Venture Capital and Private Equity Investment in India

Leonardo von Prellwitz Matricola 931014 Tutor: Prof. Stefano Bonini

Table of Contents

1. PREFACE........................................................................................................................3 2. INTRODUCTION .............................................................................................................4 3. A BRIEF HISTORY OF VENTURE CAPITAL IN INDIA ...................................................5 4. STRUCTURE OF FUNDS IN INDIA ................................................................................6
DOMESTIC FUNDS............................................................................................................................................ 6 OFFSHORE FUNDS ........................................................................................................................................... 7

5. THE REGULATORY FRAMEWORK ...............................................................................8

A) THE SEBI REGULATIONS, 1996 B) THE SEBI REGULATIONS, 2000

................................................................................................................... 8 ................................................................................................................... 8 9

C) TAXATION....................................................................................................................................................

6. PERFORMANCE ...........................................................................................................10 7. THE IT SECTOR ...........................................................................................................15 8. THE REAL ESTATE BET ..............................................................................................17 8. THE CHINESE COMPETITION.....................................................................................19 9. THE BRAZILIAN BENCHMARK ....................................................................................22 10. MACROECONOMICS .................................................................................................24
SHORT-TERM GROWTH .................................................................................................................................. 24 THE SHORT-TERM RISKS ............................................................................................................................... 25 THE CAPITAL MARKET ................................................................................................................................... 26 THE LONG-TERM STORY ................................................................................................................................. 27 Demographics ......................................................................................................................................... 28 Reforms................................................................................................................................................... 29

11. CONCLUSION.............................................................................................................31

1. Preface

This final work has been developed in concomitance with my internship experience at CNBC-TV 18 in Mumbai, India. My intention was to exploit the superior research capabilities and ties of this financial broadcaster in order to have a snapshot of the current situation of Private Equity/Venture Capital (PE and VC) investment in the promising Indian economy.

My position on the research desk at CNBC has enabled me to collect first rate data on the macro-economic picture of the Indian market and to track down key sources telephonically all around the world, from New York to Hong Kong.

Unfortunately most members of the private equity scene in the Indian environment were balking at the idea of disclosing private information about their Internal Rates of Return (IRR) and other details about their funds or their industry.

Moreover I have not received great support from the CNBC database on the PE/VC matter as the broadcaster tracks only listed companies (which are almost non-existent in the Private Equity scene). Arduous as well was my attempt to gather information from institutions such as the Indian Venture Capital Association (IVCA), Venture Intelligence or Bain Capital, who were willing to share their information only in exchange for air-time on CNBC, which I was obviously not in the position to provide.

My gratitude goes to Ryan Tang from the Center for Asian Private Equity Research Ltd. (APER), who has courteously provided me with the IRRs of the Indian and Chinese PE market.

In the end this final work is a rather exhaustive account of the overall Private Equity situation in the Indian country, from the preferred modes of entry to the analysis of its sectorial breakdown to the summary of the burgeoning IT sector.

2. Introduction

The face of global PE and VC is changing dramatically in the last few years. 2006 has witnessed the inception of funds infringing the threshold of $10bn i.e. Blackstones $15bn buyout fund and the venture of KKR (Kohlberg Kravis and Roberts) on listed markets.

At the same time the amounts raised by these funds are growing to unimagined limits (about $300bn in June according to Bloomberg) giving great focus and tremendous attention to these kinds of alternative investments.

Following such developments and the ever mounting pressure of this flattening and globalizing world, there is an increasing need for funds to diversify internationally. The factors stimulating the drive to go global can be summarized in the following:

Globalization

The need of funds to globalize is driven both by their requirement to mitigate their risk exposure by investing in different countries as well as to tap innovation, which is occurring around the globe. Adding an increased international competition and the higher cost of building a company in mature markets, the quest for global cost-efficiencies will mark the rise of future PE and VC trends. Funds increasingly need to look at India, China, Russia and Brazil to take advantage of the global outsourcing and off-shoring as well as to exploit these lowcost/high talent markets. Interconnectedness In a world of cross-pollination, cross-border and cross-sector influences the leading form of investment for global funds will be much like Multinational corporations through international collaboration. Global investors are forced to seek out local funds in emerging innovation hotbeds to help understand the chased market, addressing due diligence in the correct way and penetrate their large developing consumer markets. 4

Scale As the VC and PE industries mature, experts are pointing to a growing divide between the performance of the top-tier players and that of their smaller players, and it goes without doubt that scale is a big contributor to over-performance. A recent survey conducted by the Emerging Markets Private Equity association (EMPEA) states that 65% of interviewed managers declare a future increase in interest (compared to 45% in the same survey in 2004) to invest in emerging markets 1 . According to the National Venture Capital Association (NVCA), India is the second most attractive location, gathering the positive attention of 18% of the American fund managers.

Given these conditions, this research is meant to cover India as a possible investment target: starting from a portrayal of the current Private Equity situation in India; it shall cover the legal and tax angle of funds establishment, the macroeconomic situation and its likely impact in the short and long term.

Moreover it will contain a description of its most renowned investment targets: the information technology industry and the real estate sector. Finally, it will benchmark the current performance analysis to China and Brazil and stress the advantages and disadvantages of India.Inc.

3. A brief history of Venture Capital in India

The History of Venture Capital in India can be traced back to the 70s, when the Government of India, getting aware that an inadequate funding and financial structure was hampering entrepreneurialism and start-ups, appointed a committee to tackle the issue. Approximately ten years later the first three all Indian funds were standing: IDBI, ICICI and IFCI.

