Regulatory obstacles and systemic turbulence disrupt the dealflow, yet India retains its allure to private equity investors

One of the many paradoxes of India is that widespread optimism about the country’s future growth is accompanied by increasing skittishness among private equity (PE) investors.

So while Aparajit Bhattacharya, a partner at Hemant Sahai Associates in Delhi, believes “the fundamentals that drive investment into the country remain sound,” Yash Rana, a partner at Goodwin Procter in Hong Kong, says, “recently we have noticed a subtle shift in Indian private equity activity” that suggests “activity in India has decreased”.

Aparajit Bhattacharya Partner Hemant Sahai Associates


In January and February foreign investors pulled US$1.4 billion from India’s stock markets and sent the Nifty 50 index down 17% from the highs it had reached in November. Valuations remain strong, but complicated regulations, corruption scandals and fears over inflation are conspiring to reduce the allure of investing in India.

Some observers, such as Rajiv Luthra, the managing partner of Luthra & Luthra, suggest that the recent outflow of funds has been “almost entirely on account of [foreign institutional] investments being scaled back due to a variety of factors, many of them related to global developments”.

Bucking the trend

The slowdown in investment belies the significant growth of India’s relatively young PE industry. In 2005, PE capital in the country, channelled through fewer than 50 funds, topped US$1 billion for the first time. In 2008 it reached US$14 billion. When it dropped to about US$5 billion last year, there were still more than 300 funds active in India.

Yash Rana Resident Partner, Hong Kong Goodwin ProcterPE investments have grown “multifold”, says Nitin Deshmukh, the CEO for PE at Kotak Mahindra. According to the Indian Venture Capital and Private Equity Association (IVCA), venture capital and PE funds have raised almost US$45 billion and invested in 13,000 companies to date.

In addition, new funds – such as the US$1.5 billion India-focused buyout fund announced by KKR in January – are appearing and deals are taking place. For example, Bain Capital and GIC, a Singaporean sovereign fund, are acquiring as yet undisclosed stakes in Hero Honda, the world’s largest two-wheeled vehicle maker (see Riding solo, page XX). In clinching the deal, the two funds fought off stiff competition from other high-profile private equity firms such as Carlyle, KKR, TPG and Warburg Pincus.

Foreign funds dominate

As in most markets, there are two kinds of PE investors in India: foreign and domestic. A 2010 report by the IVCA says that 72% of all venture capital and PE investors between 2004 and 2009 were foreign.

Many of these stayed on the sidelines during the global financial crisis as Indian entrepreneurs were unlikely to sell stakes at heavy discounts and it was difficult to identify the bottom of the market. Now foreign funds are again pumping money into India and in doing so, Deshmukh says, “they have certainly driven up valuations”.

Nitin Deshmukh CEO - PE Kotak Mahindra

As a result, some domestic funds, which account for the majority of early stage venture capital and private equity investments, are sitting it out until better opportunities emerge. Deshmukh predicts this will happen when a “return disaster” brings valuations down.

Growth prospects

High valuations are just one of several problems facing investors. Still, the macro picture is one of inexorable growth. “The fact remains that India is too large a market to ignore,” says Shantanu Surpure, the managing attorney of PE specialist law firm Sand Hill Counsel in Mumbai. “Despite various negative elements … private equity investments in India will continue to grow in 2011 because the Indian economy will continue to grow at a high rate and companies require capital to benefit from that growth.”

Shantanu Surpure Managing Attorney Sand Hill Counsel

Surpure expects PE growth to be focused on seed and early-stage deals. But the areas that attract investment may change.

“Over the past five to seven years, the India growth story has made a tectonic shift from being essentially an exports-driven story to a huge domestic-consumption story,” says Vijay Sambamurthi, the founder partner of Bangalore-based Lexygen.

As a result, says Shubhada Bhave, head of the India practice at Cotty Vivant Marchisio & Lauzera in Singapore, “there are strong indications that PE activity will increase in 2011 largely driven by growing domestic consumption in India.”

Importantly, as Akil Hirani, the managing partner of Majmudar & Co, observes: “India gives a dual opportunity to companies … there is potential for exporting from India – considering production costs are still relatively low – and there is also potential to sell in India’s huge markets.”

Whether India’s growth is export-led or domestic consumption-driven, “the recent opening up in practical terms has led to a spurt in PE investment,” says Ravi Singhania, a senior partner at Singhania & Partners in Delhi. “The current growth should continue,” he predicts.

Unique characteristics

The PE landscape in India is unusual in that entrepreneurs are generally unwilling to give up control of their companies. This often leaves only minority options open to investors.

“Most private equity deals are shaping up as minority investments rather than buyouts, which permit liquidity events while limiting change of control or outright sale,” says Deepak Nanda, a partner at Foley & Lardner in Los Angeles.

Deepak Nanda Partner Foley & Lardner

But this could be changing, partly because domestic capital is expensive and foreign capital inaccessible, which makes PE an attractive option for growing companies.

