Putting private equity to work in India

Buyout firms that can exercise the disciplines of building ties and bet on the right human capital will reap the rewards of a market where east and west are meeting for mutual benefit.

India beckons private-equity investors as a land of beguiling opportunity wrapped in mind-boggling complexity. As more than 30 funds totalling $4 billion scour the country for deals, India's growth trajectory in private equity is Asia's steepest, increasing at a 51% compounded annual rate since 1998. Using the benchmark of deal value as a percentage of GDP, Bain & Company estimates that India's private-equity market has the potential to expand fourfold.

But while the economics are elementary, the task is not. Indeed, new deal activity actually went dormant in late 2005. The chief reason: elevated prices for publicly traded equities have driven up the value of potential target companies. Another complicating factor: regulators bar foreign private-equity investors from taking a controlling stake in a target company with just a sliver of equity that helps boost their leveraged returns. Instead, acquirers must typically commit 75% to 90% of the purchase price from their own capital.

With so much money chasing a limited number of high-quality companies, smart private-equity firms are differentiating themselves by honing four skills:

Choose wisely. Private-equity players have always started with a clear thesis of how value is created. In India today, three investment hypotheses are particularly promising. The first involves capitalising on the underpinnings of the global outsourcing phenomenon: India's world-class information technology (IT) and business services.

The second targets dynamic new sectors benefiting from the rise of a consumer class, including healthcare and financial services. The last recognises that selected industry niches - pharmaceuticals, automotive components and metal forging - are becoming globally competitive players.

General Atlantic Partners and Oak Hill Capital Partners took a stake in India's global back office in 2004 by paying $500 million for a 60% share in General Electric Capital International Services (Gecis). Established by GE in 1997, Gecis blossomed into a 17,000-employee unit serving nearly 1,000 GE operations world-wide.

The deal allowed GE to harvest the value it had built, while continuing to outsource its IT and business processes to Gecis. Meanwhile, the new owners have locked in new contracts that have made the company (since renamed Genpact) India's largest business process outsourcer.

Exercise quiet influence. Among the 25 largest deals in 2005, some 80% were made to acquire minority stakes in publicly traded companies. Yet, even when they lack effective control, smart fund managers, like Baring Private Equity Partners, the London-based buyout firm, put their know-how and range of contacts to use with quiet authority.

Shortly after Baring India acquired a stake in Jyothy Laboratories Ltd., the Mumbai-based consumer products company, the firm introduced Jyothy management to outside advisers to evaluate the company's high advertising expenditures. The experts found that, while Jyothy's use of national media was efficient, the company wasn't able to reach its potential market through existing sales channels. These Baring-inspired insights led Jyothy to extend its distribution network, significantly boosting sales and profits.

Bet on the right people. Because India's economy is largely being built by closely held family businesses, private-equity investors have less scope to compose their own management teams. That's why funds are maneuvering to forge partnerships with entrepreneurs who know how to navigate fast-changing markets.

Warburg Pincus found both a world-class opportunity and managers with the skill to seize it at Radhakrishna Group, the food distribution company headquartered near Mumbai. It began by betting on chairman Raju Shet', who had piloted Radhakrishna's growth from a start-up into India's largest food conglomerate. Investing $50 million for a 25% stake in Radhakrishna in mid-2003, Warburg Pincus is working with Shet' to implement a farm-to-plate reorganisation of the country's food-supply chain and to expand the company's distribution network overseas.

Stay nimble. US-based private-equity firms usually think in terms of a three- to five-year holding period for the companies in their portfolios. But India's volatile markets seldom let investors choose when to sell. Indeed, the recent decline in stock prices suggests that funds looking to unwind inflated holdings may have to move nimbly or risk seeing paper gains evaporate.

Baring learned the importance of patience when it was forced to postpone a plan to sell off a 35% stake it had in Mphasis, the business process outsourcing firm it purchased in 1998. Mphasis was forced to lower its earnings forecast in 2004, weakening interest among prospective buyers. But the owners remained confident that revenues and earnings would rebound, in 2005 and 2006, and held on. In early June, Baring sold its Mphasis stake to EDS, the information technology services firm, for $255 million - more than 25 times its original investment.

Buyout firms that learn to exercise the disciplines of building relationships, spotting emergent opportunities, quietly influencing outcomes, and betting on the right human capital will be those best able to reap the rewards of a market where east and west are meeting for mutual benefit.

(Sri Rajan is a partner with Bain & Company and leads the firm's Private Equity Practice in India. Ashish Singh is a Bain partner and leads the firm's New Delhi office. Hugh MacArthur, a partner in the Boston office, leads Bain's Global Private Equity Practice.)