An Indispensable Guide to Equity Investment in India

It is impossible to overlook the massive profits investors have earned in the Indian market over the past several years.
However, beyond the tech-heavy activity that has driven much of these profits, there are many new and interesting
areas that private equity and venture capital firms are now aggressively looking to take advantage of. The Indian
market is certainly unique. A solid understanding of this market and some behavioral adjustments will be required
from investment players who are new to India in order to maximize the returns for their investors. In addition to the
required capital, proper research in a challenging market, subtle and savvy managerial skills, and a healthy dose of
patience must also be invested to ensure success. In this article, Evalueserve’s analysis shows that those who
manage the fundamentals and persevere stand to make significant gains in the years ahead. And, their impact will
not only be felt in India, but will have a significant impact the global economy as well.

Introduction

Recent research conducted by the global research and analytics firm, Evalueserve, shows that if current trends continue, India will receive US $13.5 billion in Private Equity (PE) funding during 2007, ranking it among the top
seven countries in the world. And, this funding could rise to almost $20 billion in 2010. Our research also shows there are over 366 firms currently operating in India and another 69 have raised – or are in the process of raising – funds and are planning to start their operations soon1 . In total, these PE firms seem to have amassed US $48 billion
earmarked for investment in India between July 2007 and December 2010. Several firms that we talked to also
mentioned they would be willing to invest even more if they saw good investment opportunities. This situation stands
in stark contrast to 1996, when Indian companies only received a total of US $ 20 million. Indeed, if Indian companies do receive US $20 billion in funding during 2010, this would represent a stunning thousand-fold increase over a period of just fourteen years. Of course, the future is hard – if not impossible – to predict because private equity investments are based on a complex combination of macroeconomic, microeconomic, and financial policy-related factors that always affect the rational and emotional sentiments of the investor community. Indeed, a slow-down in growth of the Indian economy or a tightening of liquidity around the world are just two potential changes that could lead to substantially lower PE investment in India than those forecasted above.

From a demand-side perspective, assuming a real annual GDP (Gross Domestic Product) growth of 8%, an annual
inflation of 5% and a constant exchange rate of 40 Indian Rupees to the US Dollar2, our analysis shows that the
Indian economy will grow in nominal terms from approximately US $1,030 billion in 2007 to approximately $5,040
billion in 2020. Hence, it can easily absorb US $60 billion between 2007 and 2010 and as much as US $490 billion
between 2007 and 2020. However, for such investment to be useful and wealth creating, it has to be invested in
diverse sectors and not be limited only to Information Technology (IT) and IT Enabled Services (ITES) sectors.

Note: This article is largely focussed on Private Equity investment, i.e. investments in companies already generating
revenue and perhaps profit. A related article dated August 21, 2006 and titled, “Is the Indian VC Market Getting
Overheated?” can be downloaded from www.evalueserve.com and another article titled, “Investments by Hedge
Funds and Related Institutions in India” is scheduled to be published in December 2007.

Organization of the Paper

This article consists of six sections. In Section 2, we trace the growth of Private Equity (PE) in India from 1996 to the
first half of 2007, and also present our forecast for the next three and half years. Here, we also compare the PE
investment in India with a few other countries, particularly the United States, the United Kingdom and China. Section 3 discusses the break-up of this investment across different sectors and the number of individual deals of at least US $10 million in value, as well as the total value of PE deals during the past few years. Here, we will also discuss the recent trend of hedge funds investing in India. Sections 4 and 5 discuss the reasons for this increased PE funding which include the rapidly growing Indian economy, the rise of the Indian stock market, liberalization with respect to foreign direct investment into India, and the enormous potential for mergers and acquisitions that involve Indian companies. This section also discusses potential risks while investing in India. Finally, Section 6 discusses a few realities on the ground and best practices while investing in India.

Trends in Private Equity Investment in India since 1996

Private Equity (PE) and Venture Capital (VC) firms usually raise capital from their Limited Partners (LPs) consisting
of high net worth individuals and institutional investors such as insurance companies, investment banks, pension
funds, and university endowment funds. These firms then invest this capital in yet-to-be-formed companies, in newly
formed companies, in private companies not listed on stock exchanges, and in public companies that are listed on
stock exchanges (wherein they make investments using “instruments” called PIPEs, i.e., Private Investment in Public
Equity or by simply buying equity shares in the stock market). Since most VC and PE funds have a hands-on
management style and are motivated by the old adage, “if you want something done right, do it yourself,” many times, they place their own people on the boards of these companies and allow them to control the business more firmly. Since these PE funds are not always able to have a majority control (especially in public companies) some funds specialize in being “activist funds” and engage the companies’ boards and management in discussion, wage proxy battles, liquidate assets, and even force the sale of some companies.

Venture Capitalists (VCs) usually invest in newly formed start-ups that may not yet have revenues or even a well-
developed product or service ready to sell. Hence, VCs usually bet on the founding or the executive teams, the total addressable market available for the product, and deep domain expertise. In fact, since many VCs were themselves  entrepreneurs in the past, they continue to be driven by a “start-up” mentality (i.e., investing in a new innovation, developing a prototype product or service, and then making it robust enough for selling to bring in revenue) rather than a “growth via robust profits” mentality (i.e., increase revenue and profits by performing additional research and development, marketing and sales, and by other means).

In contrast, PE firms usually invest in companies that already have some revenue and that can potentially be grown
by restructuring, or by bringing new or improved products into existing or developing markets, or by otherwise
unlocking some of the intrinsic value within these companies. Of course, the eventual aim of a private equity firm is to either take the company public on a stock exchange or sell it so that the PE firm can free up its locked capital and
return some of it to its limited partners. Further, since many Private Equity managers come from diverse backgrounds such as strategy and operational consulting or investment banking, they are a bit more adept at investing in diverse sectors beyond only high-tech, biotech-pharmaceutical or a few other specific sectors.

