July 1, 2012
Interviewed by: David Snow
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Subcontinental Deal Flow

India has a huge population of people and private businesses and a wide array of private equity firms, yet the private equity opportunity there faces significant challenges, as our three expert panelists discuss in the first of a three-part series on private equity in India.

Mukul Gulati of Zephyr Peacock India Management, Sev Vettivetpillai of Aureos Capital (an Abraaj division), and Parag Saxena of New Silk Route discuss how doing private equity deals in India requires an intense, bottom-up partnership with management.

India has a huge population of people and private businesses and a wide array of private equity firms, yet the private equity opportunity there faces significant challenges, as our three expert panelists discuss in the first of a three-part series on private equity in India.

Mukul Gulati of Zephyr Peacock India Management, Sev Vettivetpillai of Aureos Capital (an Abraaj division), and Parag Saxena of New Silk Route discuss how doing private equity deals in India requires an intense, bottom-up partnership with management.

David Snow, Privcap: We’re joined today by Mukul Gulati of Zephyr Peacock India Management, Sev Vettivetpillai, CEO of Aureos Capital, and Parag Saxena of New Silk Route Partners. Gentlemen, welcome today. Welcome to Privcap.

We are talking about private equity in India, a fascinating topic. Many people want to know more about private equity in India, and therefore I think a very obvious place to start is, really, what you do all day, which is doing deals. What’s it like to do deals in India? What is distinct about the deal culture and the business culture in India?

Does it remain an attractive place right now to do business? What is your perspective, having been active there for a while?

Mukul Gulati, Zephyr Peacock India Management: We certainly think so. India is an attractive market, but it’s a bottom-up market. To use a cliche, it’s an alpha market, not a beta market. If you simply allocate assets across Indian businesses, it may be hard to make decent returns on your capital. But at the bottom up, if you really do the work to understand your businesses and entrepreneurs, it could be attractive.

And one of your questions was, how is India different? One way it’s different is the way to make money in India is to work with your entrepreneurs. Understand their growth plans. Help them in the growth of the business. That’s the formula.

Snow: So, Parag, I saw you nodding. It’s not just a matter of saying, well, I’m going to go to India. I hear it’s an attractive market. It sounds like there’s a lot of work and a lot of connections that need to be made in order to pick the right management teams to work with.

Parag Saxena, New Silk Route: I think that’s completely true of all the markets as you move away from the US, which is the most developed market, has had this going for a long time, both in venture and in private equity.

In fact, when we say private equity in India, it’s a misnomer as used in the rest of the world. You do not have the same use of leverage. You are generally not doing controlled buy-out transactions. So keeping that in mind and using the same terminology, India is different, but so are any of these markets. I don’t know Africa that well, but from what I know about African businesses and people I see, I would suspect that the challenges are exactly the same.

Exactly the same in terms of scaling up any business, which is building up the business, or as a version of what Mukul just said, it’s working with the business plan and seeing how you get to the next step, and finding talent.

Which, to me, the surprising challenge in India was– and I may be getting onto a different topic– was the paucity, despite a 1.2 billion population, the absence of talent at almost every level was one of things that surprised me.

Snow: But what kind of talent?

Saxena: If you have any friends that are looking for jobs, regardless of what it is, I can hire them. If they want CEO jobs, we can hire CEO jobs. If they’re fresh engineers looking for jobs, if they are looking for marketing positions in middle, later marketing. Virtually anything. Competence.

And it’s not a question of price. It’s competence at the job and delivering what they say is something that’s very hard to get.

Snow: I’m interested in learning how the three of you source opportunities in India. What is the network like for simply finding these opportunities? Sounds like there’s a lot of minority investments and a lot of family and entrepreneur driven investments. So maybe starting with Mukul, what is your deal network like?

Gulati: So you know, India is a misunderstood market. At least in the segment of the market that Sev and I operate– in the small to mid-market– intermediation is not such a bad thing. In America we think in the private equity business, if a deal is brokered, it’s auctioned. That is not the case in India.

Especially in the mid-market, where, in fact, intermediaries may actually help you structure a transaction, convince the entrepreneur that it’s OK, giving these guys all these rights. So for us, the number one sourcing strategy is to actually work with these unorganized intermediaries, who could be accounting firms, could be law firms, consultants, people like that, who are not formal investment banks.

But work with entrepreneurs, have good relationships with them. Now, there’s a downside to that strategy, which is that, when you get a business plan that’s prepared by these nontraditional intermediaries, it’s not a sophisticated business plan.

So until you really meet the entrepreneur, go do your own diligence, and understand the business that this entrepreneur is running yourself, it’s hard to make an assessment whether this is an investable transaction or not. So the challenge provides the opportunity.

But the amount of work that one has to do in terms of sourcing and analyzing a transaction before you even do some formal diligence and establish a dialogue about structuring a deal or evaluation, all of that. One has to do a lot of work understanding the business

We are willing to do the work. And if you’re willing to do the work, you may get some interesting value growth combinations in India. So that’s the number one strategy. Second is, of course, as you would see in the West, is developing expertise in a given sector or industry, which we have chosen to do in four or five sectors across India.

