Venture Capital and Private Equity Investment in India

Leonardo von Prellwitz

Matricola 931014
Tutor: Prof. Stefano Bonini

1
 Table of Contents

1. PREFACE........................................................................................................................3

2. INTRODUCTION .............................................................................................................4

3. A BRIEF HISTORY OF VENTURE CAPITAL IN INDIA ...................................................5

4. STRUCTURE OF FUNDS IN INDIA ................................................................................6

DOMESTIC FUNDS............................................................................................................................................ 6
OFFSHORE FUNDS ........................................................................................................................................... 7

5. THE REGULATORY FRAMEWORK ...............................................................................8

A) THE SEBI REGULATIONS, 1996 ................................................................................................................... 8

B) THE SEBI REGULATIONS, 2000 ................................................................................................................... 8
C) TAXATION.................................................................................................................................................... 9

6. PERFORMANCE ...........................................................................................................10

7. THE IT SECTOR ...........................................................................................................15

8. THE REAL ESTATE BET ..............................................................................................17

8. THE CHINESE COMPETITION.....................................................................................19

9. THE BRAZILIAN BENCHMARK ....................................................................................22

10. MACROECONOMICS .................................................................................................24

SHORT-TERM GROWTH .................................................................................................................................. 24

THE SHORT-TERM RISKS ............................................................................................................................... 25
THE CAPITAL MARKET ................................................................................................................................... 26
THE LONG-TERM STORY ................................................................................................................................. 27
Demographics ......................................................................................................................................... 28
Reforms................................................................................................................................................... 29

11. CONCLUSION.............................................................................................................31

2
 1. Preface

This final work has been developed in concomitance with my internship experience at
CNBC-TV 18 in Mumbai, India. My intention was to exploit the superior research
capabilities and ties of this financial broadcaster in order to have a snapshot of the current
situation of Private Equity/Venture Capital (PE and VC) investment in the promising Indian
economy.

My position on the research desk at CNBC has enabled me to collect first rate data
on the macro-economic picture of the Indian market and to track down key sources
telephonically all around the world, from New York to Hong Kong.

Unfortunately most members of the private equity scene in the Indian environment
were balking at the idea of disclosing private information about their Internal Rates of
Return (IRR) and other details about their funds or their industry.

Moreover I have not received great support from the CNBC database on the PE/VC
matter as the broadcaster tracks only listed companies (which are almost non-existent in
the Private Equity scene). Arduous as well was my attempt to gather information from
institutions such as the Indian Venture Capital Association (IVCA), Venture Intelligence or
Bain Capital, who were willing to share their information only in exchange for air-time on
CNBC, which I was obviously not in the position to provide.

My gratitude goes to Ryan Tang from the Center for Asian Private Equity Research
Ltd. (APER), who has courteously provided me with the IRRs of the Indian and Chinese
PE market.

In the end this final work is a rather exhaustive account of the overall Private Equity
situation in the Indian country, from the preferred modes of entry to the analysis of its
sectorial breakdown to the summary of the burgeoning IT sector.

3
 2. Introduction

The face of global PE and VC is changing dramatically in the last few years. 2006 has
witnessed the inception of funds infringing the threshold of $10bn – i.e. Blackstone’s
$15bn buyout fund and the venture of KKR (Kohlberg Kravis and Roberts) on listed
markets.

At the same time the amounts raised by these funds are growing to unimagined
limits (about $300bn in June according to Bloomberg) giving great focus and tremendous
attention to these kinds of alternative investments.

Following such developments and the ever mounting pressure of this flattening and
globalizing world, there is an increasing need for funds to diversify internationally.
The factors stimulating the drive to go global can be summarized in the following:

Globalization

The need of funds to globalize is driven both by their requirement to mitigate their
risk exposure by investing in different countries as well as to tap innovation, which is
occurring around the globe.
Adding an increased international competition and the higher cost of building a
company in mature markets, the quest for global cost-efficiencies will mark the rise of
future PE and VC trends.
Funds increasingly need to look at India, China, Russia and Brazil to take
advantage of the global outsourcing and off-shoring as well as to exploit these low-
cost/high talent markets.

Interconnectedness

In a world of cross-pollination, cross-border and cross-sector influences the leading

form of investment for global funds will be much like Multinational corporations through
international collaboration. Global investors are forced to seek out local funds in emerging
innovation hotbeds to help understand the chased market, addressing due diligence in the
correct way and penetrate their large developing consumer markets.

4
 Scale

As the VC and PE industries mature, experts are pointing to a growing divide

between the performance of the top-tier players and that of their smaller players, and it
goes without doubt that scale is a big contributor to over-performance.

A recent survey conducted by the Emerging Markets Private Equity association

(EMPEA) states that 65% of interviewed managers declare a future increase in interest
(compared to 45% in the same survey in 2004) to invest in emerging markets 1 . According
to the National Venture Capital Association (NVCA), India is the second most attractive
location, gathering the positive attention of 18% of the American fund managers.

Given these conditions, this research is meant to cover India as a possible

investment target: starting from a portrayal of the current Private Equity situation in India; it
shall cover the legal and tax angle of funds establishment, the macroeconomic situation
and its likely impact in the short and long term.

Moreover it will contain a description of its most renowned investment targets: the
information technology industry and the real estate sector.
Finally, it will benchmark the current performance analysis to China and Brazil and stress
the advantages and disadvantages of India.Inc.

3. A brief history of Venture Capital in India

The History of Venture Capital in India can be traced back to the 70’s, when the
Government of India, getting aware that an inadequate funding and financial structure was
hampering entrepreneurialism and start-ups, appointed a committee to tackle the issue.
Approximately ten years later the first three all Indian funds were standing: IDBI, ICICI and
IFCI.