Despite the key differences outlined above, at a broad level the business model for both VC and PE firms is
essentially the same. Typically, both groups charge their limited partners (LPs) a% as management fees for the
assets under management (where “a%” is usually 2%) and retain an additional b% of the profit from the initial
investment provided by their LPs (where “b%” is usually 20%).

Also, it is essentially the same group of limited partners that typically fund both VC and PE groups. In fact, many
traditional Venture Capital firms based in the United States and Europe are already investing US$ 10 million or more
today in India, and hence the separation between VC and PE investment in India has become very blurred.
Therefore, in this section, we consider the combined investment made by these two groups during the past few years.
In Section 3, we will only discuss the India investments made by these firms that are at least US $10 million each.

VC-PE investment during 1996-2006

Risk Capital Foundation seems to be the first VC-PE firm to start operations in India in 1975. During 1976-1995,
domestic financial institutions like Industrial Finance Corporation of India (IFCI), Industrial Development Bank of India (IDBI), and Industrial Credit and Investment Corporation of India (ICICI Bank) were some of the few private
organizations that provided any Venture Capital or Private Equity capital, and the actual investment made by them
was also negligible. During the period 1996-2000, several international and domestic VC and PE firms raised capital
internationally and started investing tiny amounts in India. For example, the total investment in India made by these
firms was only US $20 million in 1996 and US $80 million in 1997.

Even though PE-VC investment was only $20 million in 1996 and $80 million in 1997, the pace of growth was very
healthy largely due to the worldwide dot-com boom. Unfortunately, because this growth was driven by of the dot-com
bubble, it came crashing down soon after NASDAQ lost 60% of its value in 2000 – for example, the total number of deals declined from 280 in 2000 to 110 in 2001 – and this investment reached its low point both in the number of
deals and total value in 2003.
From 2003 onwards, India’s economy started growing at 8% to 9% annually in real terms and at 13% to 15% in
nominal terms (including inflation), and since some sectors (e.g., the services sector and the high-end manufacturing
sector) started growing at 10% to 14% a year in real terms and 15% to 20% in nominal terms, VC-PE firms started
investing again in 2004. For example, they invested US $1.65 billion in 2004, surpassing the investment of $1.16
billion in 2000 by 42%. Table 1 shows the number and value of deals in India during the period from 1996 to 2006.
Table 1: Number and Value of Deals 1996 – 2006 (in Million US $)

In addition, the exit climate for private equity investment in India improved significantly, and especially over the last
two years, the market witnessed several large and well-publicized exits. In addition to public equity markets (e.g.,
Genpact listing on NYSE and EXL on NASDAQ), private equity firms have also used secondary buy-outs or sale to
other private equity firms as exit.

Outlook for VC-PE investment during 2007-2010

Table 2 given below shows both the number of deals and the total dollars invested in India H1-2007 as well as
Evalueserve’s forecast for the number of deals and the total amount to be invested between H2-2007 and 2010. Our
analysis shows that if the current trends continue, India would receive US $13.5 billion in Private Equity funding
during 2007, thereby becoming one of the top seven countries receiving such funding in 2007. Furthermore, this
funding could rise to almost $20 billion in 2010. Our research also shows there are more than 366 firms currently
operating in India and another 69 are planning to start their operations soon. In total, they seem to have amassed US
$48 billion earmarked for investment in India during the next three and a half years, i.e.,

Table 2: Number and Value of Deals 1996 – 2006 (in Million US $)

July 2007 – December 2010, and several firms we have spoken to mentioned they would be willing to invest even
more if they saw good investment opportunities. Clearly, this is in stark contrast to 1996, when Indian companies only received US $20 million, and if indeed, Indian companies end up receiving US $20 billion in such funding then this would represent a thousand-fold increase between the fourteen years of 1996 and 2010. Of course, the future is
difficult to predict because private equity investments are based on a complex combination of macroeconomic,
microeconomic, and financial policy-related factors, which affect the rational and emotional sentiments of the investor community. Indeed, a slow-down in the growth of the Indian economy or a tightening of liquidity around the world are just two examples of changes that could lead to substantially lower PE investment in India than forecasted.

From a demand perspective, assuming an annual growth rate of 8%, annual inflation of 5%, and a constant
exchange rate of 40 Indian Rupees to one US Dollar, our analysis shows that the Indian economy will grow in
nominal terms from approximately US $1,030 billion during the calendar year 2007 to approximately $5,040 billion in 2020, and India can easily absorb US $60 billion during 2007-2010 and as much as US $490 billion during 2007-2020. However, for such investment to be valuable and wealth creating, it has to be broad-based and in diverse
sectors and not limited only to Information Technology (IT), IT Enabled Services (ITES), or the healthcare sector.
Interestingly, even though these sub-sectors seem to garner most of popular attention by many VC and PE firms, our
analysis shows they are not the biggest contributors to the growth of the Indian economy, and there are several other sub-sectors, which we will highlight later in the article that might yield better returns. Finally, even though many VC- PE firms have been focused on the IT and the ITES (IT Enabled Services, which includes the “Business Process Outsourcing” or the BPO sub-sector) sectors, a very important feature of the resurgence in the VC-PE activity in India since 2004 is that as a whole this community is no longer focusing only on these sectors. Figure 3 depicts the break- up of these investments with respect to the number of deals in 2000, and 2006 in various sectors.

Table 3 depicts the percentage of VC and PE investments as a percentage of the Gross Domestic Product (GDP) in
the United States, United Kingdom, China and India for the year 2006. Interestingly, even after incorporating our
forecast of US $20 billion of PE investments in India in 2010, since the Indian economy is likely to be $1,490 billion
during that year, this investment would represent approximately 1.35% of India’s GDP and hence on a percentage
basis, it would be still be less than the United States.

