practice at King & Wood Mallesons, where he has worked for the past 14 years. He specialises in fund formation across alternative strategies, including private equity, infrastructure, debt and credit. He oversees KWM’s India business, where he has been active since 2000 advising both international and domestic managers looking to raise capital.