PRIVATE EQUITY

IN INDIA :
CHALLENGES
AND
CONCERN
 INTRODUCTION

Private equity refers to a type of investment aimed at gaining significant, or even

complete, control of a company in the hopes of earning a high return.
Though the money used to fund these investments comes from private markets,
private equity firms invest in both privately and publicly held companies. The private
equity industry has evolved substantially over the past decade or so. The basic
principle has remained constant: a group of investors buy out a company and use that
company's earnings to pay themselves back.

Private equity is medium to long-term finance provided in return for an equity

stake in potentially high growth unquoted companies. Some commentators use the
term “private equity” to refer only to the buy-out and buy-in investment sector.
Others, in Europe but not the USA, use the term “venture capital” to cover all stages,
i.e. synonymous with “private equity”. In the USA “venture capital” refers only to
investments in early stage and expanding companies. To avoid confusion, the term
“private equity” is used throughout this Guide to describe the industry as a whole,
encompassing both “venture capital” (the seed to expansion stages of investment) and
management buy-outs and buy-ins.
 PRIVATE EQUITY IN INDIA

Indian economy is one of the fastest growing economies of the world. The strong
fundamentals of India such as average GDP growth of 8.5% for last five years,
increasing saving and investment rate, its stable democratic government, well
educated population, abundance of English language speakers have caught the
attention of the PE players and have brought it on the priority list of all PE funds.

On the one hand, Indian growth story has lured the Private equity investors and on the
other the Indian economy has gained significantly from the PE Sector. PE firms have
shared their global exposure and has had its spillover effect on various fronts such as-
corporate governance standards, knitting global connectivity, building executive
teams,
improving/raising organizational capability, enhancing evaluations and creating
liquidity.

Further, PE firms also provide the domestic entities the necessary mentoring and
advice without having to go to public markets.
 CHALLENGES AND CONCERNS

Before Indian private equity can fully realize its potential, our survey found,
promoters seeking PE capital and regulators will need to address several major legal,
cultural and business challenges that currently impede the industry’s development.
Respondents cited five barriers that they consider the most problematic over the next
two years.

• Mismatched expectations:

Reluctant to cede control over their companies at anything below a high premium
price, Indian promoters have been cool to approaches from PE firms unwilling to
meet their valuation expectations. The steep drop in Indian public equity values
following the credit meltdown in late 2008 served only to lock those mismatched
expectations in place. Deal making froze in 2009, as PE investors and company
promoters tried to determine how low equity valuations would ultimately fall. But
the quick recovery of the public equity markets since mid-2009 did not give
expectations a chance to reset. In most situations, promoters and PE investors remain
at odds over valuations. It will take a long, robust economic expansion and a
leveling off in price-to-earnings multiples to bring the two sides closer together.
• Tough competitive environment:

As the Indian economy rebounds from the downturn, promoters will be hungry for
capital to finance growth. They have a variety of sources to tap for funds, including
bank loans, Qualified Institutional Placements and initial and follow-on public stock
offerings. Private equity is near the bottom of the list, because it comes with higher
costs and more strings attached. The equity-market downturn and brief dip in
economic activity in 2009 significantly reduced access to most of these capital
sources, opening an opportunity for PE and VC investors to fill the breach. But with
about 300 VC and PE funds operating in India today, competition among them for
attractive deals is feverish. To succeed, it will be imperative for PE investors to
position themselves as providers of expertise, besides just being a source of funds.
They will also need to focus on helping the companies in which they invest meet, or
exceed, earnings growth targets if they want to realize PE-type returns. Post deal
value creation will therefore take on increasing importance even in minority holding
situations.
• Non-supportive regulatory environment:

A lack of clarity about rules and delays by agencies with overlapping responsibility
to issue clearances to operate under the Foreign Venture Capital Investment
regulations burden the industry. Onerous registration requirements on offshore VC
investors dampen the flow of foreign capital into India.

In April, however, new rules announced by the Department of Industrial Policy &
Promotion now oblige foreign investors to obtain prior approval to invest in Indian
investment funds and prohibit investments in unregistered trusts. Intended to
safeguard
against money laundering and restrict foreign ownership of real estate assets, the
regulations have the unintended effect of constraining capital flows.
PE and VC investors in India also face complex tax burdens. For example, investors
face a short-term capital gains rate of 15.8 per cent and a long-term rate of 10.6 per
cent when they profit from the sale of shares in a publicly traded company. But when
the gain is on a sale of a stake in a privately listed enterprise, rates nearly double.
India’s opaque and idiosyncratic tax laws, in place since the early 1960s, have led
some foreign PE firms to purchase tax-liability insurance to protect them from their
vagaries.

