India’s private equity (PE) sector is up in 2011 with more deals and increased value. At the global level, however, PE markets are just one major geopolitical problem or sovereign debt crisis away from being derailed. How will these contrasting local and global trends play out—and how will PE firms rise to the challenges they present?

Global PE funds are wielding vast sums of uncommitted “dry powder” they are eager to put to work. But investors are aware that the forces unleashed since the 2008-09 slump continue to make it challenging for PE funds to generate attractive returns. The slowdown in North America and the European Union has PE investors looking for growth in new regions and sectors, benefiting the Indian market, but also intensifying competition for attractive deals. PE deal value in India for the first half is up 76% from a year ago to $8.1 billion. Total exit value, however, has fallen to just $1.7 billion, 26% lower than last year, as markets have dropped sharply since January, Bain’s database shows.

To keep pace with investors’ changing tastes, many PE firms have expanded their regional footprint or moved into new fund types. But they cannot pursue diversification for diversification’s sake. Bain’s analysis has found little correlation between the number of fund types or regions in which a firm invests and its overall performance.

Before venturing outside their core, successful PE firms typically follow five steps: first, they weigh not just the attractiveness of a move into a new region or sector, but carefully assess whether they have the capabilities to succeed. Second, they ensure the opportunity will be large enough to support an investment team and related infrastructure needed to succeed—a special challenge in India, where the average deal size is less than $25 million. Third, they carefully define the “sweet spot” for investments they prefer to do based on industry sector, size, degree of control and investment thesis. Fourth, and often in parallel, they gauge the interest of limited partners (LPs) and ensure their support before committing. Finally, they communicate their diversification plans clearly to LPs, ensuring their well-thought-out investment strategy is not confused for style drift.

It is not enough only to lay the foundations for expansion into new deal territory, however. PE firms also need to professionalize their organization, with a focus on four key areas:

• Talent management: PE firms need to attract, retain and motivate the best people. Of particular concern are the morale and incentives of junior partners and analysts, many of whom joined at the height of the PE boom and have yet to profit from realized returns. PE firms will want to address these motivational issues, and possibly rebase profit-sharing policies to improve incentives.
• Investor relations: PE firms can no longer afford to think of fund-raising as a part-time activity; they need to nurture investor relationships year-round—staying connected to old LP relationships and cultivating new ones.
• Division of labour: With portfolio companies often needing more time to find their way to profitable exits, many PE firms are managing larger—and more challenging—legacy portfolios, even as they scout and close new deals. PE firms need to develop disciplines that cordon off competing demands on valuable partner time and fund resources.
• Stronger management: With investment teams operating across asset classes, regions and sectors, the business of running a PE firm has never been more complex. New regulations and compliance issues make administrative roles more demanding. Forward-looking PE firms are developing an integrative set of functions at the senior level that set the firm’s direction, facilitate the sharing of insights across investment teams, hire and retain top talent, and take the lead in fund-raising and managing investor relations.

Enhanced due diligence: As competition to land attractive assets increases, PE firms need to dig deeper to ferret out how they can make money on deals. Of course, PE firms must be very good at adding value post-acquisition, but that counts for little if a firm does not close the right deals at the right price, in the first place. Winning firms strengthen their due diligence and investment-committee processes to help avoid losers and develop the proprietary insights required to stretch for winners.

Repeatable value-creation processes: In times of economic uncertainty, PE leaders recognize the need to have value-creation skills in their tool kit. In a recent survey, three-quarters of PE respondents reported that their fund had begun to increase its involvement in portfolio company management, often by beefing up standard performance reporting. India-based PE funds, which typically hold minority stakes, also need to demonstrate to both current and potential portfolio companies their ability to add value to strategy and operations. To that end, many PE firms are assembling dedicated internal teams to unearth new operating efficiencies or growth potential and help portfolio company managers achieve them.

PE firms that strengthen these capabilities to become focused portfolio activists will be best positioned to earn outsized returns in the years ahead.

Arpan Sheth is the head of private equity practice for Bain and Co. in India; Hugh H. MacArthur lead’s the firm’s global private equity practice; and Harsh Vardhan heads the company’s financial services practice in India.