India Control Deals: Are You Buying It?

Author: Tim Burroughs

Asian Venture Capital Journal | 26 Nov 2014 | 16:51

The India private equity buyout thesis is gathering momentum, with economic and generational factors swinging in the industry’s favor. GPs must convince LPs that they have the skills to execute this strategy

Sanjay Chakrabarty claims a significant role in two of India's six largest buyouts. The former managing director at Colombia Capital teamed up with Partners Group last year to buy business process outsourcing (BPO) firm CSS Corp. for $270 million. In January he brought in CX Partners for the $255 million acquisition of Aditya Birla Minacs Worldwide, another BPO player.

On the back of these deals, Capital Square Partners, an investment holding company Chakrabarty set up in 2013 with two colleagues, is expected to launch its first private equity fund. The vehicle will likely invest in Southeast Asia as well as India, but the nascent India buyout thesis is central to Capital Square's strategy.

While Chakrabarty's initial transactions have been in IT services - CSS and Minacs are Indian companies with international operations and revenue, which means getting financing for buyouts is easier - he does not feel the opportunity is limited to this sector.

"Over the next 12-24 months you will see more control deals in sectors that have the alignment of three key elements required for control deals - existing shareholders wishing to cede control, professional management teams and cross-border business," Chakrabarty's says. He declines to comment on fundraising.

Interest in India buyouts has intensified over the last 12 months. Kedaara Capital raised $540 million for its debut fund last year, in part because LPs believed the team could deliver control deals. Everstone Capital and Gaja Capital are among those expecting buyouts to figure strongly in their next funds.

These transactions come from various sources: secondary deals from PE firms; divestments by conglomerates acting for strategic reasons or because they are distressed; and first-generation entrepreneurs facing succession-planning issues.

However, it is unclear how quickly the trickle of deals might become a torrent and not everyone is buying into the narrative. There are also concerns that, while GPs may have the will to do buyouts, they don't have the appropriate set-up and skill sets.

"In India, like other markets in Asia, conditions are only improving in that inventory, entrepreneurs and ownership are maturing and then moderate growth expectations are good for buyouts," says Juan Delgado-Moreira, managing director at Hamilton Lane. "But there haven't been many so far and we don't see an environment in which things are going to change dramatically. The prudent thing to do is not set yourself up as a fund where buyouts need to happen."

Trial and error

Of the approximately 260 India-focused funds that have reached a final close since 2004, fewer than 40 have specifically identified buyouts as part of their remit, according to AVCJ Research. In many cases it is a small portion of a predominantly growth capital strategy. Over the same period, annual average buyout investment flow has amounted to $746 million. This compares to $4.6 billion for growth capital and $1.9 billion for PIPE deals.

So far in 2014, $444 million has been deployed in buyout deals, but it is the previous two years that offered a peek at the scale of the opportunity. In 2012, deal flow reached $897 million, the highest level since the peak of 2007; in 2013, the total surpassed $1.3 billion, the largest annual figure on record. Baring Private Equity Asia's acquisition of Hexaware Technologies and the CSS transaction led the way.

Even when available, not all buyouts have proved profitable. "Actis has done the largest number of control transactions but even their track record is not all one-way - some have done well and some have not," says Alagappan Murugappan, managing director at CDC Group. "Don't underestimate the challenge of being in control of a company in India. It takes a lot of effort and a lot of interaction with a lot of different players."

The Actis portfolio includes the likes of Paras Pharmaceuticals, in which the PE firm acquired a 63% stake for $42 million in 2006 and walked away with $457.4 million four years later when UK pharmaceuticals company Benckiser Group bought the business outright. This week's exit from Nigilri Dairy Farm, owner convenience store chain Nilgiri's, was less illustrious: Actis is thought to have made a loss on the $66 million investment from 2006. The holding period was also fraught with difficulty as tensions arose with the founding family, which retained a minority holding in the business.

However, over the ensuing years, Indian entrepreneurs have become more familiar with private equity, which may mean repetitions of the Nilgiri's situation are kept to a minimum.

Gopal Jain, co-founder and managing partner at Gaja Capital, notes that Indian PE has been around for two decades but 90% of capital deployed has been put to work in the last 10 years. Many companies now have existing minority PE shareholders and so the prospect of selling control to another investor - assuming the incumbents want to exit and the company itself requires additional capital - is less daunting.

Gaja did just this in 2013 with Eurokids, India's second-largest pre-school education provider. The private equity firm led a consortium that took control of the business through a secondary transaction, which took out existing investors, and a commitment of primary capital, which helped secure the future of a growing but debt-laden company.