Investment managers also cite inconsistent tax pass-through rules as a source of

confusion that clouds investment decisions. Tax-rule changes made in 2007 restricted
advantaged tax treatment of investments made by domestic VC funds to sectors,
including nanotechnology, bio-fuels, seed research, hotel and convention centre
development, some infrastructure projects and a handful of other state- favored
initiatives.

To improve the overall investment environment, these investment-distorting

tax policies need to be reexamined.
• Promoters’ reluctance to allow PE investors to exert direct management
oversight:

Promoters and CEOs are generally not comfortable selling large equity
stakes to outside investors. The result: Most deals are minority stakes of less than
25 per cent. Finding the right company at the right valuation that recognizes the
value of a PE partnership remains a major task for fund managers. Moreover, PE
funds are often seen as a source of capital and not as an added source of expertise
and best business practices. With low stakes, many promoters expect PE firms to be
passive investors rather than activist owners that can provide business guidance.
• Underdeveloped corporate governance:

Many privately held Indian companies lack the transparent reporting and appropriate
board oversight PE and VC general managers insist upon in the companies in which
they invest. While having nothing to do with PE investments, the fraud and
manipulation of accounts at Satyam Computer Services shook investor confidence
and increased calls by shareholders for independent, tougher governance standards.
Most observers expect that pressure for additional measures to strengthen corporate
oversight will continue.

The long-term prospects for India’s PE and VC industry will hinge on the ability of
investors, promoters and government regulators to tackle the challenges that
constrain its growth while, at the same time, ensuring that the industry operates with
effective safeguards and efficient oversight.
 KEY TAKEAWAYS

• India will need to tap every potential source of capital to continue to achieve its
growth aspirations, and private equity is an important asset class that can play a
critical role in enterprise value creation.

• The emergence of India over the past six years both as a destination of interest to
global PE investors and home of a vibrant domestic PE industry coincided with
the most buoyant period in the history of private equity globally. From 2004 to
2008, PE and VC investors have invested nearly $43 billion in India, the fastest
growth rate in Asia over that period.

• The continued expansion and sophistication of Indian private equity bode well for
the industry’s outlook as the economy continues to accelerate out of last year’s
slump. New PE deal activity has been picking up since the middle of last year and
is gaining momentum in 2010. Together with China, India looks poised to lead
the growth of private equity in Asia, powering it beyond the levels of the 2007
cyclical peak by 2012.
• More than 30 per cent of PE investments in India have been made in companies
that have since grown into the nation’s 500 largest firms. These investments have
helped to power the growth of several of India’s best-known companies.

• Signs that Indian private equity may be reaching an important milestone in its path
to a more mature phase of development are evident in investors’ expectations that
deal value will grow, and that the number of buyouts will increase faster than
acquisitions of small minority stakes.

• Before Indian private equity can fully realize its potential, our survey found,
promoters seeking PE capital as well as regulators will need to address several major
legal, cultural and business challenges that currently impede the industry’s
development.
 FUTURE PROSPECTS

Private equity in India has delivered higher returns over a longer time frame and has
outstripped other investment avenues. Over the eight year period (2000-2008), on an
average, sales of PE backed companies grew at 24.9%, a significantly higher rate
than non PE backed companies which grew by 15.5%, Nifty (19%) and CNX
Midcap (20.6%). Further, PE backed companies showed annual Profit After
Tax (PAT) growth of 34.6% for the period (2000-2008), significantly higher than
non-PE backed companies which showed PAT growth of 25.30%, Nifty 50
companies posted 26.4% PAT growth and CNX Midcap companies showed
profit after tax growth of 25.4 % Private equity has entered the economic
mainstream and has gained a lot of momentum over the past few years.

As the report of the Planning Commission on 'Technology Innovation and Venture

Capital" mentions, VC/PE funding is a percentage of our FDI inflow, it should be
nurtured and encouraged further as it creates new ventures and new employment and
is invested for the long term and is not that can be pulled out at short notices..
Therefore, PE investments can significantly contribute to forex reserves and also
reduce the rupee volatility and be one of the factors towards contribution of
financial stability. Further, a simple well defined regulatory regime with no scope
of confusion can help the private equity industry to grow further.
THANK YOU
SUBMITTED BY:
RAJAT JAIN
PGP/FW/09-11/FINANCE