Goa: With the booze, the beach and a magnificent setting on the ramparts of a 16th century Portuguese fortress, last week’s 2nd Biennial China-India PE Summit turned out to be a perfect place for stressed fund managers to loosen up after a very tough year. The meet was organized by Capvent AG, a private equity, or PE, fund of funds with $1.3 billion (Rs6,539 crore) under management. But no amount of this relaxed setting could make a difference to one man’s rather bleak outlook for the PE industry. Rahul Bhasin, managing partner of Baring Private Equity Partners (India) Pvt. Ltd, a PE fund that manages in excess of $1 billion in India, is well-known for his radical views. He was in peak form on Thursday when, one the sidelines of the conference, he talked about private equity’s woes in the context of its gigantic size, the gloomy outlook for global and domestic growth, the unpredictability of long-term outcomes, and the slow recovery in the West. Edited excerpts:
Straight talk: Baring Private Equity Partners (India) Pvt Ltd managing partner Rahul Bhasin. Harikrishna Katragadda / Mint
The industry is five times too large.
We had $20 billion of investments in an $800 billion economy year before last (2007). That’s roughly 2.5% of our GDP (gross domestic product). The highest ever that the US reached was 1.4% of its GDP. Out of that 1.4%, more than 80% was taking public companies private, an opportunity that is not available in India. In China, the absolute investment numbers are similar, except that GDP is three-and-a-half times the size of ours.
The second issue is the explosion of private equity firms. There are 540 funds (active in India). I got this from one of my investors who tracked the number of people who tried to raise money from him, and includes private equity, venture capital and real estate funds. I don’t think it will be a significant exaggeration. Is the market deep enough for 50? I doubt it.
The rising tide raises all boats but when the tide is going out, and there is no ambiguity that it is going out, I think a lot of private equity firms who should not have existed in the first place will not exist. May be it’s five times too large and this means that 70-80% of the funds that exist today will not exist five years from now.
Lower GDP growth pares returns.
In India, all returns are driven by growth... The challenge is that the cost of capital of the private equity industry is very high. Investors expect that you (the fund) will offer them at least a 25% dollar return. The growth (of GDP) used to be 9-9.5% in real terms,15-16% in nominal terms, 22% in currency appreciated terms (the currency was also appreciating in 2007) and, if you picked the sectors right, you could get 5-10%. Finally, if you picked the companies right, you could get another 5-10% on that, which theoretically brought you to almost 40% returns. Assuming that we made some mistakes, still it was possible to get 30% return.
Now, the GDP growth is likely to be around 5% and, in the short term, even lower. We think this year will be closer to 4% largely because manufacturing is going to have a tough time recovering, and industrial production growth will be infrastructure-related. Agriculture has had four spectacular years in a row and it’s very tough to repeat that kind of growth.
The other reasons for lower growth.
Investable savings will come down rapidly, largely because the extra-normal profits of the resource industries in India—responsible in a large way for the jump-up in savings rate—have vanished as resource prices corrected. My own guess is savings rate will go down from 33-34% to 25-26%. We will have a lot of debt from the banking system globally, which is due for repayment, getting repaid this year. Debt will not get rolled over and, therefore, the net investable savings in the GDP will go down. It’s very tough to see how more than 13-14% of GDP can be invested this year, against 37-38% last year.
Topline growyh of portfolio companies to go for a toss.
The topline growth is going to be significantly lower in the companies private equity funds invested in. Besides, your cost of capital has not come down because risk perception has gone up. Because of high risk perception, a lot of assets all over the world are giving you very high returns. So you have to generate those returns to attract capital into India.
No margin expansion either.
If you can’t get it (returns) from (topline) growth, the second place you can typically get it from is margin expansion. We’ve been working very hard with our portfolio companies to reduce working capital cycles and expand margins, but we have not succeeded. We have helped them maintain their margins.
If you look at the cycle around 2001-02 (bottom of the cycle) profits after tax as a percentage of revenue of the Indian corporate sector was around 1.7%. Last year (at the peak of the cycle) it was 6.7%. So if you assume that the cyclicity will get repeated, you would assume that the profitability of the private sector can get hammered.