"This kind of opportunity did not exist 10 years ago," says Jain. "The asset class is creating its own ecosystem where private equity is the preferred customer for other private equity firms. If you have existing investors that own 30% of a company and you are looking to raise capital then your new investor could easily end up owning more than 50%."

Everstone's $65 million acquisition of customer interaction management solutions provider Servion Global Solutions also fits this profile. The deal, announced last week, facilitated an exit for several existing backers, including Sansar Capital, an investor since 2006.

Know your target

Familiarity is also essential when working on carve-outs from conglomerates. According to Capital Square's Chakrabarty, these transactions account for seven in every nine deals he looks at. Even though high interest rates are putting the screw on a number of large Indian companies, only one of the seven deals tends to be a distress situation where an overleveraged parent is compelled to offload a subsidiary.

If there is no pressure to sell - for example, when a divestment forms part of a wider strategic repositioning - the onus is on the private equity firm to present itself as a partner that can add value to the business. Chakrabarty previously led technology company MobiApps and set up a joint venture with a unit of Tata Group. He says this experience has proved useful when discussing divestments with corporates, particularly when the current owner wants to retain a minority interest in the business.

"There are non-financial owners in India that are coming to the conclusion that additional capital or management expertise is required for them to grow their business, so they want to cede control and retain a minority stake. That is a mindset change, which was not really present in India before," he says. "They are saying, ‘I can keep 100% of 1x or 30% of 10x.'"

These opportunities tend to arise in companies that have introduced professional management and are dealing with the realities of competing against global players. Companies that face succession-planning issues tend to be less far along the evolutionary scale.

Atul Kapur, co-founder and managing partner at Everstone, observes that control transactions for these kinds of businesses wouldn't have been an option six years ago - first generation entrepreneurs instinctively resisted selling out, seeing it as a sign of failure.

There have been two key changes. First, the second generation doesn't necessarily want to carry on the family business. Second, avenues for deploying capital have proliferated, with real estate in particular emerging as an attractive asset class. Not only does the small business owner's son want to forge his own path, but he sees property as a viable area of focus.

"They see challenges with labor, factories, distributors, banks, supply chain, and product design as too much to manage. They calculate that if the business makes an 8% net margin on $100 of sales, the business is worth $100-150 and their view is if they sell the business and invest the money, net of tax, in a 7% yielding real estate development, they make the same amount of money with significantly lesser issues," says Kapur.

Everstone claims already to be working on succession-planning transactions. In one case, there is a company with three aging founders. Two of them want to exit, while the third, who is slightly younger, would like to continue. Everstone plans to accommodate the younger founder, but bring in senior management around him and expand the business across Asia.

Gaja's Gopal also sees opportunities in this area, but adds that they are still limited in number. "India is a very young country so it is going to take time for succession issues to lead to meaningful deal flow around control," he says.

Suitably equipped

The pressing question for LPs considering commitments to Indian funds, is do these managers have the skills required to execute control transactions. Kedaara formed a partnership with Clayton, Dubilier & Rice in order to define its approach to control transactions and develop systems for attracting and deploying operating partners. Most GPs looking at buyouts claim to have built up their capabilities in this area to some extent.

CDC's Murugappan is not convinced. "I don't believe all managers have the ability or experience to manage control investments. Some are investing in their platforms and operational capabilities, but I would not say it is a widespread phenomenon," he says.

Furthermore, it is not just a case of hiring talent to fill the gaps. Anand Prasanna, a director with Morgan Creek, warns that adding a few operations executives to a framework originally designed for growth capital is a flawed approach; private equity firms must also pay attention to how these new hires fit into the internal structure and how they are incentivized.

"If you say that a PE firm is going to invest in control transactions and so the operating partners are going to add possibly 50% of the value creation in the portfolio, how much of your GP ownership and your carry goes to your operating partners? The reality is in most cases, it is not 50%. There are only 2-3 GPs who do that right. The structures have to change," he says.

LPs might be forgiven a degree of skepticism or at least wariness. While it is logical that a larger number of buyouts should emerge at this point, both in terms of the development of the private equity industry and the state of the domestic economy, GPs might be driven by necessity as much as opportunity.

Performance has suffered largely because there have been insufficient exits from a generation of minority investments. Private equity firms recognize buyouts give them control over their own destinies in this regard. In some cases, the readiness to adopt a strategy that addresses the single largest question market hanging over their industry - and better their chances of raising a new fund - may not be matched by commensurate investment in making these ambitions real.

"Control sells well right now," ays Sunil Mishra, partner at Adams Street Partners. "The argument is that GPs are not buying the market beta and are in control of their destinies so they can extract more value out of our investments. Apart from the quality of deal flow, there were a plethora of situations of small minority positions where people got stuck, so this is a lesson learnt too."