The Indian Economy Blog

January 18, 2007

Hutch-Essar: The Coming-Of-Age Of Private Equity In India

Filed under: Business — Nandan Desai @ 10:56 am

Sometime in the next month or so, the battle for control of India’s fourth largest mobile phone operator (third largest privately-owned), Hutchison-Essar, will truly begin – with the opening bids coming in. At this stage, the details are a bit murky to say the least. What we do know is that the company will be valued around $18 billion (double of what it was in June 2006 when the Hindujas sold their 5% stake). We also know that the battle will involve a fascinating cast of characters competing against and co-opting each other. They include:

  • Li Ka-shing: a Hong Kong tycoon who owns 67% of the company – he has indicated that he wants to sell his stake
  • Anil Ambani: owner of Reliance Communications, India’s second largest mobile operator – a successful bid would allow him to topple Sunil Mittal as the market leader
  • Arun Sarin: CEO of Vodafone, the world’s largest mobile operator (by revenues) – he needs Hutch to satisfy shareholders who want to see a strategy for growth
  • The Ruia family: owners of the steel and oil-refining Essar Group and the remaining 33% of Hutch – they have not decided whether to exit along with Li, hold, or try to buy out Li’s stake. They (claim they) have the right to refuse another investor from buying Li’s Hutch-Essar stake.
  • Orascom: Egyptian telecom company which owns ~20% of Li’s Hutch Telecom (not Hutch-Essar). If Reliance, Vodafone, and/or the PE firms encounter resistance from the Ruia’s and decide to buy in to the parent company, Orascom (claims it) has right of refusal.
  • The Hinduja family: definitely the long-shot here – they may try to make a play for Li’s stake
  • Palaniappan Chidambaram: If Essar decides to sell its stake along with Li, then any foreign player will need a local partner – foreign ownership in telecoms is capped at 74%

Increasingly, it looks like this will turn into a battle with Vodafone on one side, and Reliance on the other. Orascom, the Ruia’s, and possibly the Hindujas will try to play the spoilers. Vodafone’s Sarin was in India this past week for a round of meetings with the finance minister and the various executives involved in the deal. Not to be outdone, Ambani made his own trip to North Block, no doubt urging Chidambaram to (wink, wink) help keep the company primarily in Indian hands. Of course, neither Reliance nor Essar have the financial muscle to make a bid that large on their own – so they, in turn, are wooing cash-rich and deal-hungry private equity players including Blackstone, KKR, The Carlyle Group, and others to come on board as partners. Whether or not one or more of these players are eventually involved, this deal will represent a significant turning point in Indian finance – for the private equity industry; and more importantly, in the market for corporate control.

(Click to see coverage of deal)

Unlike retail and institutional investors; hedge funds and mutual funds; and other asset managers – private equity firms are known primarily for being active investors. In most cases, these firms buy a large enough chunk of a company to be able to influence management and long-term strategy decisions – usually through directorships. In some cases, the firms seek outright majority control in order to give them the power to replace the management team altogether. Due to the large size of the deals, the investment decisions are usually predicated on an agreed-upon strategy for aggressive growth. Historically, large and established private equity firms have been able to consistently beat market returns – often by large margins – primarily because of this activist investment philosophy (as well as their ability to mobilize large amounts of cheap debt financing).

Private equity firms first came on the Indian radar screen in the mid 1990s. In the ensuing years, some got carried away in tech mania, others made bets on the promise of regulatory change, and some others simply tried to get their footing. With some notable exceptions, the deals were relatively small and foreign interest was minimal. That was, of course, until a US investor sold their $300 million stake in Sunil Mittal’s Bharti-Airtel for an amazing $1.9 billion. Though the returns were certainly a magnificent advertisement for investment in India, another more subtle fact aroused the fancy of the other foreign private equity majors. A majority of the sale was done through three large half-billion dollar block trades – which were almost perfectly absorbed by the capital markets. Finally, they had an ‘exit-strategy’!

