Return From Indian Private Equity KPMG Report

Returns from Indian Private Equity
Will the industry deliver to expectations?
kpmg.com/in
2011 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

Will the industry deliver to expectations?
Table of Contents
Foreword Section 1 Section 2 Introduction Returns from Indian Private Equity How PE Funds Manage Exits and Create Value Influence of Capital Markets and Sectors Understanding the Type of Exit Influence of the Type of Entry Influence of Holding Period and Ownership Section 3 Section 4 Looking Ahead for 2012 Conclusion and Recommendations 03 05 10 13 16 19 21 25 27
Foreword
The turmoil in the global economy continues to damage value creation. Slow western economic growth followed the financial crisis of 2008 and 2009, causing 2010s sovereign debt crisis, which persists to the present time. Emerging markets, components of which are reliant on foreign capital and demand, began to see the spillover in 2011, which will continue into 2012. However, other components of emerging markets the domestic growth released by reform, urbanization and workforce education continue to attract investors. Not surprisingly then, and confirmed by an EMPEA-Coller Capital survey in April 2011, Limited Partners' (LPs) appetite for emerging market private equity (PE) attained new highs in 2011. Respondent LPs expect that PE allocated to emerging markets will increase from 13 percent at present to 18 percent in two years time. Moreover, the LPs surveyed expect that Emerging Asia PE funds will earn the highest returns of any investment class, with nearly 78 percent of LPs expecting net annual returns of 16 percent or more. Within emerging Asia, first China and, now, India are in asset classes of their own rather than clubbed with other Asian countries a reflection of their size, performance and potential. While owning an asset class makes investment decisions by overseas investors less volatile than if India was a component of a broader allocation to emerging Asia, it puts a greater burden on delivering returns. This motivates our present report, the third in a series. Earlier reports looked at the future of PE and its impact on corporate functioning and the economy. In this report, we study returns. India shares the promise of unusual return and risk with many emerging markets. Many risks are common to all emerging markets political and regulatory uncertainty and weak corporate governance among them. Many of these risks are more likely in India, even if they are not unique such as working with familyowned businesses, navigating IPO exits and compliance risks. The returns ought to justify the risks, and this is an important aspect of this report. The reader should note an unusual focus on PE exits in this report causes, type, timing, scale and so on. Unlike capital market investments, PE returns are precisely measured only by the value at exit. This prompted us to look more closely at a sample of PE exits and investments in India and undertake this study on the returns that these exits generate. We hope you find these insights interesting and useful. We would like to extend our thanks to all the respondents for their time and contribution to this research.
VIKRAM UTAMSINGH
Head of Private Equity and Transactions and Restructuring KPMG in India
RAFIQ DOSSANI
Professor of International Relations and Senior Research Scholar Stanford University
03
1 Introduction
The private equity (PE) industry in India is only about a decade old, the same as the lifespan of a typical PE fund. As the earliest funds wind down, it is worth remembering that they started in a high growth environment that later turned volatile due to the global downturn (See Exhibit 1.1). Deal value picked up only around 2004, when it crossed USD 1.5 billion for the first time. The progression to a 2007 peak of USD 14 billion reflected both the global financial boom and the emergence of the India story. The higher levels and lower volatility since 2009, despite unsettled global conditions, marked Indias emergence as an asset class. India now ranks sixth after the US, UK, Spain, France and China in terms of PE deal value, though it overtook China briefly, in 20101.
Exhibit 1.1
Private Equity Investments in India
16,000 14,000 12,000 Deal Value (USD mn) 10,000 8,000 6,000 4,000 2,000 0
107 500 110 1,160 937 78 591 56 470 90 1,737 186 2,460 280 Period 1999-2003 2004-2010 CAGR (%) -1.5% 29.6% 358 7,135 268 3,975 14,004 489 465 10,397
600 500 400 Deal Volume 300 200 100 0 2004 2005 2006 2007 2008 2009 2010 9M 2011
359 8,254
322 8,607
1999
2000
2001
2002
2003
Amount (USD Mn)

