Emerging markets continue to attract the interest of limited partners (LPs) in search of high-growth markets, partly led by slowing Western economic growth. Within emerging Asia, China and India are now in asset classes of their own, with both getting their share of allocations from LPs. Although this reduces the volatility of private equity (PE) investments, the burden on delivering returns becomes even higher.
The lack of quality exits in India, as well as the low volume is a cause of concern. Hopes were raised in 2010, which turned out to be a landmark year with exit values touching $4.6 billion spread across 174 deals. However, this exit momentum could not continue into 2011 due to volatile capital markets and other economic challenges. Till September 2011, exit values totalled $2.2 billion across 93 deals.
The slowing exit environment has seen concerns resurfacing on whether the industry will be able to deliver on investor expectations. India has also fallen well behind China in exits. The exit value for China was $8.7 billion in 2010, nearly twice that of India.
Like other emerging markets, India shares the promise of unusual return and risk. Many of these risks are more likely in India, even if they are not unique—such as political and regulatory uncertainty, weak corporate governance, working with family-owned businesses, navigating initial public offer (IPO) exits and regulatory risks due to tax uncertainties.
So, do the returns from PE so far justify these risks? Our analysis indicates that realized investments have indeed delivered a 25-30% gross rate of return. However, when we look at investments as a whole (realized plus unrealized) from the sample that we used in our industry study Returns from Indian Private Equity, total gross returns fell to 17.9%, which is only slightly above the 14.4% that investors would have earned if they had made the same investments in the Sensex. Net of manager fees and other costs, the rate of return earned by LPs (limited partners, the investors in private equity funds) could fall below the 14.4% return from the Sensex. It is also well below the benchmark of most LPs and funds.
Further, about one-third of PE investments seem to be currently losing money, but this evidence is publicly hidden by many fund managers’ decision not to divest from underperformers.
The reasons for such underperformance appear to be several. One of the major aspects undermining returns is the fact that entry valuations are relatively high in India compared with other markets such as China for many reasons, including intermediation, family ownership and the maturity of capital markets.
The volatility of the global environment has also made it difficult to time entry and exit. A closer look at our sample of investments and exits reveals that PE returns were significantly high for exits made at the top end of the market cycle in 2007, while investments in the same vintage year have not generated any returns for PE owing to high valuations.
The exit process too has been quite difficult, involving changes in governance and financial processes, managing conflicts with promoters on type, value and timing of exit. The median time just for the negotiation and structuring work is six months, which implies that fund managers must plan in advance to minimize the time between the decision to exit and the actual exit.
Overall, returns from Indian private equity are more likely to moderate, particularly as investments made at the peak of the market cycle come up for sale. Our estimates suggest that nearly $28 billion of exit value will need to be realized by private equity funds every year to 2014 to generate the desired return of 25% gross rate of return. This is almost twice the maximum amount of PE investment ($14 billion in 2007) received in India in any year and nearly six times the highest value of PE exits in 2010. Clearly, this seems difficult to come by given the volatile state of the capital market and the global economic backdrop today.
In such a scenario, what can funds do to generate alpha (additional return that an investor can generate over the expected returns).
Outperformance will require funds to build on the experience of earlier cycles. Besides trying to time the entry and exit, funds should focus on driving organic growth in portfolio companies. Secondly, funds should look beyond growth deals and make investments in neglected areas such as buyouts which, as we found, can deliver high returns when executed well. Third, funds should narrow down the possible exit strategies early and rationally so as to avoid losing windows of opportunity when the right time arises. Funds can also create differentiated investment strategies around sector specialization or deals of a particular size or ownership stake.
Undoubtedly, with its strong economic growth and entrepreneurial ability, India offers immense opportunities for private equity investments. Investors, however, need to tread cautiously and have a clear investment strategy to make the desired return.
Vikram Utamsingh is partner, transactions and restructuring and private equity advisory, KPMG. Rohit Madan is associate director, research and market intelligence, private equity, KPMG.
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