July 1, 2012
Interviewed by: David Snow
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India’s Macro Story

International investors watching macroeconomic and regulatory challenges multiply in India wonder how India’s macro story will affect private equity performance. These three experts share their strong views.

Mukul Gulati of Zephyr Peacock India Management, Sev Vettivetpillai of Aureos Capital (an Abraaj division), and Parag Saxena of New Silk Route discuss how Indian businesses enjoy “such a demand for good products or good services” that an economic slowdown should serve as a poor excuse for investment failure.

International investors watching macroeconomic and regulatory challenges multiply in India wonder how India’s macro story will affect private equity performance. These three experts share their strong views.

Mukul Gulati of Zephyr Peacock India Management, Sev Vettivetpillai of Aureos Capital (an Abraaj division), and Parag Saxena of New Silk Route discuss how Indian businesses enjoy “such a demand for good products or good services” that an economic slowdown should serve as a poor excuse for investment failure.

David Snow, Privcap: Today, we are joined by Mukul Gulati of Zephyr Peacock India Management, Sev Vettivetpillai of Aros Capital, and Parag Saxena of New Silk Route Partners. Gentlemen, I thank you for joining Privcap today. We’re talking about Indian private equity, and I think it’s very important to put it into the context of the broader Indian economy.

Private equity firms don’t necessarily make money or lose money based on broader macroeconomic themes, but they are certainly important on a number of levels. So maybe starting with Mukul. From your perspective, what are the most important aspects of the Indian macroeconomy right now that are affecting the way that you invest and the chances of success for your investments?

Mukul Gulati, Zephyr Peacock India Management: I agree with you, David. If you look at the Indian GDP in the last five years, until at least 2011, India averaged 8 and 1/2% a year growth in Gross Domestic Product. And yet most private equity funds have not made money.

So at least in this medium term, the correlation between economic growth and return for investors, whether it’s public markets or private markets, has been nonexistent. In fact, it’s been negative. And the lesson for us is that India, in particular, is a bottom-up market. Investing in the right business models, in scalable and profitable business models, is the right strategy for India. And for us, that’s been a huge lesson.

And so what we focus on is the microstructure of a given industry that our companies are operating in when we decide to invest. And whether the entrepreneurs that we’re investing in, are they empire builders or value creators. And that’s a big mistake that investors have made in India, especially with large family business where the objective is not just financial success, but another sort of notch in your growing empire. And it’s really hard for investors to get aligned with that.

And for us, the most important aspect, at the risk of repetition is whether the entrepreneur is honest, whether they are not fully– they don’t necessarily need to have all the professional skills, but are they committed to professionalism? Will they work with us in scaling of the business?

And third is, of course, the microstructure of the industry. A classic mistake in India is that everything, in every industry, in every sector, there is a supply and demand imbalance. You could take financial services. You could take infrastructure. You could take education. You could take health care.

All of these are supply deficient sectors. And yet, investors in these sectors have not made money. Why is that? You need to be– because even if you’re meeting, even if you’re well-positioned position from a supply demand point of view, entrepreneurs– and this goes to Parag’s point– have struggled because they have not found talent, people who can work with them to scale up their businesses.

So we are looking for platforms where the senior management team has the ability to attract talent, nurture talent, and scale the business with them. And that’s been the secret to success, for us at least, in the last four to five years.

Snow: Sev, I’m interested in your views on this. To what extent do macroeconomic factors in India, the growth of GDP, fuel your ability to be successful as an investor?

Sev Vettivetpillai, Aros Capital: It has some impact, especially when it comes to looking at potential exit opportunities. The capital market is a very important aspect of the pieces. But in terms of individual businesses, this is a country that has not had so much of investment over 50 years. There’s a pent up demand that is yet to be filled in the domestic market.

So for us, the macroeconomic point is important from an exit perspective, but more so the individual entrepreneur and the management team, which Mukul’s point was because we’ve seen this in Africa, which does not have a 10% year-on-year GDP growth. They have 3%, 4%. And we still made four or five times our money.

At the end of the day, the difference is the entrepreneur and the management team are actually building a business that they’re able to maneuver through the macro issues and the political issues and the rest of the issues in the market, whilst yet they perform very well in their own sector. So finding the good quality management team and a leader to lead them is in our opinion that makes money. Every aspect of the macroeconomic situation or not because that’s, at the end of the day, who drives the business.

Snow: Parag, what are your views on the view of macroeconimcs?

Parag Saxena, New Silk Route Partners: If I can extend the question slightly, partly because I agree with what my co-participants here have said, on macroeconomics the things that matter, India’s twin deficit’s much talked about, so everyone understands that. The big problem is that the rupee keeps depreciating and inflation is high, which means interest rates are high. So those make it less attractive on a relative basis.

