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Why Invest in Asian Private Equity? India as a Potential Breakout PE/VC Market
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settembre 20, 2024
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settembre 20, 2024
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Why Invest in Asian Private Equity? India as a Potential Breakout PE/VC Market |
Demographics, policy, and digitalization are converging at a time of significant change for India’s economy. Amid ongoing uncertainty in China, investors have been seeking alternate ways to obtain exposure to Asia with India being a key destination. With Indian public markets having experienced a strong run-up since 2020, global allocators have been turning to Indian private equity (PE). In this paper, we aim to examine the promising performance potential of Indian private equity, address oft-cited concerns, and share with investors how to tap into this potential breakout opportunity.
THE PARALLELS BETWEEN LAST-CYCLE CHINA AND CURRENT-CYCLE INDIA
China, over the last decade and until recently, had been one of the brightest spots in global private equity. Recalling our prior paper, "Why Invest in Asian Private Equity? The Case for Outperformance", PE investing in China benefitted from accelerated, ‘leapfrog’ growth, efficiency improvements, and valuation arbitrage. Multiple factors generated excitement in the space: the large homogeneous market, three decades of c. 10% annual Gross Domestic Product (GDP) growth, rapid urbanization and infrastructure build-out, and the accelerated development of technology. The public markets were buoyant and receptive of this rapid growth, spurring major initial public offerings (IPOs) of China-based companies on both the U.S. and Chinese exchanges. Many multi-billion-dollar businesses were created with PE and venture capital (VC) participating commensurately in this growth.
We believe that India currently possesses many of the same characteristics that made China so attractive in the last market cycle. For starters, India’s population has just surpassed China’s, and annual GDP growth for the next decade is expected to be 6.5%1 with India replacing China as the world’s fastest-growing large economy. India is investing heavily in physical and digital infrastructure, which is expected to contribute significantly to continued GDP growth. Unified GST,2 introduced in 2017, has India now behaving as one common market with the country moving up ten places in the last five years in terms of ease of doing business.3 We believe India possesses several structural tailwinds that may provide ample runway for growth—and that India may in fact be even better positioned than China was at a similar point in its growth trajectory.
INDIA MAY BE EVEN BETTER POSITIONED THAN CHINA WAS
Factor #1: More accelerated growth
While Prime Minister Narendra Modi is credited with India’s comeback story, many of the building blocks for India’s next phase of growth were introduced before he came into power in 2014. The idea for Aadhaar, which requires each Indian citizen to have a digital ID and has integrated millions of previously untracked citizens into the formal system, was born in 2010. The Unified Payments Interface (UPI) was conceived around the same time, providing India with the digital backbone for instantaneous online payments; India now leads the world in digital payments with over 100 billion transactions in 2023. In the ensuing years, the splash made by Jio, India’s largest telecom network, enabled India to offer the cheapest and fastest mobile networks in the world with COVID-19 tailwinds rapidly accelerating digital adoption. There are numerous additional initiatives underway, such as India Health ID (initiated 2020) digitizing medical records and Account Aggregator (initiated 2021) digitizing bank account information.
While the development of technology in the U.S. and China has been driven more so by the private sector, in India, it is the government that has laid the groundwork nationwide for multiple facets of society to be digitized, which we believe could potentially lead to even more accelerated growth. As shown in Display 1, India’s current mobile penetration is already on par with China’s and, in the next decade, India may overtake China’s mobile banking penetration, distinguishing the country as a clear digital-first economy.
Factor #2: India to global opportunity
While China—given its large, homogeneous market—had historically been mostly focused on domestic solutions, Indian companies in certain sectors have generally been more outward looking. Services make up a relatively high 40-50% of India’s exports, and India has a long history of business process outsourcing (BPO), serving a global customer base by leveraging its large and cost-effective talent pool. Today, some of this has transitioned into software-as-a-service (SaaS) with India becoming a potential development hub in this space. With three million developers, 50% more than in the U.S.,4 and at 50-70% lower salaries compared to U.S.,5 Indian tech companies can staff large teams, iterate on R&D more quickly, and simultaneously develop multiple products and holistic solutions while maintaining speed-to-market, making for a more compelling customer proposition. With the COVID-19 pandemic opening companies to the idea of enterprise sales originating from anywhere, India’s low cost, tech-savvy talent is expected to help grow its share of global SaaS from 5% to 8% over the next five years.6
Beyond the tech and software sectors, India has also served as a hub for emerging market solutions for decades. For example, exports in the consumer and healthcare sectors have historically offered strong price-to-quality propositions. With global supply chains diversifying beyond China, India is already proving to be a beneficiary.
Going forward, we believe India will play an increasingly important role in many global markets, from manufacturing to software and tech.
Factor #3: Focus on capital efficiency
For all the buzz around India right now, investment capital has come and gone in waves (Display 2), so for many years, companies could not rely on outside investment capital and were forced to bootstrap operations and grow in a capital-efficient manner. Additionally, until listing requirements changed in 2020, companies had to be profitable in order to go public. Even now, when examining the tech IPOs of the last three years, we observe that the market has rewarded companies with better margin profiles vs. those with high cash burn rates (Display 3). Hence, from both an entrepreneurs’ and investors’ perspective, in the Indian market, there is an implicit focus on capital efficiency. Companies that can scale profitably with lower cash burn should be generally well-positioned to generate more sustainable returns.