Private Equity Firms and Hedge Funds Investing in India

In the United States and Europe, the typical PE investment threshold is considered to be $25 million. However, in
India, since wages are between one-third and one-sixth of the United States whereas most other costs like hardware,
software, machinery, office furniture, and real estate in the large cities are virtually the same), our analysis indicates
that the comparative benchmark for PE investment in India should be $10 million. Given this assumption, Table 5
provides a break-up both by the number of deals and their total value for the period from 2005 to H1-2007; it is worth noting that during this period, only 10% to 20% of the total amount invested in India was from VCs while the remaining was PE investment; this is very similar to 14% to 18% VC investment versus 82% to 85% Private Equity
investment in the United States.

Table 4: Number and Total Value of Deals (each over US $10 million) Between 2005 and H1-2007

Similarly, if we only consider only those investments that are US $10 million or more and made in 2006 or H1-2007,
then Table 5 shows that these investments were even more broad-based than those in Figure 3.
Table 5: Percentage of the total deals by value in various sectors; deal-size at least $10 million

List of PE firms investing in India

Although PE firms like Baring Private Equity Partners, Warburg Pincus, CDC Capital, Draper International, HSBC
Private Equity, Chrys Capital (formerly known as Chrysalis Capital), and Westbridge Capital (now a part of Sequoia
Capital) were investing in India during 1996-2000, some of these firms, e.g., Westbridge Capital and Chrys Capital,
changed their strategy between 2003 and 2006 and moved from only venture investing to both venture and private
equity investing. Today, many traditional Venture Capital firms based in the United States and Europe are investing
US$ 10 million or more in India, and hence the separation between VC and PE investment in India has become very
blurred. Evalueserve’s research shows there are 366 such firms claiming to be operating in India and another 69 that
are raising capital with plans to be operating soon.

Current status of Hedge Fund investing in India

Usually, a hedge fund’s strategy is to “hedge” its bets, for example, by going “long” with respect to some of its
investments and “short” with respect to others. Given this strategy, most hedge funds typically buy and sell a set of
shares/equities or other instruments and constantly trade these to generate returns over a six to eighteen-month
period. Furthermore, because of their hedging strategy, usually these funds have a fairly high threshold for high-risk
opportunities, and by taking such risks they are often able to generate fairly high returns for their limited partners.
According to our analysis, currently there are more than 10,200 hedge funds worldwide, which cumulatively have
more than $1,800 billion under management. Interestingly, of this amount, $1,200 billion is being managed by only
the top 250 hedge funds. Since VC, PE and other alternative investment-related firms also have approximately
$1,800 billion under management, together these two groups currently manage approximately 6% of all assets under
management worldwide. Consequently, the “law of large numbers” seems to be gradually creeping up and it is
becoming harder for many hedge funds to find good opportunities. Hence many hedge funds are beginning to act like
PE firms investing with a “longer time horizon”, especially in India. Some well-known hedge funds investing in India
include D. E. Shaw Group, Farallon Capital Management, Old Lane Management (now a part of Citi-Alternative Investments), Galleon Group, Monsoon Capital, and Tiger Global Management. A few other hedge funds operating in
India can be found at http://www.evalueserve.com/Media-And-Reports/WhitePapers.aspx

Most hedge funds investing in India are not registered as Foreign Institutional Investors (FIIs) and are therefore not
allowed to trade Indian stocks directly. Hence they get exposure to Indian stocks (by using equity swaps, Contract for
Differences or CFDs, Promissory Notes or P-Notes, etc.) through large global brokers and custodians like Merrill
Lynch, Morgan Stanley, Goldman Sachs, Bear Sterns, and Citibank. Furthermore, their trading costs through these
brokers and custodians in India are quite high since these costs involve those related to brokerage fees, statutory
charges, and commissions. Although some of these costs have come down lately, the commissions alone are still
50-60 basis points (i.e., 0.5% – 0.6% of the tradeable value) as compared with 3 to 4 basis points in the United States.
Furthermore, the financing cost for short positions in Indian stocks is much higher than for long positions. Finally, the Indian stock market, which is represented by the Sensex (see Section 4 for more details), has quadrupled during the last four years giving very little incentive to “short” most stocks that are available with these custodians. Hence, unlike the US, where these hedge funds buy and sell continuously, most hedge funds in India do not participate in short movements related to any major indices or stocks, and to that extent do not create volatility in the Indian stock
market.

Given this backdrop, at least for now, most hedge funds have decided to go “long” only with respect to the Indian
public markets and some of them have even taken substantial equity in some private companies in India, thereby,
following a strategy almost identical to typical Private Equity groups. Of course, this strategy could easily change
because such a large rise eventually increases the incentive to short, thereby benefiting from a correction if the
Indian stock market becomes stagnant for some time or fluctuates wildly as it did between 1992 and 2002.

The Growing Indian Economy and Its Stock Market

Since its independence in 1947 and until 1991, the Indian government largely pursued socialistic economic policies
that severely restricted economic freedom and trade – both domestically and globally. Hence, it is not surprising that
the Indian economy grew at an average of 3.5% annually during this period. However, in 1991, the government
started liberalizing the Indian economy and the country’s annual growth rate began rising substantially. It reached
9 % in 2005 and crossed 9.2 % in 2006. Evalueserve’s analysis shows that, given the current environment and
macroeconomic factors and barring any major calamity (e.g. a natural disaster or a war), India’s annual growth rate
of 8% is likely to continue until 2020. On the other hand, during the last seventeen years, i.e., 1991–2006, annual
inflation – as measured by the average wholesale price index (WPI) price index – has been approximately 6.67%,
and given the savings rate and liquidity in the system, our analysis also shows that the annual inflation in India is
likely to hover around 5% during the next fourteen years. So, assuming a constant exchange rate where one US
Dollar equals 40 Indian Rupees, the Indian economy that was approximately $800 billion in 2005 and $910 billion in 2006 is likely to be $1,030 billion in 2007, $1,490 billion in 2010 and around $5,040 billion in 2020 (all in nominal terms). This implies that including inflation, there will be more than a five-fold increase in India’s economy between 2007 and 2020.

