The Indian private equity (PE) and venture capital (VC) market has been getting more active by the day. During the last year or so, almost all the major global VC and PE firms have either established an on-ground presence in India or raised significant India-dedicated funds. In 2006, PE/VC investment levels increased by more than 300% to almost $7.5 billion from $2.2 billion in 2005. This quantum leap was not the result of a low base—as 2005 was a record year in itself.
What is driving this PE/VC investment boom? The most important fact is Indian GDP growth coming within striking range of double-digits. Annual growth rates of 7-9% are unheard of in mature western economies, and global investors want high returns. Furthermore, several key sectors of the Indian economy (IT/BPO, telecom, pharma/healthcare, financial services, retail and automotive components) that are investment targets are experiencing even higher growth than the said levels (of 7-9%). Other key attractions include: an economy well positioned to mine the opportunities of globalisation, an increased appetite for innovation and entrepreneurship, well-regulated and fully functional capital markets and a spurt in consumerism powered by the young demographic profile. Clearly, the liberalisation of the economy has also had a significant impact, laying the foundation for a relatively stable macroeconomic environment in combination with high growth.
However, on the regulatory side, many investors would like to see the government use the current momentum to push forward with further deregulation. Some recent regulations, they fear, have not been well thought through. Examples of these include the introduction of FBT on stock options and the recent news on preference share capital requiring compliance with ECB guidelines on interest/dividend coupon caps and end-use restrictions (that is, compliance with external debt norms, unless the shares are fully-convertible). For the PE/VC industry, the new end-use restrictions are particularly harmful as funds raised via preference shares cannot be used for general corporate purposes, funding of working capital, repayment of existing loans and acquisition of shares and/or real-estate. At present, it is estimated that about 30% of the Indian VC/PE investments are structured as preference share capital. Unless this gets revised, the percentage might well come down. This is in sharp contrast with many western markets, where an even higher and ever-increasing percentage of VC/PE investments are structured with a layer of preference share capital—also referred to as ‘hybrid capital’, since it bears elements of both debt and equity in an attempt to achieve a unique mix of risk and reward.
The most common forms of preference include liquidation preference and/or dividend preference. The rationale is to grant flexibility in risk and reward distribution amongst different types of shareholders (investors and management). In most cases, financial structures involving preference shares tend to increase the overall ownership level and upside of the ordinary shares held by management. However, on the flip side, they also tend to increase the risk profile of ordinary shares, while the preference shares held by PE/VC investors tend to carry lower upside but more downside protection.
It is difficult to assess how beneficial this sophisticated distribution of risk and reward is for management teams and the economy as a whole. In general, though, virtually all investors feel that it is better that the market decides the nuances of financial structures than the government. In this respect, the April 30, 2007 press note is a disappointment.
Still, will it have a significant impact on future PE/VC investment levels in India? Given the economy’s growth, many investors have shown a higher than average risk appetite on investing in India. Hence they might well decide that the opportunity is too interesting to ignore, and might invest in ordinary shares instead. Furthermore, Indian PE/VC activity has hit record levels in spite of the fact that leveraged buyout levels continue to be low in India—on account of another set of regulations that restrict banks from lending money for the acquisition of shares. In mature markets, buyouts typically account for more than 80% of total PE/VC transaction value, but the corresponding figure in India is just 15%. This is not just the result of regulatory differences. It is first and foremost the result of different growth stages of the respective economies. Low growth in western markets reduces high-growth investment opportunities, making investors that much more dependent on the use of financial engineering and high levels of leverage for their returns. In contrast, high growth in the Indian market makes the use of leverage less important in achieving overall investor returns. Still, should regulations be eased in this area, one would expect a considerably higher level of buyout activity in India. This could then trigger another significant step-up in overall PE/VC investments levels in India.
All said, although the above regulations can sometimes be a nuisance for PE/VC investors, India’s legal environment, regulatory regime, corporate governance levels and maturity of markets, all compare rather well with many other emerging markets. And with PE/VC players in possession of record levels of funds, they are looking to deploy the money in markets that offer them what they cannot refuse: returns.
KLAAS OSKAM —The author is vice-president, Ernst & Young. These are his personal views ; Source : Financial Express