EMPEA, EMPEA Second Survey of Institutional Investor Views on Emerging Markets Private Equity, April 2006 http://www.empea.net/research/research.aspx.

With the institutionalization of the industry in November 1988 the government announced its guidelines in the CCI (Controller of Capital Issues). These focused on a very narrow description of Venture Capital and proved to be extremely restrictive and encumbering, requiring investment in innovative technologies started by first generation entrepreneur. This made investment in VC highly risky and unattractive. At about the same time the World Bank organized a VC awareness seminar, giving birth to players like: TDICICI, GVFL, Canbank and Pathfinder. Along with the other reforms the government decided to liberalize the VC Industry and abolish the CCI, while in 1995 Foreign Finance companies where allowed to invest in the country.

Nevertheless the liberalization was short-spanned, with new calls for regulation being made in 1996. The new guidelines loopholes created an unequal playing ground that favored the foreign Players and gave no incentives to domestic high net worth individuals to invest in this industry.

VC investing got considerably boosted by the IT revolution in 1997, as the venture capitalists became prominent founders of the growing IT and telecom industry. Many of these investors later floundered during the dotcom bust and most of the surviving ones shifted their attention to later stage financing, leaving the risky seed and start-up financing to few daring funds.

4. Structure of Funds in India

Given Indias peculiar Regulations and investment environment, three main types of fund structure exist: one for domestic funds and two for offshore ones.

a) Domestic Funds Domestic Funds (i.e. one which raises funds domestically) are usually structured as: i) a domestic vehicle for the pooling of funds from the investor and ii) a separate investment adviser that carries those duties of asset manager.

The choice of entity for the pooling vehicle falls between a trust and a company (India, unlike most developed countries does not recognize a limited partnership), with the trust form prevailing due to its operational flexibility.

b) Offshore Funds

Two are the common alternatives available to offshore investors: the offshore structure or the unified structure.

Offshore structure Under this structure, an investment vehicle (an LLC or an LP organized in a jurisdiction outside India) makes investments directly into Indian portfolio companies. Typically the assets are managed by an offshore manager, while the investment advisor in India carries out the due diligence and identifies deals.

Unified structure

When domestic investors are expected to participate in the fund, a unified structure is used. Overseas investors pool their assets in an offshore vehicle that invests in a locally managed trust, whereas domestic investors directly contribute to the trust. This is later used to make the local portfolio investments.

5. The Regulatory framework 1

From 1996 until 2000, the Securities and Exchange Board of India (SEBI) was empowered to regulate only domestic funds, leaving a consistent edge to foreign investors. In order to monitor (if not regulate) foreign investment in the VC sector the SEBI introduced a new set of regulations applicable to offshore funds, called the SEBI Regulations, 2000.

a) The SEBI Regulations, 1996 Under the VCF Regulations a venture capital fund can be established either in the form of a trust or a company. Though the guidelines do not appear to make registration with SEBI mandatory, the institution has made its intention clear to regulate all domestic VCFs. These are subject to investment conditions/restrictions such as: i. Aggregate minimum capital commitments from its investors should be Indian Rupees 50 million (~850.000 EUR, ~$1m) ii. A VCF cannot invest more than 25% of its aggregate Capital Commitments in any one Venture Capital Undertaking (VCU)

b) The SEBI Regulations, 2000 (Foreign Venture Capital Investment-FVCI) Foreign VC/PE players can invest in India either directly under the foreign direct investment (FDI) regime or may invest under the FVCI regime. While it is not mandatory to register with the SEBI as a FVCI, several benefits have been granted to registered users.

Investment conditions/restrictions

i. ii.

FVCI is permitted to invest its entire corpus in a domestic SEBI VCF While 2/3 of its investible funds must be placed in unlisted equity shares, the remaining third might be invested by the FVCI in: Debt or debt instruments of a VCU, in which the FVCI has equity

Primary Source: Indian Venture Capital Journal, Volume 1/ Issue 1 2005, Indian Private Equity: Venturing into India, p.34-38; Fenwick & West LLP [Greguras, Stafford and Gopalan 2006], 2006 Update on Structuring Venture Capital and Other Investments in India.

Preferential allotment of equity shares of a listed company, subject to a lock-in period of 1 year Equity shares or equity linked instruments of a financially weak, listed company (i.e. eroding between 50 and 100% Year-over-Year) The FVCI will have to appoint a domestic custodian and open a special, nonresident currency account at a bank.

Benefits

FVCIs registered with the SEBI are entitled to benefits such as Transfer of shares between residents and non-residents will not be subjected to the restrictive pricing guidelines existing for the FDI route.

Exemption from both entry and exit pricing regulations (especially significant in
case of strategic sale or buy-back arrangement with promoters)

c) Taxation

As delineated above, taxation to be borne by Funds investing in India can range from 0 to 40% according to temporal and jurisdictional factors.

Many Offshore and Domestic Funds choose the jurisdiction of Mauritius to take avail of the benefits applicable under the double taxation avoidance treaty (DTAT). Under the India- Mauritius DTAT, any capital gain earned by a resident of India is exempt from tax in India. Further, the withholding tax (WHT) on dividend also gets reduced to 5% as against normal applicable WHT of 20%.

In other words, there is no Indian tax on sales of shares in an Indian company by a Mauritius company.
Sources of Foreign Investment

4% 15%

4%

4%

20%

Mauritius USA Netherlands Germany UK

21%

Japan Other

32%

6. Performance
Private Equity Investments in India
12000 10000 Value ($m) 8000

Indias growth in Private Equity Investment during the last four

10000

years is more than astounding (approximately at 240%).

