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 being felt, 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 declining demand across the world. Several studies suggest that this will continue; as an illustration, McKinsey estimates that Indias domestic consumption will quadruple between 2005 and 2025. The countrys growth 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 1: Source: India Economic Survey, 2010-11

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 large middle class. The structure of the economy has altered significantly as well with a much larger share for industry and services. Indias abundant and well developed human capital augurs well for growth in

services; and on the industrial front, rapid growth in recent years is creating large opportunities for midsized companies. Together, these factors will ensure the resilience and heightened prospects for the economy. Growing Middle Class: The middle class (Seekers + Strivers in diagram 2) estimated at 5% of the population in 2005 (14 million) is estimated to increase to 41% by 2025 (128 million). There has been a significant rise in per capita Income this has a great impact on Consumer discretionary businesses as the share 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 hits an estimated 140 crores in 2025, India will boast of a youthful profile of the population. 63 % of the population is in the working age group of 15-59 years and this figure will grow in the years to come. This will give impetus to further growth in middle class disposable income which is also expected to rise to Rs. 2,400,000 crores by 2015. The growth being witnessed in India currently began 10-15 years ago. The predominant players are the fast 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. Today many of these companies are listed but have a market capitalisation of less than Rs. 100 crores. Such organisations have become prime targets for the PE industry for mid market investing. Indias phenomenal growth, dynamic entrepreneurs and need for capital to finance profitable opportunities has allowed 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 the past decade. KPMG says 70% of PE investments are in companies with a turnover less than Rs. 500 crores. The average 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 as obtaining debt financing from public markets is often too premature for such growing yet asset light companies. According to a study by Venture Intelligence, PE-backed companies perform better than no-PE backed companies and companies that are listed on major indices like Sensex and Nifty on aspects like annual sales growth, PAT growth, R&D growth and so on. This is partly because PE funds today become partners in MSMEs not just as providers of capital but as value creators. They have started taking an active interest in the working of their investments and see how they can grow it. With many exit options available to PE firms today, they look to maximise their investments by providing quality inputs and resources to their investments.

Source: VCCEdge

Source: Venture Intelligence (Period 2000 - 2008) Sunrise sectors demonstrate very encouraging growth figures. Many MSMEs have come up in these sectors and are doing well especially in markets such as food processing which till today remains a rather underdeveloped sub-sector. Infrastructure is poised for growth and would require substantial investment 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 attractive opportunity 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 Organisations like Bharti Airtel, Cafe Coffee Day, slowly opening his mind to the idea of Jubiliant Food Works, HDFC Bank, Educomp Solutions private equity. Thus, in a growing India, for and Pantaloon Retail are all private equity backed MSMEs, the PE value proposition is being success capital considered better when compared to other conventionalstories. 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 in demand 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 offering incentives for investments in agriculture and food processing. The population growth rate is increasing every year and we would be a nine billion population globally by 2050. According to World Wildlife Fund, to match the food requirements then, we have to produce the same amount of food in 40 years as we did in the past 8000 years. This puts agricultural and food companies in an advantageous position. Food processing is being watched rather keenly as a possible profitable investment because it is still in the nascent phase of growth. In India, milk is the most processed around 35% while fruits, vegetables and poultry is least processed at 10%. In comparison to the standard set by developed nations of 60-70% processing for various food items, there is huge scope in India for the sector to grow. The sector has received sizeable PE funds even though concerns regarding early stages of development and 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 and Return on Equity (ROE) opportunities in agriculture mainly in micro irrigation, commercial seeds, rice milling, 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, is ranked 86th in Global Competitiveness Report. The current infrastructure deficit is alarming. For example, 40 percent of the traffic is carried by only 2 percent of Indias total road network. Agriculture employs more than half of the population and 54 percent land in India is arable yet just 1/3rd of it is irrigated. Indian ports accommodate 10 million TEU of containerized traffic, less than 10 percent of the capacity of Chinas ports. With rapid growth in the economy, the need for adequate infrastructure especially 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 infrastructure development as a priority and it is developing varied PPP methods to involve the private sector in its development. Being an economy driven majorly by domestic consumption, the need for improved capacity in infrastructure is imperative for India. The utilization of critical infrastructure assets like railways, are straining to keep up with demand. Indias need to steadily expand infrastructure development offers a very attractive opportunity for value creation even in the face a global business environment embroiled in turmoil. Private sector contributed around 25% of the infrastructure investment during the 10th plan and it is expected to grow to 36% and 50% in the 11th and 12th plan. Infrastructure investment is expected to grow to 10% of the GDP and credit for infrastructure has seen substantial growth in the past decade. Infrastructure is one of the biggest investment opportunities for PE. Public infrastructure outlays will double over the next 5 years to US$ 1 trillion. The private sector will account for 40 to 50% of this. The power sector has attracted a lot of interest from PE investors. Over the next 5 years, the construction industry alone will require US$150 to US$200 billion to fund assets and working capital. This enormous growth in infrastructure is expected to have a ripple effect on allied infrastructure services. TSG Fund Scheme 1B is keen on opportunities with light asset models producing high ROE. Opportunities are likely to 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 late nineties, India is witnessing resurgence in the manufacturing sector and it is touted to be much more promising than the first wave. With the population much more skill intensive today, industry experts view India as poised to take advantage of this opportunity. The industrial output registered a robust growth 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. Electricity recorded a growth of 4.7%. India has emerged as one of the world's top ten countries in industrial production as per UNIDO's new report titled 'Yearbook of Industrial Statistics 2010'. The country ranked second in terms of manufacturing competence, according to report '2010 Global Manufacturing Competitiveness Index', by Deloitte Touche Tohmatsu and the US Council on Competitiveness. The report states that the country's talent pool of scientists, researchers, and engineers, together with its English-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 manufacturing sector sets the tone for the overall business cycle and the health of this sector is very important for the socio-economic fabric of India. According to Confederation of Indian Industry (CII) - ASCON survey, 41 out of 121 sectors in the manufacturing industry are estimated to grow at 20 per cent or more in 2010-11 as against 34 sectors that 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$ 1.01 billion. With the growth in industry and services in India it is imperative that manufacturing should grow to maintain the 8% growth motive of the economy. An 11% growth in services and manufacturing can help propel GDP growth to that level. Being an outsourcing destination for manufacturing now, this sector presents a lucrative opportunity for PE firms. With the quality of products manufactured in India rising 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 require bigger investments in the future. PE investors can invest in this sector and sub-sectors which promises bigger 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 a 16% CAGR. The sector forms the second highest share of the middle class wallet after food. It is a defensive sector and provides reasonable volatility proofing across economic cycles. The following is a representation 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 the largest capitalised space in India and innovations are becoming an active part of education. Leading organisations are looking into newer forms of technology to increase the reach of education in the country. The government wants to increase spending on higher and primary education facilities to improve the literacy rate in the country from the current 61 percent. Being one of the biggest sectors attractive private investments, education has a lot of scope in the years to come as India expands to a stronger economy. The education sector offers attractive PE investment opportunities in unregulated sub-sectors such as preschool, vocational training, test-prep, tutoring, multimedia services to school and books stationary and publishing. The following table summarizes key characteristics of the sub-sectors of education:

Current Size

Growth

Unregulated

Scalability

Preschool
K12 Higher Education

Multimedia in schools
ICT Coaching classes Test Prep Vocational Training Books

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

Segments

Market Size Key Players No of (In Rs Cr) Deals Pre-School 1800 Euro Kids, Kangaroo Kids, Shemrock K-12 47100 Educomp, DPS,DAV Professional Education 35700 NMIMS, Amity, Manipal Vocational Education 4800 NIIT, Aptech Test Preparation Multimedia Source: Edelweiss Research 3600 FIITJEE, Careerpoint 9800 Educomp, Everonn

Key Investors 2 India Venture Partnership Mgmt, Foundation Capital, Matrix Partners 3 NSR, Sequoia, 7 PremjiInvest, Matrix Partners 9 IDFC Foundation, Ventureast Fund 12 Matrix, Helix Investment Advisors 12 Temasek, Intel Capital

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

Retail

Retail Therapy is gaining popularity in India. The sector has an estimated CAGR of 10-14% on the back of favourable demographics, rising disposable income, steady economic growth, large scale real estate developments and increasing urbanization. According to CRISIL, after the slowdown of 2008-09, the retail sector is expected to at a 13.5% CAGR over the period FY09-FY14 and organized retail will grow at 22.3% over the same period. Given the low retail penetration in India, the large growth opportunity for the sector should continue over 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, the sector can witness an even stronger boom in the years to come. The logistic component of the retail costs 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 in various 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 will continue 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-sectors growth and consequently increase the required investment. Healthcare The Indian Healthcare Sector is estimated at Rs.1,76,000 crores and Hospital Infrastructure is expected to contribute 50% of the sector followed by pharmaceuticals at 25%, Insurance and Medical Equipment at 15% and Diagnostics at 10%. Indias healthcare spending as a % of GDP is still lower compared to the developed as well the emerging economies such as Brazil, China, etc and majority of the spend is from the private sector. The current infrastructure for Healthcare in India is deficient compared to the global standards 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 growth induced lifestyle changes, insufficient health infrastructure and illness profile shift from chronic to lifestyle diseases. However, many sub-sectors such as multi-specialty hospitals have large capital requirements to fund real estate and expensive equipments with longer pay-backs. By 2020, the healthcare sector will be worth US$280 billion. The public sectors investment for the same is not expected to go beyond 15 to 20 percent of the required contribution.The healthcare sector is another necessary 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 many government initiatives riddled with controversies, the private sector should look at this sector as an opportunity for long term growth-oriented investments. Private equity has played a role in the development of some of the brands in healthcare such as Apollo Hospitals, Narayana Hrudayalaya, Metropolis Labs, SRL Ranbaxy, etc. These investors are looking to invest in smaller gestation period and low asset intensity sub-sectors such as diagnostic chains, specialty hospitals and medical device units. There are new evolving models such as single specialty centres for various diseases, day care centres which are expected to have shorter break even periods, preventive care in terms of Ayurvedic and Wellness centres are gaining momentum. The sector is in need long term investments to setup the infrastructure required in rural areas of the country. Interest in healthcare among PE investors is rising because of the offer of assured returns with lesser risk. The healthcare sector also promises to be a better investment than pharmaceuticals today.