Once you have a reputation in the market that you know the sector, of course you get a lot of inbound deal flow. And so, our direct sourcing is very much driven by understanding a sector and then reaching out to entrepreneurs who are building market-leading businesses in those sectors.

Snow: Sev, is that your experience with deal flow in India?

Sev Vettivetpillai, Aureos Capital: I would come from a different perspective. I agree with what Mukul said about the intermediaries, but I would– intermediaries leaving investment bankers out of the equation. Investment bankers, I believe, have been the winners from both sides, for the sponsor all of the businesses, of the provider of capital.

Because the issue in India and part of the financial– even today, the valuations that are there, talking about, it’s impossible to make the sort of returns that you’re looking for on those bases. But using accounting firms, professional advisors, accounting, legal, are a good source of deal origination.

But I go back to the fundamentals. We, in 2007, to 2008, 2009, we didn’t do a single transaction in India, simply because we just couldn’t get our head around the valuation. So we took the initiative, early on in 2007, to move away from Bombay and go direct to the owners of businesses through the intermediaries, in places like Chennai and other places where we were able to find the valuation.

It’s not the valuation that is important when you invest in the small and mid-market. It’s the relationship. The relationship with the owner of the business is key to mitigating a lot of the risk that goes with investing in a minority position in that space.

So I look at India and say, 1.2 billion people living in India. And I look at Africa as a whole continent, and it has a billion people living in there. In Africa we have 58 countries. In India we have 38– or something about that– states. So how is it possible for anyone to sit in one location and cover 38 states when we couldn’t do it in Africa? And then we said, look, we’ve got to get closer to the owner of the businesses.

So we’ve gone to the strategy of setting up offices in Calcutta and other key locations, which we think, in the next five to seven years, we’re going to see a much bigger growth in those cities– as infrastructure comes in play. And so the origination, we’ve got to innovate in India, in my opinion, for the benefit of all of us. And that’s what we’re going to be doing.

Snow: Parag, how do you deal with the increased competition in India for deals and the fact that some of these larger deals are intermediated, and therefore possibly having a richer price attached to them?

Saxena: The space that we mostly traffic in, the $50-$100 million equity check, is generally not that competitive. There are only about four or five players that claim that, and they don’t always participate. There’s some transactions they’re interested in and some transactions they’re not.

So it’s a little less competitive in that sense. The strategy we use– and I think everyone’s past experience influences in part the way they do it. So my experience was, for almost 25 years, investing in venture deals. And the relevance of that is that it’s a company building process, so that’s the part that I like and brought to India.

So the strategy that we’ve adopted is we only invest in areas where a member of our team was either the chief executive or the chief operating officer formerly of a sizable company in India. So sizable for us is $200 million, which would be small on a global scape, but in India it’s a large company.

And every one of our partners who was in India ran a company of that size. So the deal flow and the competitive edge or lack thereof comes from that. So on the negative side, we don’t do transactions in other spaces. On the positive side, we tend to know a lot of industry scuttlebutt, et cetera, because our guys used to run companies and have typically spent 20 years or so in that business.

And this is a strategy I advocate for anybody looking to build businesses in India, to use a lot of operational talent as your partnership. Have some structuring talent because that’s clearly important. But the combination, I think, can help bring Indian companies at all levels. It’s not something that works just because you’re investing $50 million.

I think it will work just as well at smaller companies in helping execute people– as Mukul was saying, help execute business plans. It’s really working with these guys and saying, OK, I really know your business goal . And here are the three things that I have seen before. Right? And then using that experience to tell the entrepreneur that, you know, I’ve seen this movie before. Let me help you with it.

Snow: Sev said something that I’d like to follow up on which is a decision to move beyond Bombay. One often hears that the Indian private equity market has gotten very populated with managers, and yet it remains a very large country. And I would imagine that, again, as you move to places beyond the major cities, there’s not an oversupply of private equity firms or deal finders. That’s probably the case, right, Mukul?

Gulati: Yeah, absolutely. While we are headquartered in Bangalore, our businesses are all over the country. And in India, the good news is that you can get to most places, make a day trip, come back. And certainly it’s been our experience that you get, again, the combination of growth value– what you’re paying for a given business model given growth prospects– outside the big cities is better.

Because the entrepreneurs are not as sophisticated and not as plugged into the financial ecosystem as you would see in big cities. So certainly we see a huge opportunity there. But there are challenges to doing businesses in smaller cities in India.

On one hand, you may get better prices, but you may also get entrepreneurs who are less global, less savvy in terms of scaling up their businesses, not as familiar with modern management techniques. But we see a huge opportunity, because that’s where we can add value.

