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The Asia-Pacific private equity (PE) industry achieved its best all-around performance to date in 2017. Deals were larger, investment was broader and large global investors were more active than ever, according to Bain’s Asia Pacific Private Equity Report 2018.

India was among the leaders of this growth, with India-focused funds growing by 48% to an aggregate $5.7 billion in funds raised and with a total deal value of $26.4 billion, the highest in the past 10 years. Moreover, at approximately $9 billion, Indian dry powder remained at levels similar to 2015 and 2016, indicating no dearth of capital for high-quality deals. Investments and exits in India also had a strong 2017, surpassing their respective previous highs.

“We are optimistic about India’s future today. It is our second largest investment market with almost 20% of our capital deployed there," says Doug Coulter, partner and head of Asian PE investment activities at LGT Capital Partners, a Switzerland-based global multi-alternatives platform with $60 billion in assets under management, out of which PE accounts for $30 billion. Investment into Asian PE is more than $3 billion. A significant sum out of this is invested in India.

“While China is our largest Asian PE market with 50% capital deployed, you could argue that relative to GDP (gross domestic product), and relative to the opportunity set, we are overweight India, as China is a $14 trillion economy versus India’s $2.5 trillion," he emphasizes.

Coulter says when investing in India (and elsewhere), “LGT is really trying to find exceptional private equity managers and exceptional promoters. We want our managers to invest in great companies at valuations that make sense and then hopefully work with those companies to effect change and improve the businesses."

He points out that, increasingly, it is getting easier to find that ecosystem in India.

LGT’s model in India is to be extremely selective. The firm has a relatively small number of core manager relationships that are used to source additional direct opportunities. “There are two things that are tricky when deciding where to allocate your capital," Coulter says. “One is deciding where to allocate. The second and more difficult part is getting access to the best managers in India, some of whom are oversubscribed multiple times. What we like to see is a great performance from a manager who comes back and raises a similar sized fund next time around."

Explaining LGT’s India investment portfolio, he says the firm wants to allocate some of its capital in the venture capital space and in early-stage businesses, as well as in the emerging buyout space. “There is so much low hanging fruit in Indian companies. India has seen a substantial uptick in distribution both generally, and in our own portfolio as well. That is the biggest game changer."

Coulter points to Morgan Stanley’s 2017 report, which notes that India is set to become a $6 trillion economy by the mid-2020s, driven in large part by digitization, technology and venture capital. He thinks this is a realistic assessment.

“India’s current economic policy is headed in the right direction from an investment standpoint. That is why investors like us are optimistic about the country," according to Coulter. Edited excerpts from an interview:

What has worked well for LGT in India?

One of the things that worked really well in India over the past five years for us is venture investing, mostly in the telecommunications, media and technology space, but also selectively in the consumer space. India today, just like China, is a little bit like Silicon Valley in the 1980s.

It is, of course, not exactly the same, but what is the same is that investors like us are trying to lock in allocations with the best local and international venture capital firms in India and China. For investors just starting now, it is in fact already too late as the best such managers are massively oversubscribed based on excellent recent returns and distributions that have increased.

The two areas of investment we like are also, Made in India consumer-based companies, and also the opportunity to back a bunch of technology guys sitting in Bangalore who are building products for the world. You have unbelievably good engineering talent in India, at a fraction of the cost of the US. At an early stage, you can often buy into these companies at attractive valuations and you have a global marketplace for the sort of software and products they are building.

What sectors are you excited about going forward as an investor in India?

One sector we really like in India is the financial sector, non-banking financial companies (NBFCs) that are reaching out to the unbanked, whether it is microlending or just providing small loans to entrepreneurs who live outside the large metros. It remains a huge opportunity even though we already own many of these firms on an indirect basis.

In public markets, NBFCs trade at very high valuations that do not make sense from a global perspective but public sector banks are losing market share and NBFCs are selling financial products and services to the rising lower and middle classes; so maybe in this sector, high valuations are justified. It’s a similar argument with Fintech, another sector that we like.

Now, when it comes to more generic consumer businesses, we need to be careful not to pay too much for future growth. We don’t fall into the trap of saying India is big, there are 1.2 billion people, a rising middle-class, therefore, we can pay 30 times for this company that makes biscuits.

Maybe that company is worth six times and is a good investment at that level but even if we love a sector we need to keep valuation in mind.

Do the home-grown Made in India brands seem like an exciting theme for LGT?

There is a debate right now in India among private equity professionals as to whether or not there is a huge opportunity to build Made in India brands on the consumer side.

While many players say the market is just too shallow and it is really hard to execute and build scale quickly, others say the opposite. There are a handful of early-stage funds that are focusing not just on technology but on building homegrown Indian brands. Time will tell whether this creates value for investors.

The key question is whether India has reached a tipping point in terms of a sizable middle-class economy and a consumer base that has the spending power to build up these Indian brands.

For us, backing these emerging Indian brands is interesting but only as part of a much larger, diversified portfolio.

How has the PE asset class performed in India in the recent past?

Overall, I think, it is fair to say the PE asset class in India has disappointed in the past. Expectations have always been too high. That said, we see many positive signs in the current economic and political environment and are cautiously optimistic about the future. The key is to be selective whether one is backing managers or individual companies.