Capital structure efficiency not easy.
When topline growth goes away, margins growth is very hard to come by. The third thing that private equity can do is capital structure efficiency or balance sheet efficiency, which often means the ability to take away resources from a business which it doesn’t need, or bring in resources where it needs them and make that more efficient.
Here, you have a lot of structural bottlenecks, as the cost of bringing in or taking out an asset is very high because of stamp duties. The cost of bringing in or taking out labour from a business is also very high. On capital, you can bring in or take out, but you have dividend distribution tax.
P/E expansion then?
If you see where price to earnings (P/E) multiples are over the long-term (last 10 years’ average), and you look at where they are today, markets are still trading at a premium over the long-term. The last two to three years were a bubble. It’s not a reality. If you’re trading at a premium to the long-term reality, then no returns are going to come from there.
Only hope: special situations.
Special situations are alive and well. These happen when a business is being particularly badly run. Then you (an investor) get in, intervene and you fix it. That will happen when there is a corporate governance arbitrage, where the owners have not been fair to their shareholders, and you come in as private equity, and just be fair.
All drivers of growth together, but….
The last option is if you can get a conjunction of some components of all these drivers, that would be an opportunity (to invest). But then again, when you’re looking for four or five drivers of returns to meet your cost of capital, then the opportunity set available comes down sharply.
No predictability of long term outcome.
To be able to invest long-term capital, you need some amount of predictability of longer term outcomes. If you look at longer term outcomes, we are running a huge fiscal deficit. Is it an Indian problem? No, the US is doing it, the UK is doing it, and there is no guarantee how many more countries won’t do it.
Make the darn cake larger.
In a country like India, financial engineering is overrated. Here, you have to focus on making the cake larger. Trying to find sophisticated financial ways in which you can make your share of the cake larger is setting yourself up for disputes. Make the darn cake larger; stop fighting about share of cake. If it’s larger for everybody, everybody wins. Make the companies larger, make them more profitable, and there’ll be enough to go around.
The West is not going to recover in a hurry.
The probability of a recovery in the West in short term is low. Fundamentally, the West is living beyond its means. If you want to re-establish equilibrium, you have to get them to live within their means, which means they consume less. Whichever way you look at it, it’s not going to recover to where it was, suddenly. And if it doesn’t recover, then that incremental demand fillip for exporting your way out of a domestic problem is not available.
Back to basics.
Private equity essentially brings an organized, efficient managerial paradigm, to young companies. It helps them attract talent, identify long term opportunities, right resources, align the incentive structures against those resources, maintain good governance practices, and so on. The focus on basics has to increase dramatically because it’s easy to jump in when P/Es are expanding because that’s going to give you returns.
Private equity will go through a natural process of cleansing. You will also see a lot of pain and cleansing of international firms, who were very big in the leveraged buyout business. There is so much leverage in their portfolio companies.
Driving returns by simply increasing leverage is a fantastic thing to do in a bull market. You don’t ever face the cost of the consequences of that cost. In a bear market, you get leveraged loss also.
Leveraged buyout shops from the US to India. Why?
I find it quite amazing (that they are setting up here). When I read articles about their intents, etc., my summary of what they seem to be saying is that “we have problems in our home markets, there is a crisis, there is an issue with our business model, therefore we will go to India”.
I wouldn’t call it a positive vote on India. It’s more like saying “I don’t know what’s going on in my home base, let me go to some other market.”
Private equity will not get capital, but India may.
The GDPs in the West are shrinking. If you look at relative returns, India might actually be a better place (for investments).
For private equity, will India be more attractive? Yes. Will private equity as an asset class get more capital? No. Because the LPs (limited partners) will look at debt and say they can get 25% debt of some municipal corporation of some part of the US, so why would they put money in private equity? The asset allocation there will shift out of private equity into distressed debt. The likes of pension funds and endowments have prioritised their relationships. They’ve decided on who they want to stick with and who they don’t. I think we (Baring) have the good fortune at this moment of being on their priority list. We are not facing any issue (redemption pressures, etc). But can I sit here and say that there won’t be an issue tomorrow or day after? If there is a global contagion of this nature, you have to assume that you will get hurt somewhere.