Nevertheless, there are many trends that could cause the pace of Indian M&A to go up.

• Divestment of non-core holdings: Many Indian conglomerates such as the Tatas are evaluating their existing portfolios and shifting focus to core businesses while divesting non-core assets, which sometimes include substantial businesses in their own right.

   

• Building scale in the business: Groups like Reliance and the Birlas are focused on building economies of scale in their lines of business in order to achieve the competitiveness necessary to take on global players.

   

• Consolidation in fragmented industry: In industries where the market is fragmented or there are a large number of competitors such as in various consumer industries, smaller players are consolidating to form larger entities with greater market power.

   

• Entry/exit of MNCs: Many multinationals are attempting to establish their presence in India through acquisitions, including the buying out of existing joint venture partners.

   

• Privatisation: Though it has slowed from the pace of previous years, privatization of public sector undertakings remains an area of large potential in the Indian context.

   

  In addition to corporate M&A, increasing participation in India by multi-million dollar private equity funds should also be considered as part of the M&A market. The number and size of funds raised has attracted tremendous publicity with India receiving $1.5 billion in foreign flows in 2005. However, even with an increase in average deal size to $25-50 million, India has not seen many large-ticket deals or management buyouts, with “promoters” preferring to retain control instead of cashing out and selling their businesses to a private buyer, even at premium valuations.

   

  At the same time, though the venture capital market has not taken off in the last few years despite a favorable environment, late-stage and growth investing have become the dominant type of private equity transactions in India. The trend towards more big-ticket deals should continue with the correction in market prices to what many consider fair value, with large private equity houses and other institutional investors such as hedge funds searching for the next big success story.

   

  Three Investment Themes

   

  It seems evident enough that India has sound macro and micro fundamentals and that strong institutional interest has mobilized large private funds for investment. The challenge is in moving from this realization to finding good consolidation opportunities. To start comparing companies and industries in India, it helps to first see them as part of broader macroeconomic and sectoral themes – consisting of the growth in consumer spending, capacity expansion and outsourcing of services – where the benefits of the favorable macro and micro factors are most evident.

   

  • Consumer-related themes include the rapid growth in retail, media, consumer finance and durable goods on the back of strong economic growth, a rapidly expanding middle class and favorable demographic factors such as a greater working age population, increasing literacy levels and greater urbanization.  In addition to higher disposable incomes, the consumer boom is also driven by less tangible factors like an increased propensity to spend, aspiration value for well marketed products and a growing credit culture. Beneficiaries of this phenomenon include segments like leisure, health, tourism, textiles, housing and education. Currently, the areas of most institutional interest or consolidation potential comprise of booming industries like organized retail, consumer banking, media & entertainment and fast-moving consumer goods.

     

    • Capex-related themes take advantage of the favourable demand-supply dynamic created by historic underinvestment in India’s infrastructure and manufacturing capacity, high current utilization levels, and a willingness of companies to invest in capacity because of business confidence. With capacity utilization at 80-90% in sectors like steel, cement, refining and automobile production, massive investment is required to satisfy increased demand. On the back of several years of record earnings growth and visibility on future earnings due a large order backlog, companies have been busy raising funds in the capital market, gearing up to spend large amounts on capacity expansion.

       

    The government is a key driver of the capex theme both because of its own substantial spending on infrastructure and its role in improving private investment in power, transport, real estate and other regulated sectors. Historically, these have been considered risky areas due to high fixed costs and excessive government participation. One of the most promising recent developments is that firms are less reluctant to engage in high capacity spending because they are more confident about future revenue and profits.

     

    • Outsourcing-themes involve cost arbitrage, usually in service based industries where India has a strong competitive position because of its large, technically educated and English-speaking population. The Indian IT industry has been experiencing close to 50% annual revenue growth while 2.5 million new English speaking graduates are added to the workforce every year. So compelling is the value proposition of providing IT services from India (80% cost savings for US firms according to NASSCOM), that local companies like Infosys and Wipro have become leading global players in this industry while incumbents like Accenture or IBM have made India a central part of their overall strategy. Both sets of firms seek the same high margins from India-based costs and US-based pricing. The difference is that Accenture and IBM constitute “inbound” M&A as they expand their delivery or cost centers in India. Infosys and Wipro, meanwhile, are focused on “outbound” M&A as they seek to establish parity with their US competitors in sales and marketing relationships with American and European customers. An established success story which is still unfolding with different possible scenarios, the outsourcing theme is closely linked to Indo-American business ties, with IT in particular being the leading sector both in terms of profits and profile.

       

      The key industries which emerge from a consideration of these themes are the areas of maximum consolidation potential – retail, consumer goods, financial services, infrastructure, manufacturing, real estate, technology and IT enabled services. Within each of these, the best opportunities are found through an investor’s assessment of risks and returns. But whereas returns can be measured on operating and financial leverage and compared across industries, non-operating risks affecting Indian companies are not easily quantifiable.

       

      Understanding risk has always one of the main challenges of corporate finance. Even when predicting the growth and profitability for a particular industry or company, one of the benefits of adopting a thematic approach is that it helps to identify the key macro risks that could belie that growth or undermine those profits. And for any institutional investor about to shell out millions of rupees or dollars to buy a piece of the India story, the economy-wide risks are always the biggest worry.

       

      Next week the Institutional Investor will examine the seriousness of the key risks to the India story – agriculture, infrastructure, governance and education.

       

       

      (The Institutional Investor is a corporate finance and strategy specialist who hopes to catalyze anonymous yet informed debate on specific opportunities and risks in India’s economy. Next week the Institutional Investor will examine the seriousness of the key risks to the India story – agriculture, infrastructure, governance and education.)

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