Even more bewildering

6000 4000 250 2000 0 20 80 500 1160 937 590 4000 2300 774 900

is their rise from a country that barely existed on the PE

landscape as far as 1997.

M 5 ay -0 6 20 07 F

19 9

19 9

20 0

20 0

20 0

20 0

19 9

19 9

20 0

20 0

Only in 2005 the value of PE deals have increased by 85, while their number rose up

Data by: IVCA/Venture Intelligence India/Nasscom Research

from 68 in 2004 to 147 in 2005 (with more than 10 deals over $50 million).
Own elaboration on data by Securities and Exchange Board of India (SEBI). All charts and pies are of own elaboration when accompanied by the Data by tag.
1

10

With more than 100 India-centric VCFs/PEFs (May 2006) and forecasts ranging between $25-35bn (depending by the speed of the privatization process as stated by the Asian Development Bank) invested by 2011, India stays on the map of all the major players in the Industry together with China.

PE is predicted to make a significant mark in India.Inc, as investment by private equity firms is at $4bn (May 2006) versus a nominal GDP of $650bn (2006 consensus forecast by www.securities.com) and thus ratios to about 0.61% of it. With the increased commitment from global funds and investment by Indian banks into PEFs, the number of deals is clearly northbound over the next decade. Nevertheless, an overheated market may become risky, as it contributes to the build-up of other bubbles in the markets and a capital overhang.

Profitability of the deals is increasing as well, with a burgeoning share of divestments ranging in the 100% to 500% IRR area. Since 2004 some deals over the 500% IRR have appeared, signaling an extension not only in quantity but also in the quality/ critical mass of the deals. On the dim side a small intensification of negative range IRR is almost inevitable with the growing number of deals.

Range of IRR Over 500% 100% to 500% 1% to 100% 0% -1% to -100% Total

2002 0 1 11 1 2 15

2003 0 0 7 3 2 12

2004 2 3 14 0 2 21

2005 Total 4 12 13 0 4 33

6 16 45 4 10 81

Source: Survey by Centre for Asia Private Equity Research Limited

Even more attractive is the statement of the Center for Asia Private Equity Research Ltd. (APER) that the median return of the exits since 2002 was a very healthy 30%. Comparing this data with neighboring competitor China, the results seem to indicate that India so far has yielded less intense IRRs (witness the 37 deals with 100-500% IRR in China), yet has posed significantly less risk to investors (who tumbled in year 2004 with a staggering 11 disinvestments in the negative range).

11

The reasons cited most commonly for deals falling through in India are differences over valuation, combined with the fact that family owned businesses are finding it difficult to hand over rights to a private equity firm in view of the availability of numerous funding options. The same applies to listed companies, as these are held under tight control, usually by the founders and act more like privately held firms.

China Range of IRR Over 500% 100% to 500% 1% to 100% 0% -1% to -100% Total

2002 0 1 5 0 3 9

2003 0 2 5 1 2 10

2004 1 10 17 0 11 39

2005 Total 6 7 24 37 13 40 0 1 2 18 45 103

Source: Survey by Center for Asia Private Equity Research Limited

In 2006 also the geographical scope of players grew wider with a considerable attention from Japanese, Middle East and European Firms pitching their tents in India. Some of the new names include Mitsui, Sumitomo (Japan), Ishtamar and Abraj Capital (Gulf).

Acting as a magnet was last years sensational deal, when Warburg Pincus sold a chunk of its stake in cellular player Bharti Tele-Ventures for $560m. So far, Warburg (which invested ~$300m in Bharti between 1999 and 2000) has made $1.1 billion selling two-thirds of its 18% stake in Bharti.

Some of the U.S. titans have freshly entered or are just about to make a move. Kohlberg Kravis and Roberts (KKR) entry in India coincided with its 85% acquisition in Flextronics International including its Indian operations for $900m, in what became the biggest buy-out in the Indian IT space. At the
Investments by Stage 2004 2005 (2004,2005)
60 50 40 30 20 10 0

same time the arms of Blackstone and Carlyle have opened their Indian funds and will strike their first deal in the nearest future.

No. of deals

Significant developments in 2005 have included increased focus by many funds on larger and
ro w th Bu yo ut La te PI PE

Ea rly

mature deals. This included Private Issue of 12

Data by: IVCA

Public Equity (PIPE) deals- a sale of one or more publicly quoted shares to one or more private investors- which almost tripled- across sectors. Moreover, according to research firm Venture Intelligence, the share of PIPE to other type of deals advanced notably, as it came to cover 49% of all deals in 2006Q1 and whopping 67% in the second quarter. The only stage to remain stagnant was the early one, with no significant evolution. Buyouts were rather rare, collecting only five deals in 2005 with a total value of $185m, especially given the buoyant IPO options that courted enterprise up until May 2006. On the other hand 2006 especially the second half will probably be under the aegis of a buy-out boom, as Private equity players will exploit the tumbling Price Earnings ratios to strike deals with advantageous valuations.
Stage of Investment

Moreover, the buy-out boom will be

60% 51% 50% 40% 25% 30% 20% 10% 0% Early Growth Late Buyout 15% 17% 11% 16% 22% 44% India World

driven by the need for consolidation of most Indian by industries, the partly mounting on will Indian prompt

expressed competitive

pressure which

conglomerates,

owners to focus on core business and hive off less central companies.

Finally, the boom will be driven by the opening up of enterprises, needy of

Data by: IVCA, PWC Money Tree, NVCA

capital and expertise to venture in the international market. As depicted by the graph above, the Indian PIPE/Buyouts stage lags behind the world average and retains a rate of 44% of total investments (against a 51% average in the rest of the world).

