macroeconomic outlook and private equity

7/31/2019 Macroeconomic Outlook and Private Equity

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MACRO OPPORTUNITIES AND PRIVATE EQUITY IN INDIA

India Macroeconomic Environment

In the midst of world-wide turmoil, the Indian economy stands resilient. While some tremors are beingfelt, India continues to hold promise for the future. Unlike many other emerging economies, her growth

is ‘domestic consumption led’ and therefore largely unaffected by collapsing markets and decliningdemand across the world. Several studies suggest that this will continue; as an illustration, McKinseyestimates that India’s domestic consumption will quadruple between 2005 and 2025. The country’sgrowth prospects are further boosted by a growing share of industry and services in GDP.

Understandably, India is an attractive investment destination. Several factors contribute towards this: GDP growth of 8-9% per annum with a changing industrial structure creation of a new middle class with high disposable incomes the aspiration for significantly higher levels of consumption, and a young population which delivers a demographic advantage

Diagram 2: Source: McKinsey Global Institute, The Bird of Gold

Economic Growth : Economic growth has helped reduce poverty and led to the emergence of a largemiddle class. The structure of the economy has altered significantly as well – with a much larger sharefor industry and services. India’s abundant and well developed human capital augurs well for growth in

Diagram 1: Source: India Economic Survey, 2010-11



services; and on the industrial front, rapid growth in recent years is creating large opportunities for mid-sized companies. Together, these factors will ensure the resilience and heightened prospects for theeconomy.

Growing Middle Class : The middle class (Seekers + Strivers in diagram 2) estimated at 5% of thepopulation in 2005 (14 million) is estimated to increase to 41% by 2025 (128 million). There has been asignificant rise in per capita Income this has a great impact on Consumer discretionary businesses as theshare of the wallet shifts from the basic necessities to more discretionary items.

Young Population: Dependency ratio in the country is steadily declining and when the population hitsan estimated 140 crores in 2025, India will boast of a youthful profile of the population. 63 % of thepopulation is in the working age group of 15-59 years and this figure will grow in the years to come. Thiswill give impetus to further growth in middle class disposable income which is also expected to rise toRs. 2,400,000 crores by 2015.

The growth being witnessed in India currently began 10-15 years ago. The predominant players are thefast growing mid-sized organisations in select ‘sunrise’ sectors in the economy. They are redefining the

corporate landscape and will continue to offer attractive opportunities for investment.

For private equity, this is a great sign for the future.

Private Equity Industry in India

Micro, Small and Medium Enterprises (MSMEs) are critical to the growth of the Indian economy. Todaymany of these companies are listed but have a market capitalisation of less than Rs. 100 crores. Suchorganisations have become prime targets for the PE industry for mid market investing. India’sphenomenal growth, dynamic entrepreneurs and need for capital to finance profitable opportunities hasallowed private equity firms to establish themselves in India. Infrastructure (Power, Energy, Telecom,

etc.), Healthcare, Education, Banking and Financial Services, IT and ITeS sectors have generated a lot of interest bringing in a total of Rs. 1,00,000 crores in private equity investments through 3000 deals in thepast decade.

KPMG says 70% of PE investments are in companies with a turnover less than Rs. 500 crores. Theaverage deal size is around Rs. 70 crores (excluding Real Estate) signifying a growing acceptance of private equity by MSMEs as a means to grow their business. This is a better financing route for them asobtaining debt financing from public markets is often too premature for such growing yet asset lightcompanies.

According to a study by Venture Intelligence, PE-backed companies perform better than no-PE backedcompanies and companies that are listed on major indices like Sensex and Nifty on aspects like annualsales growth, PAT growth, R&D growth and so on. This is partly because PE funds today becomepartners in MSMEs not just as providers of capital but as value creators. They have started taking anactive interest in the working of their investments and see how they can grow it. With many exit optionsavailable to PE firms today, they look to maximise their investments by providing quality inputs andresources to their investments.



