PremiumMUMBAI: Sitting on unprecedented levels of dry powder, private equity as an asset class has had relentless growth. But an economic downturn coupled with covid-19 uncertainty can test its resilience. In an interview with Mint, Siddhartha Shah and Aakash Choubey, partners with law firm Khaitan & Co. open up on the future of private equity – an asset class sitting at the heart of dealmaking. Edited Excerpts:
What are the concerns in the minds of LPs (investors into private equities), as our economic growth rate falls?
Siddharth- In 2019, even amidst all the talk of slowdown in the economy, the Private Equity space still hit a high of around $ 45 billion in deal-making. This is the highest level we have seen in India. Against the same backdrop, other emerging markets are also struggling for growth. When an LP sitting 10,000 miles away is looking to allocate capital across markets, they would compare the situation with other emerging markets as well. And here, based on our experience and what we have seen when it comes to fundraising in India, we have got a fairly good share of the global LP allocation.
One sees a segregation of interest though, with large funds getting larger and smaller funds getting marginalized. What does that mean for the future of private equity?
Siddharth- The trend that we are seeing from an LP perspective, is clearly reallocation of asset classes. There has been rise in preference when it comes to credit, which is an asset class that has taken off very well; newer products are emerging from the credit space. We are seeing more structured credit – more senior subordinated structures, last mile funding structures etc. So, the credit space is clearly a big gainer.
Interestingly, even with the real estate sector facing headwinds, we are still seeing some interest. I think LPs like selective asset classes in real estate. We have seen a lot of platform deals, so that’s the other trend we are seeing as an asset class.
On the allocation among GPs, we are definitely seeing bigger players getting the bigger share of allocation from LPs as the latter are becoming more risk-averse – avoiding spreading their capital across a wider range of GPs and instead, looking to back GPs who have delivered a convincing performance. This is a disturbing trend, in a way, because it will result in some consolidation from the GP perspective. First time fund managers are therefore likely to face more hurdles in getting institutional capital.
Private equity, generally speaking, has largely been a case of too much capital chasing too few deals. Competition among private equity players is also very intense. Is that why deals are taking longer to close?
Aakash- I think that there are two or three factors that are largely affecting deal timelines. One is regulatory uncertainty. The sectors which are not yet open for business in full capacity are the ones taking longer to close the deal. Also coupled with that is your point, that a large number of people are chasing the same deal. So the processes are taking longer. Here we also see valuations chipping off, which means, that the promoters or the target take more time to realise that the valuation that one was getting earlier is no longer available. That process and that learning is taking a bit of time. But largely, things seem to be moving in the right direction and the timelines are becoming slightly shorter from what we saw in 2019.
Very often, we are seeing private equity reaching new peaks. Is the asset class at an aggregate level running ahead of itself?
Siddharth- I don’t think, I would put it in those terms. However, we are definitely at a phase when it is crucial to establish credibility for India as an asset class and demonstrate exits for PE. The exit landscape here has significantly improved since 2019. Ultimately, for any LP, the proof of the pudding is in the eating – i.e. where they have made money. I think some of the multiples India has achieved on an overall aggregate level are very encouraging. This combined with stock markets reaching highs drives a lot of exits.
We are also seeing growth in secondaries, which I think is the other asset class to watch. I believe we have only just begun to scratch the surface of what secondaries can do in the Indian funds space.
There seems to be an obsession or fear of missing out on tech. Some PE firms are also happy to amend the model. While they have been following a growth equity approach with predictable, steady revenue streams, they are also happy to back some unprofitable companies too. So how is private equity readjusting itself and what do you advise them?
Aakash- From an investment perspective, it is very clear that very few large funds or mega funds are going down the venture route. This route continues to be dominated by specific venture capitalist firms, which know how to burn, as well as earn. . Having said that, venture capital is now more important in the private equity ecosystem than ever before. And that is largely because of the secondaries that are happening - when the secondaries are not entity level but target level secondaries. Even in India, the companies going to PE hands are moving from VC hands. With this, we are seeing a new age of Indian entrepreneurs, who aren’t the original, traditional promoters.
As we enter the new decade, what are the key challenges for this asset class which would impact its future?
Siddharth- Uncertainties on the policy and regulatory side are definitely a big challenge. Factoring any risk due to massive overhaul of policies of new regulations being implemented into one’s strategy will require sharp judgement on the part of PE players selecting asset classes.
Whether the capital markets will remain sustainable is another uncertainty. The third would be global macros. Especially with the covid-19 outbreak, an indirect impact on how LPs look at emerging markets is expected.
Aakash- I would like to add some other challenges. Firstly, from the governance stand point, there is the conflict when it comes to the nominee directors, which the private equity directors would put. And we are seeing a lot more issues coming up now. Nominees of private equity to boards of Indian companies have a duty towards the company’s shareholders versus maximising profits for their LPs. That balancing act needs more thought. We are also seeing co-investment happening and more LPs establishing on the ground. So one is not chasing capital between GPs and not competing with LPs as well. Some of them are even enjoying tax benefits as in case of ADIA. Players must align and realign themselves to ensure that all involved parties are working in a cohesive manner to maximise growth going forward.
What do you think will be the impact on covid-19 on private equity asset class?
Aakash: The pandemic has quickly turned into an economic crisis, and going by history, deal making in the initial days of an economic crisis is the toughest. Having said this, private equity will be a net-gainer in this period. While intrinsic value of business are strong, valuations are expected to lower. In times like these, be it a strategic M&A opportunity requiring private capital or a creative debt / mezzanine solution or distressed opportunities, private equity will be the preferred source of capital.
Private equity already has solid dry-power (new fund raising will be very difficult in these times) and is more nimble than we expect. GPs are already trying to negotiate changes in fund documents to adjust for the impact of pandemic – be it flexibility to offer more solutions by way of expand investment strategy, or re-deployment of proceeds into portfolio companies to support them through this cycle.
There is no doubt that exits will be a challenge and many portfolios will find it hard to survive in this period, but investment made during this period will fetch higher returns than those made in an upcycle. Though present level of activity is muted, we expect a rebound starting in Q2. Healthcare, digital and automatic opportunities, insurance, infrastructure, and impact investing should witness significant interest.
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