1
EMPEA, EMPEA Second Survey of Institutional Investor Views on Emerging Markets Private Equity, April 2006
http://www.empea.net/research/research.aspx.

5
 With the institutionalization of the industry in November 1988 the government
announced its guidelines in the “CCI” (Controller of Capital Issues). These focused on a
very narrow description of Venture Capital and proved to be extremely restrictive and
encumbering, requiring investment in «innovative technologies started by first generation
entrepreneur». This made investment in VC highly risky and unattractive.
At about the same time the World Bank organized a VC awareness seminar, giving
birth to players like: TDICICI, GVFL, Canbank and Pathfinder. Along with the other reforms
the government decided to liberalize the VC Industry and abolish the “CCI”, while in 1995
Foreign Finance companies where allowed to invest in the country.

Nevertheless the liberalization was short-spanned, with new calls for regulation
being made in 1996. The new guidelines’ loopholes created an unequal playing ground
that favored the foreign Players and gave no incentives to domestic high net worth
individuals to invest in this industry.

VC investing got considerably boosted by the IT revolution in 1997, as the venture

capitalists became prominent founders of the growing IT and telecom industry.
Many of these investors later floundered during the dotcom bust and most of the
surviving ones shifted their attention to later stage financing, leaving the risky seed and
start-up financing to few daring funds.

4. Structure of Funds in India

Given India’s peculiar Regulations and investment environment, three main types of fund
structure exist: one for domestic funds and two for offshore ones.

a) Domestic Funds

Domestic Funds (i.e. one which raises funds domestically) are usually structured as:
i) a domestic vehicle for the pooling of funds from the investor and ii) a separate
investment adviser that carries those duties of asset manager.

6
The choice of entity for the pooling vehicle falls between a trust and a company (India,
unlike most developed countries does not recognize a limited partnership), with the trust
form prevailing due to its operational flexibility.

b) Offshore Funds

Two are the common alternatives available to offshore investors: the “offshore
structure” or the “unified structure”.

Offshore structure

Under this structure, an investment vehicle (an

LLC or an LP organized in a jurisdiction outside
India) makes investments directly into Indian
portfolio companies. Typically the assets are
managed by an offshore manager, while the
investment advisor in India carries out the
due diligence and identifies deals.

Unified structure

When domestic investors are expected to

participate in the fund, a unified structure is
used. Overseas investors pool their assets
in an offshore vehicle that invests in a
locally managed trust, whereas domestic
investors directly contribute to the trust.
This is later used to make the local portfolio
investments.

7
 5. The Regulatory framework 1

From 1996 until 2000, the Securities and Exchange Board of India (SEBI) was empowered
to regulate only domestic funds, leaving a consistent edge to foreign investors.
In order to monitor (if not regulate) foreign investment in the VC sector the SEBI
introduced a new set of regulations applicable to offshore funds, called the SEBI
Regulations, 2000.

a) The SEBI Regulations, 1996

Under the VCF Regulations a venture capital fund can be established either in the
form of a trust or a company. Though the guidelines do not appear to make
registration with SEBI mandatory, the institution has made its intention clear to
regulate all domestic VCFs.
These are subject to investment conditions/restrictions such as:
i. Aggregate minimum capital commitments from its investors should be Indian
Rupees 50 million (~850.000 EUR, ~$1m)
ii. A VCF cannot invest more than 25% of its aggregate Capital Commitments
in any one Venture Capital Undertaking (VCU)

b) The SEBI Regulations, 2000 (Foreign Venture Capital Investment-FVCI)

Foreign VC/PE players can invest in India either directly under the foreign direct
investment (FDI) regime or may invest under the FVCI regime.
While it is not mandatory to register with the SEBI as a FVCI, several benefits have
been granted to registered users.

Investment conditions/restrictions

i. FVCI is permitted to invest its entire corpus in a domestic SEBI VCF

ii. While 2/3 of its investible funds must be placed in unlisted equity shares, the
remaining third might be invested by the FVCI in:
ƒ Debt or debt instruments of a VCU, in which the FVCI has equity

1
Primary Source: Indian Venture Capital Journal, Volume 1/ Issue 1 2005, Indian Private Equity: Venturing into India,
p.34-38; Fenwick & West LLP [Greguras, Stafford and Gopalan 2006], 2006 Update on Structuring Venture Capital
and Other Investments in India.

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 ƒ Preferential allotment of equity shares of a listed company, subject to
a lock-in period of 1 year
ƒ Equity shares or equity linked instruments of a “financially weak, listed
company” (i.e. eroding between 50 and 100% Year-over-Year)
The FVCI will have to appoint a domestic custodian and open a special, non-
resident currency account at a bank.

Benefits

FVCI’s registered with the SEBI are entitled to benefits such as

• Transfer of shares between residents and non-residents will not be subjected to
the restrictive pricing guidelines existing for the FDI route.
• Exemption from both entry and exit pricing regulations (especially significant in
case of strategic sale or buy-back arrangement with promoters)

c) Taxation

As delineated above, taxation to be borne by Funds investing in India can range

from 0 to 40% according to temporal and jurisdictional factors.

Many Offshore and Domestic Funds choose the jurisdiction of Mauritius to take
avail of the benefits applicable under the double taxation avoidance treaty (DTAT). Under
the India- Mauritius DTAT, any capital gain earned by a resident of India is exempt from
tax in India. Further, the withholding tax (WHT) on dividend also gets reduced to 5% as
against normal applicable WHT of 20%.

9
 In other words, there is no Indian tax on sales of shares in an Indian company by a
Mauritius company.

Sources of Foreign Investment

4% 4% 4%
15%

20% Mauritius
USA
Netherlands
Germany
UK
Japan
21%
Other

32%

6. Performance

Private Equity Investments in India India’s growth in Private Equity

Investment during the last four
12000 years is more than astounding
10000
10000 (approximately at 240%).

