An elusive private equity opportunity

If the Indian economy grows at more than 8% a year during the next decade, the domestic financial services industry will have to grow three times faster. India has a healthy savings rate of 37%, but has to find ways to aggregate and channel the resulting pools of capital into those businesses that can use them most productively. The country's targeted investment rate of 40% also assumes substantial foreign investment inflows.

These challenges present a tremendous opportunity for those who invest in financial services, whether in banking and insurance, consumer and personal finance, asset-backed lending or microfinance. "Private equity and venture capital investors are viewing investments in [these] companies as an attractive entry point into the two key drivers of the Indian economy -- rising domestic consumer and infrastructure spending," said Arun Natarajan, chief executive of Chennai-based Venture Intelligence, a leading research firm.

"The Indian financial services sector has attracted private equity investment in excess of $4 billion in the past three years," said Sanjay Doshi, director of corporate finance at KPMG India in Mumbai. More than $3 billion of that was invested in 2007, but in 2009, in the aftermath of the global financial crisis, investments dwindled to just $300 million. Not surprisingly, 2007 stood out for deals: Carlyle India Advisors' $660 million stake in mortgage-lender HDFC, which was followed by General Atlantic and Goldman Sachs's $375 million deal with the National Stock Exchange and Citi's $200 million investment in brokerage Sharekhan.

While opportunities in banking and insurance are limited in the short term due to regulatory restrictions, Doshi said that the non-banking finance companies (NBFCs) provide selective but attractive opportunities. He said that these specialised lenders to businesses as diverse as commercial vehicles, construction equipment, mortgage and consumer finance are able to reach and service borrowers that banks are unable to.

Unlike banks, NBFCs do not enjoy the advantage of access to low-cost deposits and have to leverage their business at a comparatively higher cost of funds. However, their operational model is more flexible. "Their distribution reach, strong collection infrastructure and customer relationships have generated attractive returns driven by low cost of operations, lower delinquencies and attractive spreads," said Doshi.

Within the NBFC space, Doshi said there is great opportunity for the newest category, the infrastructure finance company [IFC]. "India's growth is going to be significantly driven by infrastructure investment and the Reserve Bank of India (RBI) has acknowledged the critical role played by NBFCs in the infrastructure sector through introduction of the IFC," he said. India expects to attract $1 trillion in infrastructure funds in the next five years.

But Rajeev Gupta, managing director of Carlyle India Advisors in Mumbai, is far less optimistic about opportunities for private equity investors here. He argues that NBFCs face serious cost disadvantages in relation to banks. Banks can access funds at an average cost of 7% to 8%, including the cost of a retail branch network, whereas NBFCs are forced to borrow at 10%. In two key areas they don't stand a chance against the biggest players in the banking industry. "In mortgage financing, HDFC is unassailable. Similarly in infrastructure funding, giants like State Bank of India and IDBI have a huge presence." He conceded that in certain niche areas NBFCs have a future, but as he sees it, "In the long run the big ones will themselves become banks."

Raj Kataria, managing director, investment banking, at Bank of America Merrill Lynch in Mumbai, tends to agree. "Of course there are investment opportunities in financial services but you've got to find an opening that suits private equity firms," he said.

Most of the companies operating in this space lack the required scale. Large PE firms usually look for an investment opportunity in the region of $100 million or more. But with the 5% cap on investments in banks, that would at best amount to no more than a $40 million to $50 million investment in any of the non-invested private banks in India. Barely 15 to 20 of the 5,000 NBFCs are worth looking at, he added.

Moreover, most Indian firms, even those with little track record or size, have easy access to the capital markets, said Kataria. Why should they subject themselves to the rigour of private equity, with all their dos and don'ts? "In last year's downturn, we thought there would be plenty of buyout opportunities. But with banks willing to lend, to restructure and rollover loans, promoters had little incentive to sell," he added.

Another area that has attracted a lot of attention in recent years is microfinance. What started as a programme of social lending has rapidly grown into a multi-billion dollar industry worldwide. In India, 3,000 microfinance institutions (MFIs) and non-governmental organisations lent a total of $3.5 billion to small-scale borrowers by the end of March 2009. Of that, almost $2 billion was disbursed by the top 10 MFIs. With the industry growing at 90% a year, it is estimated that the MFI industry will require between $3 billion and $5 billion during the coming five years. According to Doshi of KPMG, the spreads on microfinance lending are extremely attractive. "The cost of funds is around 13% to 15% and operating costs can add another 5% to 7%, but yield on advances ranges from 25% to 28%."

While one of its most attractive features is the low delinquency rate, there are serious risks in microfinance -- lending to the poor is politically sensitive and some state governments have initiated proceedings against companies seeking to recover loans from them. The test case for the industry in the immediate future will be the success of the first initial public offering by an MFI in India, the $270 million issue by industry leader SSK Microfinance, which will enable the partial exit of early investor Sequoia Capital.

Let them borrow 

But Gupta of Carlyle pointed to a more basic problem private equity investors face in India. Unlike in developed markets (and in many emerging markets too) where private equity firms typically use leverage to acquire assets at a competitive cost of capital, India does not allow private equity firms to borrow locally to fund deals. The RBI limits external commercial borrowing and, in any case, overseas loans introduce currency risk and hedging costs, Kataria of BoA Merrill added. Without debt, buying a controlling stake is financially impossible to justify. The result, Gupta explained, is that "many entrepreneurs who want to sell out don't get fair value for their assets".

Thanks to a policy that prevents PE funds from using either foreign or domestic debt to acquire local companies, an opportunity to restructure businesses and generate shareholder value is being lost. Worse, it thwarts a rational allocation of capital within the financial services industry itself, one that makes available funds to those who can make the best use of them.

This article was first published in the May 2010 issue of FinanceAsia magazine.