Snow: I’d like to talk about a major component of the Indian business market– and really any business market in the emerging markets– and those are family-owned businesses. What would you say are some of the things and some of the skills and tools that private equity firms can bring to an Indian family-owned business to get them to either the next level of business domestically, or get them more internationally focused? Maybe starting with Sev.

Vettivetpillai: Well, that’s our key focus. 90% of our transactions that were done in the last 15 years or so with 250 transactions has been family-owned businesses. The experience on that side is that there are key ingredients that are key to getting it done successfully.

First of all, they’re minority positions. You can have as many minority protections in your legal agreement as one wants to, but if the relationship with the owners of the business in the family are not the right way, then you tend to lose in that. So, in order to build a relationship in any partnership, it starts from day one.

And to do so, it requires you to be on call 24 by 7, very close to them, and you meet on a very regular basis. So flying in and flying out would not work in many of these cases. You’d have to be ingrained into this culture in the local ecosystem. Generally the low-hanging fruit generally have tended to be operational efficiency.

Just basic organization of your distribution network, for example. Or putting an email system in place so you have just in time information to take good quality decisions to strategic, tactical resolution. So for example, the vast majority of them are very successful at their own grind prior to coming to us.

They’re cash rich, because those are the ones you would invest in. They tend to suffer from the ability to move from their key locations to either regionally or cross border.

Having people– your teams– around the markets and the key locations, and finding local partners that will then support the acquisition and follow it up with capital gives them a great amount of comfort in knowing that they have a partner who knows the culture of the new area that they’re going into. So buy and build strategy for scaling up.

We’ve done 40% of our transactions in that area, which has been quite successful. Then there comes the last part of an equation, which is the exit. We all have it. We all have it in our agreement that we’re going to do an exit. We agreed to it and all that.

But end of the day, for anyone who could have a crystal ball and be able to say exact exit, the counters have been four years or three years, I haven’t found one yet. So the market’s changed. The business has changed from the original thesis. So the exit strategy is likely to be a new strategy that gets both through the holding period.

So having that relationship on an ongoing basis, and getting the owner of the business to agree to that new exit strategy, requires maybe a conversation every month for the next two years to get that going. When you have the owner of the business sitting next to you as the majority control, who are also in line with your thinking on an exit strategy, that becomes a much better transaction.

So relationship on the ground, strategic so people that you hire in your own team– of background, of mix of consulting, engineers, all number of different background– is part of our ecosystem in doing deals in that space.

Snow: Certainly, the exit is required for successful private equity investing. And Parag, have you also found that that’s a challenge in getting some of the groups that you partner with to understand that, look, you’re not in this for life, you’re providing transitional capital?

Saxena: Again, it’s very much a function of– on a deal-by-deal basis, you need to make sure that the person you’re partnering with– and this is a global thing– is interested at some point in an exit in the form that you’re interested in. And of course, it can be a partial exit if you’re the only seller.

It can be a complete exit where the company is listed, and the promoter or sponsor continues to have their holding. It’s been more complicated the last few years globally, but particularly in India, because the initial public offerings have been very poor. Strategic acquisitions have been less. So the number of exits in general has been few and far between.

So the industry as a whole is, I think, against a wall on that issue and needs to look for additional options. Among the things that are available to people from overseas, if they have substantial holdings, is to take the overseas entity and list that. So if you come in through a Singaporean company company, providing that it’s a very substantial part of the business.

You can’t take 20% of the business and go public with it – no one’s going to be interested. But if you have 60%, 70%, 80% of a business, then you can take the thing. And that’s an additional option. In fact, we’re looking at it for one of our companies. Don’t know if it’s going to work, but it’s an option that you need to consider.

Gulati: If I may go back to the family business point, I agree with Sev about what the low-hanging fruit is, which is operational improvements. We made 10 investments in India, and it just so happens that none of them are family businesses. They were all first-generation professional entrepreneurs.

We have nothing against family businesses. India has a large number of those family businesses, and India runs on those businesses. We have found a lot of challenges in driving the kind of professional change that we’re looking for post our investment. Inevitably, for all our portfolio companies, the operating margins decline the first year after investment.

And many times, and because we’re increasing expenditure on staffing, on systems, and as Sev said, MIS is a big low-hanging fruit. And we have challenges with family businesses. So we have turned away from that. But there’s a new opportunity which is generational change, where the son or the daughter is inheriting the business, and they are more open to professionalizing the business, and they’re more open to exits.

Saxena: By the way, that’s geography again. In Bangalore you see many more businesses that essentially– with the Infosys model. No one ever had a majority at Infosys, and you got a bunch of billionaires out of that. If you have that model as one that you grew up, you can say, OK. I don’t need to have control of the business and have it all. In other places, you’re going to see very different–

Gulati: The further north you go in India.

Saxena: The further north you go, it gets harder and harder.

Snow: Well, this has been a great conversation about doing deals in India. I think there’s a lot more to talk about. But for now, why don’t we pause. Gentlemen, thank you very much for joining Privcap.

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