8000
Value ($m)

Even more bewildering

6000
4000
is their rise from a country that
4000 1160 2300
250 500 937
barely existed on the PE
774 900
2000 590
20 80
landscape as far as 1997.
0
Only in 2005 the value of PE
6
6

M 5

F
-0
9

07
19

19

19

19

20

20

20

20

20

20

ay

20

deals have increased by 85,

Data by: IVCA/Venture Intelligence India/Nasscom Research
while their number rose up
from 68 in 2004 to 147 in 2005 (with more than 10 deals over $50 million).
1
Own elaboration on data by Securities and Exchange Board of India (SEBI). All charts and pies are of own elaboration
when accompanied by the “Data by” tag.

10
 With more than 100 India-centric VCFs/PEFs (May 2006) and forecasts ranging
between $25-35bn (depending by the speed of the privatization process as stated by the
Asian Development Bank) invested by 2011, India stays on the map of all the major
players in the Industry together with China.

PE is predicted to make a significant mark in India.Inc, as investment by private

equity firms is at $4bn (May 2006) versus a nominal GDP of $650bn (2006 consensus
forecast by www.securities.com) and thus ratios to about 0.61% of it. With the increased
commitment from global funds and investment by Indian banks into PEFs, the number of
deals is clearly northbound over the next decade. Nevertheless, an overheated market
may become risky, as it contributes to the build-up of other bubbles in the markets and a
capital overhang.

Profitability of the deals is increasing as well, with a burgeoning share of

divestments ranging in the 100% to 500% IRR area. Since 2004 some deals over the
500% IRR have appeared, signaling an extension not only in quantity but also in the
quality/ critical mass of the deals. On the dim side a small intensification of negative range
IRR is almost inevitable with the growing number of deals.

Range of IRR 2002 2003 2004 2005 Total

Over 500% 0 0 2 4 6
100% to 500% 1 0 3 12 16
1% to 100% 11 7 14 13 45
0% 1 3 0 0 4
-1% to -100% 2 2 2 4 10
Total 15 12 21 33 81
Source: Survey by Centre for Asia Private Equity Research Limited

Even more attractive is the statement of the Center for Asia Private Equity Research Ltd.
(APER) that the median return of the exits since 2002 was a very healthy 30%.
Comparing this data with neighboring competitor China, the results seem to indicate that
India so far has yielded less intense IRRs (witness the 37 deals with 100-500% IRR in
China), yet has posed significantly less risk to investors (who tumbled in year 2004 with a
staggering 11 disinvestments in the negative range).

11
 The reasons cited most commonly for deals “falling through” in India are differences
over valuation, combined with the fact that family owned businesses are finding it difficult
to “hand over rights” to a private equity firm in view of the availability of numerous funding
options. The same applies to listed companies, as these are held under tight control,
usually by the founders and act more like privately held firms.

China
Range of IRR 2002 2003 2004 2005 Total
Over 500% 0 0 1 6 7
100% to 500% 1 2 10 24 37
1% to 100% 5 5 17 13 40
0% 0 1 0 0 1
-1% to -100% 3 2 11 2 18
Total 9 10 39 45 103
Source: Survey by Center for Asia Private Equity Research Limited

In 2006 also the geographical scope of players grew wider with a considerable
attention from Japanese, Middle East and European Firms pitching their tents in India.
Some of the new names include Mitsui, Sumitomo (Japan), Ishtamar and Abraj Capital
(Gulf).

Acting as a magnet was last year’s sensational deal, when Warburg Pincus sold a
chunk of its stake in cellular player Bharti Tele-Ventures for $560m. So far, Warburg
(which invested ~$300m in Bharti between 1999 and 2000) has made $1.1 billion selling
two-thirds of its 18% stake in Bharti.

Some of the U.S. titans have freshly entered or are just about to make a move.
Kohlberg Kravis and Roberts’ (KKR) entry in India coincided with its 85% acquisition in
Flextronics International – including its Indian operations – for $900m, in what became the
biggest buy-out in the Indian IT space. At the
Investments by Stage
2004 2005
same time the arms of Blackstone and Carlyle
(2004,2005)
60 have opened their Indian funds and will strike
50
No. of deals

40 their first deal in the nearest future.

30
20
10 Significant developments in 2005 have included
0
increased focus by many funds on larger and
th

te

ut
PE
rly

mature deals. This included Private Issue of

w

La

yo
Ea

PI
ro

Bu
G

Data by: IVCA

12
 Public Equity (PIPE) deals- a sale of one or more publicly quoted shares to one or more
private investors- which almost tripled- across sectors. Moreover, according to research
firm Venture Intelligence, the share of PIPE to other type of deals advanced notably, as it
came to cover 49% of all deals in 2006Q1 and whopping 67% in the second quarter. The
only stage to remain stagnant was the early one, with no significant evolution.

Buyouts were rather rare, collecting only five deals in 2005 with a total value of $185m,
especially given the buoyant IPO options that courted enterprise up until May 2006.
On the other hand 2006 – especially the second half – will probably be under the aegis of a
buy-out boom, as Private equity players will exploit the tumbling Price Earnings ratios to
strike deals with advantageous valuations.

Stage of Investment
Moreover, the buy-out boom will be
60%
51% driven by the need for consolidation of
50%
most Indian industries, partly
40% 44%
expressed by the mounting
25%
India
30% competitive pressure on Indian
22% World
20% 15% conglomerates, which will prompt
17%
10%
11%
16% owners to focus on core business and
0% hive off less central companies.
Early Growth Late Buyout
Finally, the boom will be driven by the
opening up of enterprises, needy of
Data by: IVCA, PWC Money Tree, NVCA
capital and expertise to venture in the
international market. As depicted by the graph above, the Indian PIPE/Buyouts stage lags
behind the world average and retains a rate of 44% of total investments (against a 51%
average in the rest of the world).