During 2006, the services sector accounted for approximately 55% of the economy, the manufacturing and
industries’ sector contributed about 26%, and agriculture about 19%. Furthermore, both the services and the
industries sectors have been growing at approximately 10% annually during the last three years, which after
including inflation (of 5%) implies an average annual growth of 15%. Given this backdrop, we briefly mention three
groups of industry verticals below that are likely to be lucrative for the VC, PE and HF communities, especially
because cumulatively, they are likely to contribute approximately 6.5% of the growth or about half of the total nominal growth of 13% per year.

Three groups of rapidly growing sectors

The first group that is likely to exhibit rapid growth consists of hi-tech services and products, most of which are
currently being exported but some of which are also being consumed domestically. These hi-tech services and
products include Information Technology (IT) and application development, Business Process Outsourcing (BPO),
Knowledge Process Outsourcing (KPO), Drug Research and Clinical Research Outsourcing (CRO), Engineering
Services Outsourcing (ESO), software and solutions related to the consumer internet, software as a service (SAAS), Open Source, Software-Cum-Services, and telecommunications (both wireless and wire-line) products and related
services. This combined group of products and services is expected to grow at approximately 22% per year during
the next five years, and it is likely to contribute about 1.3% out of a total growth of 13% per year, i.e., approximately
10% of the total growth of the Indian economy. Furthermore, from a Private Equity investment perspective, it is worth noting that this group only constitutes approximately 1.3/6.5, or 20%, of the growth of these three groups combined.

The second group consists of services that are mainly geared towards the Indian domestic market although in almost
all cases, people visiting India can also benefit from them. These sectors include the retail sector, travel and
hospitality sector (e.g., airlines, hotels, theme parks), the health care sector (including medical tourism, alternative
medicinal centres and spas, hospitals, pharmacies and laboratories), the entertainment sector (including the Indian
movie and the TV industry), and the private education sector. Not surprisingly, this combined group of services and
productized services is likely to grow at approximately 19% per year during the next five years, and is likely to
contribute about 2.7% out of a total nominal growth of 13% per year (including 5% annual inflation).

Finally, the third group consists of products and services related to high-end manufacturing and infrastructure and it
includes automobiles, automotive components, electrical and electronic components, speciality chemicals,
pharmaceuticals, gems and jewellery, textiles, and sectors related to construction, real estate and infrastructure. This
combined group of products and services is likely to grow at approximately 19% per year during the next five years,
and is likely to contribute about 2.5% out of a total nominal growth of 13% per year.

The growth of the Indian stock market

As of June 30, 2007, there were 23 government-recognized, stock exchanges in India and there were more than
9,700 companies listed on these exchanges. Among these, the Bombay Stock Exchange (BSE) had 4,842 listed
companies, and this exchange happens to be the oldest exchange in Asia having been established as “The Native Stock Brokers Association” in 1875. Since BSE has the most well known indices within the Indian stock
market, we focus on a few of these indices in this article.

Figure 2 depicts three indices, Sensex or “Sensitive Index” (with a base of 100 in 1979 and comprises of the 30
companies listed on BSE), BSE-100 (with a base of 100 in 1984 and comprises of 100 stocks listed at five major
stock exchanges in Mumbai, Calcutta, Delhi, Ahmedabad and Chennai), and BSE-500 (with a base of 1,000 in 1999
and comprises of 500 listed companies in various Indian stock exchanges). Ignoring dividends, both Sensex and
BSE-100 have grown by 12.5% annually in US Dollar terms between June 1990 and June 2007, although they have
fluctuated fairly wildly during this period.

The 12.5% annual growth rate for Sensex and BSE-100 during the last seventeen years (in USD terms) consists of
the following two sub-components:

• The companies comprising Sensex and BSE-100 have individually grown at an average of 9% or more on an
  annual basis.
• Because of the consistent and substantial growth of these companies, their Price/Earnings ratios have grown
  from approximately 13 in June 1991 to approximately 21 in June 2007, which accounts for an additional growth
  of 3.5% per year.

Given that most of the companies comprising the Sensex, BSE-100, and BSE-500 are likely to grow at an average
annual rate of 11% – 12% during the next 4-5 years, these three indices may grow by at least 11% – 12% on an
annual basis. On the other hand, since the average Price/Earnings ratio of the corresponding companies is
substantially more than those in several other emerging markets (where the P/E ratios have generally continued to
hover around 12-13 for the past two decades), it is quite possible that the Indian companies listed in these three
indices are overpriced and they may not grow at all or may even drop precipitously. Finally, given the past history of
these indices, especially during 1992-2002, it is also possible that these indices would continue to fluctuate in the
near future (especially if the Indian government curbs the liberalizing of the economy or if the global economy cools
down.)

Although the eight-year period of June 1999 to June 2007 is a rather short duration for the Indian stock market, it is still worth noting that during this period, the annual price return in US Dollar terms for Sensex, BSE-100 and BSE- 500 was 18%, 21% and 25%, respectively, which implies that the 400 hundred companies in the BSE-500 but not in the BSE-100 grew much faster, and on an average these companies became more productive and/or grew more
rapidly than those in the Sensex or BSE-100.

