Private Equity in the Age of Globalization: China and India - Part 1 of 2

Arjun Sethi, An advisor and angel investor in early stage startups

The Cold War ended with a thump, rather than a bang. The Berlin Wall, so long a symbol of East-West division, was torn down by a reveling crowd rather than leveled in the course of battle. The Soviet Union, to all intents and purposes, voted itself out of existence. A chapter in human history ended.

The geopolitical stratagems, global power structures and economic interactions that marked the East-West struggle that dominated so much of international public life during twentieth century are now in transition. Most notably, this recalibration points to an increasingly intimate relationship amongst the remaining world powers. This upcoming increase in global trade openness will likely operate under the coloration of state-regulated capitalism. Nations such the United States, Japan and the Western European components of the European Union, having emerged from the fifty-year standoff, will function as the prime economic arbiters of the global future. A tangible result has been a level of corporate consolidation never before seen, spanning not just across companies and industries, but across borders and oceans. But those same 'prime economic arbiters of the global future' may have added company.

Underlying desiderata

Financial globalization presupposes a bringing into harmony of shared standards. This is being realized, at least to some extent, in the ongoing efforts at corporate consolidation and progress toward the elimination of existing global trade barriers. Discussion here is focused on one of the leading indicators implicating both of the above-mentioned developments. Private equity investment on a global scale has experienced an exponential growth over the last decade, growth that has been fueled by a rash of buyouts, mergers and consolidations (and, as it happens, that are functions of the two conditions noted above.) For private equity firms operating in the Western economy, the opportunity to enter such potentially expanding markets as those in China and India-both opened to unexampled internationalization since the start of the millennium-has been met with considerable enthusiasm. For these two nations, the focus of this discussion, private equity investment acts as a vehicle for domestic economic expansion, while at the same time allowing foreign investors to extend their consolidating interests into previously inaccessible or undesirable markets.

China and India as expanding international markets

With populations of roughly 1.3 billion and 1.1 billion, China and India are respectively the first and second most populous nations on the Earth. They share parallel interests-and face equally concomitant difficulties-in succeeding in their struggles to meet the needs, demands and ambitions of populations of such magnitude. Widespread poverty, inequality, social unrest and even political upheaval are conditions that persist both in remote rural regions and concentrated urban centers and represent genuine challenges to those nations' prospective emergence as major players in the world community.

By the same token, the magnitude of potential inherent in such national labor forces, consumer interest and resource authority increasingly has coincided with a heightened openness toward internationalization of corporate and trade interactions. On both the global scale and within their domestic contexts, the Chinese and Indian political leadership have come to recognize that it is in their respective national interests to engage in economic activities that presuppose largely unencumbered economic interdependence. This new perception is affected by and shapes the behavior of worldwide investment strategies, with foreign direct investment taking the helm in many such settings. Through the foreign privatization of such major equities as those which are likely to play a key role in the evolution and resource distribution of such nations, we have witnessed a major shift in capital investment fund strategy, a development indicative of escalating interest on the part of western investment firms in insinuating themselves as participants in this grand to build toward and benefit from this historic turning point for the great Asian powers.

Focus of this analysis

The focus of this investigation is both the role that foreign private equity investment has played in the growth of China and India and the resulting private equity investment atmosphere currently manifesting itself in both venues. The intent is to determine which, if either, is a more appealing or meritorious market to potential private equity investors than the other. In addition, the investigation yields insights into the incentives and detractions present in each of these settings.

Private Equity

Private equity is broad in concept, referring generally to a specific mode of investment, one in which a party with the financial resources-most often a corporate investor-purchases a significant private stake in a company which is not publicly traded. Nonetheless, private equity is in fact a very broad term, used to define types of funds or investments. The term signifies the source of the money as opposed to the form that the money takes on. As the name suggests, private equity is private, i.e.: it is not reachable in public markets, such as the stock exchange.