Predictably, the stage harvesting an above average amount of investments is the

late one, bolstered by the rallying capital markets up until May 2006 and beating the world
average by 8% (with approximately 25% of the investment).

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Sector-wise break-up

SECTOR No. of Deals % of deal volume Total Deal Value % of deal value
Automotive 7 5.60% 194 9.60%
Aviation 5 4.00% 51 2.50%
Finan. Services 10 8.30% 185 9.10%
Cement 4 3.20% 88 4.40%
Energy & Power 4 3.20% 128 6.30%
Food & Beverages 5 4.00% 144 7.10%
Hotel 6 4.80% 61 3%
IT & ITES 22 17.70% 244 12%
Manufacturing 5 4.00% 67 3.30%
Media & Entertain. 8 6.50% 142 7%
Pharma & Biotech. 19 15.30% 374 18.40%
Shipping 3 2.40% 70 3.40%
Telecom 4 3.20% 15 0.70%
Textiles & Apparel 10 8.10% 107 5.20%
Others 12 9.70% 163 8.00%
Total 124 100.00% 2033 100.00%
Data by: Grant Thornton Research

IT & ITES had the maximum number of private equity deals with 22 deals in 2005, followed
by pharma, healthcare & biotech, banking & financial services, textiles & apparel and
“media & entertainment”. A sector wise break-up is shown in the table below. Especially
poised for a growth trajectory are manufacturing, which experts predict will grow
exponentially in the high-end region, as well as investments based on Infrastructure and
Real Estate. The Projected EPS growth table below shows that an ICICI Bank research
forecasts consumer goods are set for a whopping 147% increase, while Construction is set
for some 95% growth).

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 Projected EPS growth for Indian listed companies 2005-2007
Consumer Goods 147%
Construction 95%
Life sciences 84%
Retail 86%
Engineering 86%
IT 73%
Auto Parts 57%

In terms of sector-wise break-up, Pharma, healthcare and

Data by: ICICI Bank Research 2005
biotech emerged as the largest sector with 18.4% share of
all PE investment, having received $ 374 million in 19 deals. The Pharma sector has been
long in the eye of private equity investors as it is extremely fragmented. The number of
companies competing in the domestic number reach astonishing numbers as high as
50.000 (according to the Asian development Bank),with the top 20 combined hold less
than 20% market share. The other significant sectors were IT & ITES with 12% of deal
value, automotive with 9.6% and banking & financial services with 9.1%.

7. The IT sector

India entered the map of international business map through off-shoring. Today, it is
uncontested market leader in Business Process Outsourcing (BPO) and is rapidly
progressing into the next phase of industry evolution –Knowledge Process Outsourcing
(KPO).

Investment in IT & ITES ($m)

Given India’s ~44% global market
share for software and back-office

64,15
service and a sector set to grow
26,6 IT Services
17,4 from $6bn to $10bn in revenues
ITES
Others by 2010, there is plenty of
160,37 Netw orking tech.
120,27 opportunities for VCFs and PEFs.
Softw are Products

50,11
Communication tech. According to research conducted
by Nasscom (the Indian IT
Data by: Indian Venture Capital Journal industry entity) and McKinsey &

15
Co 1 , the ITES-BPO industry is growing at over 50% and is expected to employ over 1.1m
Indians by the year 2008.

As illustrated in the pie investments in IT Services and ITES take up as much as

50% of the total VC/PE spending in the IT sector, amounting to ~$210m. Coming trends
for the BPO sector are: consolidation of Third party providers to gain economies of scale
and the emergence of niche players with deep domain knowledge and expertise.

Unlike BPO, which may be tagged as cheap labor outsourcing, KPO represents
more of a high-end consulting business, and could be a trampoline for India.Inc’s large
pool of low-cost English speaking, scientific, technical, academic and professional talent.

According to research conducted by Evalueserve India is set to capture 71% of the

world KPO market, with a share totaling to $12bn and a compounded annual growth rate
close to 50% for the next five years.

Expected IRR from BPO investment

The next KPO wave is set to gather huge
35-45% IRR quantities of investments, as customers will
increasingly go through the acquisition route
rather than setting up their captive offshore
centers. As shown in the charts PEFs surveyed
25-35% IRR by the Indian Venture Journal are quite bullish
about their investments in the BPO sector,
Preferred Investment Stage
forecasting an IRR in the 25-35% orbit.

13%
25%
Mirroring the global trend, the bulk of Funds
(49%) prefer to allocate their assets in “already
proven” companies. Firms that are able to reach a
13%
critical mass of $35-40m in revenues and that
49%
have grown into a 4000+ people strong are the
prime targets of capital infusion.
Early Expansion Mezzanine Other

Data by: Indian Venture Capital Journal

1
Indian Venture Capital Journal, Volume 1/ Issue 1 2005, The BPO Opportunity, p. 08-19

16
 On the other hand, to start-up BPO firms have to exhibit
a clear cut strategy and are increasingly differentiating in
multiple niches as the market becomes more and more
mature.
Finally, market analysts in India are betting on a great
comeback of the IT sector in the stock market and
predict a big jump especially given it’s underperformance
in the recent year.

VC investment, bolstered by a regained market confidence, is thus likely to soar

within the next years – especially in the early phase – while buyouts are likely to occur
within the near future, as valuations of IT companies are likely to pick-up with the rebound
in the sector.

8. The Real Estate bet

Ever since the Indian government eased the rules on foreign finance in construction in
early 2005, several funds, especially from the U.S: have been trying to invest in Real
Estate projects and companies.