If we don’t cure about those problems, then at a competitive level, the dollar or the euro or the pound sterling that would have gone to India goes somewhere else. And so the government needs to deal with macroeconomic policy. And this has to be on the fiscal side. It cannot be on the monetary side. The bank of India has done pretty much all it can do on the monetary side. They don’t have much weapons left.

And the only reason it’s important– so I completely agree with my colleagues that predicting that stuff is a hazardous occupation, even for those who do it as a full time job. And so the eyes of private equity have no clue about where interest rates are going. But it’s important for me that those deficits are contained so that the rupee is not constantly depreciating.

I’ve invested an average price of about 45 rupees. The dollar is 53 now. So I’ve lost that money without the underlying companies giving up anything on performance. That’s one.

The second reason why it’s important is, again, a year or two, but poor macroeconomic policy leads to poor capital markets. You don’t have, therefore, the ability to have robust capital markets. You don’t have the ability to sell debt, which is anyway in all emerging markets something in extreme short supply and is a serious problem. It’s something that every finance minister outside of the United States and England should be sitting up and doing something about. Because they can only help their own country and their own companies, and it’s particularly acute in emerging markets.

Then the third place where– and this is where I’m extending macroeconomic policy– policy from the government needs to send a standard message. You can invite investors or not. Businessmen are perfectly capable of dealing with a set of circumstances, but if you from time to time sit back and say, you know what? I’m going to go back 50 years and re-look at the rules, and I’m going to apply them to you anyway, that’s a really bad message to send.

So doing that is a major failure of policy and something that would make people shy away. And we’ve seen that recently, although there’s been some significant backtracking on the Indian government. And they’ve revised the proposals that were floated. Those proposals, I think, should not have been floated in the first place.

Snow: And you’re talking specifically about the regulatory regime applied to incoming capital?

Saxena: Applied to incoming capital. The same thing, of course, applies even– does a domestic guy want to deal with all kinds of balls in the air that keep changing? No, he or she doesn’t want to do that, either. But this is particularly to attract foreign direct investment. And if you want to attract foreign direct investment, you need to have a constant policy. North must be North.

Snow: So there’s economics, and then there’s kind of regulatory. And one is a bit more subject to human control. To what extent do changing Indian regulations make your lives difficult as investors? Are those just things that one can deal with? I’m interested in your views, especially Sev, someone who invests in–

Vettivetpillai: Yes, it’s an important point. I agree with Parag’s view. If there’s a consistent policy, we will figure it out and find the solutions in the medium to long term. But if these policies are attractively changed, that will be a big negative point for any investor. Africa doesn’t do that.

I’m surprised by what’s happening in India, which doesn’t make any sense, although there’s a lot of backtracking going on. But the fact that came out in the first place, you raised a negative point. But every investor’s not going to give another two years, three years, to watch and wait or committing new money to the market. So it’s a big negative point.

We have to live with a lot of these things when we invest in emerging markets. The reason why I did not mention about the ForEx risk, I mean it exists in every market we’re investing in. And we’ve learned over the years to come up with strategies to mitigate or manage that risk in one formal shape. And that’s part of the tool that every private equity, emerging market investor has to deal with.

Not that you’re going to go and buy a hedge, but nobody can. It’s too expensive to buy. So these issues are very much. And I think this is my point back to earlier on that I mentioned – we have a company, and our fund is diversified by India, Bangladesh, and Sri Lanka. We did that on a conscious basis.

When everybody wants to go to India, we still said you must split your capital to diversify the risk. And today, Sri Lanka and Bangladesh has outperformed India, their portfolio, multiples. The same point I make in Southeast Asia. Everybody wants to go into Indonesia. These are emerging markets. They may give you the big multiples, but you’ve got to diversify because policies change, the markets change very quickly.

Reactive time to correct your portfolio is impossible in a private equity industry. So you’ve got to live with it/ So my sense in all of this is that you have to have some sort of strategy, but if government starts doing something that they’re not doing, then the FDI will be affected.

Snow: Just for the record, can you– maybe, Mukul, you can help us specify, what is the set of regulations with regard to foreign investment that most private equity people are nervous about?

Gulati: More recently, the new India’s been in the news because of taxation. There’s two aspects of taxation. One is that there was some concern amongst foreign investors. Most of us go through Mauritius, especially private equity investors.

