Returns from the Indian market show an unusual pattern

Returns from the Indian market show an unusual pattern

Mumbai: The Indian private equity (PE) investment market has proved itself to be unlike any other. While the industry itself has seen changes in the ways it’s being viewed by global investors -- from being “interesting" a decade ago, to “must have" five years ago, to “looking at it cautiously" nowadays -- returns from the Indian market show an unusual pattern.

These are the findings of consultancy firm KPMG India Pvt. Ltd, which studied one-fifth of the exits made between 1999 and 2011 to see how PE funds have fared. According to the report, the most common type of exit in India is the open-market sale, accounting for nearly 38% of total PE exit volume between January 2005 and September 2011.

Next in popularity were strategic sales that accounted for 32% of total PE exit volume. Interestingly, while open-market sales are directly related to sentiment in the capital market, merger and acquisition (M&A) transactions are less affected by this due to their strategic nature.

Secondary sales offered a weighted internal rate of return (IRR) of 39.4%, compared with the 32.7% weighted IRR from initial public offerings (IPOs). Strategic sales offered gave an weighted IRR of 35.3%, while the open market offered weighted IRR of 29.3% and buy-backs 2.1%, the report said.

From a global perspective, it is unusual for secondary sales to generate the most return due to the higher levels of buyer sophistication there.

“Given the shortage of buyouts in India, a lot of capital is being reinvested in the portfolio companies of other PE funds. This gives promoters a lot of options. Going forward, this will not continue," the report cited an expert as saying.

Investors are now seriously considering exit routes other than IPOs, said Deepesh Garg, managing director, o3 Capital Global Advisory Pvt. Ltd, an investment bank.

“There are active conversations going on for secondary and trade sales," he said, adding that there is a preference for partial or full secondary sales. “There are cross-border discussions happening for trade sales. In my pipeline, 60% of the conversations are for a partial or complete stake sale by an investor to another investor."

The Indian PE market is also unusual in the relationship between entry and exit. India participates more at the growth stage, with very few early and buyout deals.

Growth-stage deals comprised nearly 58% of all PE deal value in India and over 51% of all PE deal volume between January 2004 and September 2011. Early stage deals, which were about 21% of the PE deal volume over the aforementioned period, comprised only 3% of deal value in the country. By contrast, buyout deals represented 8% of total PE deal value.

Furthermore, the report indicates that returns for early-stage deals (they have the highest investment risk) are significantly lower at 4.1% compared with 19.6% for growth-stage deals on a weighted average basis. This is a rather surprising finding as early-stage deals across the world are known for delivering better returns.

“In India, funds don’t add enough value. That’s why there is a mismatch in returns and stages," said a respondent.

Another factor that can perhaps explain the low returns include the lack of an entrepreneurial ecosystem in India, which takes businesses longer to cross the proof-of-concept risk hence increasing the time period that it takes to make money.

Also influencing exits are the holding period, ownership percentage and size of the deal. Longer holding periods and larger ownership/deal sizes should lead to higher returns—the first is a reward for holding period risk, the second gives access to better deals and allows for more fund control.

According to the report, longer holding periods appear to yield substantially higher returns. Holding periods of more than five years yielded weighted IRR of 29.3%, compared with 5% weighted IRR for holding period of less than two years.

“A five-year holding period enables one to catch at least one business cycle," said a respondent. However, another cautioned that merely holding on longer in order to add more value might not work, noting that “long holding periods are not intrinsically superior. It depends on the business cycle. If you don’t sell at the peak (of the business cycle), you may miss the opportunity".

Meanwhile, as expected, larger stakes yield higher returns. According to the report, returns were highest for deals where more than 50% of the stake was acquired. This can partly be attributed to the fact that a controlling stake allows investors to operate the company in a determined way and deliver superior results. Stakes of more than 50% yielded weighted IRR of 28.8%, compared with weighted IRR of 17.6% for stakes less than 20%. Deals in which the stake acquired was between 20% and 30% returned 26.9%.

When it comes to offering returns on the basis of deal tickets, India’s mid-market is the most attractive. The highest return, about 23.1%, is for deals between $20 million and $50 million at a cash multiple of 2.7x. Returns from deals in the range of $10-20 million are at 19.1%. On the other hand, deals below $10 million earn the least at 6%. Large deals above $50 million in size were viewed as imposing too much risk, especially that promoters might not be able to execute well enough, the report said. Deals above $100 million return 20.7%.

Meanwhile, PE exit volumes are expected to increase by more than 10% by 2012 than in 2010 as fund managers, investment bankers and consultants anticipate capital markets to strengthen in the months to come.

According to the report, nearly half (46%) of the respondents said they believed exit volume would increase by more than 10%, while around 15% expected it to remain stable. 2010 was a landmark year with exit values touching $4.6 billion spread across 174 deals. This was nearly two times the exit value in 2009 and about 56% of aggregate exit value during the four years preceding 2010. The exit momentum, however, has not continued this year due to volatile capital markets and other economic challenges. Till September 2011, exit values totalled $2.2 billion across 93 deals.

“Exits will also be a function of a fund’s life cycle. Investors are under pressure to divest when the fund life is ending," said Rohit Madan, associate director, research and market intelligence, private equity, KPMG India, over the phone. Madan says it would be difficult to come back to 2010 levels as capital markets, at least currently, do not seem to be getting stronger. “Secondary sales could drive exits," he said.

Graphics by Sandeep Bhatnagar/Mint

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