India suffers from a well publicized infrastructure problem that stems from the combination
of an enormous population and socio-democratic politics. It lags in overcrowded airports,
decaying roads, railroads and ports, as well as shortfalls in areas such as hotels, power,
water and hospitals.

This issue of inadequate infrastructure has been labelled by Prime Minister Manmohan
Singh as a top priority, emphasizing the private sector. According to some funds, the need
for investment in infrastructure in India lands the $150bn tally and gives a lot of leeway for
fund raising as well as plenty of opportunities.

Given a) the purported sum of $10-12bn committed by domestic and international property
investors in 2005 and b) the rising economy, prices have leaped 30% to 100% to
unsustainably high levels (as high as 60% per annum growth in the city of Mumbai)
creating a valuation mismatch.

17
Furthermore, valuations of the few listed companies are sky high as there are a very
limited number of them to be traded. For example, Price earning ratios for property firm
Unitech Ltd. Trade reached as high as 477 times earnings and stocks in the sector rose as
much as 2000%.

This has brought the Reserve Bank of India to worry about an asset-price bubble
and intervene through an increase in the risk weightage on real estate loans by banks,
discouraging the mortgage rates from 7.5% to 9.5%.

Nevertheless, according to a Merrill Lynch forecast 1 the Indian realty sector is

poised to grow 780% within the next ten years, leaping from 2005’s $12bn to 2015’s $90bn
in value.

Following this trend, other firms jumped in the game attracted by Internal Rates of
Return north of 25%. IDFC Private Equity’s first fund, closed in 2004, had two exits, both
with returns over 100%. Morgan Stanley invested $68m for a stake in Mantri developers
Private Ltd., Tishman Speyer tied up with India’s ICICI Bank to pour $1bn into the country.
India focused Real Estate funds have already raised as much as $2.7bn, and players like
Warburg Pincus state that one third of their research time is spent considering real estate
opportunities.

Overbuilding and non-differentiation of shopping centres give ample room for

restructuring by private equity funds. Of the several hundreds of shopping malls currently
under construction only one tenth is bound for survival.

Yet, as managers of diverse international funds put it, India is one of the last few
countries where there is primary demand for Real Estate, rather than individuals trading up
the price of property making the bubble less likely to explode anytime soon.

1
Y. A. Pitawalla for Fortune Magazine, Indian Real Estate: Boom or Bubble?, July 2006, pp. 14-15

18
 8. The Chinese competition

Private equity Investments in China

China – the world fastest-growing major
economy – accounted for 22% of private-
4500
4000
3900 equity investment in Asia last year, and
3500
3000 ranked second only to Japan (35%) in
3000
Value ($m)

2500 2005.
2000
1500 1250
1000 Nevertheless, the India-China divide in
500
Private Equity is not as large as in foreign
0
2004 2005 May-06 direct investment, where China boasted
Data by: Center for Asia Private Equity Research/Bloomberg impressive $55bn versus the Indian trifling
$5.3bn in 2004. Incredibly Chinese PE investment in the current year may come to a tie
with that in India.

Flows in 2006 are forecasted at $6bn (APER) and judging from the deal frenzy
occurring in India.Inc, investments in the latter may as well supersede the Chinese ones.
Pure Venture Capital flows are tallied at $775m in the first semester of 2006, scoring a
100% increase year over year.

According to the Economist Intelligence Unit (EIU) 1 , China lines up at number 33 in

2005’s PE environment poll. It lags behind India (32), Mexico, Russia (30), and Brazil (29).

Worst negative driver is the country’s infamous legal/policy environment. Legislation

on foreign investment is arbitrary to say the least. Growth in Funds during the first half of
2005 was hampered by a regulatory initiative known as Circular 11 and 29 by the State
Administration of Foreign Exchange (SAFE), that halted the establishment of offshore
structures to exit a Chinese company investment through an IPO on a foreign exchange-
recently SAFE issued a new circular, with new rules that should bolster investment in the
coming year.

1
Apax Partners, Unlocking Global Value Report, Section 3.

19
 Disreputable as well is China’s corrupt judicial system, the lack of a venture capital
law (VC has no legal definition whatsoever in the country) and a weak implementation of
Intellectual Property laws.

Moreover, unlike in India, China’s sizeable market lacks management quality and
has restricted access to high-end labor, thus limiting opportunities for investments.
On the other hand, the advantages of the Chinese hotbed and its long-term appeal are
obvious. China’s racy economy is on track for a fast liberalization and its’ GDP growth
(+10.2% in 2006Q1) is a huge driver for investments. The global liquidity crunch in May
2006 seems to have affected the Shanghai composite index less than other emerging
markets.

The rate of return of PE so far has been captivating to say the least. The 48 Exits in
2005 raised $1.86bn, compared with 45 Exits valued at $1.05bn in 2004- 44% of 45
surveyed exits last year had an IRR of more than 200%. Furthermore, deal sizes are to be
pushed up by the ever-increasing competition on the mainland.

State-owned companies are and will be

China PE investments by sector
looking for strategic foreign investors in (2003-2005)
the coming years. The latter were given
access to the country’s domestic share 26%

market in February –with a requirement Other

14%
Manufactoring
to buy at least 10% for three years.
Fin. Services
7%
This sale is generating a fluctuating IT & ITES
53%
environment for buy-out investors, as the
Data by: APER
State doesn’t want to sell off its assets
cheaply and is yet in desperate need for foreign expertise.

The biggest private equity buy-out, signed by the Carlyle Group last October, was
quoted at $375m for an 85% stake in equipment maker Xugong, yet is still waiting for
regulatory approval.

