Universiteit Van Amsterdam Amsterdam Business School Thesis Proposal 2012

By Tanvi Karambelkar Student ID 6487513 Thesis Supervisor Dr. Ludovic Phalippou

An Analysis of the Determinants of Private Equity Growth and Returns in India

Statement of the Research Question: Private Equity, as it is structured today, is an invention of modern finance. It gained prominence in the 1980s, a decade which witnessed an increase in the availability of credit and the birth of financial innovations such as corporate/junk bonds. In the 1980s, Private Equity acquisitions were led by leveraged buy-outs (LBO), which depended on employing financial leverage to acquire a company. The rationale for acquiring companies and leveraging them up was to increase their efficiency, often by discarding unproductive divisions and products. While LBOs spearheaded the rise of the Private Equity Industry in global finance, there are now various other strategies that PE firms employ to increase the value of their acquisitions. In 2011 alone, the global PE industry raised $225 billion for investments. In Q4 of 2011, $64 billion of new deals were announced, and $72 billion were returned back to investors through exits1. Like any dynamic industry, Private Equity has also proved to be capable of changing and staying relevant to the economy it operates in. Yet, the crux of the Private Equity philosophy is an age-old pillar of finance the creation and delivery of capital to firms that are capable of diffusing innovation to society. Like any other industry, PE is held captive by macroeconomic factors. The crisis of 2008 has had far-reaching effects on Private Equity, and some argue that it succeeded in changing the very nature of Private Equity. Most importantly, the industry has had to look beyond the borders of developed nations to find the returns that justify its undertaking. This resulted in a spread of the PE model to developing countries such as China, India, Brazil, Russia, and recently, countries in West Africa. India, especially, has witnessed astonishing growth in its Private Equity industry. From being virtually non-existent as an industry in 2000, Private Equity in India sought to raise $34 billion in 2011, and India saw the largest deal activity increase amongst all the big Asia-Pacific markets in 20102.
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Preqin, 2011 Global Private Equity Report, Preqin Global Infrastructure Review, 2011.

IVCA & Bain & Company, India Private Equity Report, Bain & Company Publications, 2011.
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The relatively recent nature of this industry in India, along with its incredible growth potential make Private Equity a timely research topic. Moreover, limited academic data makes it an important topic to explore in finance, in order to investigate the far-reaching ripples of PE activity in a developing economy. This thesis aims to analyze the impact of global market cycles and fund investment strategies on the Indian Private Equity industry. The author will do so by testing empirical research and analyzing past deal data. She aims to intertwine the two main types of academic theses a classic empirical study of leading academic studies (quantitative analysis) and a systematic case study (qualitative analysis), which will enable the author to test empirical research, and analyze past deal performance, in order to get a clear picture of the Indian Private Equity market. The availability of data on Private Equity transactions is limited, mainly because PE firms are not obligated to publish financial statements and other financial activities, or to make them public. Thus, in order to derive a well-rounded conclusion to the questions posed in this thesis, the author will use both, a Private Equity database (to conduct empirical analysis, and to test leading academic theories) and individual case studies assembled by the author (to relate the same to the Indian market). Rationale: As noted above, an analysis of the determinants of Private Equity growth and returns in India is a timely research topic. However, the author also hopes to bring the following new insights to the research that already exists in relation to her topic Hypothesis 1 - How do global market cycles affect Private Equity activity in India? Hypothesis 2 Do certain investment strategies yield higher results? Which is the most popular exit strategy in India? Why? Hypothesis 3 - Does Private Equity add real economic value to the Indian economy? While studies have been done on the role of Private Equity in developed markets, there is still a limited amount of empirical research concerning its role in developing markets. A deeper analysis of the above-mentioned questions will allow the author to gain a comprehensive knowledge on the determinants and drivers of the current boom in PE in India, and the consequences this boom will have on the Indian economy. While this thesis does not aim to explore previously unanswered issues in Private Equity as a whole, which lie largely outside the scope of a Masters Thesis (especially given the limited availability of data in PE), it aims to relate empirical data, academic research and key concepts to the Indian PE industry, in order to highlight the trajectory of Private Equity in India.

