Friday, September 24, 2021

Private equity discipline can be successfully applied to the Indian public markets

One of the reasons money has been made in the private equity (“PE“) markets in the western world is that the PE investors operate in an “inefficient” market. The public markets, on the other hand, in countries like the United States are quite efficient.

A way to measure “efficiency” of markets is to deduct the third quartile returns of an asset class from the first quartile returns, according to David Swensen of Yale Endowment in his book “Pioneering Portfolio Management”. This number (let’s call it the “efficiency quotient”) according to the book, over a ten year period, is 1.2% for US bonds and 2.5% for US public equity. The smaller the efficiency quotient, the greater is the market efficiency. This number for the US LBO (leveraged buy out) market is 13%, and for the Indian public equity over a period of five years until November 2006, is 15.1%. Based on this data, it would not be unfair to state that the Indian public markets are quite inefficient.

The rationale for this is manifold:

  • Large number of listed companies in India – India has about 5,800 listed companies compared to about 5,400 in the US, about 3,100 in the United Kingdom, and less than 2,000 in Australia. This is far too large a number for investors or analysts to follow regularly.
  • Lesser developed fund management industry – A more mature fund management industry increases the efficiency of a market since a large number of specialized and professional fund managers spend time analyzing companies and their future potential. The number of US mutual funds per company is almost 2 while the number for India is less than 0.1. Also, the level of variation of funds in countries like the US is much higher than in India. Thus the US market has a large number of specialized funds categorized by industry, size, philosophy (growth versus value) whereas the level of variation in India is fairly low.
  • Lack of investor and analyst following – About a third of all FII holdings are in the top five stocks in India, and almost 90% are in the top 100 stocks (ranked by market capitalization). Further, the analyst coverage declines quite dramatically below the top 100 stocks. This can potentially create attractive investment opportunities for a long term investor, such as Nalanda, who is willing to undertake fundamental research of undiscovered companies.
  • Lack of information availability on companies – The quarterly and annual reporting requirement for companies in India is not very onerous. The only reporting requirement (apart from special announcements like mergers and acquisitions etc.) for Indian companies every quarter is a profit and loss statement. There is no need for companies to reveal their balance sheet, cash flows, or discuss their business strategy and operations. There is no equivalent of the 10Q statement (published by listed US companies) that needs to be published every quarter by Indian companies. Thus, an investor such as Nalanda, who is willing to undertake research and analysis to understand the company and the industry has the potential to benefit from information asymmetry.
  • Dramatic reduction in liquidity of stocks with size – Many mutual funds and institutional investors in the public markets are slaves to liquidity since their capital is “on demand” (i.e. they can be forced by their investors to liquidate their position at very short notice). Most of these investors are not keen to invest in “illiquid” companies, thereby creating an opportunity for an investor who is willing to take relatively illiquid positions for long periods of time. The liquidity in the Indian market declines rapidly with size, thereby potentially offering attractive investments in companies with smaller market capitalizations. Thus, the trading volume for Patni Computers with market capitalization rank of 100 was US$3.9 million per day in October 2006 compared to US$0.08 million for Navneet Publications with market capitalization rank of 500.

Apart from reasons of market inefficiency, private equity in the Indian public markets is desirable and possible for structural reasons.

The traditional private equity model in the western world is that of “control” in order to manage the risk of illiquidity. However, there are very few control transactions available in the Indian private equity market. Most Indian entrepreneurs are unwilling to relinquish control, and so the private equity investor in India is generally caught in minority illiquid positions. This is a less than ideal position to be in, and also potentially less advantageous compared to being in a liquid minority position (of the kind available in listed companies).

As minority investor, private equity players can and do demand minority protection rights. However, there are very few instances of private equity investors in India enforcing these rights. This is due to the fact that the PE market in India is still young and unsophisticated, and the entrepreneur community is likely to label a PE investor as hostile and unfriendly if the investor starts “forcing” companies to adhere to agreements. In India, a PE investor is more likely to use influence and persuasion with the Indian entrepreneur. This is no different from a long term public market investor working with the entrepreneur to create value over the long term. A PE investor in India usually does not have the right to hire or fire management teams, change the strategy or direction of the company. These factors place the PE investor in a private company in India in much the same position as a minority investor in a listed company.

Thus, applying the private equity model of investing to the Indian public market is likely to have all the advantages of an active, long term fundamental investment approach without the disadvantage and burden of illiquidity.