On the VC side things are especially favorable in the high-tech sector. Landmark
IPOs- such as Baidu.com- and record shuttering acquisitions have attracted momentous

20
$1.06bn in more than 200 venture capital deals–60% of which went into Internet-related
firms (Zero2IPO Ltd.).

Disadvantageous is the missing link to U.S. companies. Unlike India, where a large
number of companies are co-based in the U.S., thus enabling an IPO or a sale in the
latter, Chinese firms have a harder time reaching the U.S. market.

With 28 Chinese companies listed on the NASDAQ, the government has started to
realize the importance of this pattern, launching the “independent innovation” strategy to
nurture the environment for VCs, with tax breaks for high-tech companies and a renewed
emphasis on the protection of Intellectual Property.

Incremental Value of PE reaching 1% of GDP The tremendous growth

30 path/potential of the Chinese PE
Investment in $ (bn)

25 industry is clearly to be gleaned

20
from the chart on the left. India, with
Potential
15 21,684
2005 0.61% of PE spending on GDP, is
10

5
6,56 soon to become over-exposed to
3,9 4
0 this kind of investment. China on the
China India
other hand with a GDP that is more
Data by:APER/IVCA/IMF/www.securities.com/ Economist Intelligence
Unit than three times bigger than India
(about 2.2 trillion dollars according
to IMF- April 2006) and a PE investment of mere $3.9bn could face an incredibly steep
prospering of flows to the PE industry if it is able to regain the confidence of investors
through a host of structural and legal reforms.

Considering more than 3 million privately owned companies in China, firms like
China Private Equity partners believe that around 3.000 of these would qualify to comply
with Sarbanes Oxley and be listed on the NASDAQ or NYSE.

21
 9. The Brazilian benchmark

Investment in Brazil
Even though Brazil still does not figure
2,5
among the most coveted global hotbeds,
the figure of investment in the country is
2
Investment in $bn

rising with similar growth rates as India and

1,5
China.

From $1bn of PE investment received in

0,5
2005-about one third of the investment in

0
China and slightly less then half the one in
2004 2005 June 2006

Data provided by: abvcap.com.br/valor econômico

India- 2006 is showing the same dramatic increase in interest in Private Equity, boosting
more than 100% expansion in investment over the first six months of 2006.

This followed the decision by the government in 2004 to allow PEFs and VCFs to
exit their investment through IPO’s. This increased the appeal of the sector incredibly, thus
attracting the states biggest Pension funds (such as Petronas’ and the state development
bank) to expand their participation from close to zero in 2004 to around 1% in early 2005,
reaching over approximately $225,1m.

Just like India, the Brazilian PE scene is young, having its inception date in 1995.
Nevertheless, Brazil has already witnessed Private Equity frenzy, as the second half of the
past decade saw $5bn enter the country in a widespread euphoria that was the dotcom
boom. As a legacy of that, funds in Brazil are considerably older than in India and-china
and are marked by a deeper maturity of domestic investment.

Today Brazil features whopping $4bn in divestments through IPOs and PIPEs in the
last 12 months. The period starting from 2004 saw 20 IPOs – 13 sponsored by PEFs and
VCFs – with top of the class investments in credit card manufacturer American Banknote
and software enterprise Totus.

22
 The beddings of the Brazilian economy are the main attractive for investment.
Goldman Sachs’ BRICs report projects Brazil economy to widen by about 4% for the next
thirty years, and even though such a rate lags the Indian and the Chinese one, the Country
.comes out of long period of stability and it does not fare institutional risks as in countries
like China and Russia.

The country’s capital market is renowned for its long history – the country’s stock
exchange is about 115 years old – and its stellar performance, with a weighty 73% jump of
the country’s main index within the last 12 months. The recent liquidity crunch may boost
both the Mezzanine as well as the Buyout side of Private Equity investment. Brazil’s
capital market appears less rocky than the Indian one and on the wake of the shake-out in
May it could display a preferential route for Private equity investors over the short-term.
Moreover, also long-term opportunities are alluring. As addressed by Apax’s “Unlocking
Global Value” report, most of the second generation entrepreneurs are increasingly
looking for Private Equity rather than family members to take over their businesses.

In the limelight for venture capitalists is Brazil’s experience with the new global trend
of bio-energy investment – it is the only country with a fully fledged distribution network of
ethanol fuel stations – as well as deeply entrenched culture for technological development,
with a towering 250 university incubators active in the country.

In fact, entrepreneurial environment is cited by the Economist Intelligence Unit as

the country’s most alluring factor, ranking 21st in a list of 33 countries (as stated above the
country as a whole is pecked at number 29, the highest among the BRIC countries).
On the other hand, growth in the sector is embarrassed by Brazil’s overtly complex system
of corporate and indirect taxation as well as the absence of seed finance.

23
 10. Macroeconomics

Short-Term growth
Even the government’s forecast
was topped in Fiscal Year (FY)
2006 as the economy grew
8.4%. The underlying drivers
responsible for such a notable
expansion are still in place and
are set to guide India to another
set of record years.

With an economy predicted to

grow 7.7% and 7.4% in the next
couple of years (Merrill Lynch
estimates).

The reasons for such a towering

growth are the so-called DRG factors (demographics, reforms and globalization):
• Domestic Consumption underpinned by a strong change in demographics leading
to a sharp increase of income levels
• Government policies continuing to focus on building better infrastructure and
cutting the red-tape. The FY 06-08 spending is predicted to top US $109bn, a rise
of 61% compared to the last 3 year period.
• Investment spending and Capex are on the upswing as companies enhance
capacities and exports remain strong.
Besides the DRG factors India Inc.’s long term growth story perches on a strong upswing
in: International relations, Rule of Law and a transparent and fairly taxed capital markets.

