India’s private capital revolution
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In October 1977, a growing and ambitious textile company from Naroda, Gujarat, launched an initial public offering on the BSE, issuing 2.82 million shares. As IIM Calcultta’s Anjan Raichaudhuri records in his book Managing New Ventures, 58,000 small investors from across India acquired equity in the company, and the company’s investor base included people from Gujarat’s rural areas.
The company had been set up in 1964 by a man who used to be a petrol pump attendant in the Middle East. We know that company today as Reliance Industries Ltd. In 2012, Reliance Industries chairman Mukesh Ambani said that Rs.1,000 invested in Reliance at the time of the IPO would have grown to Rs.7.78 lakh, a compounded annual return of over 21%.
At a time when Indian business was dominated by a handful of dynasties and it was all but impossible for young businesses to obtain financing from banks, the legendary Dhirubhai Ambani turned to India’s nascent public capital markets to fund Reliance’s growth.
The biggest advantage enjoyed by incumbents in those days was not just access to industrial licences under what C. Rajagopalachari had christened the License-Permit-Quota Raj, it was also the ability to secure capital to fund business growth. Today, the Reliance Textiles IPO is remembered as the event that triggered the deepening and democratization of India’s public equity markets.
The backdrop against which Dhirubhai Ambani took Reliance Textiles public to raise equity financing may seem familiar today. Once again, a clutch of business dynasties with access to capital dominate India’s business landscape. Industrial licensing, which was controlled by the commerce ministry, was done away with in 1991 by then prime minister (and commerce minister) P.V Narasimha Rao.
However, the financing bottleneck, while partially cleared, remained until recently; the rapid evolution of India’s private capital markets since the 2008 global financial crisis has truly leveled the playing field further for first-generation entrepreneurs and innovators.
At the same time, public markets have stagnated. The equity cult has been reborn in the private equity (PE) market. Just five companies went public on Indian bourses last year and only nine offerings took place till August this year. In the private market, transaction value increased from $8.05 billion across 369 deals in 2010 to $11.16 billion across 743 deals in 2014, according to VCC Edge, an investments tracker. Significantly, the median deal size declined from $9 million to $3 million, pointing to a sharp rise in early-stage investment activity.
One of the catalysts for this shift from public to private markets—and this is a global phenomenon—is the excessive regulation of IPOs. With several start-ups valued at multi-billion dollar valuations opting to delay public issues, regulators must weigh the trade-off of protections for small investors against the shift to wealth creation in private markets caused by stiff regulations, which effectively shuts out the small investor from participating in and benefiting from such wealth creation.
The private capital boom has made a number of important contributions to India’s economy. Companies that were PE-funded have created direct employment at an annual compounded rate of 8.7% over five years, compared with only 2.9% for companies not funded by PE firms.
PE-funded companies also contributed a large and disproportionate share of direct taxes, with 18.8% of direct taxes coming from just 717 PE-backed companies out a total of 19,195 companies with revenues less than Rs.750 crore in 2013-14. PE-backed companies have also showed markedly better growth in exports compared with companies from the same industry that were not PE-backed.
It’s important to recognize that private capital markets have now evolved to include all stages of company financing, from angel and seed funding for new ventures to substantial growth equity funding for high-growth start-ups. There was a time only a few years ago when there was a major funding gap both at the early stage and late stage; this gap has been closed substantially in the past seven years.
Vibrant public capital markets are critical for the health of the overall financing ecosystem. Public markets do not just democratize access to capital, but also to investment opportunities, allowing small investors participation in the capital part of economic growth over and above labour participation, hence hedging out retirement risks in an age of anxieties about inequality.
Importantly, the present government has also taken several small steps to assist the development of the public capital markets, the most important one of which is the entry of the central Employee Provident Fund Organization (EPFO) into India’s equity market. EPFO will be purchasing exchange-traded funds (ETFs) tied to the major stock market indexes and public sector units, and is expected to invest Rs.5,000 crore in the current fiscal year to March.
Recently, the Tirupati Tirumala Devasthanam (TTD) trusts, which represent one of the world’s richest religious endowments, have also started accepting share certificates as donations from devotees. The TTD endowment, which owns properties and assets estimated to be over $20 billion and by some estimates also houses the world’s largest private gold holdings, is not buying shares yet but the fact that it has begun diversifying its enormous asset base to include publicly-traded equities marks a watershed moment.
Finally, the Pension Fund Regulatory and Development Authority has permitted pension fund managers under the National Pension Scheme to invest directly in listed equities having a market capitalization of over Rs.5,000 crore. Cumulatively and over time, all these steps will ramp up domestic institutional involvement in India’s equity capital markets and balance the influence of foreign institutional investors.
Concerted efforts to liberalize private and public capital markets will make it easier for businesses to raise financing, catalyzing growth and job creation. India is unlikely to achieve China’s savings levels, which clocks gross savings at 50% of gross domestic product. Hence, India’s ICOR (incremental capital output ratio) must be lower. In other words, it should be more efficient with investments at the margin. This entails reorienting public expenditure from luddite and ineffective social sector schemes towards hard and soft infrastructure, along with a deepening of capital markets.
India still has a long way to go. Our corporate bond market needs to be deeper (without moving prematurely towards capital account convertibility) so that the issue of non-performing assets in the banking system can be ameliorated. Our derivatives market need to be more rule-based so that liquidity for hedging is reliable. The taxation issues surrounding real estate investment trusts need to be resolved to allow for the development of that market.
With the private equity and venture capital boom supplementing public markets, however cyclical the former might be, both investing and entrepreneurship in India will never be the same again. The rapid development of the private capital market constitutes a true revolution.
Rajeev Mantri is director of GPSK Investment Group. Harsh Gupta is co-founder of the India Enterprise Council. All views are personal.