Note: 2004 till 9M 2011 from Venture Intelligence as of October 24, 2011 Source: Venture Intelligence, AVCJ, Grant Thornton, Data does not include real estate deals
Volume
1.
Dealogic
04
In earlier reports, KPMG looked at the future of PE and its impact on industry and the economy. These reports established the importance of PE in helping to transform mid market Indian companies to professional standards and deliver faster growth. We found that the PE impact was most significant on business model changes, corporate governance and professional talent management of portfolio companies. PE investment also helped enhance a companys reputation with bankers and the capital markets. Today, Indian companies find PE to be an alternate source of long term capital for funding new and innovative business models and growing businesses. In this report, we study returns. India shares the promise of unusual return and risk with many emerging markets. Many risks are common to emerging markets political and regulatory uncertainty and weak corporate governance among them. Many of these risks are more likely in India, even if they are not unique such as working with family-owned businesses, navigating IPO exits, and compliance risks. The returns ought to justify the risks, and this is an important aspect of this report. The returns come from PEs long-term, transformative impact: PE helps build companies that are designed to be future market leaders. There is an irony to this finding, for the PE fund managers relationship with the portfolio company is constrained by the life of the PE fund, which is always limited (usually ten years). During those ten years, the PE fund manager fulfils four sequential tasks with respect to portfolio companies: find, invest, hold and exit. The investments occur in the
early years of a funds life, the exits towards the end. As the average holding period in India and globally is five years, the fund must exert its transformative influences within this time frame. Private equity is, thus, built around the philosophy that is possible to exit profitably over the holding period. This begs the question: can a five-year engagement, however intensive, create a long-term market leader? In the Indian context, particularly, the relative immaturity of Indian industry as typified by the predominance of the family-run businesses and weak standards of corporate governance, bringing a company to exit requires significant governance and domain skills during the holding period. This means that during the holding period, of all the PE fund managers activities, monitoring is key. But, does the limited time available not constrain the PE manager to engage sub-optimally with the portfolio company and focus on operating strategies that will make exit possible in five years rather than for the long-term? Does it force him to choose certain types of exit over others a strategic sale with a high probability of predicting the time of exit rather than an IPO with a much more unpredictable holding period, even though the returns might be lower? The key question of our study is what determines rates of return at exit? Some factors are systemic and uncontrollable: the global financial crisis of 2008-2009 tightened credit and narrowed the exit opportunities and returns for all firms. This comes under the category of factors that a PE fund cannot easily control. However, what of the factors that can be controlled choice of which sector to invest in, what percentage of the firm to invest in and how much to
invest, the entry strategy, type of exit, and when to look for exit? From the answers to these questions, we can derive some lessons about exit strategies that should be useful to PE fund managers, their investors and portfolio companies. For instance, we would like to know how exit types match the preferences of fund managers or whether the type of exit is mostly out of their control. To what extent are exit type and timing influenced by the sector invested in and other factors, such as the life of the fund? Do the most popular sectors for investment also generate the highest returns? Which types of exits generate the best returns and why? Do promoter preferences on exit matter and, if so, how are conflicts resolved? Is there a connection between the entry and exit types for example, do buyouts usually result in IPO exits or strategic sales? Our methodology is as follows: We first collected a sample of about USD 5 billion of investments which were invested over the period 1999 to 2010, and today have either been realised or remain unrealised. We were unable to verify that our sample is representative of the industrys exits and present unrealized positions. However, we felt that our sample size was adequate for the purpose of our analysis and the subject of this report. Our data analysis was then discussed through interviews with a representative sample of GPs and LPs; some of whose views are expressed herein. This report therefore, cannot be construed as representing the actual exits and unrealized positions for private equity funds in India and should be considered as an 2 indicator only .
2.
See Important Notice to the Reader at the end of the report
05
Returns from 2 Private EquityIndian
India's economic growth has propelled PE investments in the country from USD 470 1 million in 2003 to USD 8.2 billion in 2010 . Although the increase in deal volume and value indicates the attractiveness of India as a PE destination, the true measure of success of a PE investment is when the fund exits, makes a significant multiple and returns the money to its limited partners (LPs). India's growth story no longer needs to be sold to LPs but the lack of meaningful exits to date has been a cause of concern. As Exhibit 1.1 showed, the size of PE investments can be quite volatile. Most of the volatility can be attributed to external economic events. One should not deduce from this that India is a 'residual' destination for global PE money, even though most of the PE money - about 80 percent - does indeed come from overseas. Today and for the past decade, India is amongst the most important emerging market for PE after China and often competes favourably with it. It now occupies its own 'asset class'. While the volatility in PE flows into India will remain significant until the global financial crisis lasts, it is expected to significantly decline post-crisis. Now, however, a new cause for concern has arisen: India has fallen well behind China in exits. Exit value for 2 China was USD 8.7 billion in 2010, nearly twice the exit value for India in 2010.
Nevertheless, 2010 was a landmark year for exits in India as exit value touched USD 4.55 3 billion spread across 174 exits . This was nearly two times the exit value in 2009 and about 56 percent of aggregate exit value during the preceding four years prior to 2010. In comparison, PE exits in 2011 have been less encouraging due to volatility in Indian capital markets and other economic challenges like high interest rates and inflation and a slowing GDP growth. Exit value for 2011 (up to September 2011) was less than half of the PE exit value witnessed in 2010, while exit volume too lagged behind and was only 53 percent of exit volume in 2010. The fact that 2007 2009 and 2010 have generated the , highest volume of exits shows the close correlation between a vibrant capital market and PE exits.
1.
Venture Intelligence accessed on October 24, 2011. Data does not include real estate deals
2. Asia Private Equity Review, 2010 3. VCCEdge, Exit values were adjusted for PE investors share
06
Exhibit 2.1
Private Equity Exit Volume and Value
5000 4500 4000 3500 USD mn 3000 2500 2000 1500 1000 500 0
1482 93 5 152 1227 61 592 1029 92 32 1690 41 0 67 661 154 234 13 250 721 1486 334
82 1443 155 215 535
966 251 1516
241 632 1073 82 140
2005
Exit Volume 53
2006
64
2007
112
2008
60
2009
117
2010
174
9M 2011
93
Secondary Sale
Open Market
Strategic Sale
IPO
Buyback
Note: Exit value has been adjusted for PE investors' share whereever applicable Source: VCCEdge
For LPs, who tend to be global investors, capital flows are determined by return expectation across asset classes and geographies. A look at our overall sample (realized and unrealized investments) shows that private equity in India has returned a gross IRR of 17 percent which is only .9 slightly above the 14.4 percent that investors would have earned if they had made the same investments in the Sensex. Net of manager fees and other costs, the IRR earned by LPs falls below the 14.4 percent return for the Sensex mentioned above. It is also well below the benchmark of most LPs and funds, which is to earn a multiple of 3x on the typical investment
(adjusted for the five year holding period, this implies a required gross IRR of 25 percent). However, if one considers the returns only from the realized investments in our sample, the IRR jumps to 29.1 percent which is significantly higher than the corresponding 4 Sensex return of 16.2 percent . Similarly, the median IRR for our sample of realized investments was 27 percent compared to .6 the median Sensex IRR of 14.3 percent. The large difference between realized and total returns seems to suggest that funds prefer to sell their performing assets first. This could be a signalling effect to suggest outperformance, which in turn could make the GP's task of raising follow on funds
easier. Through our analysis and discussions with GPs, what also seems to emerge is that a significant number of unrealized investments that are held by funds are nearly valued at cost and have not generated any profit. This means that funds will either need to continue to hold these investments in the hope of better returns in the future or will need to sell at cost or book their losses. In either case the high returns that our realized investments show will reduce as funds reach the end of their fund life and start to divest their positions. Alternatively, fund managers will need to work harder with their portfolio companies in order to create value.
4. See Notes at the end of the report for a detailed description of returns calculation
07
Exhibit 2.2
PE Returns Snapshot
PE Investments Total Sample Investment Amount (USD mn) 5,120 Exit Amount (USD mn) 12,193 Weighted IRR 17.9% Median IRR 7.7% Cash Multiple 2.4x Average Holding Period (in years) 3.4 SENSEX IRR 14.4%
Note: All IRR and cash multiples are presented on a gross basis Source: Bombay Stock Exchange, KPMG in India analysis
Exhibit 2.3
Sensex Return Vs PE Return for Sample of Realized Investments
35.0% 30.0% Weighted IRR 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Sensex Return
Source: Bombay Stock Exchange, KPMG in India Analysis
29.1%
16.2%
PE Return
Exhibit 2.4
Private Equity Return Vs Market Return
55.0x 50.0x 45.0x 40.0x
Cash Multiple
35.0x 30.0x 25.0x 20.0x 15.0x 10.0x 5.0x 0.0x Deal by deal Return Sensex Return
Top decile exits generate a multiple in excess of 4.3x
Source: Bombay Stock Exchange, KPMG in India Analysis
A closer look at our returns data indicates that deals in the top decile are likely to return in excess of 58 percent IRR while deals in the lowest decile are likely to generate returns of minus 40 percent or lesser. Similarly, when
looking at the top quartile of exits, deals are likely to return a satisfactory return of over 32.5 percent while deals in the bottom quartile are likely to deliver a return of minus 3 percent or lower.
08
Exhibit 2.5
IRR Distribution
80 70 60 Number of deals 50 40 30 20 10 0 Less than -60% -60% to -50% -50% to -40% -40% to -30% -30% to -20% -20% to -10% 90% to100% -10% to 0% 10% to 20% 20% to 30% 30% to 40% 40% to 50% 50% to 60% 60% to 70% 70% to 80% 80% to 90% 0% to 10% Over 100% 3 6 10 22 15 9 27 33 29 17 19 13 4 2 2 2 19 68
Represents a distribution with fatter tails. Nearly 30% of PE investments end up giving negative returns
Source: KPMG in India Analysis
Exhibit 2.6
Distribution of Cash Multiple
120 100 80 60 40 20 0 0 to 1x 1x-2x 2x-3x 3x-5x 5x-7x 7x-10x Over 10x 42 27 11 5 8 111 96
This widespread IRR return suggests the existence of considerable outliers at both ends. This is confirmed by the IRR distribution table shown in Exhibit 2.5, which shows a distribution with fat tails Nearly . 30 percent of PE deals in India are likely to end up generating a negative return. One of the respondents in our survey concurred with this thought, noting that at least a third of the average PE fund portfolio is under water and remains in the portfolio . Further, deals delivering blockbuster returns (IRR>100 percent) and deals delivering significantly negative returns (IRR<60 percent) occur with relatively similar frequency. Moreover, over 50 percent of the investments tend to generate returns in the range of minus 10 percent to 30 percent. So how do returns for PE in India compare to other Asian countries and emerging markets? When we compare returns for India to its closest competitor China, returns for India lag behind on an overall basis as well as on a realized basis. The overall IRR for China is 20.4 percent as compared to an IRR of 17 percent for India. India also lags .9 behind developed economies such as Australia and Japan both in terms of overall and realized returns, as shown in Exhibit 2.7 .
Number of deals
Source: KPMG in India Analysis
09
Exhibit 2.7
PE Returns Across Asia and Other Countries
Country IRR Developing Economies India* China Southeast Asia Developed Economies Australia Japan South Korea 24.9% 20.0% 16.6% 1.6x 1.7x 1.8x 47.4% 32.5% 27.4% 2.5x 2.3x 2.5x 17.9% 20.4% 4.5% 2.4x 2.2x 1.2x 29.1% 35.1% 12.4% 3.1x 3.8x 1.8x Overall Cash Multiple IRR Realized Cash Multiple
Note: *Figure for India represents capital weighted IRR based on KPMG Analysis. Returns are presented on a gross basis Source: Asia PE Index, KPMG in India analysis
Several India-specific factors account for the relative under performance. We deal with one important factor here: the high cost of entry. Its key driver is one that we highlighted in our earlier report on the future of PE in India: the preponderance of intermediated deals relative to proprietary deals only 40 percent5 of investments are proprietary or co-investment deals. Intermediated deals are shopped around to the highest bidder, thus raising the entry costs. As an LP pointed out to us, In China, it is possible to get deals at single digit (price/earnings) entry valuations; in India, it is usually in the teens. Even for proprietary deals, the entry valuations tend to be higher than in China because of the relatively high proportion of family-owned businesses in Indian PE portfolios. Owners of such businesses tend to be financially sophisticated and secure, and so are willing to wait for a higher bidder. Given the weaknesses that are evident in Indian corporate governance, PE fund managers tend to undertake extra due diligence of family-owned firms. As a fund manager notes, We are very scared of the lemons effect: if a family-owned business is keen to sell, it might mean that the books overstate revenues and profits. Secondly, the maturity of the capital markets raises entry valuations by providing alternative
capital raising opportunities for private firms. Indian capital markets allow private companies to raise capital early on in their life. China is different. As one of our respondents noted, China's market is relatively immature and the quality of analysis is poorer than in India. This usually means that new companies tend to be under-followed and undervalued. Further, China's vibrant IPO market means that exit via the IPO route is easier than in India In India, private equity needs to compete with the primary market as a fund raising option, which becomes tougher in the Indian scenario where entrepreneurs are unwilling to lose control and do not want to exit their positions either. Indian markets are also difficult to execute in, because of regulations, leading to execution delays. A third source of competition for deals are strategic investors, due to their understanding of the business risks and tolerance for illiquidity. In subsequent sections of the report, we analyze the returns for Indian PE in detail and look at a host of factors that directly or indirectly affect returns.
5. KPMG Reshaping for future success, 2009
10
How PE Funds Manage Exits and Create Value