Furthermore, this thesis leads to additional avenues of research. Once the basis of Private Equity in India is established, these findings can be used to analyze investment and exit strategies in greater detail and compare them with developed markets. Numerous research topics can use this thesis as input, such as the role of government policy in PE investments, the feasibility of secondary fund markets in developing economies, behavioral biases of PE fund managers, and possible agency costs in Private Equity, to name a few. Theoretical Framework: One can say that the academic study of Private Equity is divided into two broad sets of thought one emphasizes the limited applicability of academic theories in, and the consequent uniqueness of, Private Equity, while the second school of thought emphasizes the importance of financial theories in understanding Private Equity. J. A Timmons, for instance, states in his 1994 textbook on entrepreneurship that "there are both stark and subtle differences, both in theory and practice, between entrepreneurial finance as practiced in higher potential ventures and corporate or administrative finance, which usually occurs in larger publicly traded companies. Further, there are important limits to some financial theories as applied to new ventures.3" On the other hand, Josh Lerner, the author of the seminal Private Equity book Venture Capital and Private Equity: A Case Study, stresses the need to study Private Equity through the framework of modern financial theory, in order to comprehend the developments and effects of PE in relation to a broader macroeconomic environment4. The author, whilst agreeing with Timmons on the differences in the practical application of financial theories in public and private companies, leans towards Lerners view of understanding private equity as a function, and consequence of, modern financial theory. As noted earlier, there are three main questions posed in this thesis How do global market cycles affect Private Equity activity in India? How do Private Equity investment strategies affect returns? Which is the most popular exit strategy in India? Why? Does Private Equity add real economic value to the Indian economy? In order to answer these questions within the framework of modern financial theory, it is important to first state the framework itself. To start with, the author assumes that international finance, since WWII, operates as a consequence of the combination of two dominant theories namely, economic neoliberalism and social/Keynesian liberalism. Thus, it is pertinent to describe these schools of

James Timmons, New Venture Creation. Entrepreneurship for the 21st century, Irwin Publishing, Boston, 1994.

4 Josh Lerner, Venture Capital and Private Equity A Course Overview, Harvard Business School & National Bureau of Economic Research, 1997

thought before we proceed to a review of the literature that is to be used in the thesis. Economic Neoliberalism Economic neoliberalism, as advocated by Milton Friedman, was embraced by the Reagan administration in the USA and the Thatcher administration in the UK in the 1980s. The author argues that international finance is based largely on a combination of economic neoliberalism and Keynesian liberalism, and thus, developments in Private Equity should be analyzed and measured within this context. Wendy Larner succinctly describes the neoliberal school of thought as, understood to rest on five values: the individual; freedom of choice; market security; laissez faire, and minimal government." These values underpin the new institutional economics (built on public choice theory, transactions cost theory and principal-agency theory) which, together with a new emphasis on managerialism, comprise the intellectual basis of the neo-liberal challenge to Keynesian welfarism, and provide the theoretical impetus for deregulation and privatization.5 Keynesian Economics One cannot argue that modern finance descends from just one school of thought. Instead, it is a consequence of a combination of the dominant theories of international finance since WWII. Keynesian economics, which enjoyed supremacy from WWII to 1980, and which is resurfacing as a valid alternative to neoclassical liberalism since the credit crisis of 2008, has also greatly influenced the vehicles of modern finance, with Private Equity being no exception. Marc Lavoie identifies the fundamental beliefs of Keynesian economics as follows, A belief in any of the statements put below would probably qualify his or her holder to be part of some of brand of Keynesianism. The existence of involuntary unemployment. The principle of effective demand and the paradox of thrift. The existence of an independent investment function. That capitalism is the best system but that it needs to be tamed. That markets, especially financial markets, are inherently unstable. The need for fiscal countercyclical policies. The need for capital movement impediments, managed exchange rates. The role of animal spirits and fundamental uncertainty. The nonneutrality of money, the significance of liquidity. The dangers of wage and price deflation. The existence of path dependence, multiple equilibriums, and hysteresis. The existence of imperfections that thwart price adjustments.6 Once this framework has been established for the purpose of the thesis, the
Larner, Neoliberalism: Policy, Ideology, Governmentality, Volume 63, Studies in Political Economy, 2000. Marc Lavoie, Are we all Keynesians?, Volume 30 (2), Brazilian Journal of Political Economy, 2010.
6 5Wendy