Predictably, the stage harvesting an above average amount of investments is the late one, bolstered by the rallying capital markets up until May 2006 and beating the world average by 8% (with approximately 25% of the investment).

13

Sector-wise break-up
SECTOR Automotive Aviation Finan. Services Cement Energy & Power Food & Beverages Hotel IT & ITES Manufacturing Media & Entertain. Pharma & Biotech. Shipping Telecom Textiles & Apparel Others Total No. of Deals 7 5 10 4 4 5 6 22 5 8 19 3 4 10 12 124 % of deal volume 5.60% 4.00% 8.30% 3.20% 3.20% 4.00% 4.80% 17.70% 4.00% 6.50% 15.30% 2.40% 3.20% 8.10% 9.70% 100.00% Total Deal Value 194 51 185 88 128 144 61 244 67 142 374 70 15 107 163 2033 % of deal value 9.60% 2.50% 9.10% 4.40% 6.30% 7.10% 3% 12% 3.30% 7% 18.40% 3.40% 0.70% 5.20% 8.00% 100.00%

Data by: Grant Thornton Research

IT & ITES had the maximum number of private equity deals with 22 deals in 2005, followed by pharma, healthcare & biotech, banking & financial services, textiles & apparel and media & entertainment. A sector wise break-up is shown in the table below. Especially poised for a growth trajectory are manufacturing, which experts predict will grow exponentially in the high-end region, as well as investments based on Infrastructure and Real Estate. The Projected EPS growth table below shows that an ICICI Bank research forecasts consumer goods are set for a whopping 147% increase, while Construction is set for some 95% growth).

14

Projected EPS growth for Indian listed companies 2005-2007 Consumer Goods 147% Construction 95% Life sciences 84% Retail 86% Engineering 86% IT 73% Auto Parts 57% In terms of sector-wise break-up, Pharma, healthcare and biotech emerged as the largest sector with 18.4% share of all PE investment, having received $ 374 million in 19 deals. The Pharma sector has been long in the eye of private equity investors as it is extremely fragmented. The number of companies competing in the domestic number reach astonishing numbers as high as 50.000 (according to the Asian development Bank),with the top 20 combined hold less than 20% market share. The other significant sectors were IT & ITES with 12% of deal value, automotive with 9.6% and banking & financial services with 9.1%.

Data by: ICICI Bank Research 2005

7. The IT sector
India entered the map of international business map through off-shoring. Today, it is uncontested market leader in Business Process Outsourcing (BPO) and is rapidly progressing into the next phase of industry evolution Knowledge Process Outsourcing (KPO).
Investment in IT & ITES ($m)

Given Indias ~44% global market share for software and back-office

26,6 17,4

64,15 IT Services ITES Others 160,37

service and a sector set to grow from $6bn to $10bn in revenues by 2010, there is plenty of

120,27 50,11

Netw orking tech. Softw are Products Communication tech.

opportunities for VCFs and PEFs. According to research conducted by Nasscom (the Indian IT

Data by: Indian Venture Capital Journal

industry entity) and McKinsey & 15

Co 1 , the ITES-BPO industry is growing at over 50% and is expected to employ over 1.1m Indians by the year 2008.

As illustrated in the pie investments in IT Services and ITES take up as much as 50% of the total VC/PE spending in the IT sector, amounting to ~$210m. Coming trends for the BPO sector are: consolidation of Third party providers to gain economies of scale and the emergence of niche players with deep domain knowledge and expertise.

Unlike BPO, which may be tagged as cheap labor outsourcing, KPO represents more of a high-end consulting business, and could be a trampoline for India.Incs large pool of low-cost English speaking, scientific, technical, academic and professional talent.

According to research conducted by Evalueserve India is set to capture 71% of the world KPO market, with a share totaling to $12bn and a compounded annual growth rate close to 50% for the next five years.
Expected IRR from BPO investment

The next KPO wave is set to gather huge

35-45% IRR

quantities of investments, as customers will increasingly go through the acquisition route rather than setting up their captive offshore centers. As shown in the charts PEFs surveyed
25-35% IRR

by the Indian Venture Journal are quite bullish about their investments in the BPO sector,

Preferred Investment Stage

forecasting an IRR in the 25-35% orbit.

13% 25%

Mirroring the global trend, the bulk of Funds (49%) prefer to allocate their assets in already proven companies. Firms that are able to reach a

13% 49%

critical mass of $35-40m in revenues and that have grown into a 4000+ people strong are the prime targets of capital infusion.

Early

Expansion

Mezzanine

Other

Data by: Indian Venture Capital Journal

Indian Venture Capital Journal, Volume 1/ Issue 1 2005, The BPO Opportunity, p. 08-19

16

On the other hand, to start-up BPO firms have to exhibit a clear cut strategy and are increasingly differentiating in multiple niches as the market becomes more and more mature. Finally, market analysts in India are betting on a great comeback of the IT sector in the stock market and predict a big jump especially given its underperformance in the recent year.

VC investment, bolstered by a regained market confidence, is thus likely to soar within the next years especially in the early phase while buyouts are likely to occur within the near future, as valuations of IT companies are likely to pick-up with the rebound in the sector.

8. The Real Estate bet

Ever since the Indian government eased the rules on foreign finance in construction in early 2005, several funds, especially from the U.S: have been trying to invest in Real Estate projects and companies.

India suffers from a well publicized infrastructure problem that stems from the combination of an enormous population and socio-democratic politics. It lags in overcrowded airports, decaying roads, railroads and ports, as well as shortfalls in areas such as hotels, power, water and hospitals.