It is important to grasp the purpose of private equity in order to understand the difference between private equity and venture capital. Private equity today mostly comes from private equity firms. These firms are not really known, yet hold huge companies and amass fortunes. They are commonly referred to as venture capitalists, although this is not accurate in many cases. Private equity companies buy an undervalued company, change the company, make it more valuable, and then sell it. Upon occasion, the private equity firm will purchase an undervalued firm listed in public offering and take it back to private status while they 'work on it'. This provides the firm making this private equity investment with the opportunity to create its own Initial Public Offering (IPO) with the stake in its possession at a later date when the stock has appreciated in value, or "Investing in no-publicly held securities through a negotiated process," (Bance, [2004]). This definition is fairly descriptive in that it becomes clear that the process is indeed negotiated; the return on the investment varies and the proportion of the company's profits that the investor keeps is arranged between the investor and the firm.

Contingent factors

The success of an investment depends on a number of factors. Paramount among them is the ability of the firm to achieve favorable terms as a condition of its initial investment. These may be consequent to, inter alia, the declining fortunes of the equity being prospected, the vulnerability of the prospected company's ownership to hostile takeover or the nascent state of the prospected company. Likewise, it may well have an interest in courting outside capital without directly becoming a publicly traded company. This is an investment circumstance that naturally favors the interests of corporate investment over the interests of pubic traders.

Still, even though private equity had typically been one of the least accessible of investment modes, usually reserved for only those select firms with sufficient capital means to undertake such an approach, its popularity is on a distinct upswing. Globalization has given it an enhanced strategic relevance as an investment tool. The relaxation of international standards regarding foreign investment in developing countries has generated a global flood of fund projects for which private equity investment is the preferred mode of resource acquisition. This, in turn, is a function of the nature of its benefits-ones that accrue to both the contracting government and the investing firm-and to the huge number of emerging projects in modernizing sectors of Asia and Africa. As a consequence, each year of the new millennium has witnessed an ever-higher number of international buyouts, pointing to the increasing private equity status of various companies. To this end, "there were $255.3 billion of announced buyouts globally last year according to data compiled by Bloomberg, a third more than in 2004." (Cheung, [2007]) The atmosphere which serves as the backdrop in this current era in global economic activity is increasingly the interest of capital-investment firms in parts of the world where the demand is greatest and the conditions are most favorable for the development and monetary infusion of those companies that, for one strategic reason or purpose, do not wish to become publicly traded.

Underlying political considerations

Beyond the economic realities and investment principles that play directly into our understanding of the subject, there are myriad political considerations that likewise must be taken into account in any forum in which such vast sums of capital are traded or otherwise at work. Indeed, private equity firms are typically aimed at funds related to significant social service concerns or public utilities that can have a direct effect on public living standards, popular access to needed public resources or, as a consequence of these and other factors, the way that public relates to or perceives its government. In light of this, private equity investment can be direct route for a firm taking such an interest to leverage its influence on an entity which itself can have a genuine influence on overall public policy. (As is made clear in the discussion below, this is one of the core aspects of private equity investment that cannot necessarily be quantified, at least with any measure of confidence.) The determination of a government or firm to deposit multiple millions (or billions) of dollars into a foreign economy almost inherently dictates that either the conditions there have become more accommodating to such foreign investment or that it is the expectation of the foreign government or firm that political and/or social conditions will ultimately flow in the direction of such an accommodation.

Private equity investment in India

A nation conventionally (and correctly) regarded as one stricken by endemic poverty and a dysfunctional distribution of wealth, India, nonetheless, has "today become the tenth largest economy in the world with a GDP of over $166 billion." (Dickenson Associates, [2006]) This rise in economic status should not have been unexpected. Certainly, it has been a long and difficult effort to overcome the disadvantages that have characterized its history as a deeply conflicted British colony. Nonetheless, India is today a veritable bastion of democracy in a part of the world otherwise resistant to many of the strains of political and economic modernity. And in accompaniment with this great expansion has been the increased level of interest that it has attracted from foreign investors, individuals and institutions confident in India's potential to be the center of capitalist development in South Asia. Private equity investment in India has paralleled its rise in world economy ranking. According to the Bain & Company capital management firm, "the private equity market in India, which attracted $2.2 billion in investment capital in 2005, will reach nearly $7 billion in 2010." (Krauss, [2006]) This relatively short term project parallels a belief by many that India is a top destination for investment funds, with its future growth likely translating into major profits.