There was some concern that the treaty that Mauritius has with India may not be valid, and Mauritian investments in India will be taxed in India, which is a big challenge for foreign investors. Recently, the government has clarified that that’s not going to be the case, at least for the next one year. Then there was the issue of–

Snow: At least for the next one year. Nice vacation.

Gulati: Exactly. The second issue was related to non-treaty countries, and which is the famous Vodafone case, where the government basically is changing the rules of the game while the game is being played. And to retroactively tax a transaction, which most people thought four or five years ago shouldn’t have been taxable. So that alone is not a huge deal, but sends the wrong message in a competitive global investment environment.

And so that’s been the recent regulatory issue. To me, I think these issues will be sorted out over the long run. And to me, the most fundamental issue is growing infrastructure in India. Unlike China, India is a country that grows despite the government, not because of the government.

Our entrepreneurs in India have tremendous energy. And wherever the government has stayed out, the entrepreneurs have done a great job building industries. Telecom 10 years ago is a good example of that. The IT business in India is a good example of that, where government had no or minimal interference. And we built world class businesses in these sectors.

But the infrastructure is one area. And then related soft infrastructure, which is education, health care. Which unfortunately, does require government intervention and India is struggling there.

But there’s an upshot of that, which is if you look at our entrepreneurs in India, they are used to operating in an uncertain environment. If you’re successful in India, because the government policy’s uncertain, India is a highly competitive market, my guess is that you’ll be successful elsewhere. And one of our teams is to take our successful mid-market entrepreneurs to other emerging markets. We’ve been talking about Africa.

And as both of my co-panelists know, a lot of Indian businesses are now expanding into Africa. I would argue that Indian entrepreneurs are better positioned to succeed in Africa or the Middle East or Southeast Asia then, say, American or British entrepreneurs. Because Indian entrepreneurs are used to operating in a corrupt environment with poor infrastructure.

And in our portfolio, we’ve had some examples of successes where we have a company that sells software to banks and portfolio managers. And we find that we can get in Africa, which has the same level of per capita GDP as India. The pricing we have is 3x of what we charge in India because it’s less competitive than India is. And that’s one of the new teams that have emerged for us as an investor, where we leverage world class entrepreneurs who are operating in a third world environment.

Snow: So the brain drain is coming back from the west into India, and then right back out the door down to Africa.

Gulati: No, I think it’s great. I think it’s great for India, and it’s great for Africa.

Snow: Do you have investment themes like that, where it’s the Indian facing company with strong African ties?

Vettivetpillai: Yes. And the other thing is that it’s absolutely right. Quite a number of Indian companies have already come in to Africa, mostly the service industry today. And there’s a big Indian population in Africa already. So that allows them to penetrate the market a lot faster and be successful in it.

But what is also interesting is the other way around, African businesses looking to tie up in Indian businesses, to take advantage of the domestic market. So it’s not in the quality of the other way around, but it’s starting to happen.

And what they are tending to do is these African businesses are first setting up operations in Dubai, and that’s a stepping stone. And then they’re moving up into Asia as they get trade going and build relationships. So I’ve seen both ways, which is a separate topic, but I believe the South-South axis trade is going to become a major part of future.

Snow: I want to switch gears a bit and talk about deal flow as a result, perhaps, of expected slower growth. Do you think, and are you seeing evidence of this, that perhaps in a market where people expect there to be a certain amount of GDP growth at their backs, they are less interested in the private equity proposition and the capital and ideas that private equity might be able to bring? But in the expectation that there will not be those tail winds, they suddenly realize that they need to improve their operations and up their game in order to compete better? Have you seen any evidence that that is driving deal flow?

Saxena: No, I haven’t seen evidence that it’s driving deal flow, but I think the more important point actually is can private equity firms deal with slower growth in India? They can. Right? They can deal with slow growth.

They will still find– Mukul made the point about this being a bottoms-up business in a previous panel. But you’ll find businesses that are serving needs. The biggest issue in front of India is if you said to me, if you were a 25-year-old that was looking for what should I do for the rest of my life, I’m thinking of going to India, what business should I go in? I would say it doesn’t matter at all. It’s merely executing it well.

There is such a demand for good product or good services in India that anything you did would do well. And if the GDP growth rate fell dramatically from where it was, that’s not going to take away the bottoms-up argument for the need for those services. What it is going to take away, and that’s why it’s really important for India to drive growth, is it’s not going to lift people out of poverty.

To the extent that there is a trickle down effect– and this is a very debated point, of course– to the extent that there’s a trickle down effect, unless we do something for the 600 million people that are still living on a dollar a day or less, long term prosperity is impossible. So that needs to be something to make the market attractive in a 20-year period, in a 50-year period, or a long period of time. And everything that is done to help that happen from a policy standpoint is the task of the government.

