Private equity (PE) is taking a renewed look at India as there is a lot of positive sentiment towards the country, and its fundamentals appear to bear it out but these funds are also exercising cautious, balanced optimism to avoid repeating past mistakes, Ralph Keitel, Regional Lead for PE funds in East Asia and Pacific at IFC, said in an interaction.
“There have been a couple of false starts for India – it looks positive this time and what you are seeing is that many LPs (Limited Partners or investors in these funds) are willing to underwrite that positive outlook. At the same time, GPs (General Partners/Private Equity firms) have gotten better. Most have learned their lessons and know that they have to add more value to build companies that someone wants to buy ultimately, and also that scale and price matters. The shakeout in the Indian PE space is not over, but the good GPs have built out their teams. Also, LPs have become more cautious – they know what to expect from India and that GP selection matters,” he said.
We’ve seen IFC back a couple of PE funds across this region in the recent past. There does not appear to be a common thread that connects these vehicles. Some are doing SMEs, a couple of them are doing tech, some are related to distressed assets, some are in emerging Asia. What got IFC interested in these funds in the first place? Is it riskier to back new managers when compared to established ones?
Let me step back and provide some context, as the LP side of what IFC does is a bit unusual. A lot of institutional investors around the world want to develop a private equity program, as they know that this is where returns are in a low-yield world. For most, the first step learning about PE is by investing in funds. The next step, for many, is partnering more closely with their core GPs to develop a co-investment program to get more direct exposure. The final step, for the larger ones, is often to develop their own direct investment teams.
IFC —a sister organization of the World Bank and member of the World Bank Group— is not like this. We’ve been around for more than six decades and are, first and foremost, a direct investor and lender for project financing in emerging markets. Out of the $3-5 billion of equity per year that we do, only 10-15 per cent is through funds. We utilize funds mainly for two reasons: one is to get additional deal flow for our direct investment colleagues, and the other is to complement what IFC does directly, i.e. use funds for things that IFC does not do as well. For example, IFC is a large global financial institution with a huge overhead and doesn’t do small deals very well. So, for smaller deals, say below $1-5 million in size, we usually do that through funds. Or for very early-stage tech deals, we also prefer to do those through funds.
As IFC’s funds group, our objective is to build a balanced portfolio, but everything we do has to have a dual mandate, meaning it must be commercially viable and have a significant developmental impact. IFC seeks to address strategic, highly developmental sectors that create bottlenecks for poor people in emerging markets – such as infrastructure, agri-business, health, education and access to finance. It is part of our mandate to actively encourage the creation and development of the PE industry in emerging markets. IFC is one of the largest investors in private equity funds in emerging markets, and we estimate that we have generated 300,000 new jobs through our PE investments over the last 10 years.
This means that in the less developed, or frontier, markets, we are usually one of the first backers or even an anchor of first-time funds. But we continue to back both our established managers, as well as add new managers, and we constantly try to find the right balance. If every market was sufficiently developed for PE, with enough GPs and commercial LPs, then we would no longer play a role, but this is clearly not yet the case. On the other hand, we also can’t invest all our money only with first-time managers in frontier markets. We need to be able to develop proof of concept: by backing new managers and helping them achieve first close of their funds, or reach their target and thus successfully deploy capital, we can demonstrate to other LPs that EM PE is a viable asset class.
When we started backing funds in China, India, Brazil and other markets more than two decades ago, there were no domestic private equity groups in these markets. We made good returns, and this, in turn, brought in additional money and helped to create the asset class. We then went on to try and replicate this in lesser developed markets like Thailand or Indonesia. And now, we are doing the same in places like Myanmar and Mongolia – the wheel keeps spinning. As part of the World Bank Group’s new approach, we are working together to help countries maximize financing for development – and we’re, therefore, seeking to actively scale up our commitments to funds in these markets. Of course, the risk goes up because now many of these remaining frontier markets, where private capital has not arrived, have less scale. But fortunately, while investing in frontier markets remains tough, we, as IFC, have learned our lessons from the past and are applying those as we evolve. Over time, we got better at the selection process – you develop a good feel of what works in a particular market and what kind of skillsets GPs need to succeed.
When we did a review of our portfolio a few years ago, we were pleasantly surprised that first-time managers, as a group, did no worse than our overall portfolio. Rather, many of these funds, particularly in frontier markets, have done exceedingly well by making use of their first-mover advantage.
India today has a reasonably developed PE market, and yet you continue to back first-time managers there. It has a large number of local GPs, and it also has a reasonable number of global GPs.
India is different from China because its GDP per capita is much lower, so there is still a significant developmental angle for IFC. We did seed a lot of new first-time managers in India before, and after the global financial crisis, and not all of them have done well. So our performance in India is not as good as we would have hoped or even as good as other parts of Asia. But this is in line with what most LPs will tell you about their India portfolio –exits were not happening for the longest time, so the majority of DPIs are dismal. So there is still a case to be made for an organization like IFC in India.
If you put the total number of GPs in the context of the size of the country and the population it has, India is still a nascent PE market and can’t be considered a no-brainer for all LPs or institutional investors. When LPs look at India, many conclude that it simply does not perform, or that it may be too early for them. Most have realized that India does not develop along the same trajectory that China does, and that PE there remains a risky proposition. IFC, therefore, has a big role to play – we can demonstrate that PE in India is a viable industry. Hence we continue with our portfolio approach, where we continue backing some of our larger managers, while also selectively putting money into some of the first-time managers, especially in the SME space. This will spur greater interest in the SME sector in the country for investors, help create significant numbers of jobs, and provide essential goods and services to their local populations.