Impact of colonialism

Ironically, it must be noted that India's colonial history is as much responsible for its receptiveness to western investment as it is for its lengthy struggle to achieve a positive independent identity. Without a doubt, the longstanding history of English education and interaction with western economic systems today makes India a natural partner to western capitalist-derived globalization. This disposition also has roots in the all too evident need for development throughout the Subcontinent, as well as by India's leading (an exponentially increasing) role as a provider of services and technical support to American firms. In both of these, we can see that India has been a key player in bridging the gulf separating Eastern and Western economies. As a globalization 'node,' India is proving itself capable of moving rapidly toward solutions to some of the problems impeding economic structural development.

While it is an intuitive observation, there appears to be a case to be made that one of the legacies of India's colonial experience is its level (and abundance) of bureaucracy. "What does excessive bureaucracy consist of? . [The] cost of entering and exiting businesses in India is high. Compliance with health, safety, and environmental standards is costly, due to excessive inspections and documentation requirements, and there is a great deal of inter-state bureaucracy of questionable utility (for example, the 'entry forms' that some states require whenever goods are moved across state borders. There is no real logic to this practice.)" (KPMG, Manufacturing in India [2005], 19)

Domestic political considerations

The relationship between the rapid expansion of the Indian capital market and its heightened emphasis on a global investment strategy has given the Indian government as much incentive to open its doors to foreign firms as it has given these firms economic cause to enter an increasingly saturated field. The result has been an incredible boom to India's equity market, where in the first half of fiscal year 2005-2006, India was the site of roughly U.S. $7.96 billion of foreign direct investment (FDI), which represented over three times as much of such investment as was reported during the comparable period of the prior year. (Moniz, [2006])

India's hospitality toward foreign investment has taken the form of an increased willingness to permit foreign investment to attain majority interest in some of the nation's largest industrial and service sectors (e.g., telecom and infrastructure). These major state-regulated concerns are increasingly receptive to what appears to be an endless flow of western capital into "development of new airports, laying of natural gas pipelines, petroleum infrastructure, captive mining of coal and lignite, mining of diamonds and precious stones, as well as the development of townships where complete foreign ownership is now welcome." (Moniz, [2006]) This particular agenda characterizes the larger appeal of India. On a less favorable note, it also reflects disparate official attitudes at the state level. "The World Bank says that the six states and territories that have attracted most foreign direct investment were also rated as having the best investment climates on a broad range of measures. Investment is clearly flowing to locations that yield the best return, irrespective of government attempts to lure investors into some less attractive states." (KPMG, Manufacturing in India [2005], 30)

Infrastructure deficiencies

The shortcomings of Indian infrastructure, while hardly the Achilles heel of the national economy, remain a troublesome reality for both Indian government planners and prospective investors. If pitted roads, decaying regional airport and seaport facilities, and, quite often, tainted water are readily apparent to the foreign visitor (and investor), it is the limitations imposed by underdeveloped sectors essential to production that are the more troubling. "Nowhere is India's weak infrastructure more obvious than in power. In cities and towns across the country, richer homes hum with the sounds of diesel generators during frequent brownouts. Poorer ones sit in darkness and silence. According to India's ministry of power, in the previous financial year up to March 31, peak demand exceeded supply by about 10,500 megawatts, or 11.6%." (A tale of two sectors [2007]) It is not as though there has been insufficient effort to resolve the power delivery shortfall. Rather, a congeries of factors has placed impediments on adequate rates of expansion. "At the heart of India's power problem lie the government-owned State Electricity Boards or SEBs. Afraid of angering powerful farmer lobbies, state governments tend to heavily subsidize agriculture at the expense of industry. In states such as Punjab and Andhra Pradesh, the promise of free power to farmers has been an electoral campaign staple. Theft has played a major role, too: It's not uncommon for consumers to simply hook their homes and businesses illegally to the transmission grid, or to bribe corrupt board employees to look the other way. Between 1992 and 2002, 40% of the power generated in India was stolen." (A tale of two sectors [2007]) Resolving the underlying problems means, essentially, addressing long-standing cultural factors-e.g., the ostensible right to 'free' electrical power-factors that are fostered, rather than impeded, by the processes of democratic government. To the extent that the would-be investor is required to work his way around these impediments (e.g., by installing private sources of power) he may be less sanguine about investing in the Indian economy.

