Research

Archana Hingorani, Chief Executive Officer and Executive Director of IL&FS Investment Managers, shares her perspectives on the key challenges currently facing the private equity industry in India and offers guidance on strategies for success in this new investment climate. IL&FS Investment Managers Limited (IIML), a subsidiary of Infrastructure Leasing & Financial Services Limited (IL&FS), is one of the oldest and largest private equity fund managers in India, with over US$3.2 billion in assets under management.

You have personally been involved in the Indian private equity industry for over 15 years. How has the industry fundamentally changed over this time period and, as the industry currently struggles to return to the fundraising and investment peaks seen prior to the global financial crisis, what key lessons have private equity practitioners in India learned over the past few years?

I believe that the portfolio approach to private equity, which has historically been a natural investment strategy, no longer holds in the post-global financial crisis world. While I can’t generalize across all markets, I know with certainty that in our own portfolio—which in itself is fairly large across the three verticals of classic private equity, real estate and infrastructure—the energy required for a portfolio approach today is much greater than it was just a few years ago. This is regardless of whether the company in which you are investing is new or mature, listed or private.

For example, in an old school portfolio, you would likely have perhaps three or four companies that need intense time allocation, others that need a medium amount of time allocated, and of course there would be some companies that were truly on a growth path and therefore did not need any significant intervention from the fund manager—and rightfully so, because that is how a portfolio is built. However, this is no longer the norm. Today, each portfolio company requires a lot more work in terms of the strategic thought and operational clarity that a fund manager must bring alongside the entrepreneur. Without having these operational touch points, and knowing what is going on with the firm on a more intimate basis than perhaps the monthly check-ins that you had before, there doesn’t seem to be enough levers to create value.

This has been one of the biggest changes in operational patterns that fund managers have had to deal with in the current environment, but it has also been a great learning point: you need to provide the right level of people, resources and focus in everything that you do. So perhaps your strategy as a fund manager needs to adjust as a result. Instead of doing 15 to 20 deals in a portfolio, maybe you only want to do six because you need to pay so much attention to each one of them. In the past, some fund managers would claim that their particular niche was a focus on operations or strategy, but those lines are now completely blurred. The necessary approach has materially changed in our industry and all funds need to embrace an operational focus.

Another great lesson learned over the past few years has been that nothing happens at the speed at which it is planned, especially in emerging markets. The pace is always slower than you expect because there are complex extraneous factors that come into play, and therefore business plans have a tendency to be too optimistic in 20/20 hindsight. Private equity players typically “derate” a company’s projected growth rate; for example, reducing the entrepreneur’s projections by 25%. However, a key takeaway for the industry is that even when you do that, you still may not end up matching your own internal “de-rated” business plans vis-à-vis reality. This is typical of a market like India, so you have to plan for how you are expecting the growth—the trajectory and the timeframe that is required to take the business to the next level—and know that each case will be different. You can’t expect that just because something happened in one instance, it will be similar in others.

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As you mentioned, IL&FS is very active in real estate and infrastructure investing in addition to traditional private equity. How do you evaluate these three sub-asset classes and how does the risk-return profile for each differ in India?

On one level, you are targeting a similar return for all three subasset classes due to the growth aspect of being in an emerging market. However, the risk-return profile for each is uniquely different. In the classic private equity model, your alignment with the entrepreneur is superior vis-à-vis the other sub-asset classes because you are putting in capital alongside someone who is 100% focused on that business on a daily basis. In theory, the entrepreneur only wants to grow that particular company, as opposed to the infrastructure asset class, where an entrepreneur may have ten different power projects, all of which he or she has to pay attention to. If something were to go wrong with this one particular project, he or she will have others to feed from. In real estate, this distinction becomes even more compelling

We believe that the most efficient way to invest in the infrastructure space is through a platform that does multiple projects of the same genre, so, for example, a power or road holding company, in order to give us the best access to that sector’s growth. However, when you invest in a 500MW plant, your exit options are limited to either another large player coming in or the entrepreneur himself buying you out, so this impacts your return profile. In contrast, in real estate it doesn’t make sense to invest through a holding company because you don’t have the ability to see how the different projects are performing. In addition, your exit is not hindered by the fact that you are investing in a single real estate project. But then you return to the same problem of the real estate entrepreneur having 20 projects or more, and you are only investing in one of them.

This key distinction makes these sub-asset classes different from a risk profile perspective, so you shouldn’t directly compare returns across all three. Given that there is a higher degree of risk in the infrastructure and real estate sectors, the type of investment that you do perhaps needs to be structured differently—in terms of the cash flows, control, preferential treatment, etc.—because the entrepreneur may not be fully aligned with you. In the last five years, nobody in the industry was talking about returns of less than 25%, be it in infrastructure, real estate or classic private equity, primarily because of the underlying growth of the Indian economy. Today, you may want to scale down your return expectations and put structures in place that also lower your risk. Over time, investors in India will reassess their views on this riskreturn profile. This change in framing also translates to what is going on in international markets—most international investor’s models look at real estate and infrastructure in terms of yieldbased returns rather than growth-based returns.

Regulatory uncertainty, particularly surrounding taxation, appears to have had a significant negative impact on investor perceptions of India, with the Vodafone case and concerns over the General Anti-Avoidance Rule that threatens to revoke India’s double tax agreement with Mauritius being just two examples. As an investor, how concerned are you about the regulatory environment in the country?

