Even as India Inc. is forced to down the potent cocktail of falling demand, margin pressure and earnings declines, the hangover, it seems, may be felt by the private equity funds. After making a record number of deals over the last two years, both the size and number of deals dwindled in 2008, with PE players forced to take on the dual challenge of mobilising funds in a tough credit market and scouting for the right investment candidates in a deteriorating economy.
But aren’t PE investors likely to benefit from lower valuations and the moribund IPO market, even as cash-strapped Indian companies line up for funding? Which are the companies and businesses preferred by PE investors in the current scenario? Here’s an analysis.
Why deal volumes slackened
Despite the vicious meltdown levelling stock valuations, the number and value of PE deals recorded actually fell in 2008. According to Grant Thornton India, the total number of private equity deals announced in 2008 was lower, at 312, with the total announced value at $10.59 billion, compared to the 405 deals with an announced value of $19.03 billion in 2007.
The average deal value took a hit, down to $33.93 million in 2008 compared to $46.99 million in 2007. As valuations fall sharply across the board, the shrinking deal size doesn’t come as a big surprise.
But what explains the lower deal volumes? Shouldn’t lower asking prices and the credit crunch have paved the way for more PE deals? Not really.
The protracted slump in equities has left many private equity investors in bad shape as a big chunk of the money they had raised in the last couple of years went in as private investments in public equity (PIPE). “That more than 70 per cent of the private equity money went into PIPE deals may explain the current tardiness in deal volumes,” said Mr Nitin Deshmukh, Head of Kotak Private Equity, as a good majority of these deals are under water, with “some having lost as much as 90 per cent of their original investment. It is these investments and funds that may be in deep trouble now.”
Apart from this, deal volumes have declined for three key reasons. One, with the earnings outlook for quite a few businesses turning murky, PE players feel that investment opportunities in the market have shrunk.
Two, companies that may have lined up PE money to fund their expansion plans are wary of the deteriorating environment. “With companies now postponing their expansion and capex plans, the demand for PE money has certainly thinned,” said Mr Amit Chander, Head of Investments, Healthcare & Education, at Baring Private Equity Partners India. Besides this, there is also “a palpable loss in risk-appetite among Indian entrepreneurs”. So, even if PE investors don’t have a problem in spotting multi-baggers in terms of the return on investments, “there certainly is one in the demand for PE money.”
Three, PE investors such as IDFC feel that the collapse in valuations in the listed space is yet to be reflected in promoter expectations on unlisted ventures.
Entrepreneurs, in many cases, are still taking the view that the market meltdown is a temporary phenomenon, and thus should not materially bring down valuations for long-term investors such as PE funds.
Will they pick up?
It is worth noting that the primary reason for the problems faced by PE funds is not wrong investment decisions; it is wrong timing. Since returns on the PE investments made through PIPE deals were at the mercy of stock market cycles, the sudden reversal in the cycle took many of them by surprise.
The PE industry had its own share of froth during the boom when, from just under 40 funds in 2004, the number of private equity funds rose to well above 200 in 2007. “That shows the euphoria in the market. Every deal was getting finalised, irrespective of the sector, company size or even the deal size, and some of them well within 15 days,” said Mr Deshmukh.
Having said that, PEs do remain fairly confident about steering their existing portfolio of investments. For one, a presence on the company’s board, gives these players a greater say in that company’s strategic decision-making.
Second, while the equity downfall may have left funds with smaller time horizons in the lurch, there aren’t too many such funds. Most funds invest with over a five-year-plus time-frame. Funds may also see significantly lower growth and returns than they projected at the time of investment, which in turn may stretch the holding period of their investments.
But as “return expectations are also influenced by returns in other asset classes and the opportunity cost of investment,” most investors may be willing to dynamically revise their expectations in line with market conditions.
On that score, “funds with seven-year or ten-year time-frames may score better as they have more room to manoeuvre and tide over the current challenges,” says Mr Chander.
Which are better placed?
The challenges, therefore, may be pronounced only for those funds that were launched at the peak of the market euphoria and executed deals at sky-high valuations. The ones that showed restraint then and have plenty of cash in hand at the moment may be spoilt for choice. This may also explain why funds that are entering the market now or the ones that did fewer PIPE deals previously may dominate the PE arena in the next couple of years.
New funds such as Morgan Stanley Private Equity Asia, which recently inked its first deal in India, or existing funds such as IDFC PE, which raised close of Rs 3,000 crore towards the fag end of 2008, or Kotak PE, which has sufficient funds left from money raised in 2007, may stand the best chance to grab quality companies at attractive valuations. And what may help them is the flagging of the primary market, once the most sought-after means of raising capital.
What lends more credence to the domestic PE story is that Indian private equity players operate on a very low leverage. This may well remain the trend in the coming years as “leveraged buyouts happen typically only in developed markets,” said Mr Chander. “In India, we will continue to see growth capital for some more time.”
The coming year may see fewer deals at reduced valuations as PEs are likely to switch to disciplined mode and be doubly careful in selecting investment candidates. The focus may also be more on investing in companies with a niche business presence and management ‘bandwidth’, though many opportunities may crop up during the year. Overall focus may remain on mid-sized and smaller companies, despite larger companies being cheaper now.
Sectors preferred
“Since PE money, in general, figures at the extreme right of the risk-return bar, their high-risk and high-return aspiration will find a better match only in smaller and mid-sized companies,” explained Mr Chander.
And PE companies’ expectation of boardroom presence in the companies they invest in corroborates this stand, as larger companies are less likely to comply with such a request.
In terms of sector choices the year promises to be diverse. Quite unlike in 2007 and 2008, when real estate and IT & ITES enjoyed most of the attention, the coming year may see a broad-basing of sectors on the PE radar. Investments in sectors such as healthcare, education, consumer goods and infrastructure are expected to dominate, given their relatively strong domestic demand, even as export-oriented businesses face headwinds from recessionary trends in US and Europe.
Funds may also be seen betting increasingly on agro-based companies, given the sector’s strong demand undercurrents and counter-cyclical nature. Recent deals by Blackstone in Nuziveedu Seeds ($50 million) and Morgan Stanley, through its Asia fund, for a minority stake in Biotor Industries ($37.8 million) are instances.
Source : http://www.thehindubusinessline.com/iw/2009/02/08/stories/2009020850570700.htm
