Mumbai: In a bull market, largely 2006 and 2007, private equity had its excesses in India, but in 2008, with the global economic crisis playing out in full, this asset class came under severe stress. It may now be time for many private equity fund managers to introspect, and think of why they are doing what they are doing. Varun Sood, co-founder and managing partner of Zurich-headquartered Capvent AG, one of the three fund-of-funds (the others are Thomas Weisel India Opportunity Fund, which was recently taken over by US-based Guggenheim Partners LLC, and Evolvence India Fund) that have offices in India, talked to Mint about the merit in approaching private equity a certain way, keeping the supranationals (referring to the sovereign wealth funds) at bay, understanding what kind of investors are right for private equity - it’s not the small guy, it’s not the big guy, it’s somebody who understands the business – and how all these by themselves will auto-regulate the private equity market.
Capvent, which has offices in Mumbai, Bangalore, Goa, Zurich and London, manages a billion dollar global fund, a China fund and a mid-market Europe fund, apart from two India-dedicated funds of $150 million and $200 million each. It also has a joint venture with US-based investment manager Hatteras, with the JV managing another $2 billion global fund. In India, Capvent has backed 13 private equity funds so far, with commitments ranging anywhere from $10-45 million. Edited excerpts from an interview with Sood:
Give us an insider view of corporate governance in private equity and whether there should be more regulation of this industry in India?
Private equity is sort of an imported concept into India. It replicates pretty much what has existed for many years and has been developed elsewhere, because it’s not an easy concept. So, unless things are done properly, there’s a lot of scope for abuse. There is scope for two main issues in private equity: moral hazard and adverse selection.
Introspecting: Varun Sood
It’s very important to have stringent corporate governance standards, but nobody is going to or needs to regulate private equity because that will be dangerous (in itself). It has to be self-regulated. On the general subject of corporate governance, the issue really is if standards aren’t maintained to be absolutely top level, then reputational issues will creep in and private equity will get a bad name.
Some of the issues that have come up in the last few years have been what we call style drift, where we have people saying that they’re doing something and then going and investing in the stock market. Why is that a problem? Because, for investors, they are paying very high fees to these private equity funds. And these funds don’t need to be paid that kind of fees if they’re going to buy stock market listed investments, which I could do. So there’s a lot of negative stuff right now on that particular subject. Why should they be buying public securities, when private equity is all about reducing risk, understanding the business, taking something in hand, shaping the risk and making it a better deal?
The argument of several PE managers has been that if they give investors the returns promised, what’s the big deal about where they invest. And a lot of LPs (limited partners or investors in these funds) seem to be comfortable with that.
It’s not exactly that. People are comfortable only when there is a momentum-driven environment when anything goes. A lot of 4private equity firms have made the market believe that that’s the story (if the firm’s giving the returns, why should investors be bothered with where it invests), and the market not being made up only of sophisticated investors, many enter the market at the wrong time. Those who do that are those who are not sophisticated, not knowledgeable, have seen only one (private equity) group, and they come in at the last minute. It’s like when a taxi driver gives you stock tips, that’s the time you need to get out of the stock markets, right? It’s the same thing. And right now, there are lots of private equity firms that thought that they could raise money from the non-sophisticated end of the market. They are the non-specialists. But it’s a specialist business at the end of the day.
A new fund, for instance, has raised $500 million from the public. They don’t come to the specialist investors of course, and specialist investors wouldn’t look at them anyway, because the fund has no experience in private equity in India. They’re just raising money and they make a lot of fee income. People make massive amounts of fee income, and they don’t actually need to deliver. Think about it in the context of India. A couple of percent (as fee) on your funds makes you tens of millions of dollars.
That’s the second problem. You should be somewhat focused. Private equity is an entrepreneurial game. You can’t do this and that. You have to do one thing, and you’ve to decide on what you want to do. And they just see fee income.
(But let me) tell you the risk involved for a bank. If you default in private equity, normal terms is you can forfeit your entire investments. The way private equity firms work is, they don’t keep the capital, it’s drawn down. So if the investor doesn’t pay up, then the banks have to go and help the private equity firm. When they help them out, they put themselves into a minefield, as they are now advising. And as advisors, they can be sued at any time by hundreds of people. They don’t realise the risk, and I think it’s very short term.
That’s what I mean when I say corporate governance. Private equity funds need to be a little bit more aware of the fact that... they not only need to select their investments well, but also their investors.
Why would somebody self-regulate in a market like this?
Because there’s no other way to do it. It has to be self-regulated.
Typically if you look at examples of good self-regulation kind of models, there has always been a threat of some kind of institutional regulation out there, hasn’t there?