From the international fund perspective, which is where most of the money for private equity comes from, the initial regulatory discomfort arose when people started questioning India’s tax treatment policies, especially on a retrospective basis. All governments around the world right now are looking at ways to improve their tax revenue base. Therefore, if our government were to announce that tax policies would change on a going forward basis, I believe that most rational investors, institutional or otherwise, would accept this. However, when you say that this policy now impacts everything one has done on a retrospective basis, this is real cause for concern.

However, there has been a transition in the government ranks and the new people in place don’t seem to share the views of their predecessors. We are now seeing a systematic process by which the government is trying to allay fears about retrospective tax-related issues, general anti-avoidance, etc. As one example, the government is looking to resolve the Vodafone case in an expeditious manner to the satisfaction of all parties. In the last several years, we have also seen greater interaction between the Indian government and our industry.

Going forward, many governments are likely to change tax laws, and India is no exception. However, so long as there is clarity, long-term consistency and certainty in tax policies, we do not see this as an issue with investors. The government has been taking the right steps recently and we expect that an investor-friendly approach will be maintained in the next budget, which will be closely watched by global investors.

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Another common concern plaguing the Indian private equity industry is that a challenging exit environment has resulted in disappointing returns. To date, IL&FS has managed nearly 80 liquidity events through its portfolio companies—how has your strategy for exits changed since the global financial crisis, if at all? Given the freeze in the IPO markets, how viable are other exit channels?

If you go back to the mid-1990s to 2000, the Indian market was so small that it was nearly inconceivable to exit a stake via an IPO. Therefore, a lot of the early exits that we did were strategic sales, which offered an interesting variety of returns. Slowly, the IPO market began to dominate the exit landscape from mid- 2000 onward. And, in addition to strategics and IPOs, in the last five years we have seen the emergence of trade sales, which started off primarily with new fund managers trying to enter India. These firms were generally more comfortable taking over a transaction that had already been “risk-rated” and they were therefore willing to accept a lower return just to make their entry strategy right. Around 2005 to 2006, we also saw secondaries taking place with the likes of Coller Capital, etc. While IPOs have been challenging over the last couple of years, strategic sales are still abundant. Trade sales continue as well, but the dynamic has changed in that buyers today believe they should get as large of a discount as possible—so it has become a more prominent strategy for distressed situations.

The number of exit types that you can do today in India has increased as the market has deepened at every level. However, a new dimension has developed that I think will take on greater importance: the ability to do exits in a package format. Traditionally, exits take place at the individual deal level. But increasingly we are seeing that investors don’t mind buying a category of investments; for instance, two real estate projects, three power projects, or perhaps four pharmaceutical projects in a portfolio. These investors, found both internationally and locally, may have a particular focus or understanding of a sector, and are therefore willing to invest in assets as a bunch rather than on an individual basis in order to have enough “meat” to take them to the next level.

India has developed somewhat of a reputation for talent industry going forward. instability in the private equity industry with the number of spinouts and management turnovers rising in recent years. How does your firm source and, more importantly, retain talent in this competitive environment?

We are certainly not offering the highest remuneration in the country. The industry in India today has so many foreign players paying more than the average Indian salary, but we have chosen not to benchmark ourselves against them. So how do you retain talent in a situation where you are constrained by the fact that your firm philosophy is to pay the right value—and not overpay just because that is the market trend?

We have put together a three-pronged strategy for our employees. First, we set a yearly performance benchmark that we expect our employees to live up to, and so they strive toward that. In addition, our firm is publicly listed, so we are using that to our advantage by creating employee stock ownership plans (ESOPs) for those who have been with us for a certain number of years. These are tradable commodities through which employees can build their net worth. Lastly, we have an attractive carry policy, which is structured to give 70% of the profits that our funds make back to the employees. This approach has served us well in times when the markets have been euphoric and thus made it very enticing for individuals to move from one place to another.

Looking forward, what role do you see private equity playing in India over the next three to five years?

The investment opportunities that India offers are incredibly broad and deep. Even ignoring infrastructure and real estate and focusing just on classic private equity, the industry breadth that you find in the country is so diverse. In India, you have the ability to invest in almost any type of business, running all the way from manufacturing and pharmaceuticals to IT, retail and media. Assuming the capital is applied in a proper manner, there is huge potential for growth and that in itself is the reason why private equity will continue to play a very important role in the country going forward. And adding on infrastructure, our industry becomes even more critical. When you hear the numbers on the monetary investment required to take the country to the next level—even the lowest of these estimates—it is clear that we still need a significant amount of capital to come in.

The industry in India faced a turning point in 2002/2003, when the sector suddenly became glamorous, be it from a career perspective, an entrepreneur perspective or a media perspective. In fact, the media has made private equity into something larger than life, crediting it with much of India’s growth. There were so many other sources of capital in the country that went toward building our economy, alongside regulatory reforms, that I do not think one can solely credit private equity for what has happened in terms of growth over the last 15 years. With the private equity industry becoming deeper with several new alternative sub-asset classes being added, as well as different layers of risk-taking capacity, we can see sharper hints for this expectation of our industry going forward.

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