A couple of years ago, private equity, or PE, players were spoilt for choice in terms of investing opportunities. Funds were flowing in and there was room for everyone, as evidenced by the frenetic pace of deals and the ever expanding competitive landscape, even in the face of increasing valuations. Today, in comparison, opportunities still exist, but discussions are subdued, tinged with a sense of caution. Transaction levels are low since the bid-ask spread continues to remain high.
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Venture Intelligence research shows that in India, the number of PE deals declined by nearly 88% during the quarter ended March compared with the same period last year. PE firms invested around $526 million (around Rs2,477 crore) across 36 deals during the quarter, significantly lower than the amount during the same period last year (which witnessed 133 deals totalling $3.9 billion) and also lower compared with the immediate previous quarter ($1.2 billion across 63 deals).
PE is usually a source of growth capital, and not really a source of last-resort funding in most cases, especially in a young market such as India. In the current environment, reasonable forecasting is very difficult and most investors believe that the strategy of waiting and watching will yield better results, since they can analyse the robustness of business models and take an informed view on potential investments when the environment takes a more positive turn.
One of the encouraging aspects of this slowdown is that valuations are increasingly more rational and realistic, so intelligent investments at present are set to yield high returns in the future. However, this decline in asset prices and valuations during the last year has made some PE investors hold back from making investments with the hope that they might be able to make the same investment at an even lower valuation in future. In addition, with quite a few investments running into rough weather, PE funds have tempered their earlier broad-based investing strategies.
Conservatism in investments has increased among limited partners, or LPs, also. Along with the funds, they too are waiting for uncertainty in the economic and financial environments. They are circumspect about capital calls since their overall portfolios are affected.
Coller Capital’s Global Private Equity Barometer survey showed that two-thirds of LPs globally will have little or no “headroom” for new fund commitments till December. North American LPs will be particularly stretched —28% of them expect to be over their allocations by then. Furthermore, as most of India’s businesses are family-owned, top managements and promoters are reluctant to dilute their equity at the current low prices.
In spite of the pull-back, India and China mopped up the largest number of PE deals in the Asia-Pacific region in the first quarter of this year, accounting for at least 70% of all PE investments in the region. While a slowdown can’t be denied, PE funds with cash realize that this is the time for serious transactions, and to identify quality assets from distressed sellers, not distressed assets.
One of the fallouts of the crisis has been the emergence of new target sectors for PE funds. Traditional favourites such as real estate, infrastructure and IT have lost their sheen in recent months, and PE investors are looking to deploy their funds in sectors where the outlook is still upbeat, to insulate themselves from segments directly exposed to the turmoil in the global financial markets. It is sectors such as education, health and microfinance that have recently caught everyone’s attention.
Education, with its opportunity for scalability, huge mismatch in supply and demand, and high returns is a current favourite. PE and venture capital, or VC, funds have already made at least 30 investments worth $300 million in education-related companies in the past 24 months. Some funds have been forward-looking and already have portfolios in these sectors. For example, PE players invested $250 million in microfinance in the last two years, most of which was focused on rural areas, which have been rather insulated from the downturn.
Globally, PE funds have followed a partnership structure, and thus have been more comfortable nurturing talent in-house, so as to maintain cultural continuity. When setting up operations in a new country, they have preferred to bring someone in from headquarters or groom someone internally. However, the trend in India has been different, driven by the fact that the industry is nascent and has seen sudden growth. There was also a shortage of talent, since many large global funds did not have Indians who could move and set up the new venture here.
As a result, these funds sourced talent through lateral recruitment, which has contributed to hiring activity in India over the last four-five years. Given the nascent market, lateral moves have been seen from investment banking, management consulting and industries, into senior investing roles.
However, the effects of changing dynamics in the PE market are also being felt in the talent structure of PE firms. So far, PE firms focused on individuals who understood the market and could source and conduct transactions. Going forward, as the investment cycle matures, and particularly in the current economic environment, they will focus more on individuals who can engage with their portfolio companies.
This has led to the segregation of responsibility areas within the PE process, since the skill sets required in larger PEs to identify, evaluate and consummate transactions are different from the skills required to work with portfolio companies.
A number of funds have divided these responsibilities— deals are done by PE professionals, while the management with portfolio companies is done by individuals who bring with them operating experience and a deep strategic insight. In the more mature PE markets of North America and Western Europe, this is a well-established practice, as seen in funds such as TPG Inc., KKR and Co.,Bain Capital Llc. and Morgan Stanley . In India, the trend has started, with several senior industry executives joining funds such as India Value Fund and Future Capital Holdings. However, this model is likely to undergo some evolution before it stabilizes in India.
As PE funds increase involvement in their portfolio companies, their role as primary investors is expanding. PE professionals would thus need to engage in the due diligence process more extensively to understand business fundamentals and identify opportunities to improve performance. As part of boards of their investee companies, they will also need to be comfortable with working closely and frequently with the management, helping streamline decision-making and giving candid feedback. The ability to assess management will be a core competency and this evaluation would need to take place within a few weeks of completing an investment.
As the sentiment in the economy and capital market improves, PE firms will have a number of choices—to increase stakes in existing holdings, add new opportunities to their portfolios or exit investments that do not have the potential to yield the earlier projected returns. Whatever the strategy, success will depend on whether the fund stays true to the fundamental objective of PE—providing funding to individuals and companies that base their growth on innovation and expertise, thereby creating a high potential for growth in the future. Staying true to this will help them grow their reputation in this ever competitive sector.
Anjali Bansal heads the India practice of Spencer Stuart, an executive search consulting firm, and is based in the firm’s Mumbai office.
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