author can measure developments and growth of Private Equity and its value through the definitions of growth and economic value-creation, as stated in these theories. Literature Review: To aid the empirical analysis of this thesis, the author aims to derive her academic context from the following research articles Measuring the impact of public market cycles on Private Equity Private Equity investments in emerging markets function as a diversification tool for investors. The phenomenal increase in the Indian PE industry can be attributed to the growth of the Indian economy, as well as to the credit crises, when investors started searching for alternative markets to invest in. The author aims to analyze the effect of public market cycles on investments in PE in India. Paul Gompers et. al, in the article Venture Capital Investment Cycles: The Impact of Public Markets analyzes the effects of public equity market cycles on PE and VC investments, between 1975 and 1980. The paper argues that investments increase when public market signals become more favorable. Ludovic Phalippou and Maurizio Zollo, in the article What drives Private Equity Performance, study the drivers of PE performance, and argue that it co-varies positively with business cycles and stock-market cycles. David T. Robinson and Berk A. Sensoy, in their article Cyclicality, Performance Measurement and Cash Flow Liquidity in Private Equity aruge that public and private equity waves move together, and that high private equity fund-raising forecasts low private equity cash flows and low market returns. Jason Draho, in The Convergence of Public and Private Equity Markets: Cyclical or Structural, argues for an eventual convergence between private and public equity markets. The article tries to analyse the changings in PE trends during times of recession and during times of boom. Measuring PE Return, Strategies, and Risk In conducting research in Private Equity, it is crucial to derive the most accurate renditions of the risk and return of the asset class under scrutiny. Actual private equity returns and their methods of calculation has been the focus of various academic research articles. As an asset class, Private Equity is unique due to the nature of its cash flows, which generally begin with a negative cash flow, followed by one or two positive cash flows. Intermediate valuations of assets, while attempted under certain regulations, have insofar proved unsatisfactory at measuring the value of the investment between cash flows7.
7 Prof. Phalippou, Lecture Notes, Advanced Asset Management, MIF Program, Amsterdam Business School, 2012.

Thus, the author aims to use the following research to aid her calculations of private equity returns in her thesis. Phalippou et. al argue in Private Equity Performance and Liquidity Risk that the inclusion of a liquidity risk premium in calculating private equity required returns reduces the alpha of the investment to zero. Phalippou & Gollschalg argue in The Performance of Private Equity Funds that performance reports by the Private Equity industry are overstated. This is due to a bias towards reporting better performing funds in the data. Furthermore, adjusting for risk and fees further reduces real return. Steve Kaplan and Antoinette Schoar in Private Equity Performance: Returns, Persistence and Capital Flows investigate private equity fund performance. They argue that fund performance increases with experience, but better performance also leads to follow-in funds and raise larger funds, which results in a concave relationship between fund size and performance. (Kaplan et al, 2003) Phalippou outlines, in The Hazards of Using IRR to Measure Performance: The Case of Private Equity, the difference between IRR and effective Rate of Return (RoR), the pitfalls of IRR, and suggests the implementation of a Modified IRR to calculate PE returns. Christian Diller and Christoph Kaserer argue in What Drives PE Returns? that deal valuations are driven by overall fund inflows into the industry. They opine that fund returns are driven by GP skills as well as stand-alone investment risk. Measuring the Impact of PE to an Emerging Economy To answer the question, the author aims to use the following articles. Magogodi Makhene in Alternative Growth: The Impact of Emerging Market Private Equity on Economic Development, shows how alternative investments, when fully incorporated into the local market, can create growth, jobs, technological advancement and integration with the global economy. Allen Berger et. al aim in The Economics of Small Business Finance: The Role of Private Equity and Debt Markets in the Financial Growth Cycle to provide a comprehensive analysis of the effect of private equity on the financial growth cycle of small and medium sized businesses in an economy. Ernst et. al compare in Are private Equity Investors Boon or Bane for an Economy A Theoretical Analysis, private equity acquisitions to standard investments and analyze the motivations of private equity investors. The publication The Corner House analyzes the various ripple effects of Private Equity in the domestic and global economy in Taking it Private: The Global Consequences of Private Equity. Lee Harris, in A Critical Theory of Private Equity, analyzes the agency