Sambamurthi recognizes that most Indian entrepreneurs like to hold on to their companies. But pointing to a recent deal he worked on, in which a consortium of buy-out funds successfully took over an Indian listed technology company, he says there is “an increased openness to buy-out transactions”.

“A lot of deals [are] being cooked right now,” says HV Harish, a partner at Grant Thornton India in Mumbai.

Vishal Gandhi, the managing partner of Gandhi & Associates in Mumbai, expects PE deals to multiply: “Combine a growing economy with a deep pool of entrepreneurs, promoters and limited opportunities to raise capital and PE is poised to grow,” he says.

“A very important driving factor is the impressive growth of small and medium-sized enterprises [SMEs] in India and the requirement for … growth capital,” says Krishnava Dutt, the managing partner of Argus Partners in Mumbai. “Though SMEs were hard hit during the financial meltdown, this sector is showing positive signs of growth and has generated a lot of interest among PE investors,” Dutt says, adding that while negative sentiments persist, “in the long run I do not see these having a material impact on the growth of PE investment”.

Diljeet Titus, the managing partner of Titus & Co, cites another promising development. “The emergence of entrepreneurs in India who consider PE their full-time occupation has also created an environment for PE investment,” he says.

Changing fashions

In 2007 the hottest sector for private equity was real estate, for which 10 funds raised US$3.2 billion. By 2009 the allure of real estate sector had diminished and just US$700 million was raised. This figure dropped to US$100 million between and January and October 2010, according to Preqin, a private equity research company.

Currently, the most fashionable sectors include infrastructure, manufacturing, pharmaceuticals and education (see Choosing the right sectors, page XX).

“The infrastructure sector accounts for the majority of PE investments in India,” says Shigeyoshi Ezaki, a partner at Anderson Mori & Tomotsune in Tokyo.

According to Preqin, India will need US$1 trillion in infrastructure investment over the next five years. To date, some 38 foreign India-focused infrastructure funds – half managed domestically – have raised US$9.5 billion.

Macquarie State Bank of India Infrastructure Fund, for example, invested US$200 million in GMR Airports Holding, a unit of GMR Infrastructure, in late-March. This US$2 billion fund, the largest overseas PE fund in the sector, was formed jointly by Australia’s Macquarie Capital Group and India’s State Bank of India.

In August 2010, Blackstone announced plans to invest US$4 billion over the next five years in infrastructure in India. Other active funds include 3i India Infrastructure Fund and Trikona Capital. Nine more are expected to start up in 2011.

Infrastructure “has received an impetus in the form of increased funds and tax-related incentives” says Bhumesh Verma, a partner at Paras Kuhad & Associates in Delhi. The introduction of tax-free bonds, infrastructure debt funds, tax incentives and a comprehensive policy for public-private partnerships all play a role in making infrastructure a good bet.

Most of the investments so far have gone into power and energy, roads and highways, but other areas, such as ports and logistics are growing rapidly. “PE investors have a strong belief that urban infrastructure areas such as water, sewage systems, solid waste management and waste water management will also offer strong growth potential,” says Ezaki.

Other hot sectors

Other hot areas for private equity include IT, outsourcing, retail and financial services. In mid-March, the insurance sector was given a boost from a visit by Warren Buffett.

Buffett came to persuade India’s billionaires to give to charity, but took the time to meet holders of insurance policies in Delhi. Although his company, Berkshire Hathaway, merely sells the policies of another company, Bajaj Allianz, he talked up insurance in India.

“I really cannot think of a more authoritative stamp of approval for the prospects of this sector,” says Luthra. “On many other fronts, I would say that we are moving in the right direction, with FDI restrictions about to be relaxed in some sectors,” he adds.

One such sector could be retail, where prospective investors are lobbying for the easing of restrictions. India currently allows 51% FDI in single-brand retail and 100% in cash-and-carry stores. In July 2010, the Department of Industrial Policy and Promotion (DIPP) released a discussion paper on permitting FDI in multi-brand retail chains, but as yet no decision has been taken. The delay is frustrating PE investors.

Investor-friendly changes

PE investments are regulated by the Securities and Exchange Board of India (SEBI) through the SEBI (Venture Capital) Regulations, 1996, and the SEBI (Foreign Venture Capital) Regulations, 2000, which apply to domestic and foreign funds respectively. In addition the government’s policy on foreign direct investment (FDI) is regularly updated by the DIPP.

Bhattacharya at Hemant Sahai Associates says that one of the most significant recent developments on the regulatory front has been the advent of circulars that consolidate FDI policy. These circulars, which have been published at six-month intervals since March 2010, have gone a long way towards demystifying FDI policy and making it more accessible.

Ragi Singh, an associate at Wragge & Co in Birmingham, UK, expects the increased clarity brought about by these circulars to encourage investment.