Table 6 depicts the number of companies listed on the BSE between June 1999 and June 2007. Not surprisingly, the
number of Initial Public Offerings (IPOs) on the BSE went down dramatically during the 2001-2003 period because of the dot-com bust and because of the NASDAQ crash of 2000. However, this number has been growing again since
2004 and is expected touch a new record in 2007. Despite the fact that almost 250 companies were listed on BSE
during this period, 1,250 companies were de-listed because of performance and the legacy of the dot-com era.
Finally, although US $10 million or less was being raised during a typical IPO in 2000 and 2001, this amount has
been increasing steadily, which indicates that earlier companies were using BSE as an alternative for raising Venture
Capital Funding, but now many of them are using it as an alternative for raising Private Equity Funding. Indeed, many smaller Indian companies are going to the other 22 stock exchanges in India to raise smaller amounts and using those exchanges as alternate means for raising capital.

Table 6: Initial Public Offerings & Price/Earnings’ Ratios for Bombay Stock Exchange (2000–07)

Opportunities and Risks for PE Investing in India

Most VC and PE firms have a time horizon of five to seven years in the United States and Europe, and they expect to
provide an average net annual return of 13% to 15%, i.e., double the investment of their limited partners in
approximately five years. However, the PE firms currently operating in India seem to have a time horizon of three to
five years and their expectation of an average net annual return is between 25% and 27%, i.e., double the
investment of their limited partners in three years. These elevated expectations can be attributed to the following key
factors:

• In many respects, the maturity of VC and PE investments in India today is probably similar to that in the United States in the early 1970s, and hence, by and large investors are likely to take more risks (with respect to finding the right companies, their financial transparency, etc.) and hence would expect higher returns in return for the greater risk.
• There are broader risks associated with India as an emerging market, which include the possible depreciation of
  the Indian Rupee, high inflation, and the Indian government not liberalizing the economy any further.
• High volatility in the Indian stock markets, and hence the corresponding expectation of high returns.
  The rise of the Indian stock market, which is epitomized by the growth of the following indices between June
  1999 and 2007 (adjusted in US Dollar terms): Sensex at an average annual rate of 18%; BSE-100 at 21%; and
  BSE-500 at 25%.
• A fairly impressive set of PE firms as role models, e.g., Chrys Capital, Francisco Partners, General Atlantic,
  Oakhill Capital Partners and Warburg Pincus, who have realized at least 30% in annual return during the last 3 to 4 years for their limited partners.

However, given that so many Venture Capital, Private Equity and Hedge Funds are beginning to invest actively in India, good investment opportunities will become more difficult to find, and hence, an annual return that is 7% to 9% more than that of Sensex or BSE-100 (i.e., 18% to 20% per year assuming Sensex and BSE-100 continue to grow at
10% to 12% per year) seems to be a more likely scenario, in which case the principal amount is likely to be double in four years (and not three). In light of this analysis, Evalueserve believes there are some key opportunities and short- term risks while investing in India:

Playing the Indian stock market

As discussed in Section 4, the Indian stock market, which is epitomized by the Sensex, BSE-100 and BSE-500, has
been growing at approximately 42% annually in nominal terms since June 2003, and has thus more than quadrupled
in four years. Although this growth rate is likely to slow to a more reasonable level, there will still be substantial
opportunities for VC, PE and HF firms to do substantial research and cherry-pick companies that are growing
annually at 25% or more (including the 5% inflation). Incidentally, when it comes to cherry-picking such opportunities, Chrys Capital has done an excellent job between 2003 and 2007. Before 2003, Chrys Capital used to mainly provide VC financing to start-ups and smaller companies. However, it changed its strategy and started investing between $20 million and $200 million in 2003. Furthermore, it became an activist fund (see Section 2 for definition), started providing growth investment to medium and large private companies, and its average annual return on investments during the past four-year period has been over 50% per year.

Public Sector Undertakings (PSUs)

The Indian economy was a socialistic economy between 1947 and 1991. As a result, the Indian government owned
many companies – called Public Sector Undertakings ( PSUs) – especially in the following sectors that were
considered critical to the Indian economy: financial services (e.g., those in banking and insurance), utilities (e.g.,
those in electricity, oil, gas, telecommunications), capital goods (e.g., those related to earth movers, electronics,
heavy electrical), transport services (e.g., those related to airports, railroad, containers, shipping), and metals and
mining (e.g., those in aluminium, steel, and copper). However, gradually the Indian government has been reducing its stake in many PSUs and now owns only 51% in some of them. In fact many of these are currently listed on the Indian stock market and the enterprise value of just the top 42 PSUs listed on BSE, which constitute a BSE-PSU index with a datum of 1000 on February 1, 1999, currently exceeds $210 billion.

Not surprisingly, these PSUs were quite inefficient before the Indian government privatized them (at least partially).
However, just like the BSE-500, the 42 PSUs comprising the BSE-PSU index have become significantly more
efficient and productive as indicated by the data given below:

• On a US Dollar adjusted basis, the BSE-PSU index has grown at approximately 23.5% per year during June
  1999 and June 2007. This is only slightly less than the 25% annual growth of BSE-500 but more than the annual growth of BSE-100 and Sensex of 21% and 18% respectively (during the same eight-year period).
• Since 1991, the average, annual net profit per employee in the PSUs in the BSE-PSU index has improved by
  approximately 16 times and gone from approximately $1,000 per employee to $16,000 per employee. Similarly,
  the average, annual revenue per employee has gone up by approximately ten times during June 1991 and June
  2007. Indeed, some PSUs have done better than others. For example, India’s largest retail bank, State Bank of
  India, which also happens to have the largest number of branches and offices of all the retail banks in the world,
  has seen its profit go up 25 times with only 89% of the workforce that was employed in 1991, thereby, resulting in productivity improvement of 28 times.

