“It (India) has favourable demographics. It is the only country in Asia that has similar demographics to China, and is much less developed—arguably, the opportunities are there," he said, while adding that investors believed in the India story, and from the macroeconomic perspective, it would be difficult for them not to bet on India.
At the same time, Leahy warned that the flood of capital coming in could also cause problems—from unscrupulous promoters who divert money, or having to pay off local politicians and government officials, to high valuations. Edited excerpts:
For PE, 2017 has been the best year for both investments and exits in India, surpassing their respective previous highs. When funds from Singapore are investing in India, and do deals where, what are they asking you?
First, it is promoter risk—‘who am I getting into a deal with’? For a majority of deals, the funds are picking up a minority, or a large minority (in the company) as part of the transaction and, therefore, especially in the case of private equity, you are taking a long-term risk on a family, or a person, or a group of people. You are entering into a long-term relationship with them.
Second, people are concerned about corruption, particularly at the government level in the states—at the federal level. PE is concerned about business risks, the functionality and the ability to execute across such a vast country. But promoter risk is number one—and you’ve seen that play out lately in India with the likes of Nirav Modi, Vijay Mallya and several others—although not all of these may be PE-linked.
In terms of promoter risk, for China, South-East Asia and India, it is different from the West, where for reasons of history and development, the level of institutional investment in companies is far greater. Due to the rapid development of economies in Asia, a lot of these non-conglomerate companies have grown up, and are run by families, especially in India, and it is very much the case of the Chinese diaspora in South-East Asia (SEA).
In China, you have a very different kind of risk in state-owned entities—that is a different kind of animal, and is more recent. Understanding the cultural differences and the way people in different countries think and react - that is part of putting together a successful deal with private equity. We assist in understanding some of these.
In the seven years that you’ve looked at India, have PE investors become a lot wiser? Now, they are looking at board seats, path to control, targets that their portfolio companies need to meet, rather than just getting into the deal with a minority stake like we saw during the first wave of investments before the global financial crisis.
On the whole, yes. I think PE now is far more likely to employ firms like us to help them do deals in markets like India. Yet, when valuations gets too high, and there’s too much dry powder in market which drives competition, then PE may still rush to get into deals—but generally, the processes of evaluating companies have become better. Regulations have helped a bit—Sebi (Securities and Exchange Board of India) has done a good job over the last couple of years to hold more companies accountable. So I think, even for firms in the unlisted space, there has been a rubbing off effect from that. By-and-large, it’s improved—It has not become a lot easier to do deals, as it has become very competitive—Indian entrepreneurs are notorious for driving a hard bargain, and there are still problems associated with disputes, corruption issues…
Despite all these concerns and challenges you’ve mentioned, does the wave multifold increase in investment flow in 2017 suggest PE firms are also driven by the fear of missing out, as India is among the few market that can absorb the dry powder and offers large deals?
I think it’s a confluence of things. You saw the quick change of investor sentiment when Modi came in—he was seen as being investor-friendly. Modi has made things happen quite quickly, and investors liked it. The macroeconomic picture in India has improved. It has favourable demographics. It is the only country in Asia that has similar demographics to China, and is much less developed—arguably, the opportunities are there. But you still have the same problems when you have a flood of money coming into developing market—it is very easy for that money to be mis-allocated—from unscrupulous promoters who divert money, or having to pay off local politicians and government officials—generally speaking, investors may be overpaying. But for investors, they believe in the India story, and from the macroeconomic perspective, it is difficult not to bet on India. The problem is not whether I should put my money into India or not, but, how do I find investments, and where do I find the right deals—because everyone is trying to do the same. That played out in China as well—it is still playing out.
What is your take on the four years of the Modi-led government?
Some of the shine has come off. But, by-and-large, he has got a good scorecard. There has been unpleasantness around some of the BJP (Bharatiya Janata Party) activities—but, India is a complicated place. By and large, Modi is still seen as pro-business and investor friendly, and therefore people are still trying to put money in India, and they are still positive. You’ve got to remember, India is similar to China in population, but you are accountable in a democracy. India is democracy unlike China, and that comes at a price. The attitude about India and China is that, India has paid the price for being a democracy, and China has yet to pay, and that will come—it’s easy to build roads and world-class infrastructure in an extremely powerful one-party state where you have absolute control. You can’t do that in India—it’s a difficult country to govern. Whoever runs India, it will always be a difficult job—a lot of compromises and haggling and deal-making is needed.
For investors, how critical is that the BJP-led government or a strong government comes back? Or does India have own economic cycle, irrespective of the strength of the government in the centre?
