The Viewpoint Next Big Leap for Indian PE The Manufacturing Sector

Bar & Bench brings to you the next article on ‘The Viewpoint’ series with its Knowledge Partner Amarchand Mangaldas. Amarchand Delhi Corporate Partner Raghubir Menon and Associate Anirban Bhattacharya in this article discuss whether the manufacturing sector is the next big leap for Indian Private Equity..The advent of PE funds over the past couple of decades in India has had an interesting impact on the private sector. While the pre-liberalisation emphasis was on the development of labour intensive manufacturing industries (largely a policy thrust and driven by India’s socialist outlook), subsequent periods saw the dawn of a thriving services sector ripe with capital from private sources. Research seems to suggest that this is a remnant of India’s socialist past where the credit structure was aimed at favouring large-scale capital and labour intensive publicly owned entities (the PSUs) and deterred the formation of private sector firms in these sectors. Hence, while the public sector had easy access to capital, the private services sector started developing mainly because of its less capital intensive nature. In addition, the “license raj” was only applicable to firms manufacturing tangible assets, which effectively permitted the services and technology industries to develop without much interference or oversight from the government. When privately sourced capital started trickling into India post-liberalisation, the services and technology sector was a prime target for investment essentially due to the relaxation of regulatory constraints, regulatory incentives from the 1990s onwards, measurable and quantifiable risk factors, its less capital-intensive nature and the potential of short-term investment horizons and returns..The growth curve of the private-sector large scale manufacturing industries was not as steep as compared to the services and technology sector. The private-sector manufacturing industries were generally dissuaded by the play of policy to root out competition with the PSUs. Pre-liberalisation policy specifically encouraged small-scale private enterprise. In addition, flow of foreign capital was extremely limited in the pre-1990 era and domestic entities were highly dependent on domestic credit. As scant domestic credit was routed to the PSUs, the growth of any privately-managed capital intensive industry was difficult, except in the case of industrial houses and groups with deep pockets. In addition, since the primary creditor was usually a publicly owned entity and the primary lender could only be a publicly owned bank, it is likely that debt was a means of channelising capital as a part of central policy. It has been theorised that the apathy of debt enforcement mechanisms in the pre-liberalisation era may be attributed to this lack of a typical creditor-debtor relationship between capital intensive industries and the banks..Upon liberalisation, the evolution of debt enforcement laws was not able to match the pace and expectations set by PE investors. This resulted in an environment where the private lender has muted legal protection from the risk of default. On the other hand, banks generally do not finance long term debt due to the high risk exposures or insist on exposure to 25-30% of the capital requirement. In other words, there is no viable source of sustainable capital for a capital intensive manufacturing industry to grow..It is often an accepted paradigm that capital intensive manufacturing industries are more suited for debt financing rather than equity due to the heavy asset-base which serves as effective collateral for reducing the risk profile of the financing and due to the long gestation period of such industry. On the other hand, the services and the technology sectors do not have any tangible collateral to speak of since these industries ride high on intellectual properties and soft skills and are hence more suited for equity financing. Given the post-liberalisation apathy of the debt enforcement regime, the services and technology sectors proved to be prime targets for PE investors. Studies show that private lending in India is below levels in comparable developing countries and, in general, it has been empirically proved that the equity market is more developed than the corporate debt market. Empirical studies also appear to confirm that equity financing dominates private service and technology sectors..For foreign PEs, reduced risk portfolio would, of course, be a more attractive proposition. Given that equity financing is easier and less risky and investing in the services and technology sector is now tried and tested, the choice is well laid out for the foreign PEs. However, foreign PEs typically have a very cautious and guarded exposure to emerging markets. Even though Indian markets have evolved from a frontier market to a more developed market (owing to factors like higher liquidity and lesser information asymmetry), it is still considered as an emerging market from a foreign investor’s perspective. Information asymmetry, a socialist regulatory regime (even though liberalisation is taking place) and an ineffective enforcement system are the major reasons why India is still profiled as risk-prone as compared to other developed economies. In this environment, a foreign PE investment in large scale capital and labour intensive manufacturing industries becomes all the more tricky..However, the paradox is that one of the other reasons why India is still an emerging market is the quantum of the deal size. If one were to study the historic landmark PE investments in North America and Europe in the 1980s-90s, most of the big-ticket acquisitions were of large-scale capital and labour intensive manufacturing industries. Companies like Unocal, Pan Atlantic Steamship Company, RJR Nabisco, The Coca Cola Company, Goodrich Tire Company, TWA, Revlon, Freescale Semiconductor – the list goes on. The investment by KKR in RJR Nabisco in 1989 was the largest PE