Although these productivity and efficiency improvements seem very impressive, there is still room for further
improvement – according to Evalueserve’s estimates by as much as 60% – within these 42 PSUs, and even more
within the other PSUs that do not constitute to the BSE-PSU index. Furthermore, since the Indian government is
planning on opening the banking sector completely to foreign competition (by 2009) and is also planning on further
liberalizing other sectors – e.g., metals and mining, utilities, and capital goods’ sectors – these PSUs do not have any
choice but to become more productive, efficient and aggressive with respect to both organic growth and acquisitions.
Hence, these PSUs provide a good opportunity especially for the activist PE and HF firms that can help these PSUs
grow to the next level. Of course, since most of these PSUs are still quite hierarchical, bureaucratic, and stodgy and
usually have a disdain for taking any advice or being influenced by third parties, the Private Equity firms would have
to patiently “weave” their way into them to effect appropriate change.

The following examples show that at least some PE firms are beginning to get interested in this sector:

• In 2003, Actis paid $60 million for a 29% stake in state-owned Punjab Tractors, India’s most profitable maker of farm tractors and forklifts (in 2003), which demonstrated 20% quarter-on-quarter growth in revenues and 26% in profits shortly after this investment. Later on, Mahindra and Mahindra acquired Punjab Tractors.
• US-based hedge fund, DE Shaw with assets worth over $30 billion, is believed to have put in a bid in response to IFCI’s (Industrial Finance Corporation of India’s) decision to sell a 26% stake to strategic investors. US based
  private equity group, Blackstone, may also join the race to acquire a 26 percent stake in this oldest state-owned financial institution.

Family-run businesses

Some of the most profitable, efficient and productive companies in India – e.g., those run by the Tatas, Ambanis,
Premjis (Wipro), Birlas, Singhs (Ranbaxy) and Bajajs – are family-run businesses. As shown in Table 7, 47 of the
BSE-100 companies are partially or wholly family-run businesses and had a total market capitalization of $345 billion as of June 2007. Despite such impressive statistics, our analysis shows that the examples above seem to be
noteworthy exceptions. By and large, a majority of family-run businesses do not succeed. In fact, over the last fifty
years, more than 70% of for-profit organizations in India were started as family-run businesses and corporations, but
less than two-thirds survived the first five years and only one-third survived the next twenty. This is because these
businesses suffer from a lack of effective corporate governance, lack of management structure and often a lack of
vision to expand domestically or globally. Consequently, an investment in such companies could be a win-win for
them as well as for the PE firms. However, for this strategy to really succeed, the PE managers should be able to
bring not only capital but also their strategy and operational expertise to bear, and they may have to work in “deep
and dirty trenches” along with these business families and their management teams.

Merger and Acquisition opportunities, especially Spin-offs from larger companies

As mentioned in Section 2, the eventual aim of a private equity firm is to either take the company public (i.e., list it on
a stock exchange) or sell it so the PE firm can free up its locked capital and provide a return to its limited partners.
Given the rapid growth of PE investments and the rapid consolidation of some of the more maturing industries (e.g.,
IT and IT Enabled Services), the M&A activity within India is already growing quite substantially. Furthermore, since
Indian companies are now becoming more confident of acquiring and successfully integrating non-Indian companies, this M&A activity is likely to grow even faster. Clearly, since many PE managers have investment banking and consulting backgrounds, they can certainly help their portfolio companies during this process.

For the year 2006, Table 8 compares the total value of deals in India as a percentage of India’s GDP to those in the
United States, United Kingdom, Japan and China. On a percentage basis, Indian companies are ahead in Mergers
and Acquisitions (M&A) when compared to China and Japan but they still have some distance to go to catch the
United States or the United Kingdom.
Table 8: Total M&A Deal Value in Different Countries (2006), US$ billion

Another opportunity for the Private Equity industry is in either buying – or helping their portfolio companies to buy captive units of multi-national or domestic companies that are likely to be spun off from their parent companies.
British Airways started this trend in 2002 when it decided to sell a majority stake of its IT Enabled Services (ITES)
captive unit in India called WNS Global Services to Private Equity firm, Warburg Pincus. General Electric followed
suit two years later by selling its captive unit (now called Genpact) to General Atlantic and Oakhill Capital Partners.
These two companies, WNS and Genpact, recently went public on the New York Stock Exchange and currently have
a market valuation of more than US $700 million and $3 billion, respectively. More recently, The Netherlands based
company, Philips, sold its ITES unit to Infosys and currently Citigroup is negotiating with several firms to sell its ITES captive unit, eServe. Indeed, it is not surprising that several PE firms are involved in negotiations with Citigroup in buying eServe wholly or partially for one of their portfolio companies or to create an entirely new company. At Evalueserve, we believe that during the next three to four years, between 20 to 30 multinational companies are likely to sell – partially or wholly – their captive units since the main tasks performed within such captive units seem to be proper hiring, training, retaining of personnel and providing high-quality processes and services, which these multinationals do not consider as their “core” business.