As noted earlier, PE funds are typically structured as finite life funds with the philosophy that it is possible to invest and exit profitably across many companies over a period of 10 years. Thus, it becomes imperative for PE fund managers to manage the exit process well to generate the desired returns. During the typical holding period of five years, PE funds besides providing capital to the portfolio company also provide transformative inputs which often take the portfolio company into the next level of growth. Our survey revealed that PE funds help in value creation in portfolio companies in a number of ways. The most important areas relate to help in attracting the right talent, assistance in developing new business models for the company, improving corporate governance, helping the portfolio company to expand and access new markets, besides providing patient capital for the company during its growth phase.
Exhibit 2.8
PE Funds Contribution to Value Creation
25% 19.3%
20%
15%
14.0% 12.3% 12.3% 12.3% 8.8% 7.0% 5.3%
10%
5%
3.5%
3.5% 1.8%
0%
Helped in attracting talent Helped develop new business models Offered patient capital for company in growth phase Helped business to expand and access new markets Improved corporate governance in company Helped in building world class capability Helped access other sources of funding specifically debt Helped in efficiency improvement Enabled infrastructure capacity development Others Helped improve the perception of the quality of the company
Note: Data represents percentage of responses Source: KPMG in India Survey, 2011
We also asked PE fund managers to identify the primary source of value creation in their portfolio company. Our survey indicated that EBITDA growth was the primary driver of value creation in 57 percent of the cases driven primarily by organic growth. In 30 percent of the cases PE made money primarily due to multiple expansions (see
Exhibit 2.9). In other words, the contribution of PE is partly due to timing the business cycle rightly, i.e., obtaining an expansion in the multiple. While timing the cycle appears to be important, our survey indicated that organic growth was more important and is consistent with the overall picture that emerges of PE's transformative impact.
11
How PE Firms Manage Exits and Create Value
Exhibit 2.9
Primary Source of Value Creation
4%
Primary Source of EBITDA Growth
9%
12% Organic growth of the portfolio company 54% EBITDA Growth Multiple Expansion Other Leverage Reduction 19% Any other (changing product mix, entering new markets) Cost reduction through operating efficiencies Acquisitions by the portfolio company
15% 30% 57%
The exit process begins with an assessment of the likely type of exit, such as an IPO or a strategic sale. Once the options are narrowed, an exit process begins. Some parts of these processes are governancerelated: putting in place an independent board, and testing the adequacy of corporate governance and financial systems to meet the buyers' requirements (for instance, the standards for listing the firm). Other parts relate to the actual divestment process: negotiating with buyers and brokers, completing legal and compliance requirements, and so on.
The portfolio company's management needs to come on board with the exit process. 'Company management' usually also means the majority owners, since management are usually promoters who keep a controlling stake. Overt disagreements with promoters on the type of exit are rare. Most promoters prefer IPOs and open market sales to other types of exit, since it allows them to retain control of the company. Even secondary sales are preferred to strategic sales by promoters for the same reason, although less preferred
than public market options due to having to share control in the case of secondary sales with a new financial investor. Strategic sales thus become one of the least preferred option of promoters and the most preferred by the fund manager. This may lead to potential conflicts between fund managers and promoters on the type of exit, as well as on timing and valuation. The disagreements may be significant, as our survey shows (Exhibit 2.10).
Exhibit 2.10
Portfolio Company Disagreement with PE Fund
Valuations
3.4
Type of Exit
3.3
Timing
2.9
Partial or complete exit
1.7
Note: 5 being high disgreement and 1 being low disagreement Source: KPMG in India Survey, 2011
12
Our survey also indicated that during exit discussions, the highest disagreement between the promoter and the investor is on valuations and the type of exit. The survey further highlighted that under most circumstances PE investors tend to influence the choice of exit. However, a few noted that such control is driven by the stake held in the portfolio company and the type of business.
Exhibit 2.11
How Much Control do Investors Exercise on Exit Type?
3.3
0.5
1.5
2.5
3.5
4.5
Note: 5 being complete control and 1 being least control Source: KPMG in India Survey, 2011
Exhibit 2.12
Time Taken to Exit
25%
20%
55%
3-6 months 6mths- 1 yr Over 1 yr
Note: 5 being high disgreement and 1 being low disagreement Source: KPMG in India Survey, 2011
The survey also indicated that it usually takes between six months to a year to actually exit after the decisions to exit the firm (including agreeing on the price with the buyer) is taken. The most important challenges for the fund managers during the exit process were
related to hurdles during execution and taxation issues. Other issues faced by funds included speed of execution, negotiations on representation and warranties and structuring of transactions.
13
Influence of Capital Markets and Sectors

Exhibit 2.13
Amongst the larger factors that influence exit activity, capital markets bear a strong correlation with PE exit volume (see Exhibit 2.13). This is due to the fact that rising markets support higher valuations and easier exits compared to a downward trend which makes exits difficult to come by as risk aversion replaces risk appetite.
BSE Sensex Value and PE Exit Value

25000 20000 15000 10500 5000 0
31/Dec/03 31/Dec/04 31/Dec/05 31/Dec/06 31/Dec/07 31/Dec/08 31/Dec/09 31/Dec/10 31/Dec/11
Sensex hits peak of 21,206 on Jan 10, 2008
500 450 400 350 300