investment for 17 years! The deal sizes are voluminous because the investors expect the returns to be higher. It is difficult for services and technology companies to give such high returns. In developed economies, investment in services and technology companies start off with venture capital funding and once the companies have developed, serious high-value funding is infused. Unfortunately, in India, a huge untapped potential investment market which exists in the area of large scale manufacturing industries is being permitted to sit idle due to reasons elaborated above which, if harnessed, may benefit the economy in multiple ways and give a definite boost to the growth of the Indian economy..Also pertinent to note is that in developed economies, the PE investment market is dependent on debt funding in addition to private funding (i.e., high net individuals, pension funds, mutual funds, etc.). The debt financing was required simply because the deal value far surpassed PE fund corpus’. In addition, the debt would usually be collateralised by the assets of the target company, thus reducing the risk exposure of the PE investors. This is a typical leveraged buy-out (“LBO”) model. Traditional corporate raiders would also carve up a target, hive off various business verticals (after using cleaning-up value maximising tactics like segregating all debt into a single company) and earn multiples of their initial investment. Accordingly, managements of many target companies were averse to PE investments. This paved the way for the need of PE investors to buy control of target companies. The point is not to compare LBOs with a mere financial investment, but to give a viable option to the investor of a complete buy-out with the aid of leverage. This option is critical when the investor assesses that the present management of a company is not being able to unlock its true value and the company will fare well under a different management. LBOs have helped PE investors to achieve newer milestones in making acquisitions, realising profits and add immense value to the target company. The quantum of the profits, the deal size, value-adds to the target and increase capitalisation has shown the true potential which the PE investors are capable of unlocking..In addition, the corporate bond market has also been an important source of funding for many capital intensive manufacturing industries. A corporate bond may be collateralised by the assets of a manufacturing unit and the term of the bond may be long enough for enabling the unit to utilise the capital effectively to yield viable returns..It is time that reforms are introduced to encourage LBOs as well as corporate debt in India. Since 1991, there has been a sea change in the Indian regulatory environment as well as the scope of opportunities in the Indian markets. While it is well documented how the economy was liberalised by the Government in 1991 following the balance of payment crisis, many academics have argued that unlike popular perception, most of the reforms had already been proposed before the crisis which acted as more of a catalyst for implementation rather than the cause of conception. Studies indicate that many of the liberalising reforms in the 1990s have had domestic origins and seldom have the reforms been susceptible to the influence of the global market..While there have been efforts to revive the corporate debt market, like the introduction of commercial papers and certificate of deposits as collaterals, permitting credit default swaps for unlisted corporate bonds and introducing ‘junk bonds’, the results are yet to yield. The most important issue of enforcement remains unaddressed. In addition, LBOs are generally looked down in the global market since they over-burden the assets as well as the revenue stream (which otherwise could be recapitalised for capital expenditure). Long term leverage also increases the cost of credit. However, these issues may be resolved by ingenious engineering of credit structures. Steps like short-term credit, easier refinancing options for the PE funds, provisions of payment to the lenders by the PE funds at the time of dividend distribution coupled with mandatory yearly or two-yearly dividend distribution by target companies may considerably reduce the risks associated with LBOs. The LBOs will not work unless Indian banks are encouraged as a matter of policy to explore and consider assuming the risk associated with investment in manufacturing industries, provided that there are PE investors who are willing to invest. In addition, evolution of domestic PE investors should be encouraged so as to reduce the risk profile for the domestic banks, since a loan to a domestic borrower will be easier to enforce. The recent Alternative Investment Fund Regulations which regulates, among others, debt funds, private equity funds and infrastructure development funds is definitely a step in the right direction..It is important to appreciate that these efforts indicate that the regulators have identified the drawbacks which are limiting the scope of PE investments in the domestic market and are pushing the PE investment into a predictable cyclicality. Predictability in investment options potentially decreases the time for speculation and increases the frequency of booms and busts. In hindsight, one may argue that introduction of measures like corporate bonds and LBOs earlier than today may have been premature for the Indian market, simply because there were no PE investors, domestic or foreign, who would be willing to assume risks associated with large capital intensive manufacturing units. However, the Indian market has since developed and the investor community is mature enough for them to start venturing into this hitherto untapped opportunity. Investment in manufacturing units will unleash a wholly new sector of PE investment which will begin a new chapter in the post-liberalisation story of India..Raghubir Menon is a Partner and Anirban Bhattacharya is an Associate with Amarchand Mangaldas.