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$20bn PE invt in 2010 – a perspective

Posted by fairval on November 17, 2007

Can $50bn of PE investment be absorbed in 3 years? Certainly, since supply creates its own demand in capital markets

Private equity numbers are being bid up. A paper released last week said private equity investment in India could grow to around $20bn per annum in 2010, from $7.5bn or so in 2006. Considering that just 3 years ago, in 2004, PE investment was less than a billion dollars, the growth looks quite rapid.

So are these numbers possible? The one big argument that the paper by Evalueserve gives is that the funds to make this possible have already been raised. The report says that over 400 funds are active or about to be active in Indian markets. In total, they seem to be sitting on $48bn to be invested between now and Dec’10. This averages to $120mn per firm, a reasonable number.

The other issue, which the paper doesn’t address in quite so much detail is – can the Indian market absorb it?

Lets first take a macro economic look at this. In 2007 itself, PE investments, at around $12bn will total around 1.1% of GDP. By 2010, this will reach 1.3% of GDP, if growth is as projected.

In itself, 1.3% of GDP is not a large figure. Indian economy is growing at 8-9% per annum. This requires annual investments at the rate of 30-35% of GDP, taking an incremental capital output ratio (ICOR) of 3.5 to 4. A lot of that will come from domestic savings, and rest from abroad. Indian plan documents do tend to assume a current account deficit (CAD) of around 2% per annum. The actual current account deficit in the last ten years has been less, at around 1% on an average. Even in 2007, despite record oil prices, CAD is expected at 1.5% of GDP.

Current account deficits tend to be bridged by foreign investment as part of capital account. Private equity is part of capital account. Others are portfolio investment and FDI other than private equity. As we noted, PE itself is now more than 1% of GDP. Portfolio investment or FII inflows was running at around $17bn for the first ten months of 2007. PE and FII flows could cross $30bn for 2007, or amount to around 3% of GDP. External commercial borrowings have been in the $18-20bn region in the last 2-3 years. Total capital account surplus could well cross 5% of GDP this year. The burgeoning capital account surplus is one reason why rupee has appreciated this year (the other being, dollar is depreciating against all global currencies anyway).
This is one big dilemma facing the Indian economy – are we structurally capable of coping with such large flows? So either policy makers get the capital account surplus down, or current account deficit goes up from 1% of GDP range to 4% or so. The first requires capital controls, the other perhaps means stronger rupee. Fiscal measures like easier import regime and so on have little leeway left now. In all, it is a complex game.

One dumb answer to this conundrum could be a big bear market in the next two years. If the FII inflow figure drops to the long term average of less than $10bn, then some pressure on the rupee eases.

The micro economic question – are there enough number of firms which need this kind of PE investment – is easy to answer. Supply creates its own demand, atleast in capital markets. As they say, a fool and his money are soon parted. If there is $48bn of money waiting to be invested, it probably will get invested. Business plans will get created, expansion or Greenfield projects will get cooked up. If the real economics of the project doesn’t look good, the numbers will be goosed up, or balance sheets will be dressed up. We have seen that any number of times, whether in private or public equity markets. When investors are crazy to invest, promoters and entrepreneurs will oblige them with supply of fresh equity paper. It happened in early 90s in India, and in the late ‘90s in the dotcom boom in the US. It has happened many times earlier.

This is not to say that there isn’t genuine demand for large PE money. Numbers do show there is need for large investment.

Once again, we reverted to some macro numbers and did some back of the envelope calculations. If you start with a projected annual GDP growth rate of rate of 9%, and an ICOR as stated above, one can work down to a number which shows that Indian organised sector needs to invest maybe even $150bn a year. In June’07, KV Kamath of ICICI Bank had made a statement saying Indian corporates will invest $500bn or so over next 4-5 years. Our number is a little more aggressive, and could be due to difference in assumptions. We then put some debt equity and retained earning assumptions, and you get to what kind of money needs to be raised from outside. Depending on debt equity assumptions, requirement of external equity ranges from around $25-30n levels to around $45-45bn levels for FY08.

In general, around $30-50bn of external equity will be required over next 3-4 years. So if $20bn of this comes from private equity in 2010, this means share of private equity will equal or exceed public equity in 2010. This is not astonishing, even in 2006, private equity exceeded public equity. Also, some PE money also goes into buying secondary equity, and not to fund fresh equity.

To summarise, at a micro level, some more increase in PE investments can be absorbed. Figures like $20bn or more as we cross 2010 become palatable only under certain assumptions, like say a 10% GDP growth rate, or lot of wrong investments.

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