Sharp recovery post elections
BSE Sensex
PE Exit Value (USD mn)
Sustained bull run in the Indian markets
250 200 150 100 50 0
Lehman crisis, markets hit a bottom
BSE Sensex Value
PE Exit Value
Note: Outliers have been omitted for ease of representation, Each dot represents PE exit, Exit value represents total value of liquidity event Source: VCCEdge, Bombay Stock Exchange, KPMG in India Analysis
Besides, being a key factor in determining the choice of exit and timing of exit, company valuations are also a function of conditions in the capital markets which directly impact returns. Hence, its not surprising that deals done at the top end of the market cycle are likely to yield lower returns compared to deals done at the bottom end of the market cycle. This is evident when one looks at the sample of
returns for deals done at the peak of the market cycle in 2007 which have yielded an IRR of minus 0.3 percent on a capital weighted basis. On the other hand deals done during the uncertainty of 2009 have generated the highest IRR of over 86 percent. 2004 and 2005 were other good vintage years with returns of 42.3 percent and 31.1 percent respectively.
Exhibit 2.14
Returns by Vintage Year
Years 1999-2003 2004 2005 2006 2007 2008 2009 2010 Total Weighted IRR 33.3% 42.3% 31.1% 19.4% -0.3% 6.3% 86.5% -18.4% 17.9% Median IRR 28.1% 15.0% 19.9% 12.3% 3.4% 6.4% 5.5% 0.0% 7.7% Cash Multiple 4.9x 4.0x 2.9x 2.0x 1.2x 1.4x 1.6x 0.9x 2.4x Average Holding Period (in years) 6.8 5.3 4.6 4.1 3.4 2.6 1.4 0.6 3.4 Sensex IRR 20.0% 28.1% 26.9% 12.4% 3.8% 5.9% 44.1% 22.6% 14.4%
Note: All IRR and cash multiples are presented on a gross basis Source: Bombay Stock Exchange, KPMG in India analysis 2011 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.
14
Further, the reverse should be true for exits as bullish markets are likely to yield higher returns compared to bearish markets. This is particularly true for exits in 2007 which yielded an abnormally high return of 77 .5 percent on capital weighted basis as PE funds were able to cash in on the upsurge in capital markets and earn supernormal returns. Another good year for exits was 2010 which returned a decent 30 percent IRR. This underscores the fact that timing the exit is a crucial aspect which determines the likely return the investor will make.
Exhibit 2.15
Returns by Exit Year (Only for realized investments)
Years 2004-06 2007 2008 2009 2010 2011 Total Weighted IRR 36.1% 77.5% 22.3% 6.0% 29.7% 16.8% 29.1% Median IRR 36.1% 111.1% 32.2% 0.4% 27.1% 20.1% 27.6% Cash Multiple 4.2x 3.8x 1.6x 2.5x 3.0x 3.1x 3.1x Average Holding Period (in years) 3.8 2.5 2.3 3.8 4.3 4.9 4.0 Sensex IRR 22.0% 37.8% 26.0% 7.0% 9.9% 15.1% 16.2%
Note: All IRR and cash multiples are presented on a gross basis Source: Bombay Stock Exchange, KPMG in India analysis
The survey respondents indicated support for the above findings. As shown in Exhibit 2.16, the state of capital market environment and portfolio company performance are amongst the most crucial factors impacting the decision to time the exit and affecting, in the process, the holding period. Other important factors impacting the exit decision include state of the domestic business cycle and status of remaining fund life. As one fund manager noted, One reason for the five year
holding period in India is that we can catch the business cycle on the upswing. If we invest at a high prior to a downturn, we expect that we will exit during the next upturn without a loss and, hopefully, some profit from organic growth. If we invest during a downturn, we will make a large profit during the subsequent upturn. Thus, regardless of the cycle, we expect to exit profitably on average provided we are disciplined about exiting during the upturn.
Exhibit 2.16
Factors Influencing Timing of Exit Decision
State of capital market environment Portfolio company performance State of domestic business cycle Status of fund / Remaining fund life Preferences of portfolio company management Type of industry/sector that the portfolio company belongs to State of global business cycle Contractual agreements with promoters of the portfolio company, eg., buyback... Time to exit and related transactions costs 0 1 1.5 2 3 4 5 1.7 2.6 2.6 2.4 3.3 3.6 3.5 3.8
Note: 5 being highly significant and 1 being least significant Source: KPMG in India Survey, 2011
15
Influence of Capital Markets and Sectors
The difficulty in exit may reflect the capital market environment, as noted. But, it may also reflect poor underlying performance relative to investor expectations. Unlike public equity funds, where the option to disinvest (exit) lies with the LP the option in , the case of private equity funds lies with the fund manager. Until the fund exits from an investment, the LPs must wait. It is quite likely that underperforming investments will be held for as long as possible, since waiting may be viewed as a costless option by the
fund manager. If so, we would expect that unrealized investments would be valued less, on average, than realized investments. Does the choice of sector selection also influence returns? Our study indicates that the top performing sector in our sample based on capital weighted IRR was energy & energy equipment that returned 42 percent. This was followed by engineering & construction which returned an IRR of 38 percent while healthcare & pharmaceuticals and manufacturing gave returns of around 27
percent each. On the other hand, the lowest performing sectors based on weighted average IRR were auto & auto components and consumer & retail, both of which have eroded capital for investors. Our survey indicated that the sector returns tend to be driven by the nature of the sector whether it is capital intensive in nature, the pace at which it is growing and most importantly the entry valuation - whether you are the first to identify the sectors potential before competition drives up valuation.
Exhibit 2.17
PE Returns Across Sectors
Sector Agri & Food Auto & Auto Components BFSI Consumer & Retail E-commerce & Online Services Energy & Energy Equipment Engineering & Construction Healthcare & Pharmaceuticals Hotels, Resorts & Leisure IT & ITES Manufacturing Media & Entertainment Other Services Others Telecom Transport, Shipping & Logistics Overall Weighted IRR 16.2% -7.2% 9.5% -8.8% 20.6% 41.6% 37.8% 27.0% 2.9% 15.6% 27.3% 11.2% 28.5% 12.8% 24.7% 6.6% 17.9% Median IRR 4.0% -1.1% 6.9% 0.6% 1.6% 16.9% 29.2% 25.8% 4.6% 0.0% 11.8% 7.9% 21.6% 9.0% 6.4% 10.2% 7.7% Cash Multiple 2.0x 0.9x 2.6x 0.9x 2.3x 5.1x 2.6x 2.4x 1.4x 1.9x 2.4x 1.8x 1.7x 1.9x 4.2x 1.4x 2.4x
Note: Transportation, Shipping and Logistics includes logistics infrastructure, Consumer and retail includes gems and jewellery, education, retail and apparel, specialized retail etc., Agri and Food includes agri inputs, unprocessed foods, processed foods and restaurants, Others include real estate, All IRR and cash multiples are presented on a gross basis Source: KPMG in India Analysis
Notwithstanding the diversity of sectors for investment, PE funds tend to be generalists. The reasons are several. They include some LPs preference for a general emerging market-like portfolio in India, though this is changing as India acquires its own asset-class
status. A second factor is the lack of depth, i.e., availability of a large number of deals, in most sectors. The lack of deals means that it is not possible for a GP to find enough investments to justify sector specialisation.
16
Understanding the Type of Exit