costs that arise from the structure of private equity funds. Agency costs have the potential of a conflict of interests between investors and fund managers, thus resulting in a loss of value of shareholders. Shourun Guo et. al argue in Do Buyouts Still Create Value? that high levels of debt does result in creation of higher value for acquired companies. Shai Bernstein et. al argue in Private Equity and Industry Performance that private equity capital create positive value in an industry, and aids in increasing industry performance.

Methodology: In order to attend to the questions posed in this thesis, the use of both, case study analyses and empirical evidence will be undertaken. The author aims to gather data through individual collection from media and other trust-worthy sources, and through the use of two databases, namely, PE Research India and a Private Equity Database made available to the author by her thesis supervisor. PE Research India is Indias largest Private Equity database, with over 1700 transactions recorded from 2004. The other PE database that will be used uses compiled deal data of over 150 Indian Private Equity deals, and over a 1000 global deals. Hypothesis 1 What is the Impact of Global Market Cycles on the PE Industry in India? Through answering this question, the author aims to study the relationship between global market cycles and PE activity in India. Thus, an inherent assumption will be that global market cycles are significant in the trajectory of PE activity in India. In order to test this hypothesis, and to ascertain the relationship between the two phenomena, PE activity will function as the endogenous variable, and global market cycles, as measured by Worldwide GDP growth, as an explanatory variable. A Linear Regression, using time-series techniques, will be performed to analyze the impact of public market cycles on PE investments in India. Two regressions will be performed, one in which the dependent variable is Total Funds Raised in time t and the other, where the dependent variable will be Total Funds invested in time t. The independent variable will be Global GDP growth in time t. Global PE investments in time t, and the availability of credit, measured through the LIBOR, will serve as control variables in the regressions. Thus, in its simplest form, the linear regression will assume the following mathematical construction

Where: y(t) = dependent variable (either PE Fund Raising or PE Investments) 7

X = Independent Variable at time t B = Coefficient of Independent Term = Error Term

Hypothesis 2 Do Certain Investment Strategies Yield Higher Returns in Indian Private Equity? What is the most popular exit strategy in India? Why? In order to determine how different investment strategies affect returns, the author aims to use a Multinomial Logit Model of regression. Such a model predicts the probability of a possible outcome, given a set of independent variables. Thus, the possible outcome will be the kind of return, and different PE investment strategies will serve as the independent variables that affect the outcome. The investment strategies that will be considered are buy-&-build, leveraged buyouts, quick flips, operational efficiency and a variable for a tactic of combining any of the above strategies. In order to predict if the observation I (investment strategy) has an outcome of k (level of return), the regression will be arranged mathematically as follows