Organisations like Bharti Airtel, Cafe Coffee Day,Jubiliant Food Works, HDFC Bank, Educomp Solutionsand Pantaloon Retail are all private equity backed

Source: VCCEdge

Source: Venture Intelligence (Period 2000 - 2008)

Sunrise sectors demonstrate very encouraging growth figures. Many MSMEs have come up in thesesectors and are doing well especially in markets such as food processing which till today remains arather underdeveloped sub-sector. Infrastructure is poised for growth and would require substantialinvestment to bring it up to the standards set by other leading developing and developed economies.MSMEs will play a key role in its development. For PE investors, these key sectors would be an attractiveopportunity in their preference for both mid market and large scale investments.

The use of PE in the growth phase of mid-sized companies has reaped benefits for all to see. Because of such examples, the Indian entrepreneur is

slowly opening his mind to the idea of private equity. Thus, in a growing India, forMSMEs, the PE value proposition is beingconsidered better when compared to other conventional capital sources.

‘Sunrise sectors’

Agri Business & Processed Food

The world is going through a major food shortage and the impact is felt in India too. The mismatch indemand and supply, a growing population and depletion of cultivable land, is leading to high food price



inflation in India. With the aim improve food security in the country, the Government is offeringincentives for investments in agriculture and food processing.

The population growth rate is increasing every year and we would be a nine billion population globallyby 2050. According to World Wildlife Fund, to match the food requirements then, we have to producethe same amount of food in 40 years as we did in the past 8000 years. This puts agricultural and foodcompanies in an advantageous position. Food processing is being watched rather keenly as a possibleprofitable investment because it is still in the nascent phase of growth. In India, milk is the mostprocessed around 35% while fruits, vegetables and poultry is least processed at 10%. In comparison tothe standard set by developed nations of 60-70% processing for various food items, there is huge scopein India for the sector to grow.

The sector has received sizeable PE funds even though concerns regarding early stages of developmentand the lack of proper systems and processes loom large. In the last 3 years, PE funds have invested Rs.2500 crores in 45 companies in the agriculture and processed food sector. There are high growth andReturn on Equity (ROE) opportunities in agriculture mainly in micro irrigation, commercial seeds, ricemilling, ready to eat foods and horticulture. There are 150 agricultural and allied services companies

listed in India and they provide good scope for PE investments.

Infrastructure Services:

India, though the second most populous country and second fastest growing economy in the world, isranked 86 th in Global Competitiveness Report. The current infrastructure deficit is alarming. Forexample, 40 percent of the traffic is carried by only 2 percent of India’s total road network. Agricultureemploys more than half of the population and 54 percent land in India is arable yet just 1/3 rd of it isirrigated. Indian ports accommodate 10 million TEU of containerized traffic, less than 10 percent of thecapacity of China’s ports. With rapid growth in the economy, the need for adequate infrastructureespecially in power and transport sectors has become critical. Road power, irrigation and railways are

integral to the economy and it must be scaled up. The government has started treating infrastructuredevelopment as a priority and it is developing varied PPP methods to involve the private sector in itsdevelopment. Being an economy driven majorly by domestic consumption, the need for improvedcapacity in infrastructure is imperative for India. The utilization of critical infrastructure assets likerailways, are straining to keep up with demand.

India’s need to steadily expand infrastructure development offers a very attractive opportunity for valuecreation even in the face a global business environment embroiled in turmoil. Private sector contributedaround 25% of the infrastructure investment during the 10 th plan and it is expected to grow to 36% and50% in the 11 th and 12 th plan. Infrastructure investment is expected to grow to 10% of the GDP andcredit for infrastructure has seen substantial growth in the past decade.

Infrastructure is one of the biggest investment opportunities for PE. Public infrastructure outlays willdouble over the next 5 years to US$ 1 trillion. The private sector will account for 40 to 50% of this. Thepower sector has attracted a lot of interest from PE investors. Over the next 5 years, the constructionindustry alone will require US$150 to US$200 billion to fund assets and working capital. This enormousgrowth in infrastructure is expected to have a ripple effect on allied infrastructure services. TSG FundScheme 1B is keen on opportunities with light asset models producing high ROE. Opportunities are likelyto be in toll management, specialized infrastructure equipment suppliers, EPC in waste management,BOP companies and so on.