In this section, we examine which exits would be most preferred by a PE fund manager. Specifically, we seek to understand: do certain types of exits yield higher returns? What kind of exit will be preferred by a PE firm under what conditions and why? As noted in Exhibit 2.18, the most common type of exit in India is the open market sale. Open market exits accounted for nearly 38 percent of total PE exit volume over the period January 2005September 2011. This can be attributed to the fact that once a company is listed on a stock exchange, it is fairly easy for a PE investor to sell off in one shot or dribble its stake, depending on the liquidity in the companys stock. Next in popularity were strategic sales that accounted for 32 percent of total PE exit volume over the mentioned period. Interestingly, while open market sales are directly related to sentiments in the capital market, M&A transactions are less impacted by conditions in capital market due to their strategic nature.
Exhibit 2.18
Exit Volume by Type
Secondary Sale 12% Buyback 10% IPO 8%
Total exit volume (2005-9M 2011): 673
Open Market 38%
Strategic Sale 32%
Source: VCCEdge
The survey respondents considered open market exits as the easiest to do in India. Strategic sales and buybacks were considered to be the most difficult despite the fact that nearly 32 percent of exits have been through strategic sales. Strategic sales were considered difficult due to the lack of strategic buyers while buybacks are hampered by the lack of enforceability. Also, buybacks or put
options as they are called, for obvious reasons are considered the option of last resort, to be tried only in the worst case scenario after all other options have been exhausted. Moreover, other exit options such as an IPO and open market sales are market dependent and also face regulatory restrictions in the form of lock in periods restricting the sale of shares.
Exhibit 2.19
Ease of Exit Options in India
Open Market
1.6
IPO
2.3
Secondary Sale
2.5
Buyback
3.3
Strategic Sale
3.4
Note: 5 being most difficult and 1 being easiest Source: KPMG in India Survey, 2011
17
Understanding the Type of Exit
But does the ease of exit option also translate into higher returns? As shown in Exhibit 2.20 for our sample, there is not much difference between returns from different types of exits, with the exception of buybacks. While the low return on buyback may be explained these are underperforming deals that are sold back to promoters it is interesting that secondary
sales earned the highest return (followed by strategic sales, IPO and open market sales on a weighted average basis). From a global perspective, it is unusual for secondary sales to generate the highest return due to high levels of buyer sophistication. As one of our respondents noted, Given the shortage of buyouts in India, a lot of capital is being reinvested in the portfolio companies of
other PE funds. This gives promoters a lot of options. Going forward, this will not continue. Secondary sales offer an additional advantage: they enable a maturing investment to continue to remain under PE guidance for some more time than may be possible within a single funds lifespan.
Exhibit 2.20
Returns by Exit Type
45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Open Market Strategic Sale Weighted IRR Secondary Sale Median IRR IPO Cash Multiple 2.1% Buyback 1.1x 5.5% 35.3% 30.1% 29.3% 2.8x 4.0x 37.4% 39.4% 3.4x 35.7% 3.5x 32.7% 2.9x 24.9% 3.0x 2.5x 2.0x 1.5x 1.0x 0.5x 0.0x
3.6x
Note: Data pertains to realised deals only, All IRR and cash multiples are presented on a gross basis Source: KPMG in India Survey, 2011
The returns from strategic sales can be explained from the fact that strategic buyers are willing to pay a higher premium to enter into an established business due to operational synergies or to get a head start into a new market. Also if a majority stake is on offer it is possible for the seller to get a high control premium. Half the PE fund managers' that we surveyed did not have a preferred choice of exit with most calling it opportunistic and preferring with the one that delivers the highest return for that particular divestment. The remainder had strategic sales at the top of the list followed by public market sales (IPO/open market), as the preferred modes of exit. There are several reasons why a strategic sale is preferred. For one thing, the stake being sold might be too small to justify an IPO, whereas strategic buyers tend to be open to a wide range of investment sizes. Second, if the investment has not done outstandingly well, a strategic sale is still possible at some valuation while an IPO might be unlikely. Third, and perhaps the most important, exit via IPO requires a vibrant stock market. Since stock market activity is influenced by the business
cycle of the economy, the timing of an uptick in markets may not match the time when a portfolio company is ready for exit. Strategic buyers, on the other hand, think long-term and are less influenced by short-term market swings. This allows the portfolio firm to be positioned appropriately over a period of years by building relationships with desired acquirers several years in advance. Exhibit 2.21 shows the importance that PE fund managers attach to different factors influencing the exit type. While most of the important factors such as the state of capital market and state of the domestic business cycle, portfolio company performance and the preferences of promoters are as expected, it is interesting that fund life and transactions costs associated with exits are relatively unimportant. Given our earlier discussion on how fund life critically affects every portfolio decision, this suggests that fund managers have managed to invest within a disciplined framework that accounts for the time it takes to exit and the costs involved this is a sign of the increasing maturity of the PE industry in India.
18
Exhibit 2.21
Factors Determining Choice of Exit Type
State of capital market environment Portfolio company performance Preferences of portfolio company management State of domestic business cycle Type of industry/sector that the portfolio company belongs to State of global business cycle Contractual agreements with promoters of the portfolio company, eg., buyback clauses, Status of fund / Remaining fund life Time to exit and related transactions costs Others 0
4.2 4.0 3.5 3.1 2.9 2.8 2.1 2.0 1.7 0.9 1 2 3 4 5
We also asked fund managers to identify factors which influence their decision to partially exit from a portfolio company against a complete exit from such company. The tendency to book partial profits and take some money off the table is the most important factor that affects the decision to make a partial exit. Taking the cost out when valuations are high, allows the fund to participate in further upside and get the fund managers carry meter ticking.
Partial exits can also be a result of changes in regulatory factors which lower the attractiveness of the industry. Further, partial exits are important in cases where the fund owns large stakes, which might be difficult to sell especially in new/unique industries given that capital markets may not know the appropriate valuation.
Exhibit 2.22
Factors Influencing Partial vs Full Exit
Tendency to book partial profits
3.5
Liquidity Requirements Signaling effect to market Availability of options Regulatory factors Other Expectation of significant upside 0 0.3 1 2 3 0.7 1.8 1.9 2.7
3.3
19
Influence of the Type of Entry

Exhibit 2.23
In this section, we explore the relationship between entry and exit. The Indian PE market is unusual in that, unlike most countries, it participates at the growth stage, with very few early and buyout deals. Growth stage deals comprised nearly 58 percent of all PE deal value in India and over 51 percent of all PE deal volume in India over the period January 2004- September 2011. Early stage deals which were about 21 percent of the PE deal volume over the mentioned period comprised only 3 percent of deal value in the country. By contrast, buyout deals represented 8 percent of total PE deal value.
PE Deal Volume by Entry Type

600 500 400
27 90 11 64 12 4 65 12 77 8 24 2005 Buyout Early 190 18
Number of deals
20 60 8
300 200 100 0 6 1 30 3 36 17 2004
11 42 12 15 39 6 134
261
259
9 45 10 149
200
64 18 2006
77 18 2007 Growth
106 13 2008 Pre-IPO
64 12 2009 PIPE
86 9 2010 Others
94 17 9M2011
Note: Growth stage deals include growth as well as late stage deals Source: Venture Intelligence, KPMG in India analysis
Normally, we would expect the highest risks to be found in the earliest stage deals, as well as the highest potential to make a difference. However, our study indicates that returns for early stage deals are significantly lower at 4.1 percent compared to 19.6 percent for growth stage deals on a weighted average basis. Our survey
indicated that fund managers were also surprised at this finding. One attributed it to the immaturity of the industry, noting that: In India funds dont add enough value. Thats why there is a mismatch in returns and stages. Another factor that can perhaps explain the low returns include the lack of an entrepreneurial eco-system in India. Hence,
businesses take longer to cross the proofof-concept stage, increasing the time period it takes to turn profitable. Early stage investing needs an eye for quality and since it is fairly new in India, might start to give higher returns in the future.
Exhibit 2.24
Returns by Deal Stage
40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Early Growth Weighted IRR
Note: All IRR and cash multiples are presented on a gross basis Source: KPMG in India analysis 2011 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.
35.3% 2.9x
36.2%
3.5x 3.0x
2.6x 25.2% 1.7x 19.6% 2.0x 15.0% 11.6% 9.3% 4.1% 1.6% Pre-IPO Median IRR PIPE Cash Multiple Buyout 2.0x 24.7%
2.5x 2.0x 1.5x 1.0x 0.5x 0.0x
20
Another unexpected finding is that buyouts have returned 24.7 percent. This is unexpected because of the perception that promoters demand a 'control premium' to sell out. As one of the survey respondents noted, Promoters run a lifestyle business and don't usually want to sell out. Yet, despite the higher entry valuation that this implies, there appear to be some opportunities in buyouts. PIPE deals are an unusually large phenomenon. They accounted for nearly 17 percent of total PE deal volume over the period January 2004 to September 20116, yet several PE firms and LPs do not look on them as 'true' PE investments. At best, they are viewed as 'balancing investments', i.e., a way to invest spare funds in liquid, undervalued stocks, with an ability to make a quick rather than a substantial return. Our study indicates
that PIPE returns are more or less in line with the public market at 15.0 percent. Some respondents of this survey noted that the scope for adding value might exist in PIPES, since the stake may sometimes be large enough to justify a board seat; but mostly, the investment is passive. Still, as one fund manager noted in our survey, PIPES are ok to do - why not, if a fund can spot a company where the market does not capture the full value of the company? There would be more PIPEs if the 15 percent threshold was higher. Under the new Takeover Code which came into effect on October 22, 2011 the initial threshold for trigger of an open offer has been raised from 15 percent to 25 percent7. This is likely to provide an impetus for PE investment in small and mid cap companies.
Exhibit 2.25
Relationship Between Entry and Exit Type
Entry/Exit Buyout Early Growth PIPE Pre-IPO Buyback 0% 0% 18% 3% 0% IPO 0% 33% 16% 0% 0% Open Market 13% 17% 25% 88% 100% Secondary Sale 13% 17% 25% 3% 0% Strategic Sale 74% 33% 16% 6% 0%
Note: Data pertains only to our sample of realized deals Source: KPMG in India Analysis
An analysis of the relationship between entry and exit types indicates that buyouts in India mostly get exited via strategic sales (see exhibit 2.25), while other entry types are more diversified in exit types. In a buyout, the decision maker on exit type is solely the fund manager; whereas in other types of investments, the promoter will have a say in the type of exit. Adding a signalling dimension,
one survey respondent noted: It is natural that buyouts will exit through strategic sales because the investors control the company. If the PE funds own a majority and exit through IPO, the market will worry that there is something wrong with the company. PIPE deals and pre-IPO deals are expectantly realized through open market sales.
6. Venture Intelligence, Data does not include real estate deals 7 . VCCircle.com, October 2011
21
Influence of Holding Period and Ownership