Short-term risks while investing in India

Since the Indian economy has been growing at a fairly rapid pace, particularly between July 2003 and June 2007,
this growth may be overheating its economy. The following are several short-term risks worth investigating:

• In several sectors (e.g., IT and IT Enabled Services, telecom services, airline services, high-end construction
  services), demand is beginning to exceed supply – especially for skilled workers and equipment. These severe
  skill shortages are causing wages to balloon, thereby causing inflation and attrition.
• During the last year, bank lending for commercial property rose 75% and residential property increased 35%.
  Furthermore, the prices of commercial property in some – but not all – cities have increased five-fold during the last four years and prices for residential property in a few other cities have quadrupled. Since wages have not risen by even half that much, the real-estate bubble in these cities can burst, thereby, leaving some investors
  with substantial losses and debt. (See Section 6.3 also.)
• As mentioned in Section 4, the Price/Earnings ratio for Sensex and BSE-100 is close to 21, which is significantly
  higher than the corresponding ratio of 12 for similar indices in other emerging countries. Even though the
  companies comprising the Sensex, BSE-100 and BSE-500 are growing rapidly, much of this increase seems to
  be speculative and fuelled by Foreign Institutional Investors (FIIs), especially foreign mutual funds. Since even in the past (e.g., 1992-2002), the Indian stock market has exhibited wild fluctuations, it could easily repeat this
  behavior again.
• India is heavily dependent on short-term Foreign Institutional Investors (FII), who have bought equities and other securities, rather than the longer-term foreign direct investments (FDI). During the last four years, there has been more than $40 billion of FII investment in India compared to $23 billion of FDI investment. Most of the FII investments can be recalled very quickly in a crisis. Clearly, rapid influx of this money has driven the Indian stock market to dizzying heights, but our analysis shows that a quick flight of this money (out of India) is likely to harm the Indian economy significantly by depreciating the Indian Rupee by as much as 25% and by depressing the Indian stock market by as much as 40%.
• Since January 2007, the Indian Rupee has appreciated with respect to the US Dollar by more than 10%, and with respect to British Pounds, Euros and the Yen, it has risen by 8%, 7% and 11%, respectively. This appreciation is a double-edged sword for the Indian economy. On one hand, this appreciation has benefited the economy by making imports – particularly crude oil – cheaper and has also helped in controlling inflation. On the other hand, this appreciation is beginning to hurt Indian exports and may end up decimating some of the low-margin export sectors because they have to compete with Chinese goods. (Here, it is interesting to note that the Chinese Yuan has only appreciated by 3% with respect to the US Dollar and even less with respect to other currencies.)

On-the-Ground Realities and Best Practices for PE Investing in India

This section advocates a number of best practices and highlights some of the key differences between private equity
investing in India versus the US or Europe.

Find “diamonds in the rough” and then help polish them

The five hundred companies comprising the BSE-500 are likely to have revenues of approximately $360 billion in
2007. Furthermore, as mentioned in Section 4, since June 1999, these companies have been performing better than
the hundred companies comprising BSE-100 or the thirty companies comprising Sensex. In some ways, these
companies do not have much choice if they want to emerge as winners during the liberalization of the Indian
economy.

In addition to the BSE-500, our analysis shows there are another 22,000 for-profit organizations (i.e., companies,
partnerships, and family-run businesses) that would earn approximately $135 billion in revenue in 2007 and most of these are facing the same challenges with respect to growth, productivity, and efficiency. However, at least one-
fourth (at least 5,500) of these companies either have good processes or unique Intellectual Property that is likely to make them winners but they are “diamonds in the rough” and suffer from the following drawbacks:

• Since private equity investing in India is still a nascent phenomenon, PE firms that may be well known in the US, Europe or Asia, do not yet have significant brand recognition in India. In fact, the executive management in many of these companies may not even understand how PE firms work. Consequently, it will be up to Private Equity managers to find and convince the management of these firms of the benefits of PE investment. However, once these PE managers find good companies, in many cases, they are likely to agree upon more realistic valuations (e.g., 10 to 12 times earnings) as compared to those prevalent in the IT and ITES sectors.
• Since the executive management of these companies is very resistant to giving up control and dislike even the
  notion of bringing in external directors, it would be up to the Private Equity managers to convince the executive
  management of their value proposition, of course, in addition to providing capital.
• Many of these companies are very regional in nature (e.g., they may only produce and/or only sell in Northern
  India) and hence would need advice with respect to strategy and operational expertise in marketing and sales
  within India and abroad. In addition, most of them would require guidance and help with sales and acquiring and integrating non-Indian companies.

Clearly, finding such companies and doing due-diligence on them is more challenging in India as compared to US or
Europe markets because there is very little market research available and because these companies and even the
corresponding sub-sectors may not be very transparent. Furthermore, since most of these companies may not
appear on the “radar screens” of the big strategy and management consulting firms (e.g., McKinsey and Company,
Bain & Company, etc.), the PE managers would have to either perform this research themselves or employ global
research firms with a strong presence and experience in India (e.g., Evalueserve) to do this research. Finally, these
PE firms would also have to find senior and experienced professionals in India, who may have worked in the
corresponding sub-sectors capable of conducting thorough SWOT (Strengths, Weaknesses, Opportunities and
Threats) analyses. We believe that such India-based on the ground analysis may cost a PE firm between $25,000
and $50,000 for a specific sub-sector and/or a specific company – but with investments likely to be $10 million or
more, this should be money well spent.

Diversify, diversify, and then diversify a bit more

Given that many managers in the VC and PE firms come from science and technology backgrounds, they are
instinctively attracted to the high-tech industry. However, as mentioned in Section 4, this area is likely to contribute
only 10% of the overall growth of the Indian economy, and will contribute only 20% to the growth of the three fast
growing areas mentioned in Section 4. On the other hand, even though deals in the IT and ITES sector dropped from
65.5% in 2000 to 28.8% in 2006 (see Table 3), IT and IT Enabled Services (ITES) constitutes only a sub-sector of
the overall high-tech sector, and this sub-sector is getting overheated with valuations of many – if not most –
companies running at 30 to 50 times their earnings. In contrast to this, the Sensex is only trading at 21 times
earnings. Furthermore, because of the availability of cheap capital, many “lemming” companies have started during
the last four years in the IT and ITES sector, but most may not survive the next three years. Incidentally, even within
the IT and ITES sub-sector, there are sub-sectors (e.g., open source, robotics related to machine tools, and
animation) that have largely remained untouched so far by the PE industry in India.