(Reference: India Private Equity Report 2011 | Bain & Company, Inc)



Manufacturing

Manufacturing is slowly coming back in the national economic space. After the decline in the latenineties, India is witnessing resurgence in the manufacturing sector and it is touted to be much morepromising than the first wave. With the population much more skill intensive today, industry expertsview India as poised to take advantage of this opportunity. The industrial output registered a robustgrowth of 8.6 percent year-on-year in April-December 2010-11. Among the three major constituents of the IIP, mining and manufacturing recorded growth rates of 7.7% and 9.1% respectively. Electricityrecorded a growth of 4.7%. India has emerged as one of the world's top ten countries in industrialproduction as per UNIDO's new report titled 'Yearbook of Industrial Statistics 2010'. The country rankedsecond in terms of manufacturing competence, according to report '2010 Global ManufacturingCompetitiveness Index', by Deloitte Touche Tohmatsu and the US Council on Competitiveness. Thereport states that the country's talent pool of scientists, researchers, and engineers, together with itsEnglish-speaking workforce and democratic regime make it an attractive destination for manufacturers.Manufacturing has linkages with all sectors in the economy. The progress made by the manufacturingsector sets the tone for the overall business cycle and the health of this sector is very important for thesocio-economic fabric of India.

According to Confederation of Indian Industry (CII) - ASCON survey, 41 out of 121 sectors in themanufacturing industry are estimated to grow at 20 per cent or more in 2010-11 as against 34 sectorsthat had reported such growth during 2009-10; the top performers being air conditioners, tractors,fertilisers, construction equipment, tires, et al.In the last quarter of the fiscal year 2010-11, manufacturing attracted PE investments worth US$ 1.01billion. With the growth in industry and services in India it is imperative that manufacturing should growto maintain the 8% growth motive of the economy. An 11% growth in services and manufacturing canhelp propel GDP growth to that level. Being an outsourcing destination for manufacturing now, thissector presents a lucrative opportunity for PE firms. With the quality of products manufactured in Indiarising to international standards, the country is getting recognized for high value goods requiring a fair

amount of engineering precision and quality. The manufacturing sector is growing and would requirebigger investments in the future. PE investors can invest in this sector and sub-sectors which promisesbigger and better growth prospects in the years to come.(Reference: http://www.ibef.org/economy/manufacturing.aspx)

Sectors with Consumer Driven Opportunities

Education

The Education market in India is estimated at more than Rs. 1,60,000 crores and is expected to have a16% CAGR. The sector forms the second highest share of the middle class wallet after food. It is adefensive sector and provides reasonable volatility proofing across economic cycles. The following is arepresentation of the current key characteristics of the education sector:



The above features of the industry make investment into this sector safer than most others. It is thelargest capitalised space in India and innovations are becoming an active part of education. Leadingorganisations are looking into newer forms of technology to increase the reach of education in thecountry. The government wants to increase spending on higher and primary education facilities toimprove the literacy rate in the country from the current 61 percent. Being one of the biggest sectorsattractive private investments, education has a lot of scope in the years to come as India expands to astronger economy.

The education sector offers attractive PE investment opportunities in unregulated sub-sectors such aspreschool, vocational training, test-prep, tutoring, multimedia services to school and books stationaryand publishing. The following table summarizes key characteristics of the sub-sectors of education:



The following table shows how different companies in the PE space have invested in different types of education services in the sector:

Source: Edelweiss Research

Several of these sub- spaces are ripe for investment in a “synthetic startup” or “roll -up” play; PEinvestment is made into a strong team of entrepreneurs who then build a multi-regional companythrough a serious of inorganic acquisitions. Education has seen a lot of PE interest with more than 20deals in the year 2010 across various segments such as vocational education, pre schools, multi-mediaand K-12 schools. Some of the investments that are made are 24x7 learning, Excelsoft, Tutorvista, WLCIndia, etc.