Adopting a more friendly attitude toward foreign investment

The nation is advertising itself today as a prime venue for the investment or foreign capital, projecting itself as an avid participant in the push toward a free trade-based global strategy as a major component of the fight against endemic poverty. While it may not be entirely clear that foreign corporate investment does this-and certainly there are myriad arguments to suggest that this is an overly optimistic take on private equity investment-India has nonetheless incorporated into its growth strategy an anticipated dramatic increase in foreign firms' control entitlement. To this end, in 2006, "during the World Economic Forum in Davos, India made an all-out push to promote itself as a business-friendly environment for investment. In a move that seemed timed to coincide with the forum, the government lifted limits on foreign direct investment. The most notable change was in the retail sector where outside firms selling a single brand, such as Nike, will be allowed to own a majority stake in Indian stores." (Knowledge Wharton, [2006]) The operating principle is that expanded interest of western investors in all sectors of India's economy will eventually result in an improvement in overall economic conditions as well as bring in capital necessary for construction and infrastructure development.

But there are larger, more amorphous-yet ultimately crucial-factors at work. "Liberalization is increasingly a function of state governments as much as for the central government. [Nonetheless,] the central government has succeeded in opening many sectors of the economy to foreign investment. For example, vehicles, consumer electronics, and white goods are fully liberalized, while insurance and media investments are restricted to minority partnerships." (KPMG, Manufacturing in India [2005], 16) Investment, of course, does not operate in a vacuum. Certain-often unspoken-factors are expected to be at work. The investor likely anticipates a vehicle for redress if in-country counterparts fail to meet contracted requirements. India's judiciary is considered well-nigh incorruptible. But justice in India proceeds only slowly, given procedural requirements and a reported backlog of 25 million cases, all told. By the same token, local officialdom occasionally has an unfortunate history of corruption. To at least some extent, foreign investors may be tempted to bypass time-consuming legal processes in favor of questionable assistance from venal officials.

Prospective negative outcomes incident to over-investment in a few sectors

This has been true so far, at least to the extent that the low cost of its labor force and the aptitude of its population toward technological sophistication have joined together to make India a top site for private equity investment in the infrastructure sector. But private equity investment here is somewhat different from our conventional understanding of the process, suggesting the influence of globalization on the selection of development strategy. Understood in these terms, "while the traditional route for private equity firms is to buy a controlling stake in struggling, mature corporations and then try to turn them around, in an emerging economy such as India these firms act more like venture capitalists. They look for promising companies in industries ranging from tech to textiles and seek to give them a boost, doing everything from injecting more capital for expansion to holding the hand of management and providing strategic guidance." (Kripalani, [2005])

This suggests that foreign investment interest in India has its origins in an anticipation of broad-based growth. However, it is also indicative of the ways in which India's development hinges on the still uncertain promises of globalization. A nation whose growth has to this point been founded entirely on the basis of its importance to the world as an affordable center for technological support and expertise, India has yet to prove itself a safe long term bet for the reach of its economic growth and actually achieved level of modernization.

Look for part 2 of 2 of this article in the next Buzz or read the entire article in chapter 13.2.2.d: Private Equity in the Age of Globalization: China and India of the Encyclopedia of Private Equity.

Mr. Sethi is currently an advisor and angel investor in early stage startups. He is also a Strategic Advisor at Saset Healthcare, a start-up involved in the design and manufacture of high end ultrasound machines. Prior to Saset Mr. Sethi worked with the Carlyle Group. In 2002 Mr. Sethi co-founded Advanced Tuning Products, an ODM distributor for Garrett/Honeywell Aftermarket. He is the author of several Venture Capital and Private Equity articles, and writes regularly on his blog. Mr. Sethi holds a BA in History (Honors), from the University of Maryland College Park and BA in Liberal Studies (Honors), from Boston University.

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