Exhibit 2.26
The final factors that we consider as influencing exits are holding period, ownership percentage and size of the deal. Intuitively, we would expect that longer holding periods and larger ownership/deal sizes would yield higher returns. The first is a reward for holding period risk; the second because it improves access to better deals and allows for more fund control.
Returns by Holding Period

35% 30% 25% 20% 15% 1.8x 10% 5% 0% Less than 2 years 2-3 years Weighted IRR
Note: All IRR and cash multiples are presented on a gross basis Source: KPMG in India analysis
6.0x 29.3% 4.9x 5.0x 4.0x 18.5% 14.6% 9.6% 1.7x 8.2% 2.3x 3.0x 2.0x 1.0x 0.0x 3-4 years Median IRR 4-5 years Cash Multiple Greater than 5 years
24.0%
1.0x 5.0% 1.6%
10.1%
5.8%
As the chart above shows, longer holding periods appear to yield substantially higher returns. This appears to be consistent with the argument that an investor ought to earn greater reward for the greater liquidity risk implied by longer holding periods. However, there are two more factors at work. First, as discussed earlier, underperforming investments tend to be held on to in the
hope of doing well down the road. A PE fund would also like to hold on to highperforming investments. Over time, such investments could grow to be a substantial share of the portfolios total value. These arguments suggest that though constrained by fund life fund managers hold on to both dogs and stars. That returns rise with holding period is, therefore,
interesting and only partially explicable. Apart from intrinsic factors such as the portfolio company performance, a longer holding period also depends on the state of capital markets and the stage of the industry and economys business cycle. This is supported by survey respondents, as shown in Exhibit 2.27 below.
Exhibit 2.27
Factors Influencing Holding Period
Portfolio company performance
4.6
State of sector's business cycle
4.2
State of capital markets
3.9
Other
0.5
Note: 5 being highly significant and 1 being least significant Other includes view of future potential, incremental IRR, etc. Source: KPMG in India Survey, 2011
22
As one of the respondents of this survey noted, five year holding period enables A one to catch at least one business cycle , while another cautioned that merely holding on longer in order to add more value might not work, noting that, Long holding periods are not intrinsically superior. It depends on the business cycle. If you dont sell at the peak (of the business cycle), you may miss the opportunity. Turning to the influence of ownership and size effects, we find that, as expected, larger stakes yield higher returns. Returns were highest for deals where more than 50 percent of the stake was acquired. This can partly be attributed to the fact that a controlling stake allows investors to operate the company in a determined way and deliver superior results.
Exhibit 2.28
Returns by Stake Acquired
50% 3.0x 40% 2.5x 30% 20% 10% 0% -0.1% -10% Less than 20% Between 20% and 30% Weighted IRR
3.5x 3.0x 2.6x 26.9% 17.6% 18.5% 1.6x 11.8% 7.4% 3.5% 28.8% 2.5x 2.0x 12.6% 15.8% 1.4x 1.5x 1.0x 0.5x 0.0x
Between 30% and 40% Median IRR
Between 40% and 50% Cash Multiple
Greater than 50%
Nevertheless, our findings surprised several fund managers, who felt that a holding beyond 50 percent but less than 100 percent would rob the promoter of the incentive to perform. In addition, taking control required more fund manager time than might be worth it. As one of the respondents of this survey noted, There are huge bandwidth issues with control deals. It takes twice as much time to manage control deals compared to minority deals. In fact, the
sweet spot was deemed by survey respondents to be between 20 percent and 30 percent - an ownership stake that assures adequate influence without creating incentive issues and which allows the promoter to be substantial even after subsequent rounds of funding. In our sample, deals in which stake acquired was between 20 percent and 30 percent returned 26.9 percent as compared to 17 percent for the total sample. .9
Exhibit 2.29
Sweet Spot for Investor Ownership
20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 0% to 10% 10% to 20% 20% to 30% 30% to 40% 40% to 50% 50% to 60% 60% to 70% 70% to 80% 80% to 90% 90% to 100% 8% 6% 8% 8% 6% 6% 14% 14% 11% 19%
23
Influence of Holding Period and Ownership
Exhibit 2.30
When it comes to return by deal size, we expected, that returns would increase by deal size since larger ownership would require, typically, larger commitments of capital and entail greater fund manager commitment. As Exhibit 2.30 shows, the effect is not as marked.
Returns by Deal Size