The advantages it poses over the other emerging markets (EMs) can be
summarized in:
• Economy: least dependent market on commodities with a solid export growth
story
• Markets: The diversified markets with a substantial Return on Equity percentage
give an invidious valuation in comparison to the other EMs

24
 • Political Structure: India’s democratic structure poses less risk of financial or
political anarchy.

This structure is particularly appetible for international companies that are entering
the country in droves and are competing to gain the best local talent and the best local
customers.

The endeavor to entry is manifested by: a) in the increasing share of FDI spending
from USD 7.5bn in FY 06 to ~ USD 12bn in FY 07 (with companies like Nokia shifting their
whole telecom network management hub to the country); b) the entrance of global
financial companies like Goldman Sachs and CSFB or Private Equity players like
Blackstone, Carlyle and 3i; c) with billion dollar buyouts of domestic companies like BFL
(BPO sector) or DSP (Financial Services).

On the other hand also Indian companies are not staying idle and are boosting their
global presence as well as reinforcing their domestic expansion.
On top of that, India champions an historical International standing as the last 6 months
have seen improving relations of India with all major powers: US (Defense), China (joint oil
bids, opening of road route, trade, etc) and ASEAN (Free Trade Agreements).

The Short-Term Risks

India, like most other high growth markets is exposed
to internal as well as to external risks.

- An anticipated interest rate hike by the Reserve Bank

of India (RBI) is the prime reason for the fear of a
contracting growth rate in the country, reducing credit
growth and abating capex. In April, the RBI warned
that the economy «needs to prepare itself for higher orders of pass-through into
consumer prices». Meanwhile, the economy has been growing faster than
expected, posting 8.4% growth in FY06. The RBI had also stressed that India
«cannot afford to stay out of step» with global monetary tightening, and that it will
“swiftly” respond to evolving global developments. With crude oil prices close to $70

25
 a barrel, and central banks around the world hiking rates, the RBI followed through
and is likely to hike the rate at least another 25bp by the end of 2006.

- A US $10 per barrel increase in oil prices from the current ~USD 70 could:
increase inflation (WPI) by 2.6% and lower growth by 1%.

- With economic growth still over-dependent on exports, the US current account

deficit and the risk of consumer spending crunch as well as a fall of the dollar
exchange rate loom on the growth prospects of India.

- An inadequate monsoon could pose a threat to political stability: i) States

scrambling to declare themselves flood/ drought affected, leading to misallocation of
capital and a hiatus in Reforms (Enam Research)

The Capital Market

Even though the Private Equity investment in India has risen dramatically in the last two
years, buyout funds have been rather renitent to buy into a market boosting a Price
Earnings ratio among the highest in emerging markets and selling to a premium even to
the S&P Index.

Sensex Price Earnings

25
23,3 20,5
20 15,5 15,7
14,1
15 12,7
16,3
P/E

13,6 14,7 14,4

10 12,6 13,7
9,3
5

0
95

96

97

98

99

00

01

02

03

04

05

06

06
19

19

19

19

19

20

20

20

20

20

20

20

20
ne
Ju

Data by: CNBC-TV18 Research

The ever-rising Sensitive Index (Sensex) posed a great opportunity to Venture Capitalists
trying to place an IPO on a market exuding confidence. From the paltry 3300 points in

26
December 2002 the Index made a spectacular rise to reach quota 12000 in April 2006.
The rally took the average price-to-earnings ratio of the 30 stocks that make up the
benchmark as high as 25 times earnings. In fact, 2005 saw as much as 25 private equity-
backed IPOs on the Indian markets.

After the world witnessed a massive correction on global scale that hit India hardest
(given its over-dependence on Foreign Institutional Investors) the outlook for prospective
buyout funds has become rosier.

The drop has brought the price earnings ratio to hover around the 16-17 band, still
significantly higher than other emerging countries like China. Currently both sides of the
private equity spectrum are on the wait: uncertainty waivers IPOs (witness the somber Air
Deccan IPO in late May) while buyout funds are deferring their massive entry to the first
sign of a bearish market.

Generally IPOs in India are not an easy game as the Indian public markets lack
liquidity and many Indian companies are thinly traded. Nevertheless, the markets know
how to respond to big names, witness the $560m block trade of BhartiTele-Ventures by
Warburg Pincus in a shockingly brief time.

The Long-term story

Source: PriceWaterhouseCoopers

27
 Scores of investors and funds have been looking at China, but there are many
reasons to believe India might be a bigger growth story in the long-run.
As portrayed in the graph, India is the only country sustaining rates of growth of
over 5% for the next 30 years. India’s service led strategy gives a clear edge in today’s
globalizing world.
Analysts predict an extended period of considerable growth, basing on the two
following factors:

a) Demographics:

India currently boasts a population of over one billion people and claims one third of
the world’s software engineers. Nevertheless, unlike China, it refrained from
applying a one-child policy thus giving leeway to a growing workforce and a
decreasing age dependency rate. With over 54% of the population below age 25
and booming middleclass, there is a strong support for a consumer splurge – with
the Economist Intelligence Unit (EIU) believing that by 2020 consumer spending will
be rivaling the bigger European markets.
Nevertheless, as stated by Goldman Sachs’ BRICs report, even though Income per
capita will increase by 35 times current level (in 2050), the number will still be small
in comparison to other Emerging countries like China, Brazil and especially Russia.
This up-rise of consumer spending is particularly going to be beneficial to
companies operating (and acquiring) in the consumer goods sector (poised to
experience 147% growth as shown in the graph at page) and the lifestyle sector (
leisure, convenience and entertainment).

Moreover, its large base of English-

speaking population gives it a clear
edge in its burgeoning service sector
efforts. A deep pool of the
entrepreneurs and executives are
expatriates experienced in Western
business, in particular U.S. This
widespread pool will donate India a
different nature of entrepreneurship

28
than China, as these expatriates have worked in many different roles: from
managers to doctors or to IT specialists.