So very high up on that is infrastructure, which is both hard infrastructure, better roads, railroads, transportation in all forms, communication in all forms, and soft infrastructure, education, at all levels. Those things are crucial, and they will make the market inherently more attractive. They will make that rupee depreciate less so it will be an attractive market.

But from a deal doing point of view, can you find attractive things in Europe today? Absolutely you can because you can find things that are priced very cheaply, and if there’s some businesses that are necessary for people, you’ll find them. Same argument would hold here at a slower GDP. So to make it attractive, it’s obviously better to have a high GDP. What’s really important is going to lift people out, give them more purchasing power.

Snow:  Why don’t we close the conversation on exits again, back to exits. The capital markets are very important. They are tied to macroeconomic performance. And in a market with a dearth of exits, it’s hard to convince the new capital to come in because they haven’t seen evidence of harvesting of previous investments. Maybe starting with Sev, what do you predict for the Indian private equity and venture capital market going forward by way of the ability to realize the investments that have been made?

Vettivetpillai: Well, if you go back and analyze the conversation and the discussions we’ve had, so the market is a good market. You can find good deals. You need to find the management team to drive it. Basic capacity for demand for the products so the company can grow. So it’s all the necessary ingredient to grow a company is there.

But the exit question comes up. An exit question becomes a real challenge if you start to pay prices which does not give you the return. I can sell any company today that is doing well, but am I happy with the price I’m getting? No, I’m not, because I paid too much.

So the exit is not so much of an issue in the capital market itself. It helps it in that. It helps to hide mistakes because the capital market is going up. You also get a bit of uplift along the way as a seller.

But in today’s term, the importance of how much you pay for a business and the time you have holding and what you can do within that period of time, there is the return you’re likely to get for a risk capital perspective, the enterprise becomes that much more sensitive because of where the capital market is what it is. But a good business can get an exit. Question is, are you happy with exit?

Snow: Mukul, what do you expect from the capital markets in India as far as an opportunity to exit, and to what extent do you just have to be independent of what the capital markets do, and just say, as Sev said, a good business will be able to be sold at a good price.

Gulati: I agree with Sev. We cannot count on the capital markets. That’s out of our control. We think the markets will bounce back, but who knows? My guess is as good as yours.

So we have to build businesses that will be attractive to strategic buyers. And if the public markets are cooperating, we’ll have a good exit from the public markets. But we can’t count on that. We have to count on building scalable businesses, and we will find buyers.

And there are two other areas of exit, which are going to be important in India going forward. They haven’t been in the past. One is M&A. And there are global strategic buyers and large domestic companies who want to buy businesses that we are building.

The reason M&A hasn’t happened in India is that entrepreneurs haven’t been willing to sell. And that’s partially generational, partially cultural. But we think that’s changing.

And our own focus is to find entrepreneurs who will, at the right price, are willing to sell the entire business. Because those are the best exits in a strategic M&A. And so we’re looking for businesses that will have characteristics that will make them attractive to strategic buyers. So that’s one.

The third opportunity that at least Sev and I have in the size of businesses that we are investing in is to sell our stake to larger private equity funds. That hasn’t happened so much. And in private equity 101, people say that you don’t sell to other financial buyers because the financial buyers will not give you a lot of value.

In India, that may not be true because we think that there’s an overhang of capital. In funds that are $300 to $500 million in size, they typically like to make $30 to $50 million of investments per deal. We think that some of our companies will grow to that size, and we’ll sell our stake to them. And so I agree with Sev that as long as the businesses scale, we will realize the right price.

Vettivetpillai: Can I just add on to Mukul’s point as well because out of the three exits we’ve done in India, two has been to financial investors. The last one was to Warburg Pincus. So I agree. But the business is sound, so that’s where the capital is coming in. But if the business wasn’t, they’re not going to buy from us, either.

The other point I think it’s going to be a chronic problem, which we’ve seen it in Africa, and I think it’s going to happen in India, but it’s going to take a bit of time to do it. A business is based in Bangalore can expand all the way to Calcutta or to the north by acquisition? In order to be able to do that, people will say that the sponsor in Bangalore would not necessarily understand what’s going on in Calcutta, only it’s one country.

If the private equity houses can move into those locations and find transactions, I think there’s a regional buy and build strategy just waiting to happen. And that’s where we believe, because we’ve done it very successfully between Kenyan business to Tanzanian, Ugandan, West African businesses, from Nigeria, moving into Ghana, and other places. And that’s where we think it’s got to go in order to build and have that strategic look.

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