50% 4.0x
40% 2.7x 30% 1.9x 20% 2.0x 19.1% 16.1%
2.9x 32.1% 1.8x 14.3% 8.2%
3.0x
23.1% 14.1%
20.7%
2.0x
10%
1.0x
6.0%
4.0% 0.0x $10 mn to $20 mn Weighted IRR $20 mn to $50 mn Median IRR $50 mn to $100 mn Greater than $100 mn
0% Less than $10 mn
Cash Multiple
The highest return, about 23.1 percent, is for deals between USD 20 million and USD 50 million at a cash multiple of 2.7x. Returns from deals in the range of USD 10 million to 20 million are also relatively high at 19.1 percent. This reiterates the attractiveness of Indias mid market opportunity. On the other hand deals below USD 10 million earn the least (6.0 percent). The reasons appear to be several. As one fund manager noted, a deal size between USD 10 million and USD 50 million allows the company to cross an important inflexion point and takes the company into the next (higher) level of valuations. Another respondent noted that this size of deal also is significant enough for an IPO or a strategic sale. However, some respondents were cautious, arguing that a
deal size beyond USD 10 million imposed significant risk, whereas smaller deals allowed better diversification. Large deals, beyond USD 50 million in size, were viewed as imposing too much risk, especially the risk that the promoters might not be able to execute well enough. However, we notice that deals above USD 100 million return an acceptable 20.7 percent. In fact, when one takes into account median IRR such deals have earned the greatest return. A reason for this could be that as deals get larger, the number of funds in that space reduces which allows investment at reasonable valuations. However since companies of this size are more mature, deals of this size would not deliver abnormally high returns.
24
25
Looking 3 for 2012 Ahead
The exit environment is expected to be difficult over the next two years. More than USD 31.5 billion was invested by PE funds in India from 2006 to 20081. Assuming a five year holding period and if funds are expecting to get back 3x on their investment which translates into a 25 percent IRR, that is nearly USD 95 billion in exit value that needs to take place over the next three years. Even when one considers USD 9.1 billion in exit value realized over 2009-2011 (till September 2011)2 assuming that these exits are for vintage years 2006 and beyond, nearly another USD 85 billion will need to be realized over the next three years to 2014. This translates to about USD 28 billion of exit value per year over the next three years. This is almost twice the maximum amount of PE investment (USD 14 billion in 2007) received in India in any year. Such a large amount of divestment appears unlikely and we, instead,
expect returns to reduce going forward owing to the legacy of underperforming investments that will be carried to maturity. Further, with capital markets remaining choppy on the overhang of high inflation and the global sovereign debt crisis, exits through IPOs and public market sales may remain low until the markets revive. In such a scenario, PE funds will need to explore alternate methods of exit. Nearly one third of this survey respondents also believed exit volume would decrease somewhat (between 10 percent and 20 percent) in 2011 and 2012 as compared to 2010, which was a blockbuster year for exits. Another 8 percent believed that exit volume will decline by more than 20 percent. On the other hand 46 percent believed that exit volume would increase by more than 10 percent while 15 percent expected it to remain stable.
Exhibit 3.1
Outlook for Exit Deal Volume in India
35% 30% 25% 20% 15.4% 15% 10% 5% 0% Decrease significantly (> 20 percent) Decrease somewhat (10-20 percent) Remain stable (+/- 10 percent) Increase somewhat (10-20 percent) Increase significantly (>20 percent) 7.7% 23.1% 23.1%
30.8%
Note: Data represents percentage of respondents Source: KPMG in India Survey, 2011 1. Venture Intelligence, Data does not include real estate deals 2. VCCEdge, Exit value includes only the PE investors share 2011 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.
26
Of course, this depends on the state of capital markets, which is viewed to be the factor most likely to influence exit. The state of capital markets has a much wider influence than on IPO exits and is likely to influence all types of exits. Most fund managers interviewed in the survey believed that taking a company public would be the most popular exit route followed by open market sales. However, this might change in the future as pointed out by one of our respondents as promoters are now building businesses to sell out This would enable . more strategic sales to take place.
Exhibit 3.2
Most Popular Exit Route
15% 33% 19% IPO Open market sale M&A (sale to strategic investor) Secondary Sale (to financial investor)
33%
Volatile capital markets, regulatory hurdles and mismatch in valuations are likely to be some of the biggest challenges for exits in India over the next two years. Disagreements between promoters and the fund and the lack of strategic buyers may also hamper the growth of exits, although to a lesser extent. Liquidity to exit large stakes will continue to remain a challenge and act as an impediment to large deals. Liquidity can create a challenge even while exiting mid market investments because even if the IPO is successful, there might not be enough liquidity or interest in the stock. Hence, the fund might not be able to offload its stake without the risk of negatively affecting the stock price. Delays in regulatory clearances and uncertainty of tax laws can further act as a dampener even if other things seem to be working out well and going according to plan.
Exhibit 3.3
Biggest Challenge for Exits
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Volatile capital markets Valuation mismatch Regulatory hurdles Management and promoter disagreement Lack of strategic buyers Others 18.8% 15.6% 9.4% 6.3% 6.3% 43.8%
27
Conclusion and 4 Recommendations
This report highlights many valid reasons to be worried about returns in todays PE environment in India: the depressed global economic environment and its spillover effects on India and other emerging markets; rapid changes in investment and exit opportunities, high entry valuations; the presence of return outliers that raise the probability of large negative returns, the challenges of sharing control with promoters on exit type, timing and valuations; lack of sector depth; and a weak IPO market. These factors adversely affect holding periods, investment and ownership decisions, and returns. Equally, one should discount the invalid reasons sometimes offered. For instance, the sophistication of Indias deal environment relative to China is a reason why entry valuations are relatively high in India. More than one fund manager has bemoaned this situation and wished that he operated in a less efficient environment, with fewer dealmakers and less savvy promoters. What our respondent probably does not appreciate is that such efficiency comes with other advantages that make the fund managers functioning far easier: more predictable rules, better protection of intellectual property and more efficient capital markets. Such an environment also protects promoters and investors better. While the short-term cost may be higher valuations, the long-term, transformative outcome of a more efficient deal environment is that it forces fund managers to focus on organic growth to achieve returns. A second invalid reason is sometimes offered by LPs and it concerns China. They point to Chinas superior performance and note that its more vibrant IPO environment is the driver of better performance. In fact, as our report shows, other factors, such as high entry valuations, also matter. Further, Chinese capital markets are today where
India was in the 1980s: an immature secondary market within a growing economy created opportunities for bankers and brokers to profit from investor ignorance through IPOs. Indias mature secondary market of today is an important reason why its IPO market is difficult: retail investors are well-informed about todays weak global and domestic growth environment and are reluctant to invest. Given the many valid reasons for concern, and with PE investors looking for opportunities (dry powder is estimated at USD 20 billion1 and new fund-raising by an estimated 60 PE/VC firms may add another USD 13 billion2), what should be done?
?
Manage timing, but do not be obsessed by it. Instead, focus on organic growth
Organic growth drives return in about 60 percent of investments, while timing the business cycle is the key driver in 30 percent of investments. So, while timing is important, over-allocating resources to calling the business cycle wastes resources that may be better used in monitoring. On timing, both on when to enter and when to exit, the evidence suggests that a simple strategy of investing in uncertain times and exiting after a period of capital market buoyancy will lead to better performance than trying to call the cycle of particular sectors or other factors. For instance, transactions made during the uncertain months of 2009 yielded abnormally high returns, as did exits during the buoyant months of 2007 For LPs, the message on . timing is also clear: given the long time-lags between fund closure and full investment, and between a decision to exit and actual exit, and given the rapid economic swings, they should support their fund managers efforts to invest and exit through at least one, if not two, complete business cycles.
1. Bain India Private Equity Report, 2011 2. VCCircle.com, October 2011
28
? Consider
realizing underperforming investments
About a third of PE investments are currently losing money, but the evidence is publicly hidden by many fund managers decisions not to divest underperformers. In an exit environment driven by IPOs, as in China, such underperformers would indeed be hard to exit. However, the Indian environment offers a greater diversity of exit options. Secondary sales, M&A (strategic sales) and buybacks, especially the latter two are, globally, an important source of liquidity for underperforming investments. This is true for India as well. By realizing losses quickly, fund managers will not only reduce the risk of massive losses later, but save the resource that is most valuable to their LPs: time spent in monitoring losers, which may then be shifted to more promising investments.
?on Focus
with promoters on type, value and timing of exit, negotiations with bankers and acquirers on structuring and representations, and so on. The median time just for the negotiation and structuring work is 6 months. So, the addressable issues such as bringing in independent directors should be addressed as soon as possible to avoid losing windows of opportunity. Second, there is not much difference in return between different exit types, with the exception of buybacks, which are usually a fallback option for exiting underperforming investments. Hence, considerable fund manager time can be saved by selecting the most rational exit option without worrying about its effect on return. Partial exits are always possible, although this depends on the type of entry and exit. A buyout, for instance, can rarely be fully exited through an IPO, as a full exit sends the wrong message to public investors. On the other hand, a typical stake of 20-30 percent ownership in a growth stage investment may be divested in many ways. Given the advantages of a strategic sale, including the advantage of preparing for this very early on in the investment cycle, this should be considered as a first option. Third, a secondary sale should not be viewed as a forbidden option, as it sometimes is. PE investors have generally been reluctant to exit via secondary sales as indicated by the low exit volume for such deals. However, as our study shows, secondary transactions offer relatively high returns. As the PE industry matures in India, more and more PE funded companies will come up for sale. These companies might have
significant unrealized value which a PE player might not have been able to harness fully due to a limited fund life. Since already owned by a PE fund, the company would have in place adequate systems and processes along with satisfactory corporate governance. As competition for quality deals increases, the incidence of such transactions is bound to go up.
? specialisation is possible, but Sectoral
will require greater resource commitment by GPs.

