India briefing: Good doing business with you

One tax rate across all of India; one unified market. It has taken a decade of wrangling, but the government is close to introducing a nationwide Goods and Services Tax, replacing the indirect taxes levied at state and federal level. 

The GST is a central plank in Indian prime minister Narendra Modi's reform agenda, and it will be transformative, according to Everstone Private Equity managing partner Dhanpal Jhaveri. “It's the most significant piece of legislation since independence. It makes India one market in which to sell goods and services.”

“In the short term there could be potential challenges as businesses align themselves, but it will be positive in the longer term,” says Jhaveri. “Most industrial, as well as consumer businesses, will benefit from the increased ease of doing business. The administrative burden will be reduced and the cost of logistics will also come down.”

The new law, which is still being tweaked and requires individual state legislature approval, is expected to come into force in July.

It is also expected to boost tax collection, benefiting projects such as infrastructure which are deemed critical to growth. EY describes the GST as “game changing” for the Indian economy. Beyond transforming the way tax is structured, calculated and paid, the firm says it will impact goods and services pricing, supply chain optimisation, information technology and accounting systems, and compliance.

Another revision of the tax system, the amendment announced last May to India's double tax treaty with offshore jurisdiction Mauritius, also redraws the landscape for GPs. It removes the exemption on capital gains tax for Indian entities domiciled on the island. The two-year transition period begins in April. The change could prompt some funds to move jurisdiction, says Mumbai-based Tata Capital partner Bobby Pauly, who believes more investors will set up onshore.

Reflecting on the measures, Gopal Jain, managing partner at Mumbai-based Gaja Capital Partners, says: “Long-term stability in tax policies is possibly the most important missing piece for the industry.”

The Modi government's wider pro-business agenda should also benefit the industry. February's budget was met with broad approval from fund managers, although the latest GDP growth figure of 7 percent growth announced days later was higher than many expected in light of the disruption caused by the November demonetisation initiative.

“The central government has been broadly reformist in nature and sees the big picture,” says Jhaveri, who is also based in Mumbai. “It's very focused on improving the quality of life for the average Indian and reducing the friction in doing business with the government.”

The government has introduced a number of initiatives, including passing a new bankruptcy code and anti-trust legislation, abolishing the Foreign Investment Promotion Board (and a layer of paperwork obstructing foreign investment), digitising government services, and instigating land and labour reform.

Another longstanding issue managers say the government and central bank need to address is further reform of the banking system, which is clogged with non-performing assets and restricted lending acquisition finance. The Indian M&A market remains shallow as a result. 

“The government needs to help clean out the NPAs in the system,” says Samena Capital's managing director for India credit, Pavan Gupte. “There have been positive structural changes to Indian enforcement, but this has not yet been perfected, for example the new bankruptcy code remains untested.”

However, dealflow remains strong, the GPs agree. Everstone is currently investing its third buyout fund, a 2014-vintage vehicle that raised $730 million, while Gaja is investing its $240 million, 2013-vintage Fund II. Tata is mulling launching a successor to its Tata Opportunities Fund, a $595 million, 2011-vintage vehicle currently investing.

Transaction sizes are increasing and pushing fund sizes to where “$400 million-$600 million has become the norm, from about $200 million-$300 million previously”, says Pauly. The local market, typically dominated by minority transactions, has seen a notable rise in control deals. Buyouts now represent about a third of deal value, he says. “It is significantly higher than four or five years ago.”

Exit pressures, corporate stress and succession issues are driving a rise in buyouts, says Jain. In short, “Indian PE is maturing,” he says.

In hand with greater control comes greater emphasis on making operational improvements. More firms are exploring a buy-and-build strategy and GPs are increasingly comfortable taking control and finding management talent, Jhaveri notes. “There is a pool of talent in and outside India – people returning from overseas that want to work in fast growing businesses in financial services, consumer and IT sectors.”

“Businesses almost always need more than a financial solution,” says Jain. In response, like Everstone, Gaja has built in-house operational expertise.

On price, historically, buyers and sellers in India have not seen eye to eye, but Jhaveri describes valuations today as “reasonably sanguine”.

“There is some froth in some sectors where there's a lot of capital chasing assets. Currently in healthcare, particularly hospitals, values have been eye-popping,” he says. The consumer sector is due for a price correction, he adds.

However, Jain reiterates his belief in India's domestic consumption story. “We didn't lose focus even when other investors – almost en masse – flocked to export oriented sectors such as IT in the 2008-14 phase,” he says.

Another sign that the market is maturing is the speed at which negotiations are curtailed if there is a significant gap between buyer and seller on price, says Jhaveri. However, executing deals remains a slow process, with due diligence and documentation taking up to six months.

In contrast, the exit market is moving fast. Realisations picked up in the last half of 2015 and continued through 2016 until the government's demonetisation initiative halted activity in the fourth quarter, says Pauly. Over the period, about $5 billion-$6 billion was returned to investors. By value, secondaries and strategic sales were prevalent, and by volume, the public equity market was a popular route, he says.

At the end of March, Gaja Capital listed portfolio company CL Educate, which followed its partial exits of RBL Bank and TeamLease through initial public offerings last year. 

“We had a great exit year in 2016 and we see this continuing into this year and next,” says Jain. “Increasing domestic appetite for equity will continue to drive public equity markets and therefore IPOs.”

Pointing to a gap in the buyer profile, Jain adds: “Domestic buyside activity in M&A markets will also improve over time.” 
Banks overlook the financing needs of small- and medium-sized businesses in India, so debt funds are stepping into the breach.

The likes of KKR, Everstone and Samena Capital, have already done it. Now Baring Asia Private Equity is joining them, setting up a team to exploit the opportunity in Indian credit. The pan-Asia investor is in the process of launching a country-specific fund to offer short-term structured finance to domestic businesses.

Restrictions on bank lending for acquisitions and the lack of a domestic corporate bond market mean there is a gap for alternative sources of finance to fill. 

“Banks are good at servicing large corporates and then go straight down the scale to micro-finance and retail,” says Gupte from Samena Capital, which launched its first India credit fund in 2013. “This leaves a lot of the mid-market segment excluded from the banking system.”

It is not difficult to source opportunities, says Gupte. “Lots of opportunities come to our door. We spend most of our time trying to understand the entrepreneur, their business and whether an equity deal or a credit one is most appropriate and best aligned – the latter is the main challenge.”

Why is the strategy so popular? “It's all about the yield curve, it's that simple,” says Gupte. The yields from a direct lending strategy are very attractive on a risk-adjusted basis compared with declining bank interest rates of 6-7 percent on fixed deposits, he notes. “In addition, other India-dedicated alternative strategies like private equity have not delivered cash returns on a consistent basis.”

Samena's new credit fund will be in the range of $150 million-$200 million targeting 15 to 20 loans, each with a three to five year maturity. Its current fund has undertaken 13 private debt transactions, of which more than half have been exited. 

The government's announcement in November that certain 500 ($7.64;  €7.07) and 1,000 rupee notes were no longer valid and had to be exchanged, took many, including the private equity industry, by surprise. The initiative was intended to crack down on the shadow economy, curtail the use of counterfeit notes and cut off funding for illicit activities.

Although some businesses were thrown off balance by the prolonged cash shortages that followed, the long-term impact on portfolio companies is expected to be benign. “It creates a level playing field,” says Pauly. “The impact on portfolio companies was temporary. Going forward, it bodes well.”


 Jhaveri adds: “You can question the execution, but you can't question the logic. It will have the long-term benefit of cleaning up the system.”