Even with all this positive momentum, we observe that many Indian general partners (GPs) with compelling track records struggle to fundraise from international limited partners (LPs). We believe it is important to understand the history behind this and how to think about the perceived risks of investing in Indian private markets going forward.
THE “BAGGAGE” – CURRENCY DEPRECIATION, HIGH VALUATIONS AND LIMITED EXIT OPPORTUNITIES
Those who have been investing in India for the last few decades bear a lot of scar tissue. Many investors were burned by disappointing returns in Indian PE/VC. It is not uncommon to see Indian GPs report their returns in Indian Rupee (INR), which, when translated into U.S. dollars, appear underwhelming. Other common gripes included the perceived high entry valuations of underlying target companies and the lack of distributions.
We believe the magnitude of these issues is lower today than in the recent past, but that these considerations must still be proactively managed by GPs.
Issue #1: Depreciation
Steep depreciation and volatility in the Indian Rupee (INR) have been concerns of investors for decades. At its worst, between 2007 and 2013, the INR depreciated over 50% against the dollar.7 In the last decade, the INR has continued to depreciate, but at a more modest and predictable rate. During this time, given a much more proactive central bank, India’s foreign exchange reserves position has significantly strengthened and inflation has moderated to 2.9%,8 resulting in a more controlled INR depreciation at an average of 4.0% p.a.. Morgan Stanley Research currently expects INR depreciation going forward to be more moderate, at c.2% per annum.9
This moderation notwithstanding, due to the prior steep depreciation era, GPs on the ground have generally become much more aware of the effects of depreciation, especially as most Indian PE and VC funds are denominated in U.S. dollars, with GPs’ carried interest also tied to dollar-denominated returns. Indian GPs today manage foreign exchange (FX) risk through a combination of diversification within the portfolio,10 balancing domestically oriented versus export-focused U.S. dollar-revenue-driven companies and/or underwriting to higher returns. The most sophisticated investors include currency as an input in their models to see how the impact of currency flows through the business.
Issue #2: Valuations
India has been notorious for high valuations, both in the public and private markets. But are valuations really that high?
Issue #3: Exits
While India has been evolving in the last decade as a market for control-oriented buyout deals, it is still predominantly a minority investing market with the percentage of minority deals hovering around 60% (compared to around 80% a decade ago).16 Hence, public market activity makes up about 70% of PE/VC exit value.17 However, we believe that exit markets will continue to evolve on the basis of the following:
Nevertheless, even as exit markets in India continue to expand, we would note that exits and distributions need to be actively managed given the ebbs and flows in capital markets and M&A activity. Based on our experience, the best managers plan for multiple exit paths at entry, and the DPI of top-quartile managers in India stacks up well against developed markets.
OPPORTUNITY SET MISMATCH
Some large allocators have opted to bypass Indian PE funds completely, choosing instead to set up direct teams in-country. Asset owners like Temasek, GIC, CPPIB, OTPP, and KIC are examples of large allocators who have set up dedicated Indian offices and have collectively invested $9 billion in Indian private equity deals in 2023.21 As shown in Display 5, Indian funds may simply be too small for global allocators with the largest dedicated Indian GPs, Kedaara and ChrysCapital, managing funds at $1.5-2.0 billion, and most Indian GPs raising less than $300 million per fund. Several large allocators seeking exposure to India have chosen global or regional funds that are active in India, including Advent, Baring-EQT, KKR, and Warburg Pincus. There may simply not be enough large funds to absorb the potential demand for India PE/VC. It is a situation that is unlikely to correct overnight, as local GPs will need to prove themselves and increase fund sizes gradually to remain commensurate with prior track records. In the meantime, this opportunity set mismatch may prove to be a positive, keeping the overall capital supply at reasonable levels.
In our view, India PE/VC has the potential to outperform. The turbo-charged yet capital-efficient growth trajectory with multiple tailwinds (domestic growth, India to Emerging Markets, India to Developed Markets) combined with reasonable valuations presents a compelling investment opportunity. Nonetheless, execution is not easy. While exit markets have begun to open, the situation is still evolving, and exits need to be planned early and actively managed.
We remain constructive but selective on India. It is necessary to partner with experienced investors who are well connected, have robust diligence processes, and an active hands-on approach. We have a preference for managers who have seen end-to-end deal cycles and have found ways to deal with some of the baggage from 15-20 years ago. We also look for GPs who are ready to hit the ground running, with tight underwriting and narrow time horizons, strong execution capabilities and several exit avenues identified early, given the need to work against depreciation. But for those who can navigate the nuances in this market, we believe breakout potential exists.
Source: MS PES analysis, Preqin, data as of 31 December 2023; No. of GPs: based on GPs' latest fund size based (for regional/global GPs, based on the amount allocated to India for their latest fund). No. of deals annually: calculated as average number of deals per year between 2018-23.
Data provided is for informational use only.
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Managing Director
Morgan Stanley Private Equity Solutions Team
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