Along with regressing the data available to the author, a case-study analysis will also be performed. By compiling the popularity of different investment strategies in PE investment cases compiled by the author of the thesis, an analysis of which strategies are popular will be possible. This analysis, combined with the rate of return for different investment strategies, will give the author a clearer picture of the determinants of private equity investment strategies in India. Hypothesis 3 - Does Private Equity Activity Create Real Economic Value? Determining a concrete answer to this question is largely out of the scale of a Masters Thesis. This is because the sheer amount of information, data and time needed to analyze the individual effects of an industry on the $1 trillion Indian economy. However, the author aims to approach this question theoretically, and conduct a conceptual analysis of PE activity in India, using the academic articles mentioned above, and an individual case study that analyzes the performance and effects of approximately 35 Indian companies that used to be a part of Private Equity funds. The author will select various different investments in order to minimize any selection bias in this study. The author hopes to find a correlation (either negative or positive) by individually analyzing the performance of companies that were subject to private equity takeovers. Moreover, the author will also parallel the performance of these companies with the performance of comparable companies listed on the Bombay Stock Exchange and the National Stock Exchange, in order to analyze if going private did indeed

benefit the companys returns and its level of efficiency.

References: Magogodi Makhene, Alternative Growth: The Impact of Emerging Market Private Equity on Economic Development, Neumann University, 2009. Allen Berger et. al, The Economics of Small Business Finance: The Role of Private Equity and Debt Markets in the Financial Growth Cycle, Volume 22, Journal of Banking and Finance, 1998. Ernst et. al Are private Equity Investors Boon or Bane for an Economy A Theoretical Analysis, European Financial Management, 2011. Kavaljit Singh, Taking it Private: The Global Consequences of Private Equity, Volume 37, The Corner House Briefing, 2008. Lee Harris, A Critical Theory of Private Equity, Volume 35, Delaware Journal of Corporate Law, 2010. Shourun Guo et. al, Do Buyouts (Still) Create Value? Volume 67 (2), The Journal of Finance, 2011. Shai Bernstein et. al, Private Equity and Industry Performance, NBER, Harvard Business School Working Paper 10-045, 2009. Franzoni et. al, Private Equity Performance and Liquidity Risk, 24, Netspar Discussion Papers, 2010. Phalippou & Gollschalg, The Performance of Private Equity Funds, EFA Moscow Meetings, 2005. Steve Kaplan and Antoinette Schoar, Private Equity Performance: Returns, Persistence and Capital Flows, No. 4446-03, MIT Sloan Working Paper, 2003. Phalippou, The Hazards of Using IRR to Measure Performance: The Case of Private Equity, University of Oxford Working Paper, 2008. Christian Diller and Christoph Kaserer, What Drives PE Returns?, Volume 15 (3), 9

European Financial Management, 2009. Paul Gompers et. al, Venture Capital Investment Cycles: The Impact of Public Markets, Volume 87, Journal of Financial Economics, 2008. Ludovic Phalippou and Maurizio Zollo, What drives Private Equity Performance, No. 05-41, Financial Institutions Center, Wharton University Press, 2005. David T. Robinson and Berk A. Sensoy, Cyclicality, Performance Measurement and Cash Flow Liquidity in Private Equity, No. 2010-021, Charles A. Dice Center Working Paper, 2010. Jason Draho, The Convergence of Public and Private Equity Markets: Cyclical or Structural, Volume 19 (3), Journal of Applied Corporate Finance, 2007. Marc Lavoie, Are we all Keynesians?, Volume 30, (2) Brazilian Journal of Political Economy, 2010. James Timmons, New Venture Creation. Entrepreneurship for the 21st century, Irwin Publishing, Boston, 1994. Josh Lerner, Venture Capital and Private Equity A Course Overview, Harvard Business School & National Bureau of Economic Research, 1997. Wendy Larner, Neoliberalism: Policy, Ideology, Governmentality, Volume 63, Studies in Political Economy, 2000. Preqin, 2011 Global Private Equity Report, Preqin Global Infrastructure Review, 2011. IVCA & Bain & Company, India Private Equity Report, Bain & Company Publications, 2011.

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