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Investing in the New India Story

The question most posed by international investors visiting India is turning to “when” rather than “if”.   There is a growing view that the new paradigm in India is underway and is set to be very different from the situation twelve months ago. The Hong Kong investment and business community was early to spot China’s growth and benefit from it. The equivalent for India are a hardy set of investors who have spent the last 10 years building platforms that can survive the storms of India and have the people, process and practices to show for it.

It is clear that the Modi government is re-instating and re-shaping the India Story. The initial policy decisions are substantive – while obviously not meeting the needs and wishes of all those affected and indeed many more radical and reassuring measures remain to be implemented – and this has already begun to change the mood of the domestic and international community as well as the Indian voter. There is goodwill from the international community and for this to continue, the government knows it will need to continue to deliver economic performance and more positive experiences on-the-ground to investors. The policy and reform announcements by the current government, along with Mr. Modi’s track record in Gujarat adds to the hopes and expectations of the global investing community.

From a more practical perspective, it is clearly too early to conclude that the promises and policy will translate seamlessly into results on-the-ground and double-digit growth; and while formulating an investment strategy, due regard must be given to the history of volatility in India and the possible impact of external factors such as the end of US “tapering” and its impact on the Indian markets. Keeping history in mind and looking ahead at the end of 2014, investors should consider the following with regard to their selection of asset classes, sectors and managers when investing in India:

  1. Public Equities:
    • Large and Liquid: Today and On-Going. Large-cap public stocks are the initial beneficiary of positive macro news and the large companies will also be the first ones to benefit from de-bottlenecking initiatives. Scale and liquidity in these stocks offers a degree of security and exit options not always available in smaller companies
    • The Middlestand of India: Next in Line. Mid-cap, closely held companies offer significant returns potential and are often beneficiaries in the second phase of the reforms process once a new capex cycle is initiated and vendors start to get orders. Governance and management quality varies widely in these companies, therefore careful selection is and has always been critical to generating returns. Exit more than entry has been the issue. India is yet to deliver on the exits from well-managed companies that clearly have strong fundamentals but this look set to change as “pent-up” demand for Indian stocks grows at the pace it has been in 2014.
  2. Private Equity:
    • Private equity opportunities were aplenty in the last wave of India’s growth from 2005 to 2008 especially. However, without liquidity the exits from those that entered at that time were elusive. The new government’s broader attack on creating foreign capital flows into the country while stoking domestic investment seems like a stronger platform for the PE investor. Legal structures, enforceability of contracts and especially the bureaucratic court process continues to be a challenge in India. Therefore the best type of private equity deals are likely focused on:
      • Structures Straight equity deals with de-facto control over driving value creation through a structured management plan and a high-quality management team, or
      • Secured Return Structures. Structured equity or mezzanine debt deals with a guaranteed minimum return (usually between 12-18% in local currency) and an option to share in the equity upside are coming to India and look set to re-shape the capital structure. These will take some time to be tested and proven.
      • “Betting on winners”. These are investment that select very carefully for entrepreneur within a sector, company and state. The easiest choices are the “clean” industries unencumbered by political considerations such as technology and e-commerce.   Many such bets have faltered in the past on waves that lost their way because of a structural, cultural or regulatory issue e.g. the “IT company wave”; the “Power sector wave”, the “Telecom wave”. So, timing is clearly a key determinant of value.
  3. Sector Selection: The unfolding of economic and political reforms will impact sectors based on a variety of factors particularly in sectors with deep-rooted structural issues and significant government involvement
    • Phase 1: Knowledge Industries. The reforms process will likely quickly benefit those that are already geared up to work with foreign companies and foreign markets, in particular knowledge-oriented sectors including IT services and hardware, technology, e-commerce, analytics, pharmaceuticals, and healthcare services. A general wave of optimism and global re-recognition of India as a young, vibrant, tech-savvy country has already started to reflect in increasing amounts of capital flowing into these sectors in recent months. Learning from the last few years, investors will be on the search for companies with differentiated business models, low leverage, low regulatory complexity and a clear revenue model;
    • Phase 2: Industrial Growth. The important beneficiaries of a broad opening up of India has to be the mass citizenry and this requires the growth of core industrial sectors – manufacturing, energy, infrastructure and real-estate – and the success of these will depend on the successful implementation of reforms in these sectors. There is tremendous latent demand for physical infrastructure and real-estate and a strong push for manufacturing by the Modi government. These sectors are far more capital intensive than knowledge services, therefore if reforms are successfully implemented, significant attractive opportunities for capital deployment will open up;
    • Phase 3: Natural Resources, Commodities and Agriculture. If the government succeeds in introducing deep structural reforms, it will begin to open India for the exploitation of its massive natural resource base. The beneficiaries will be sectors which need deep structural reforms and have long gestation cycles such as agriculture and minerals. These sectors have deep structural issues which will take time to change even with an aggressive reforms push by the government.

Foreign investors have been burned in their previous faith in India and so no doubt some will wait to see how well the Modi government implements. However, there is a long history of patient investors who have weathered the storm at the end of the Congress era that has just passed and are well-positioned to be beneficiaries of the changes that are now underway. Foreign reporting on these trends in India tends to be late and those that move earlier to find the opportunities are likely to a heavier risk for a higher reward.