This issue of inadequate infrastructure has been labelled by Prime Minister Manmohan Singh as a top priority, emphasizing the private sector. According to some funds, the need for investment in infrastructure in India lands the $150bn tally and gives a lot of leeway for fund raising as well as plenty of opportunities.

Given a) the purported sum of $10-12bn committed by domestic and international property investors in 2005 and b) the rising economy, prices have leaped 30% to 100% to unsustainably high levels (as high as 60% per annum growth in the city of Mumbai) creating a valuation mismatch. 17

Furthermore, valuations of the few listed companies are sky high as there are a very limited number of them to be traded. For example, Price earning ratios for property firm Unitech Ltd. Trade reached as high as 477 times earnings and stocks in the sector rose as much as 2000%.

This has brought the Reserve Bank of India to worry about an asset-price bubble and intervene through an increase in the risk weightage on real estate loans by banks, discouraging the mortgage rates from 7.5% to 9.5%. Nevertheless, according to a Merrill Lynch forecast 1 the Indian realty sector is poised to grow 780% within the next ten years, leaping from 2005s $12bn to 2015s $90bn in value.

Following this trend, other firms jumped in the game attracted by Internal Rates of Return north of 25%. IDFC Private Equitys first fund, closed in 2004, had two exits, both with returns over 100%. Morgan Stanley invested $68m for a stake in Mantri developers Private Ltd., Tishman Speyer tied up with Indias ICICI Bank to pour $1bn into the country. India focused Real Estate funds have already raised as much as $2.7bn, and players like Warburg Pincus state that one third of their research time is spent considering real estate opportunities.

Overbuilding and non-differentiation of shopping centres give ample room for restructuring by private equity funds. Of the several hundreds of shopping malls currently under construction only one tenth is bound for survival.

Yet, as managers of diverse international funds put it, India is one of the last few countries where there is primary demand for Real Estate, rather than individuals trading up the price of property making the bubble less likely to explode anytime soon.

Y. A. Pitawalla for Fortune Magazine, Indian Real Estate: Boom or Bubble?, July 2006, pp. 14-15

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8. The Chinese competition

China the world fastest-growing major economy accounted for 22% of private4500 4000 3500 3000 3000 2500 2000 1500 1000 500 0 2004 2005 May-06 1250 3900

Private equity Investments in China

equity investment in Asia last year, and ranked second only to Japan (35%) in 2005.

Value ($m)

Nevertheless, the India-China divide in Private Equity is not as large as in foreign direct investment, where China boasted impressive $55bn versus the Indian trifling

Data by: Center for Asia Private Equity Research/Bloomberg

$5.3bn in 2004. Incredibly Chinese PE investment in the current year may come to a tie with that in India.

Flows in 2006 are forecasted at $6bn (APER) and judging from the deal frenzy occurring in India.Inc, investments in the latter may as well supersede the Chinese ones. Pure Venture Capital flows are tallied at $775m in the first semester of 2006, scoring a 100% increase year over year. According to the Economist Intelligence Unit (EIU) 1 , China lines up at number 33 in 2005s PE environment poll. It lags behind India (32), Mexico, Russia (30), and Brazil (29).

Worst negative driver is the countrys infamous legal/policy environment. Legislation on foreign investment is arbitrary to say the least. Growth in Funds during the first half of 2005 was hampered by a regulatory initiative known as Circular 11 and 29 by the State Administration of Foreign Exchange (SAFE), that halted the establishment of offshore structures to exit a Chinese company investment through an IPO on a foreign exchangerecently SAFE issued a new circular, with new rules that should bolster investment in the coming year.

Apax Partners, Unlocking Global Value Report, Section 3.

19

Disreputable as well is Chinas corrupt judicial system, the lack of a venture capital law (VC has no legal definition whatsoever in the country) and a weak implementation of Intellectual Property laws.

Moreover, unlike in India, Chinas sizeable market lacks management quality and has restricted access to high-end labor, thus limiting opportunities for investments. On the other hand, the advantages of the Chinese hotbed and its long-term appeal are obvious. Chinas racy economy is on track for a fast liberalization and its GDP growth (+10.2% in 2006Q1) is a huge driver for investments. The global liquidity crunch in May 2006 seems to have affected the Shanghai composite index less than other emerging markets.

The rate of return of PE so far has been captivating to say the least. The 48 Exits in 2005 raised $1.86bn, compared with 45 Exits valued at $1.05bn in 2004- 44% of 45 surveyed exits last year had an IRR of more than 200%. Furthermore, deal sizes are to be pushed up by the ever-increasing competition on the mainland.

State-owned companies are and will be looking for strategic foreign investors in the coming years. The latter were given access to the countrys domestic share market in February with a requirement to buy at least 10% for three years. This sale is generating a fluctuating environment for buy-out investors, as the State doesnt want to sell off its assets cheaply and is yet in desperate need for foreign expertise.
Data by: APER

China PE investments by sector (2003-2005)

26% 14% 7% 53% Other Manufactoring Fin. Services IT & ITES

The biggest private equity buy-out, signed by the Carlyle Group last October, was quoted at $375m for an 85% stake in equipment maker Xugong, yet is still waiting for regulatory approval.

On the VC side things are especially favorable in the high-tech sector. Landmark IPOs- such as Baidu.com- and record shuttering acquisitions have attracted momentous 20

$1.06bn in more than 200 venture capital deals60% of which went into Internet-related firms (Zero2IPO Ltd.).

Disadvantageous is the missing link to U.S. companies. Unlike India, where a large number of companies are co-based in the U.S., thus enabling an IPO or a sale in the latter, Chinese firms have a harder time reaching the U.S. market.