Crucially, expatriates will provide for a layer of skilled middle-management that is

missing in other Asian emerging markets. Sectors that are going to benefit from this
characteristic are likely to be Pharma and Auto components, already starting to
expand internationally.
As depicted in the graph above, India’s age dependency is on a steeply declining
trend; from today’s 65% it will tumble to 55% in the next twenty years. By the year
2025, India’s age dependency rate will be lower than China’s (and other Asian
Tigers), and will provide for a long-term advantage over the Western and the
Chinese economies, struggling to support their retirees.

b) Reforms

Ever since Prime Minister Singh started to exit autarchy in 1991 to save the nation
from a financial and economic crisis, India’s share in global trade has grown
exponentially.

Since then the country has witnessed an increased liberalization from its hampering
“license raj”, a system of industrial licensing, price controls, selected credit
allocation and capital controls.
The country has shifted its focus dramatically from the previous emphasis on the
small sector to a strategy of international competition, giving leeway to national
titans to be forged by mergers and acquisitions-domestic as well as foreign- and
able to compete on the global scene.

29
 Source: World Bank

Nevertheless, the entrepreneurial environment in India strongly lags behind other

Emerging Markets. India’s government is constantly afflicted by extreme left
members of the parliament that are extremely business unfriendly, provide for
political instability and a poor regulatory quality (as shown in the chart above). This
makes setting up a venture in India an extremely time consuming and risky.

30
 11. Conclusion

This research portrayed the image of a blossoming but risky Indian Private Equity scene.
The first part expounded in brief how funds investing in India are structured, the loopholes
that advantaged foreign funds over domestic ones for years and the preference given to
Mauritius as a foreign haven for low-taxed investments in the Indian private equity scene.
The second part described the current size of investments, their subdivision through
various stages, the differences with their world averages, and their sectorial subdivisions.
Furthermore, it continued by depicting the situation in competitor markets such as China
and Brazil.

The last chapter was dedicated to analyzing the macroeconomic framework and the
likely impact it is going to have in the short and in the long term.

While it is apparent that the Indian market is in an investment boom (at 0.61% of
GDP Private Equity investment has about the same ratio as the U.S: or Sweden) and set
to grow considerably in the next year at a rate of about 60%.

The main problems in this scenario are: the languishing reforms by an

entrepreneurially unfriendly government and a likely demand glut in a scenario not ready
to support the bulk of Private Equity players that are streaming to the country.

Political reforms opening India up for trade started approximately in 1992, fourteen
years later than the Chinese ones, yet the Private equity spending has already reached a
par level between the two markets (with funds like the Intel Capital one structuring bigger
funds in India than in China).

In my view, there is an excessive, bubble like concentration of investment that is

significantly increasing risk for the players in the market. Returns are high, witness the
increasing share of 100-500% IRR exits, but as more and more funds gather around few
companies there is a risk in creating a bubble that is likely to burst with a downturn in the
market.

31
 Fortunately for India, it is less dependent on the United States from the export point
of view, thus decreasing the likelihood of a downturn on an upcoming consumer spending
crunch from the U.S: or the worries connected with their accumulating current account
deficit (a problem faced by China instead).

On the other hand, the big role that Foreign Institutional Investors (FIIs) play on the
Indian stock market plays a big role in increasing the uncertainty of investments for Private
Equity investors looking for an Initial Public Offering and witnessing the markets crash with
prodigious speed as FIIs retire their backings all of a sudden.

In my opinion the safe bet in India, providing high returns with a lower percentage of
risk is the sector that made India well known around the world: BPO and KPO. KPO is a
business that can hardly be any more successful than in India, given the large base of
English-speaking and highly skilled labor force.

Other high yield sectors are surely going to be much riskier than the ITES, with the
manufacturing sector suffering from the poor infrastructure in the country and facing a
competition from China that is likely going to be more lucrative for funds. On the other
hand Real Estate is going to provide a mix of highest yield connected with highest risk.
Valuations to be achieved by a real estate company are immense, but the same is true
with losses to be suffered by an imploding price bubble.

From my benchmark I glean that the Brazilian market is the best one to invest to
reap benefits in the short term, while the Chinese one is better for short-to medium term,
should an investor have to choose between the two.

India on the other hand is best for the long term, as it is going to lever on its
macroeconomic advantages. The sustained long term growth and the decreasing age
dependency rate give it an inviting perspective.

The only concern for such a view is an increase in the power of the extreme left-
wing representatives, which are a threat for the business climate and for the political
stability of the country.

32
 12. Bibliography

- Apax Partners, Unlocking global Value Report, 2006

- Citigroup, Y. Huang and C. Tan, Asia-Pacific Economic Strategy, June 2006

- Economist Intelligence Unit, Foresight 2020: Economic, industry and corporate trends,
March 2006

- Ernst and Young, Transition: Global Venture Capital Insight Report 2006

- Ernst & Young, Renewal and new frontiers, 2005

- Fenwick & West LLP, F.M. Greguras and S. R. Gopalan, Update to Structuring Venture
Capital and other investments in India

- Goldman Sachs Global Economics Group, The World and the BRICS Dream, February
2006

- Grant Thornton, Dealtracker Annual Issue, 2006

- Grant Thornton, Dealtracker June 2006

- S. Howes, Will India become an economic superpower, March 2005

- Indian Venture Capital Association, PE and VC Investment Trends 2005, personal copy

- Indian Venture Capital Journal, The BPO Opportunity, Issue Nr.1 2006

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- Wharton Private Equity Review, Finding Value in a crowded market, 2006

- http://www.worldbank.org

33
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- http://www.asiape.com, with special material sent by Ryan Tang on request

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34