A possible answer to this problem lies in a more nuanced acceptance of private equity, or PE, as an alternative source of long-term funding than has been seen in the recent past. PE funds now sit on several billion dollars of assets and as the equity markets seem poised to remain dormant for some time, Indian entrepreneurs will need to tap this large pool of funds.

Somewhat disappointingly, although there have been some high visibility transactions in 2007, many prospective companies remain untapped. As one who has been on the buy side of a few private transactions, I can attest that owners, temperamentally imbued with an unrealistic perception of the value of their company, perhaps reinforced by the exuberance of 2007, turned off a large number of funds. In most cases, unless owners were confident that they had fully ripped off the investor of any remnant of value, no transaction seemed to get done. Funds did not do themselves any favours either, by queuing up for almost any investment idea.

Moreover, even after transactions did take place, there has sometimes been resistance to even the most well-intentioned management interventions. A consequence of this is that, though media attention has focused on the deals that did happen, in a far larger number of potential transactions through which the economy could have benefited, governance and expertise were turned away by the well-established players. Hopefully, the frozen market for capital will induce more Indian SMEs to open their doors enthusiastically to PE, which can in turn play their role towards efficient capital allocation and improved governance.

Since PE as a class has received its share of calumny for many reasons, it is worth understanding how firms in the business can add so much value, in the context of new or small companies.

PE funds set a high governance bar for their investees, a fact that becomes clear as early as the due diligence phase, where most funds will set a premium on a disciplined approach to running a company.

Moreover, in the context of today’s fund constraints, PE also plays an important capital allocation role, as investment committees of PE funds usually have an intimate knowledge of what really works in various management situations, making it unlikely that poor business cases will pass through their filters. This is somewhat different from public equity, where we know that during a boom, all companies will find takers and during a bust, even the best issues are turned away. Equally, as the time frame of PE investing is between three and six years, it is long enough to provide a chance of success yet short enough to weed out the long gestation, high-risk investments.

PE companies also have refreshingly direct incentive structures when compared with mutual funds or individual investors. This alignment of incentives between the fund managers and the underlying investments ensures that fund managers work actively to rebuff the wishful thinking and hubris that are perhaps the most common enemies of good financial returns.Furthermore, as individual managers in the fund are responsible for a limited portfolio of companies, such funds have the management bandwidth to focus deeply on their investments. The incentive alignment story does not end there. Good investors will also usually insist that companies offer enough equity to their employees to ensure that day-to-day decisions are in the best interests of the company.

Finally, good PE funds encourage a wide diversity of thought at the board and management levels within the company, a nice change from the club-like environments which pervade many industries. In several cases that I am aware of, the presence of an established PE investor in a company has been a major factor in encouraging the association of Tata companies with new organizations.

This combination of intelligent, incentivized people with the ability to directly influence managements is an extremely valuable intermediation role played by this sector. Indeed, Michael Jensen of Harvard and Steve Kaplan at the University of Chicago, have gone so far as to define PE as an engine to transmit superior governance systems from investors to investees. It is for playing this role between the unknown entrepreneur and the public capital markets, that private investors charge their fees. PE returns have outstripped the S&P 500 by nearly 50% over the last 20 years.

For all the above reasons, Indian entrepreneurs will hopefully be more prepared to accede to more reasonable valuations and the greater governance that these funds demand. The recent correction in valuations may provide the dose of realism that facilitates a move in this direction. If this were to happen, and as we get more investment through the private route, we should see a parallel strengthening of governance mechanisms, in this most exciting part of our corporate sector where innovative and nimble SMEs strive for growth.

Finally and most critically, this focus on governance combined with the distilled experience of external investors can significantly facilitate further capital raising including listing, most of which value will accrue to the entrepreneur. Consequently, if the present crisis in liquidity can accelerate the depth of the private market, one can look forward, over the next few years, to a new wave of Indian companies, heirs to icons such as Fedex, Apple and Oracle, which were founded on private funds. These investments will soon come to the top table of the Indian corporate world, thanks to a sharper focus on disciplined management. Were that to happen, the dark night of the capital markets may yet have a silver lining.

Also ReadGovind Sankaranarayanan’s earlier columns

Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes on issues related to governance.The views expressed in this column are personal. Write to him at ruleofthumb@livemint.com