Big picture, India has not delivered for PE. Where do you see the country?
There is currently a lot of positive sentiment towards India and the fundamentals appear to bear it out – but as LPs, we are a cautious bunch, and we don’t want to make the same mistakes again. There have been a couple of false starts for India – it looks positive this time and what you are seeing is that many LPs are willing to underwrite that positive outlook. At the same time, GPs have gotten better. Most have learned their lessons and know that they have to add more value to build companies that someone wants to buy ultimately, and also that scale and price matters. The shakeout in the Indian PE space is not over, but the good GPs have built out their teams. Also, LPs have become more cautious – they know what to expect from India and that GP selection matters.
Overall for India, the macro is better: the rupee is more stable, the current account deficit and inflation are more under control, and the Modi effect is still there and the government is delivering. Given the size and complexity of India, it is quite remarkable as to what has already happened – the bankruptcy law, GST – these all provide positive stimulus for the industry. People are re-discovering their faith in the India story – politically, the regulatory environment and the investment opportunity.
For PE, I would describe the current attitude towards India as cautious, balanced optimism. As a result, the top PE funds in India are oversubscribed – they have top-tier LPs with a longer-term focus. Also, you are now seeing an evolution of the industry with more sector-specific funds and different strategies. For IFC, there is still a lot to do, especially in sectors that are still not as attractive to PE, and we will continue to back fund managers who will deliver and contribute to sustainability. Everyone recognizes that India is a very competitive and highly intermediated market, and that pricing continues to be high. The public markets are expensive, and with many deals priced off their listed peers, that is the main concern.
Does it make it more challenging for PE that India’s public markets are expensive? Unlisted companies may be looking at the peers, and expecting similar valuations, when talking to PE to raise growth capital.
PE will have to demonstrate the value-add they bring – they need to show that they can drive M&A, bring in stronger management, and create linkages and strategy, so this is the next phase for PE to evolve.
PEs should be in a position to say that while they may be buying at a discount to public market valuations, they will be able to expand the pie enough for everyone to benefit. In many markets, you see that sellers don’t necessarily always go with the PE group that pays the highest price, but with the one that can credibly demonstrate the biggest value-add. The more I see cases where the highest bidder does not win the deal, it encourages me that all parties involved – entrepreneurs, sponsors and GPs – are learning from previous mistakes.
For Asia, are LPs competing to get into a few good GPs, or are the opportunities big enough for all LPs to deploy capital?
This is not just in Asia, but a global phenomenon – successful managers are able to raise ever larger funds, and often in record-time, whereas new GPs, especially first-time managers, struggle. While there may be more players in the market, the average fund size is 50 per cent larger than what it was even three years ago, and this is driven by the large end of the market. For first time managers, it is not easy – it is as difficult to raise a new fund in a market like Indonesia today, as it was 7-8 years ago, even though the industry has evolved. This is because everyone is crowding into the larger managers, so the larger ones are able to extend their platforms, build new strategies, get into adjacent asset classes, while the smaller ones struggle to get off the ground. LPs are looking for stable teams, proven track record – and in many cases, this means they gravitate to the few proven managers.
Be it SEA, India or even China, are too many GPs chasing too few deals?
We live in a world with abundant capital – this imbalance between availability of capital and strong deal flow is something that we are seeing in all markets. As a result, GPs need to be able to demonstrate that they have proprietary deal flow – which they can do by looking at niches, building out sector-specific expertise. This allows them to get deals not through an intermediary or auction process, but through the value addition they bring. I would be concerned if I was an active investor in the upper-most end of the market – deals greater than $100 or $200 million – about the high multiples that are often being paid. For smaller managers, they have less scale, they don’t have the ability to bring in as many top people or build out large platforms, but the benefit they have is that many segments of the market are much less competitive.
Successful GPs can create their own deal flow, say by backing corporate spin-offs, but the reality is that there are only so many deals of over $100 million in less developed markets like SE Asia – you typically have 1-2 each in markets like Indonesia and Vietnam annually, so I’m not sure it adds up when you see so many mega funds raising $6 billion or $9 billion just for Asia. So, I am happy that IFC’s strategy is to focus on the mid-market and the SME space where multiples are still in the single digit and proprietary deal flow really does exist.
While mid-market may be less competitive, it comes with a new set of problems – governance and compliance issues, management structures that may not reflect the times, and many of these companies are family-owned.
The challenge of LPs is to find GPs, who have shown or have the ability to show, that they can work with such entrepreneurs. It takes as much, or even more, time to do a $10-20 million deal as it takes to do a $200-million deal. For the smaller deals, GPs need to be much more hands-on and present on an almost daily basis. It is not like the large deals where a GP has money to hire loads of lawyers, auditors and advisors, let alone a new management team. For smaller deals, you are dealing with founders who often have very little training – these are entrepreneurs that have bootstrapped their companies for 3 or 5 or even 20 years without the help of outside consultants or even board members. This presents both a challenge and opportunity, especially if the investment comes in the form of a minority stake. Besides smaller deals being much more work, they are also much riskier as it is more difficult to exit, so you really need to grow the company to achieve sufficient scale for an exit.
And in the end, when you do succeed as a small SME-focused fund manager and you double your money on a $2 million investment, the profit is nowhere near the same absolute reward as for a $200 million deal upon exit. I have a tremendous amount of respect for these smaller fund managers – they are so deeply involved with the companies they back and, at the same time, have to work so hard to get their funds off the ground.