What do you see as the key challenges in PE that India needs to overcome to perform better in the near future?

1) A shallow market

A lot of money poured into India in the pre-global financial crisis (GFC) era. It was the kind of market where if you were coming out of a large investment bank with a good resume, you could go around the world talking about India and quite easily raise $300 million with very few questions being asked. So, too much money came into a market that was actually quite shallow and the returns were disappointing.

Today, a small handful of elite managers raise funds before they are launched but many still struggle to raise capital because their historical returns have been disappointing.

A recent McKinsey study notes that between 2001 and 2014, there was $100 billion of PE capital that came into India, backing about 3,000 firms. The returns were quite disappointing overall, but if you were with the right groups, in the right companies, you did very well. We think that will continue to be the case.

2) Paying high valuations on the way in, hard to make money on the way out.

Probably the biggest criticism levelled at PE managers in India is the high multiples paid for businesses. India has usually been an expensive market on the public side and on the private side as well. If you overpay at entry, it is hard to make money on the way out. Those who do not pay attention to valuation are unlikely to make money over the long term.

3) Small firms listed on stock exchange

Another problem with PE in India is the approximately 7,000 listed Indian firms. While there are a lot of very large important firms listed, the vast majority are very small and probably never should have been listed as the shares rarely trade.

The issue is these are exactly the kind of firms, often family owned with revenue less than $100 million, that, in markets like China, are great targets for PE.

The founder opens up his company to professional capital and the private equity firm comes in, sits on the board, adds value, adds international connections, etc. In India, that whole private market opportunity is much smaller in part due to the size of the public market universe.

4) PE investment into listed companies

There are several thousand SMEs in India that are publicly listed and, unfortunately, a lot of PE firms have pursued these firms as investments. While there are always good justifications for doing so, at the end of the day, this introduces volatility into your private market portfolio.

Most limited partners or LPs, want private companies in their PE portfolios. The other concern, of course, is the reduced ability to do proper diligence on the way in, and a lack of control over the company once you are an investor. While there are a handful of PE managers that have done well on an opportunistic basis in the listed market, it is something most LPs want to minimize.

5) Too much funds chasing wrong sectors

In the pre-GFC years, because a lot of PE funds raised too much capital, they had to deploy it in capital-intensive industries. Therefore, you saw a lot of GPs investing in infrastructure or even realty. That did not end well.

What worries you about the current investing environment in India?

Pre-Modi, India was the most unloved emerging market in the world. LPs had no interest in the same market they were throwing money at in 2007. But LGT continued to invest in India post-GFC and those vintage years have been extremely successful.

Post-Modi, LPs suddenly got very interested again in India. Fund-raising is back to near all-time highs and there are quite a few Indian funds that have a one and done close with many investors desperate to maximize allocations. Maybe this is a warning sign that these will not be good vintage years.

Fund sizes are creeping up again as they did pre GFC. Managers always say, ‘well, GDP is growing, the companies are bigger, we can deploy our capital, the opportunities are better,’ which is true. But PE is a pro-cyclical industry.

When times are good, the fund sizes get bigger, the deals get bigger, the valuations get higher, the vintage years are not as good and the returns are disappointing. So the current environment does concern us.

That said, we still need to deploy capital so our job is to find good stewards of that capital, be disciplined on the direct side and deploy through the cycles as we never know for sure which will be the great vintage years and which will be less good.

Many people look at India and make the argument it is a lot like China 10-15 years ago with regards to PE investment climate and opportunity. Do you agree?

While there are clearly some similarities, it is important not to overstate the comparisons. There are just far more private companies of scale in China to invest in than India.

China has great entrepreneurs, as does India, but India is just a shallower market. Being selective in terms of where you invest your capital is even more important in India.

As a limited partner, we meet many managers, most of whom talk about the Indian consumer or the Chinese consumer with most saying more or less the same thing.

The question is have you made money backing Indian consumers or Chinese consumers and do you have the right network to start with. It is not just about knowing the right people, but also being able to assess the quality of the promoter, the quality of the business model and the scale of the opportunity.

How does India compare with South-East Asia in your view for PE investing?

If I compare India to South-East Asia, it is a little bit like comparing China to India. It is true that Asean (Association of Southeast Nations) is a $2.6 trillion economy—so, about the same size as India. However, it is a myriad of countries, languages, laws, and regulations. So that is one problem.

At least, if you are an Indian private equity firm, you can set up shop in Mumbai, Delhi and maybe Bangalore, and cover the whole country. Yes, there are many languages in India, but you can work that out. Malaysia, Thailand, Singapore, Indonesia, and Vietnam—these are all fundamentally different places, with differing economies, languages, cultures, and politics, so the big issue is where do you even put your team and how do you construct that team? A lot of South-East Asian managers end up in Singapore, but then, you are still getting on a plane and travelling to Bangkok or Jakarta, so are you really local? These individual Asean markets are also quite small, as are the targets that PE is pursuing. Finally, too many first-time funds have raised capital, not entirely unlike what we saw in India pre-GFC.

The assumption is that returns from these recent vintages will not be great. The other problem in South-East Asia is there is still little proof of concept in terms of fund returns and exits.

There are many examples of great private equity investments where people have come in and done good deals and have made good money. But at a fund level, it has been pretty disappointing.

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