Retail

CurrentSize

Growth Un-regulated

Scalability

Preschool

K12

Higher Education

Multimedia in schools

ICT

Coaching classes

Test Prep

Vocational Training

Books

Segments Market Size(In Rs Cr)

Key Players No of Deals

Key Investors

Pre-School 1800 Euro Kids,Kangaroo Kids,Shemrock

2 India Venture PartnershipMgmt, FoundationCapital, Matrix Partners

K-12 47100 Educomp,DPS,DAV

3 NSR, Sequoia,

Professional Education 35700 NMIMS,Amity,Manipal

7 PremjiInvest, MatrixPartners

Vocational Education 4800 NIIT, Aptech 9 IDFC Foundation,Ventureast Fund

Test Preparation 3600 FIITJEE,Careerpoint

12 Matrix, Helix InvestmentAdvisors

Multimedia 9800 Educomp,Everonn

12 Temasek, Intel Capital



“Retail Therapy” is gaining popularity in India. The sector has an estimated CAGR of 10 -14% on the backof favourable demographics, rising disposable income, steady economic growth, large scale real estatedevelopments and increasing urbanization. According to CRISIL, after the slowdown of 2008-09, theretail sector is expected to at a 13.5% CAGR over the period FY09-FY14 and organized retail will grow at22.3% over the same period.

Given the low retail penetration in India, the large growth opportunity for the sector should continueover the next decade. If the current challenges such as underdeveloped supply chains, absence of mature 3PL industry, poor infrastructure such as bad warehousing facilities and roads get addressed, thesector can witness an even stronger boom in the years to come. The logistic component of the retailcosts is currently 10% in India compared to 5% in Global retail.

The retail industry has had about 50 PE transactions of the approximate value of Rs 2500 crores invarious sub sectors such as Food & Grocery, Apparel, Mobile, Online Retailing, Service Retailing etc..With the favourable age demographics and rising middle class income level, the retail sector willcontinue to attract capital for growth from PE firms. Planned improvements in the GDP constituents will

only give further stimulus for the retail sector and its sub- sector’s growth and consequently increase therequired investment.

Healthcare

The Indian Healthcare Sector is estimated at Rs.1,76,000 crores and Hospital Infrastructure is expectedto contribute 50% of the sector followed by pharmaceuticals at 25%, Insurance and Medical Equipmentat 15% and Diagnostics at 10%. India’s healthcare spend ing as a % of GDP is still lower compared to thedeveloped as well the emerging economies such as Brazil, China, etc and majority of the spend is fromthe private sector. The current infrastructure for Healthcare in India is deficient compared to the globalstandards in terms of both beds and doctors. Rural areas are especially under served.

The private healthcare delivery sector in India is poised for rapid expansion driven by economic growthinduced lifestyle changes, insufficient health infrastructure and illness profile shift from chronic tolifestyle diseases. However, many sub-sectors such as multi-specialty hospitals have large capitalrequirements to fund real estate and expensive equipments with longer pay-backs. By 2020, thehealthcare sector will be worth US$280 billion. The public sector’s investment for the same is notexpected to go beyond 15 to 20 percent of the required contribution.The healthcare sector is anothernecessary sector that requires heavy investment to expand healthcare facilities across the country.Although the sector is growing, the ground level reality for a country like India is different. With manygovernment initiatives riddled with controversies, the private sector should look at this sector as anopportunity for long term growth-oriented investments.

Private equity has played a role in the development of some of the brands in healthcare such as ApolloHospitals, Narayana Hrudayalaya, Metropolis Labs, SRL Ranbaxy, etc. These investors are looking toinvest in smaller gestation period and low asset intensity sub-sectors such as diagnostic chains, specialtyhospitals and medical device units. There are new evolving models such as single specialty centres forvarious diseases, day care centres which are expected to have shorter break even periods, preventivecare in terms of Ayurvedic and Wellness centres are gaining momentum. The sector is in need long terminvestments to setup the infrastructure required in rural areas of the country. Interest in healthcareamong PE investors is rising because of the offer of assured returns with lesser risk. The healthcaresector also promises to be a better investment than pharmaceuticals today.

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