As we have seen in this report, most funds are not specialised by sector. The reasons, as we noted earlier, are several. They include some LPs preference for a general emerging market-like portfolio in India, though this is changing as India acquires its own asset-class status. A second factor is the lack of depth, i.e., lack of a large number of deals in most sectors. Still, given the relatively low costs of Indian professionals, limited sector specialisation may be worthwhile. However, it will require GPs to expand staff. As one LP told us, Indian fund managers operate funds that are too large for the number of partners. There is scope for expanding their professional base.
? 3x in 5
the average deal, not on
outliers
The fat-tails distribution of Indian PE shows that investments do not distribute themselves smoothly across the return spectrum. Instead, outliers are significant contributors to average return. Given the low likelihood of positive outliers only 9 percent of deals earned an IRR of 60 percent or higher it makes sense to seek a risk profile that focuses on deals whose return is expected to be close to the average.
? Narrow
years still makes sense.
the range of possible exit strategies early and rationally
The exit process is often tortuous, involving changes in governance and financial processes, managing conflicts
Despite the inability to earn this widelyadopted benchmark, a 3x return is required if investors are to get a fair return after accounting for costs and risk. Some strategies to get there: focusing on organic growth, and avoiding intrinsically short-term deals like PIPES that returned funds with high IRR to LPs whose options to invest the funds may be limited.
29
Conclusion and recommendations
? between Invest
USD 20 million and USD 50 million and own between 20 percent and 30 percent
India is a mid-market opportunity. As such, it is important to invest a sufficient amount in companies that will make them attractive to the IPO market and strategic buyers this means that exit values need to be at least USD 250 million. In turn, the entry value, assuming a 3x multiple, should be about USD 80 million. Our report shows that taking a stake between of about 20 percent to 30 percent yields the best returns for investors, as it optimally blends the PE managers ability to monitor without dis-incentivizing management. Hence, the optimal investment range should begin at USD 20 million for an ownership stake of at least 20 percent.
? Look beyond
generate significantly high returns. The ownership of majority stake in the company does entitle PE investor to define the companys growth strategy as well as garner any control premium that may be there on its exit.
?on Focus
risk assessment
GPs would be advised to focus more on risk assessment and fraud risk management. Various scandals and litigation between investors and promoters can often significantly impact returns and highlight the need for greater focus on these areas of corporate governance. There is an increasing need to focus on business risk, conduct extensive due diligence and build in all such scenarios while evaluating transactions. As the Indian PE market matures, returns are likely to moderate. Outperformance will call for GPs to build on the experience of the earlier cycle and to address the risks involved while making such investments. Undoubtedly, with its strong economic growth and entrepreneurial ability, India offers immense opportunities for PE investments; however, investors need to tread cautiously and build in the risks involved to demonstrate PE capital as smart money.
growth stage deals when investing
GPs perhaps need to look beyond growth deals and make investments in often neglected deal types like buyouts. Although buyouts in India are difficult to execute as promoters of Indian businesses are averse to selling out their business, they returned 24.7 percent IRR for the firms in our study. Recent PE exits in Paras Pharmaceuticals and VA Tech Wabag demonstrate that such transactions, if properly executed, may
30
Notes
a) The data for this study has been collected by KPMG b) Our sample consists of returns data for about USD 5 billion of investments which were invested over the period 1999 to 2010, and today have either been realized or remain unrealized c) The sample consists of a mix of full exits, partial exits and unrealized returns d) In case of partial exits the investment amount has been proportionately reduced to account for only the stake exited e) All aggregate IRRs are capital weighted average IRRs unless otherwise mentioned f) IRRs for public market indices are calculated by investing the equivalent cash flows that were invested in private equity into the public market index
g) Index returns for each exit has been calculated using date of first private equity investment and date of last exit as the entry and exit dates h) The index refers to the Sensex unless otherwise stated i) j) All IRR and cash multiples are presented on a gross basis i.e. they do not reflect management fees, carried interest, taxes, transaction costs and other expenses All available cash flows have been used to calculate exit returns
k) Dividends if any have been ignored.
Important Notice to the Reader

? The information used in this report is from various sources including but not limited to various databases, DRHP annual reports of the ,
company, stock market announcements, press releases, news articles and ROC filings
? This report is not a prospectus nor does it constitute or form any part of any offer or invitation to subscribe for, underwrite or purchase
securities nor shall it or any part of it form the basis to be relied upon in any way in connection with any contract relating to any securities
? The information contained in this report is selective and is subject to updating, expansion, revision and amendment. It does not purport to
contain all the information available on this subject. No obligation is accepted to provide readers with access to any additional information or to correct any inaccuracies, which may become apparent. The report is based on a sample of PE returns in India and should not be considered representative of the entire industry, but should be considered as indicative only
? not independently verified any of the information contained herein. KPMG, nor any affiliated partnerships or bodies corporate, nor We have
the directors, shareholders, managers, partners, employees or agents of any of them, makes any representation or warranty, express or implied, as to the accuracy, reasonableness or completeness of the information contained in the report. All such parties and entities expressly disclaim any and all liability for, or based on or relating to any such information contained in, or errors in or omissions from, this report or based on or relating to the readers use of the report.
31
Contact our Private Equity Team
Vikram Utamsingh
Partner and Head Private Equity Advisory & Transactions and Restructuring +91 22 3090 2320 vutamsingh@kpmg.com
Nishesh Dalal
Partner Transactions Services +91 22 3090 2659 nishesh@kpmg.com
Punit Shah
Partner Fund Structuring and M&A Tax +91 22 3090 2681 punitshah@kpmg.com
Bhavin Shah
Partner Fund Structuring and M&A Tax + 91 22 3090 2701 bhavins@kpmg.com
Tushar Sachade
Partner Fund Structuring and M&A Tax +91 22 3090 2683 tushars@kpmg.com
Dinesh Anand
Partner Forensic and Integrity Services +91 124 307 4704 dineshanand@kpmg.com
Nandini Chopra
Partner Corporate Finance +91 22 3090 2603 nandinichopra@kpmg.com
Rohit Madan
Associate Director Research and Market Intelligence Private Equity +91 124 334 5448 rohitmadan@kpmg.com
Nikhil Bedi
Director Forensic and Integrity Services + 91 22 3090 1966 nikhilbedi@kpmg.com
32
Acknowledgement
In order to provide a broad-ranging industry view in the study, we interviewed various General Partners and Limited Partners whom we would like to thank for their time and insights. We would like to acknowledge the commitment and contribution of our core team comprising of Rohit Madan and Gaurav Aggarwal without whom this report would not have been possible. We would also like to express our gratitude to the Brand and Design team of KPMG.
Contacts
Vikram Utamsingh Partner and Head Private Equity Advisory and Transactions & Restructuring T: +91 22 3090 2320 E: vutamsingh@kpmg.com Rajesh Jain Partner and Head Markets T: +91 22 3090 2370 E: rcjain@kpmg.com Nishesh Dalal Partner Transaction Services T: +91 22 3090 2659 E: nishesh@kpmg.com Rohit Madan Associate Director Private Equity T: + 91 124 334 5448 E: rohitmadan@kpmg.com
kpmg.com/in
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 2011 KPMG, an Indian Partnership and a member fi rm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. Printed in India.

Return From Indian Private Equity KPMG Report

Transféré par

Informations du document

Description originale:

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Return From Indian Private Equity KPMG Report

Transféré par

Droits d'auteur :

Formats disponibles

Returns from Indian Private Equity

Will the industry deliver to expectations?

Returns from Indian Private Equity

Amount (USD Mn)

See Important Notice to the Reader at the end of the report

Returns from 2 Private EquityIndian

82 1443 155 215 535

966 251 1516

241 632 1073 82 140

Returns from Indian Private Equity

55.0x 50.0x 45.0x 40.0x

Source: Bombay Stock Exchange, KPMG in India Analysis

Source: KPMG in India Analysis

Source: KPMG in India Analysis

Returns from Indian Private Equity

5. KPMG Reshaping for future success, 2009

How PE Funds Manage Exits and Create Value

14.0% 12.3% 12.3% 12.3% 8.8% 7.0% 5.3%

How PE Firms Manage Exits and Create Value

Primary Source of EBITDA Growth

15% 30% 57%

Partial or complete exit

3-6 months 6mths- 1 yr Over 1 yr

Influence of Capital Markets and Sectors

BSE Sensex Value and PE Exit Value

500 450 400 350 300

PE Exit Value (USD mn)

Sustained bull run in the Indian markets

250 200 150 100 50 0

Lehman crisis, markets hit a bottom

BSE Sensex Value

Influence of Capital Markets and Sectors

Understanding the Type of Exit

Open Market 38%

Strategic Sale 32%

Understanding the Type of Exit

Influence of the Type of Entry

PE Deal Volume by Entry Type

27 90 11 64 12 4 65 12 77 8 24 2005 Buyout Early 190 18

300 200 100 0 6 1 30 3 36 17 2004

106 13 2008 Pre-IPO

2.5x 2.0x 1.5x 1.0x 0.5x 0.0x

Influence of Holding Period and Ownership

Returns by Holding Period

1.0x 5.0% 1.6%

State of sector's business cycle

State of capital markets

Between 30% and 40% Median IRR

Between 40% and 50% Cash Multiple

Greater than 50%

Influence of Holding Period and Ownership

Returns by Deal Size

40% 2.7x 30% 1.9x 20% 2.0x 19.1% 16.1%

2.9x 32.1% 1.8x 14.3% 8.2%

0% Less than $10 mn

Looking 3 for 2012 Ahead

Conclusion and 4 Recommendations

1. Bain India Private Equity Report, 2011 2. VCCircle.com, October 2011

realizing underperforming investments

will require greater resource commitment by GPs.

the average deal, not on

years still makes sense.

the range of possible exit strategies early and rationally