With 28 Chinese companies listed on the NASDAQ, the government has started to realize the importance of this pattern, launching the independent innovation strategy to nurture the environment for VCs, with tax breaks for high-tech companies and a renewed emphasis on the protection of Intellectual Property.

Incremental Value of PE reaching 1% of GDP

30

The

tremendous

growth

path/potential of the Chinese PE industry is clearly to be gleaned

21,684

Investment in $ (bn)

25 20 15 10 6,56 5 3,9 0 4

Potential 2005

from the chart on the left. India, with 0.61% of PE spending on GDP, is soon to become over-exposed to this kind of investment. China on the other hand with a GDP that is more than three times bigger than India (about 2.2 trillion dollars according

China

India

Data by:APER/IVCA/IMF/www.securities.com/ Economist Intelligence Unit

to IMF- April 2006) and a PE investment of mere $3.9bn could face an incredibly steep prospering of flows to the PE industry if it is able to regain the confidence of investors through a host of structural and legal reforms.

Considering more than 3 million privately owned companies in China, firms like China Private Equity partners believe that around 3.000 of these would qualify to comply with Sarbanes Oxley and be listed on the NASDAQ or NYSE.

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9. The Brazilian benchmark

Investment in Brazil
2,5

Even though Brazil still does not figure among the most coveted global hotbeds, the figure of investment in the country is rising with similar growth rates as India and

Investment in $bn

1,5

China.

From $1bn of PE investment received in

0,5

2005-about one third of the investment in China and slightly less then half the one in
2004 2005 June 2006

Data provided by: abvcap.com.br/valor econmico

India- 2006 is showing the same dramatic increase in interest in Private Equity, boosting more than 100% expansion in investment over the first six months of 2006.

This followed the decision by the government in 2004 to allow PEFs and VCFs to exit their investment through IPOs. This increased the appeal of the sector incredibly, thus attracting the states biggest Pension funds (such as Petronas and the state development bank) to expand their participation from close to zero in 2004 to around 1% in early 2005, reaching over approximately $225,1m.

Just like India, the Brazilian PE scene is young, having its inception date in 1995. Nevertheless, Brazil has already witnessed Private Equity frenzy, as the second half of the past decade saw $5bn enter the country in a widespread euphoria that was the dotcom boom. As a legacy of that, funds in Brazil are considerably older than in India and-china and are marked by a deeper maturity of domestic investment.

Today Brazil features whopping $4bn in divestments through IPOs and PIPEs in the last 12 months. The period starting from 2004 saw 20 IPOs 13 sponsored by PEFs and VCFs with top of the class investments in credit card manufacturer American Banknote and software enterprise Totus.

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The beddings of the Brazilian economy are the main attractive for investment. Goldman Sachs BRICs report projects Brazil economy to widen by about 4% for the next thirty years, and even though such a rate lags the Indian and the Chinese one, the Country .comes out of long period of stability and it does not fare institutional risks as in countries like China and Russia.

The countrys capital market is renowned for its long history the countrys stock exchange is about 115 years old and its stellar performance, with a weighty 73% jump of the countrys main index within the last 12 months. The recent liquidity crunch may boost both the Mezzanine as well as the Buyout side of Private Equity investment. Brazils capital market appears less rocky than the Indian one and on the wake of the shake-out in May it could display a preferential route for Private equity investors over the short-term. Moreover, also long-term opportunities are alluring. As addressed by Apaxs Unlocking Global Value report, most of the second generation entrepreneurs are increasingly looking for Private Equity rather than family members to take over their businesses.

In the limelight for venture capitalists is Brazils experience with the new global trend of bio-energy investment it is the only country with a fully fledged distribution network of ethanol fuel stations as well as deeply entrenched culture for technological development, with a towering 250 university incubators active in the country.

In fact, entrepreneurial environment is cited by the Economist Intelligence Unit as the countrys most alluring factor, ranking 21st in a list of 33 countries (as stated above the country as a whole is pecked at number 29, the highest among the BRIC countries). On the other hand, growth in the sector is embarrassed by Brazils overtly complex system of corporate and indirect taxation as well as the absence of seed finance.

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10. Macroeconomics
Short-Term growth Even the governments forecast was topped in Fiscal Year (FY) 2006 as the economy grew 8.4%. The underlying drivers responsible for such a notable expansion are still in place and are set to guide India to another set of record years. With an economy predicted to grow 7.7% and 7.4% in the next couple of years (Merrill Lynch estimates). The reasons for such a towering growth are the so-called DRG factors (demographics, reforms and globalization): Domestic Consumption underpinned by a strong change in demographics leading to a sharp increase of income levels Government policies continuing to focus on building better infrastructure and cutting the red-tape. The FY 06-08 spending is predicted to top US $109bn, a rise of 61% compared to the last 3 year period. Investment spending and Capex are on the upswing as companies enhance capacities and exports remain strong. Besides the DRG factors India Inc.s long term growth story perches on a strong upswing in: International relations, Rule of Law and a transparent and fairly taxed capital markets.

The advantages it poses over the other emerging markets (EMs) can be summarized in: Economy: least dependent market on commodities with a solid export growth story Markets: The diversified markets with a substantial Return on Equity percentage give an invidious valuation in comparison to the other EMs

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Political Structure: Indias democratic structure poses less risk of financial or political anarchy.

This structure is particularly appetible for international companies that are entering the country in droves and are competing to gain the best local talent and the best local customers.