A host of big spenders like Blackstone, Carlyle, TPG, and others committed to India in no uncertain terms – poaching away talent, and opening their own big, shiny offices at Nariman Point, Mumbai. The next stage, still ongoing, is the vigorous hunt for good investments. In looking for deals which can satisfy their hunger for returns, western private equity players have found their traditional investment model challenged by three central facts about the current Indian corporate world:

  1. A hunger for financing so that they can take advantage of the massive growth in opportunities – both in India and abroad.
  2. An equal revulsion toward ceding any corporate control to the investor – either because the company is family owned, or simply because the owner is worried about the prospect of challenges to his power
  3. A comparative lack of debt financing in most Indian companies. (This should be a plus because it means that the large companies can absorb a good deal of debt – thus bolstering the investor’s returns.)

In the countries where the industry is most vibrant, private equity serves a critical economic function: it acts as a powerful force that aligns management’s interests with those of shareholders. It challenges the notion of the almighty CEO or chairman by acting as a check on their power, and benchmarking their performance. Ideally, corporate governance improves, profits grow faster, and operations are more efficient [see comment 1]. This is contingent on the ability of these firms to buy a large enough stake to gain control and be able to influence management in the first place.

Foreign PE firms in India have not quite gotten to this stage yet. Till date, with few exceptions, private equity deals have been financed mostly with equity; and rarely is the investor given anything close to majority control [see comment 2]. Indian CEOs want these firms as ‘partners’ – though not the type that can tell them how best to run their business. However, as the industry matures, and the honchos of the Indian business world move on to these PE firms, this reality is slowly changing and the market for control of India’s most-promising businesses is rapidly expanding. This is most clearly represented by the potential Hutch deal – where a 67% stake is up for grabs.

An expanding market for control is in the best interests of the shareholders of these Indian companies. More importantly, it is in the best interests of the broader economy. As private equity (both domestic and foreign) expands, there will be an increasing premium attached to good management. Growth will be generously rewarded by the market; and disappointing performance will be punished.

Despite this seemingly cold calculus towards management, private equity and venture capital firms are a lot more patient than most other classes of investors. This is because when big-ticket asset managers (like pension funds, oil sheikhs, and university endowments) plow their money into private equity funds, they essentially lock-it in at the sole discretion of the fund’s managers. This gives the manager the flexibility to negotiate long-term strategy with the management teams on potential investee companies, and it gives management the confidence that the investor will not pull out at the hint of trouble; or simply to create liquidity.

Over the coming months, it will be interesting to see what happens with the Hutch-Essar deal. It will represent a significant turning point in the evolution of private equity in India which began about a decade ago.

Will the Ruia’s – who have plainly admitted that their existing business (steel and oil refining) has no overlap with Hutch’s – relent in the face of Reliance Communications and Vodafone (and possibly Orascom), who both have more domain knowledge, financial muscle, and are hungrier (my guess) for market share in the world’s fastest growing mobile market?

What will the entrance of cash-rich private equity firms mean: will they use their international connections to out-maneuver, or will they pay a hefty price to buyout the assorted ‘Rights of First Refusal’?

Or, will babudom prevail – neatly condemning the fate of the deal to the courts?

6 Comments »

  1. 1. This of course does not mean that the impact of private equity is necessarily benign. There are some areas where it can go terribly wrong – such as when they create excessive debt in portfolio companies, or when they collude with management against individual shareholders interests. However, these deals mostly have a net positive impact on wealth creation – demonstrated most clearly by the outstanding returns of the top-tier firms (top quartile firms usually beat the market by as much as 15%, annualized). Aside from the managers of the fund, this additional wealth enriches not just the few and already wealthy; but also your average investor who has the majority of his assets in his retirement account, not to mention the other shareholders of PE-backed companies.

    Comment by Nanubhai — January 18, 2007 @ 10:57 am

  2. 2. Most of the cases where the investor is given control are for small to mid-sized companies trying to gain market share, and establish themselves.