But when you have a sophisticated investor base that can deal with this, they sort it out themselves. It’s pretty much like porn, okay. In France, when Canal-Plus came out (in the mid-80s), they said guys are paying for this channel, they are adults, and we are not the keeper of moral values. If they are paying for it, they probably want it, they probably know how to deal with it, so we’ll let them see this stuff. So in private equity, you treat this market as a specialist market. Yes, you have to have some basic regulation as to who can invest and who cannot, and how can you distribute this stuff. That’s very important. We don’t even have that, and that’s the problem. But beyond that, you don’t need to regulate any more. The kind of players who end up in the market will be sophisticated players.
So you’re not in favour of total hands-off stuff when you say some sort of regulation needs to be there?
I am very much in favour of selling regulation and private equity being treated differently. The problem is they (the government) don’t treat it differently to a mutual fund.
What kind of corporate governance standards do you look for when you invest in a fund?
We look primarily at sectors that are under-served, we look at alignment of interest, because if the whole deal is done well, then it (India) is a great sector to be in. The fund needs to align interests with the owner of the company who’s selling, and the fund needs to have the same alignment with us. Alignment is only credible when it also works on the downside. That means you need to also have pain on the down, and not only performance-related income. So we’re looking at that kind of alignment, and at somebody who is really a little bit ahead of the curve, who is looking at sectors that are really going to grow, people who are contrarian, people who know what the business is all about; not investment bankers. We take months and months, years sometimes, to take decisions on groups. It’s a highly sophisticated business and we’ve got 25 people doing just that. We’ve invested $1.5 billion across the world.
Why wouldn’t that level of sophistication be there in the business purely from a market-driven perspective?
The way the things work is, there is hype in the market at certain times, and in that hype situation, anybody and everybody think they can do anything and everything. We take our investors based on whether they are considered to be someone who is qualified to make their own decisions, with a minimum networth etc. We would never take an investor who suddenly thinks it (private equity) is a great idea.
India is the only place in the world where banks are investing in private equity, which is a really ridiculous situation because banks got out of private equity in the US and Europe in the late 1990s, realizing that it’s a very bad use of their capital. There’s a bank in India, which shall go unnamed again, raising a billion dollar fund, and they said they will put in $50 million of their own money. A billion dollar fund would, of course, give them a lot of fees. And $50 million for them was a small price to pay, because people would say, “Look, that’s 5% of the fund.” But, $50 million, if you calculate it in terms of equity capital for the bank, would mean a single loan of about a billion dollars. This bank’s total balance sheet is about $20 billion dollars. It’s one of the most ridiculous situations I’ve seen. The bank can probably set up a 1,000 branches in India and probably get a better return.
The only reason they are going along this route is the fee story. And now, there’s another set of people who are running around, which are the family businesses. There’s no reason for them to do private equity.
This is probably one of the world’s best markets for private equity, because India is a capital efficient place. India is a place where your factor costs are clear; people are used to building their businesses with small money. That’s the most attractive thing.
Are we sitting on a time bomb of sorts, if we don’t get our act of regulating this sector right?
Like everything in India, we are looking at slowing and retarding what is otherwise a fantastic institutional source of growth capital. India is at a point, which in economic history, is unique. It is probably like Germany after World War II. They had a time when they needed capital to build up businesses. The way they did it was they got banks to finance everything. Potentially we have private equity.
The key thing for people to focus their efforts on is the return-driven aspect. (But) there are lots of mistakes that can be made. For instance, the government is completely unaware of supranationals (sovereign wealth funds such as Abu Dhabi Investment Authority) coming in. They have a low cost of capital and there’s no reason why they should be allowed to buy private companies. At the end of the day, you have a sovereign state buying. There’s no problem with the sovereign state, but they are not even allowed to invest in America and England, and people are very uncomfortable, as a sovereign state has all kinds of connotations.
And here there’s India, which has got its eyes closed. You might see chunks of Indian industry being bought up by states such as Oman and Abu Dhabi, which have very little to offer except for capital, and that capital at a very very low cost to them. Basically, nobody can compete against that. In my opinion, even International Finance Corporation (IFC) shouldn’t be allowed to invest in private companies. Even India contributes to the IFC, and the IFC’s job is development, and there’s more than enough commercial sources of private equity out there that competes on reasonable levels of return of capital as opposed to the IFC. The IFC has no reason to be in areas that are already endowed with capital.
The time bomb is very much like Korea and Japan. These two countries are not very friendly to private equity, but they had times in their economies when they had a knife at their throat, and they had to sell their crown jewels to big US funds and banks, who obviously bought very quickly and sold again very quickly. In the case of Japan and Korea, basically these funds got sued because they stripped these companies down.
You’ve got to make fair deals in life. If you don’t make fair deals, it comes back to bite you. When Enron got such a sweet deal with a government guarantee, for essentially a commercial service, they did it because they got too sweet a deal, and that sweet deal came back to bite everybody.
Corporate governance needs to be cognizant of the fact that there are lots of other stakeholders in the business. There should be a level playing field. With regard to private equity, if there’s one place where there’s regulation needed, it’s on these supranationals and US pension funds, because these guys have a force which is unmatched. That has to be taken care of very carefully.