The endeavor to entry is manifested by: a) in the increasing share of FDI spending from USD 7.5bn in FY 06 to ~ USD 12bn in FY 07 (with companies like Nokia shifting their whole telecom network management hub to the country); b) the entrance of global financial companies like Goldman Sachs and CSFB or Private Equity players like Blackstone, Carlyle and 3i; c) with billion dollar buyouts of domestic companies like BFL (BPO sector) or DSP (Financial Services).

On the other hand also Indian companies are not staying idle and are boosting their global presence as well as reinforcing their domestic expansion. On top of that, India champions an historical International standing as the last 6 months have seen improving relations of India with all major powers: US (Defense), China (joint oil bids, opening of road route, trade, etc) and ASEAN (Free Trade Agreements).

The Short-Term Risks India, like most other high growth markets is exposed to internal as well as to external risks.

- An anticipated interest rate hike by the Reserve Bank of India (RBI) is the prime reason for the fear of a contracting growth rate in the country, reducing credit growth and abating capex. In April, the RBI warned that the economy needs to prepare itself for higher orders of pass-through into consumer prices. Meanwhile, the economy has been growing faster than expected, posting 8.4% growth in FY06. The RBI had also stressed that India cannot afford to stay out of step with global monetary tightening, and that it will swiftly respond to evolving global developments. With crude oil prices close to $70

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a barrel, and central banks around the world hiking rates, the RBI followed through and is likely to hike the rate at least another 25bp by the end of 2006.

- A US $10 per barrel increase in oil prices from the current ~USD 70 could: increase inflation (WPI) by 2.6% and lower growth by 1%.

- With economic growth still over-dependent on exports, the US current account deficit and the risk of consumer spending crunch as well as a fall of the dollar exchange rate loom on the growth prospects of India.

- An inadequate monsoon could pose a threat to political stability: i) States scrambling to declare themselves flood/ drought affected, leading to misallocation of capital and a hiatus in Reforms (Enam Research)

The Capital Market Even though the Private Equity investment in India has risen dramatically in the last two years, buyout funds have been rather renitent to buy into a market boosting a Price Earnings ratio among the highest in emerging markets and selling to a premium even to the S&P
Sensex Price Earnings
25 20 P/E 15 10 5 0
19 96 19 97 20 00 20 01 20 02 20 03 20 04 19 95 19 98 19 99 20 05 20 06 Ju ne 20 06

Index.

23,3 14,1 12,6 13,6 15,5 12,7 14,7 13,7 9,3 14,4 15,7

20,5

16,3

Data by: CNBC-TV18 Research

The ever-rising Sensitive Index (Sensex) posed a great opportunity to Venture Capitalists trying to place an IPO on a market exuding confidence. From the paltry 3300 points in 26

December 2002 the Index made a spectacular rise to reach quota 12000 in April 2006. The rally took the average price-to-earnings ratio of the 30 stocks that make up the benchmark as high as 25 times earnings. In fact, 2005 saw as much as 25 private equitybacked IPOs on the Indian markets.

After the world witnessed a massive correction on global scale that hit India hardest (given its over-dependence on Foreign Institutional Investors) the outlook for prospective buyout funds has become rosier.

The drop has brought the price earnings ratio to hover around the 16-17 band, still significantly higher than other emerging countries like China. Currently both sides of the private equity spectrum are on the wait: uncertainty waivers IPOs (witness the somber Air Deccan IPO in late May) while buyout funds are deferring their massive entry to the first sign of a bearish market.

Generally IPOs in India are not an easy game as the Indian public markets lack liquidity and many Indian companies are thinly traded. Nevertheless, the markets know how to respond to big names, witness the $560m block trade of BhartiTele-Ventures by Warburg Pincus in a shockingly brief time.

The Long-term story

Source: PriceWaterhouseCoopers

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Scores of investors and funds have been looking at China, but there are many reasons to believe India might be a bigger growth story in the long-run. As portrayed in the graph, India is the only country sustaining rates of growth of over 5% for the next 30 years. Indias service led strategy gives a clear edge in todays globalizing world. Analysts predict an extended period of considerable growth, basing on the two following factors:

a) Demographics:

India currently boasts a population of over one billion people and claims one third of the worlds software engineers. Nevertheless, unlike China, it refrained from applying a one-child policy thus giving leeway to a growing workforce and a decreasing age dependency rate. With over 54% of the population below age 25 and booming middleclass, there is a strong support for a consumer splurge with the Economist Intelligence Unit (EIU) believing that by 2020 consumer spending will be rivaling the bigger European markets. Nevertheless, as stated by Goldman Sachs BRICs report, even though Income per capita will increase by 35 times current level (in 2050), the number will still be small in comparison to other Emerging countries like China, Brazil and especially Russia. This up-rise of consumer spending is particularly going to be beneficial to companies operating (and acquiring) in the consumer goods sector (poised to experience 147% growth as shown in the graph at page) and the lifestyle sector ( leisure, convenience and entertainment).

Moreover, its large base of Englishspeaking population gives it a clear edge in its burgeoning service sector efforts. A deep pool of the

entrepreneurs and executives are expatriates experienced in Western business, in particular U.S. This widespread pool will donate India a different nature of entrepreneurship 28

than China, as these expatriates have worked in many different roles: from managers to doctors or to IT specialists.

Crucially, expatriates will provide for a layer of skilled middle-management that is missing in other Asian emerging markets. Sectors that are going to benefit from this characteristic are likely to be Pharma and Auto components, already starting to expand internationally. As depicted in the graph above, Indias age dependency is on a steeply declining trend; from todays 65% it will tumble to 55% in the next twenty years. By the year 2025, Indias age dependency rate will be lower than Chinas (and other Asian Tigers), and will provide for a long-term advantage over the Western and the Chinese economies, struggling to support their retirees.

b) Reforms Ever since Prime Minister Singh started to exit autarchy in 1991 to save the nation from a financial and economic crisis, Indias share in global trade has grown exponentially.