New sub-sectors are emerging in the Indian economy

As the disposable income for the middle and rich classes is increasing, their changing habits and tastes are leading
to the creation of new sub-sectors, eco-systems, and supply chains. For example:

• India currently has 325 airplanes that fly domestically but this number will exceed 750 by 2010, thereby,
  generating $12 billion in annual revenue (in 2010). Of this $12 billion, approximately $2 billion will be used for maintaining these airplanes. However, there are hardly any airline maintenance companies today and this sub- sector is likely to grow exponentially in the near future. Similarly, there are almost no airplane certification companies in India that can audit and certify that airplanes have complied with all maintenance requirements. Currently, most of this work is being outsourced to companies in the US and Europe.
• Traditionally, Indians have consumed liquor mainly to get intoxicated. Those who could afford it drank branded beer, rum and whisky, whereas those who could not lived and died by the “hooch” (illicit/country liquor). As the disposable income of the middle and rich classes has increased and as they have become more aware of European and American tastes, Indians have begun to acquire a taste for fine wine. Consequently, two wine companies in India – Sula Wines and Champagne Indage – are growing at 40% to 50% a year and have recently received capital from GEM India Advisors, Arisaig Partners, and Indivision Capital.
• The Indian automotive industry (for both domestic and export purposes) is likely to quadruple in revenue and achieve $165 billion in 2016, but in this process is likely to face a shortage of 2.5 million skilled personnel (that include mechanics, maintenance professionals, assemblers, and specialized IT professionals). Hence, a learning services company, Adayana, which has been building e-learning courses for specialized sectors in the US market, has turned its attention to the Indian market. It will be working with the Society of Indian Automobile Manufacturers and 38 automotive companies in India to create a curriculum and then provide a low cost solution to train a million or more professionals – both on a generic basis and on a more customized basis for these 38 companies. Incidentally, Adayana has recently received funding from Kubera Partners, a private equity group, and has been doubling every year for the past three years with half of its workforce based in the United States and the other half in India.
• Although the real estate and hospitality (hotels) sectors are not new to the Indian economy, thanks to the booming Indian economy and the Indian middle class, the demand in these sectors has been growing very rapidly. Indeed, during the past four years, these sectors have provided average annual returns of around 30% and although these returns are likely to come down, these sectors are still likely to be fairly lucrative for the PE and HF communities. Hence, it is not surprising that during the first half of 2007, PE and HF community invested $1.8 billion in these two sectors and they seemed to have raised more than $9 billion (out of a total of $48 billion) for investment during the next three and half years; Morgan Stanley, D. E. Shaw, Avenue Capital, Starwood Capital and Walton Street Capital are only some of the funds currently investing in these sectors. Interestingly, although these sectors are growing fairly rapidly, there are hardly any title insurance companies currently providing insurance with respect to the titles and the deeds of commercial or residential properties. Finally, as mentioned in Section 5.5, some cities and regions in India may be already overpriced with respect to real estate (although even these cities have a demand-supply gap with respect to hotels) and hence the investing community would need to do its research before investing in this sector.

India is neither the United States nor China

Although it is fashionable these days to compare India and China, actually the two countries are quite different.
Indeed, a lot of progress in China is because of the government whereas that in India it is despite the government.
For example, the communist government in China can easily plan projects in a very structured and systematic
manner without worrying about the courts or public opinion, whereas most projects in India get delayed because of
Indian courts and because of strong public opinion. Similarly, although India and the United States share democracy
as one of their fundamental tenets, India is a poor country with a severely underdeveloped infrastructure, whereas
the US is one of the wealthiest countries with a very well developed infrastructure. Because of these reasons, it
behoves VC and PE firms to consider investing in Indian companies “in their own right” rather than pursuing the
following strategy: “if it has worked in the US or China, it will work in India too.” Given below are examples of three
companies that are likely to cater only to countries like India:

• Because of the unreliable supply of electricity throughout India and because of the Indian government clamping
  down on the use of diesel generators in many large and medium-sized cities (due to immense pollution), a set of
  universal power supplies called “inverters” have already become quite popular and are expected to become more so during the next few years. According to Evalueserve, the market size of these inverters (and the associated batteries) would grow from approximately US $1.2 billion in 2007 to US $3 billion in 2010. Hence, it is quite likely that by 2010, there would be at least two or three companies with combined annual revenue of one billion Dollars and these companies are likely to have unique Intellectual Property with respect to products, processes and sales networks. Furthermore, given their unique Intellectual Property, these companies are also likely to export to other countries in Africa and South-East Asia.
• Because of poverty, low education and the tropical climate, diseases like Malaria and Dengue, which are spread
  by mosquitoes, are quite common in India (and also in parts of Africa and South-East Asia). Hence, the market
  size of mosquito repellents in India was already US $400 million in 2006 and is likely to grow to $1 billion by 2010.

Again, it is quite likely that at least one company would emerge with $250 million or more in revenue and will
begin exporting in a big way to other regions in Africa and South East Asia.

• Castrol India produces many different kinds of engine oils and lubricants in India (e.g., those for motorcycles,
  two-wheeler scooters, cars, trucks, tractors, and pumps) and is likely to have revenues of $500 million in 2007.
  Since the requirements of consumers in large cities are quite different from those in villages, Castrol India has
  designed unique products for each market segment, e.g., engine-oil pouches for 10 cents each that can be sold
  in villages and small towns. One of its unique features is its distribution network that consists of almost 100,000 outlets throughout India. According to Evalueserve’s estimates, there are at least 20 companies in a variety of sectors that could become as big as Castrol India, if they could receive proper advice and operational consulting especially with respect to building a similar distribution network.