Another important development is the decision to allow mutual funds registered with SEBI to accept subscriptions by foreign investors beyond just foreign institutional investors, which was announced in the recent budget (see Learning new rules, below). Observers say this will give Indian mutual funds direct access to foreign investors and will widen the class of foreign investors in India’s equity market.

“The government is pushing for more and more legislation that will facilitate broader investment,” says Nanda at Foley & Lardner. “Many see the proposed changes as a positive sign that India is attempting to become friendlier towards foreign investment.”

Regulatory challenges

Despite these welcome developments, many foreign investors believe that the pace of regulatory liberalization is too slow.

“Private equity investors are frustrated by the mixed signals about the timeline for opening up,” warns Valérie Demont, a partner at Pepper Hamilton in New York.

Valerie Demont Partner Pepper Hamilton

For example, foreign investors have been limited since 1999 to 26% ownership of Indian insurers, which means MetLife’s US$139 million investment in India cannot get any higher. Speaking recently to the New York Times, MetLife’s chief executive for Europe and India, Shailendra Ghorpade, said while the company’s “commitment to India is as strong as it ever was … we would like to see an opportunity for us, and people like us, to participate fully in this marketplace.”

Calls to speed up the pace of liberalization are accompanied by complaints about the level of complexity in the current rules. Indeed, regulatory ambiguities and disagreements over the interpretation of regulations have long been a source of discontent among investors.

A case in point is the Vodafone tax controversy, which has “resulted in much uncertainty surrounding the economics of investments and business transactions,” says Demont.

Dangling a corrot: Investors are spurred on by hints of further liberalization.
Dangling a corrot: Investors are spurred on by hints of further liberalization.

India’s tax department is demanding the payment of US$2.6 billion in capital gains tax on a US$11 billion sale that Hong Kong-based Hutchison Whampoa made to Vodafone. Tax officials hold that Vodafone should have deducted the money from what it paid Hutchison, but Vodafone says that as the transaction happened outside India, no tax is payable. The company argues that if any tax is owed, it is up to Hutchison to pay. Hutchison, however, has already exited India.

In September 2010, Bombay High Court affirmed the tax department’s power to seek capital gains tax on the transaction. As a result, investors have been re-evaluating the tax structures of their deals while they await the outcome of the appeal, which is due to begin on 19 July.

A related concern is the new direct tax code that is set to take effect in April 2012. The code could result in a change to the terms of the double taxation agreement with Mauritius, through which many PE investments to India are routed.

Rana at Goodwin Procter says the change could lead to capital gains made on such deals being taxed even if they are made through entities that hold Mauritius tax residency certificates.

But Rabindra Jhunjhunwala, a partner at Khaitan & Co in Mumbai, welcomes the new tax code, which he thinks will remove inconsistencies. Currently, he says, “India’s overall complex regulatory and taxation regime may act as a significant barrier to PE investments.”

Other observers are worried about recent changes made by the Reserve Bank of India (RBI) to regulations governing the use of compulsorily convertible debentures. These instruments offer protection from equity risks and are routinely used by PE investors in India. The changes – said to be aimed at safeguarding the interests of resident controlling shareholders and promoters – will mean that exit prices have to be decided at the time of entry.

Another area of concern is debt, which is an important component of PE investment. A restrictive regime for external borrowing has hampered investment. “The absence of a developed debt market combined with a very uncertain and complex bankruptcy and insolvency regime … has significantly reduced the attractiveness of investing in India,” says Demont at Pepper Hamilton.

PE investors are also anxious about the coming Supreme Court decision in an appeal by SEBI of a January 2010 decision of the Securities Appellate Tribunal (SAT) in the Subhkam Ventures case. SEBI had ruled that a minority stake in a company was a controlling stake because the investors had veto rights. The SAT reversed this ruling. PE investors are often given veto rights, which many see as giving them control of a fund, explains Sandeep Parekh, the managing partner of Finsec Law Advisors.

Corruption concerns

Legal and regulatory problems aside, many prospective investors cite corruption as a major concern.

Corruption is a “concern to every domestic and international investor,” says Mona Bhide, a partner at Dave & Girish & Co in Mumbai. The Indian press has played a “tremendous role in exposing the scams” and “public awareness in India has been on the rise,” she says, adding that the government has been “responsive, cautious and effective in its dealings”.

Mona Bhide Partner Dave & Girish & Co

Verma of Paras Kuhad notes that “the impact of the scams on market sentiments may not last very long.” Still, corruption affects deals “and requires strict diligence at the time of investment,” says Prem Rajani, the managing partner of Rajani Associates in Mumbai.

Scott Seabolt, a partner at Foley & Lardner in Detroit, notes that according to Transparency International’s Corruption Perception Index 2010, corruption is perceived as being worse in India than in China.

“Exposure under the (US) Foreign Corrupt Practices Act (FCPA) can extend to board members … and to investors in some circumstances,” Seabolt warns. “PE firms making investments in India ignore FCPA risk at their peril”.