Since then the country has witnessed an increased liberalization from its hampering license raj, a system of industrial licensing, price controls, selected credit allocation and capital controls. The country has shifted its focus dramatically from the previous emphasis on the small sector to a strategy of international competition, giving leeway to national titans to be forged by mergers and acquisitions-domestic as well as foreign- and able to compete on the global scene.

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Source: World Bank

Nevertheless, the entrepreneurial environment in India strongly lags behind other Emerging Markets. Indias government is constantly afflicted by extreme left members of the parliament that are extremely business unfriendly, provide for political instability and a poor regulatory quality (as shown in the chart above). This makes setting up a venture in India an extremely time consuming and risky.

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11. Conclusion
This research portrayed the image of a blossoming but risky Indian Private Equity scene. The first part expounded in brief how funds investing in India are structured, the loopholes that advantaged foreign funds over domestic ones for years and the preference given to Mauritius as a foreign haven for low-taxed investments in the Indian private equity scene. The second part described the current size of investments, their subdivision through various stages, the differences with their world averages, and their sectorial subdivisions. Furthermore, it continued by depicting the situation in competitor markets such as China and Brazil.

The last chapter was dedicated to analyzing the macroeconomic framework and the likely impact it is going to have in the short and in the long term.

While it is apparent that the Indian market is in an investment boom (at 0.61% of GDP Private Equity investment has about the same ratio as the U.S: or Sweden) and set to grow considerably in the next year at a rate of about 60%.

The main problems in this scenario are: the languishing reforms by an entrepreneurially unfriendly government and a likely demand glut in a scenario not ready to support the bulk of Private Equity players that are streaming to the country.

Political reforms opening India up for trade started approximately in 1992, fourteen years later than the Chinese ones, yet the Private equity spending has already reached a par level between the two markets (with funds like the Intel Capital one structuring bigger funds in India than in China).

In my view, there is an excessive, bubble like concentration of investment that is significantly increasing risk for the players in the market. Returns are high, witness the increasing share of 100-500% IRR exits, but as more and more funds gather around few companies there is a risk in creating a bubble that is likely to burst with a downturn in the market.

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Fortunately for India, it is less dependent on the United States from the export point of view, thus decreasing the likelihood of a downturn on an upcoming consumer spending crunch from the U.S: or the worries connected with their accumulating current account deficit (a problem faced by China instead).

On the other hand, the big role that Foreign Institutional Investors (FIIs) play on the Indian stock market plays a big role in increasing the uncertainty of investments for Private Equity investors looking for an Initial Public Offering and witnessing the markets crash with prodigious speed as FIIs retire their backings all of a sudden.

In my opinion the safe bet in India, providing high returns with a lower percentage of risk is the sector that made India well known around the world: BPO and KPO. KPO is a business that can hardly be any more successful than in India, given the large base of English-speaking and highly skilled labor force.

Other high yield sectors are surely going to be much riskier than the ITES, with the manufacturing sector suffering from the poor infrastructure in the country and facing a competition from China that is likely going to be more lucrative for funds. On the other hand Real Estate is going to provide a mix of highest yield connected with highest risk. Valuations to be achieved by a real estate company are immense, but the same is true with losses to be suffered by an imploding price bubble.

From my benchmark I glean that the Brazilian market is the best one to invest to reap benefits in the short term, while the Chinese one is better for short-to medium term, should an investor have to choose between the two.

India on the other hand is best for the long term, as it is going to lever on its macroeconomic advantages. The sustained long term growth and the decreasing age dependency rate give it an inviting perspective.

The only concern for such a view is an increase in the power of the extreme leftwing representatives, which are a threat for the business climate and for the political stability of the country.

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12. Bibliography
- Apax Partners, Unlocking global Value Report, 2006 - Citigroup, Y. Huang and C. Tan, Asia-Pacific Economic Strategy, June 2006 - Economist Intelligence Unit, Foresight 2020: Economic, industry and corporate trends, March 2006 - Ernst and Young, Transition: Global Venture Capital Insight Report 2006 - Ernst & Young, Renewal and new frontiers, 2005 - Fenwick & West LLP, F.M. Greguras and S. R. Gopalan, Update to Structuring Venture Capital and other investments in India - Goldman Sachs Global Economics Group, The World and the BRICS Dream, February 2006 - Grant Thornton, Dealtracker Annual Issue, 2006 - Grant Thornton, Dealtracker June 2006 - S. Howes, Will India become an economic superpower, March 2005 - Indian Venture Capital Association, PE and VC Investment Trends 2005, personal copy - Indian Venture Capital Journal, The BPO Opportunity, Issue Nr.1 2006 - K. Can and S. Jan, Risk Management in Private Equity Funds: a Comparative Study of Indian and Franco-German Funds, Journal of Developmental Entrepreneurship May 2006 - Merrill Lynch, R. Varma and S. Sharma, India Economics: RBI raises rates unexpectedly, June 2006 - PriceWaterhouseCoopers, The Evolution of BPO in India, April 2005 - PriceWaterhouseCoopers, Destination India: A Brief Overview of Tax and Regulatory Framework, December 2005 - PriceWaterhouseCoopers, J. Haksworth, The World in 2050, March 2006 - PriceWaterhouseCoopers, Global Private Equity Report 2005 - PriceWaterhouseCoopers, M&A Bulletin India 2005 - Wharton Private Equity Review, Finding Value in a crowded market, 2006

- http://www.worldbank.org 33

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