If it is not Modi-led, it has to be some similar form of an investor friendly government. It is a vast country with several states, but the central government is playing an increasingly important role of setting the agenda. Investors don’t like to change. People are positive to the changes the Modi-led government brought in, and want more of the same. People understand and investors have seen what can happen, and how quickly things can go badly wrong—they are sensitive to that issue, and want stability.
Sitting here in Singapore, if an investor were to ask you where to put their monies—would you recommend South-East Asia, China or India?
It’s impossible to ignore China. The issue is what to invest in, and how to address the China market. We have clients that avoid anything to do with the government in China and only invest in private firms and controlled deals. Others are prepared to take a bigger picture view and will invest in growth capital and pre-IPO investments. But if you are looking at an Asia exposure, it is impossible to ignore the two behemoths—China and India. Then you start to look at other interesting countries—Indonesia is still attractive, but it is difficult to do deals, its government is a bit flip-flopping. Malaysia is completely up in the air at the moment with the change in the regime, Vietnam is fairly attractive and lots of Singapore money is pouring in, as it is seen as a mini-China. By and large, looking at developing Asia, it is extremely positive—it is not about finding the deals and understanding the risk with those transactions.
So when it comes to finding deals, with so many funds chasing the same deals, is it not pushing valuations to all-time highs—will we see corresponding returns?
As long as capital markets stay open, strong as they are, I don’t see an end to increasing valuations. People are looking for yield—markets are open and companies can fund themselves, they can borrow money, they can refinance, and they can go to market, and exits are more achievable—so they use exits to drive up M&A prices, and even the private market is a good source for deals. As long as that happens, I don’t see much of that slow down, and valuations will continue to rise. Is it going to end in tears? It might eventually—I would imagine the vintages of PE funds maturing in the next five years will be much more challenging than the previous 5-7 years, where a lot of more financial engineering was possible. While some of the valuations you see are heroic, we are yet to see too many of them fall over, but if you have 2-3 very high profile LBOs turn sour, the sentiments can change very quickly. But we may see this more likely to play out in US or Europe than Asia, because you have a different growth trajectory here, and the organic growth that you see in Asian firms can probably help support higher levels of leverage. Ultimately, they will come to a point where there are not enough deals to go around, and valuations will get to a point where they are unsustainable. Will that lead to a crash? Not necessarily, but it will lead to the closure of some of the PE firms, which is happening already. You should see that—there is some kind of bifurcation in the industry—the bigger PE firms are just getting bigger and bigger, and you’ve got a lot of niche firms—but middle market funds are struggling to get to scale.
Yes, the bigger PE firms are getting bigger, and at the same time, we are seeing a lot pension and sovereign money also chasing deals. Also, many of global PE firms today have Asia-specific, or China-specific and even India-centric funds. How does that change the PE landscape?
Yes, the Canadian pension funds, and others like Temasek are big investors now. For the PE landscape, the big LPs have learnt from the GPs, and they are beginning to write their own terms, and one of the first things they seek is co-investments. While this has been around for a long time, it is increasingly the case with the more sophisticated LPs – they are almost competing with GPs, they are also having a say in the deals the GP does.
SEA and India have several sector-agnostic PE firms? What is their future?
Not very rosy – many of them won’t be able to scale and raise new funds, and will have to close. There’s strong demand at the top of market for allocations with some of the biggest funds. When people launch new funds, generally speaking, unless they are a major name, it takes a long time, it’s difficult, and the founding team may be required to put in matching fund requirements and negotiate very hard. Historically, we’ve hand fund-of-funds structure, but that market is less active now than it was a few years ago. So, some of them have to rely on family offices and below - that’s not an easy market to tap. Ultimately, the ones that are successful are the ones that have produced outsized returns - they have produced Alpha and they outperform their peer group, and gradually they built up their track record - because all of these stories of the big PE firms started out as small firms many years ago - maybe it was easier then, and it is a more difficult environment now - while it is not impossible to do it even today, it will take a really long time, and one has to be very disciplined to grow the PE business. If you are just providing growth capital, and are a small regional sector agnostic PE player, it is difficult to differentiate, and a lot of different type of funds are out to eat your lunch. I see a lot of funds in the credit space, or the structured credit space chasing PE deals – they’ve come into the market only in the last 10 years, and some of these funds do deals very quickly, and they are added competition. You need a very clear and compelling strategy and mission and objectives to attract LPs – you just can’t run on the mid-cap or growth-cap sector agnostic Asia play to attract sufficient LPs that can get you to a place where you can sustain yourself – once you hit that level, then it is about execution and performance.