    Comment by Nanubhai — January 18, 2007 @ 10:57 am

  3. This is a very significant transaction from the point of view of both strategic and financial/PE investors in India (even though it is occuring in a relatively mature area like telecom). You are right it is essentially a faceoff between Vodafone and Reliance. Interestingly, the Ruias may have been coopted by Sarin, which would make a Reliance bid (supported by the PE firms) less likely to suced. From a practical perspective, this deal could go many ways with both Essar and now Orascom indicating their intention to ‘spoil’ the deal through their right of first refusal. It will be very interesting to see where the chips fall. Even for those of us involved in the transaction on the ground (representing one party or another), it is very difficult to tell what is going to happen.

    An important point you raised was about the market for corporate control (of lack therof) in India. How can Hutch’s value suddenly be double of what is was six months ago? The reason is the control premium. As a purely financial/minority investor, I will not pay a cent above market price, but if I can gain control, the company is worth more to me. How much more is it worth to Vodafone vs. Reliance, i.e. who can afford to pay a bigger premium? It depends upon how effecive the eventual combination is at improving revenue growth and achieving cost synergies. Clearly in both of these respects, Reliance would be ahead and be able to pay a higher premium. The other key ingredient in a successful bid would be cheap financing as this drives your return on investment (how much you pay for making the investment) and Reliance has also secured this.

    Adding to this (wink wink) that Vodafone is a foreign firm, the advantage is with Reliance unless Vodafone is successful in making a joint bid with Essar – exactly what Sarin is currently trying to do.

    Comment by Motabhai — January 18, 2007 @ 7:12 pm

  4. While it is far from clear which of the major players (Essar, Vodafone, Reliance, Hindujas, Maxis, Orascom) will finally win, I guess Indian might benefit more if Vodafone takes over Hutch.

    If Essar takes over, it will strain its finances and might not be able to concentrate on its other businesses, mainly dealing with Infrastructure & production. For India, it would be more beneficial if Essar pockets the $6billion+ and goes full blooded on its infrastructure projects rather than being saddled with $12b+ loans.

    If Reliance takes over, it might kill competition, as it would leave just two players – Bharti & Reliance who might then easily attack the smaller players Idea, Spice, and this over-consolidation might not be good for consumers. Again with Reliance, it would be better if they use their financial muscle for infrastructure (from country’s point of view, as they need to spend more on retail, refineries etc.

    Regarding Orascom, it will surely hit the security regulations (it has operations in Pakistan) and Maxis doesnt have power to go alone. And Hindujas dont have too much of telecom expertise to develop Hutch much more.

    This leaves Vodafone that has enough technology to ramp up Indian telecom industry. It will surely modernize Hutch better & will give a run for Bharti & Reliance and this healthy competition would make the Big 4 get better & better. The consumers will get better deal, and overall Indian economy will prosper.

    Though it is unclear whether Vodafone can go in for $20b+ valuation, I wish it enters the market for the sake of overall bettermend. I dont know whether Indian government has this in mind or could once again become a pawn to Reliance’s interests.

    Comment by Balaji Viswanathan — January 23, 2007 @ 1:02 am

  5. Finally the news is out and Vodafone bags the Prize (Hutch) for 19 Billion US$.

    This is indeed a positive development for all the players – the government, the consumers and the players themselves.

    The entry of a Technologically and Financially Powerful player in Vodafone will push Bharti and RelComm to work for greater effort to win consumers and they will work harder to earn every ARPU $… Which is best for everyone…

    India is comfortably a large market – remember that DESPITE so much growth in Mobile Telephony only 150 million Indians have mobile phones.. which means that some 950 Million Indians are still not having mobiles. The market is big enough to accomodate atleast 6 players. We will have Reliance, Bharti, Tatas, Birlas(Idea), Vodafone and BSNL and also some smaller players and there is enough room for all of them to grow .

    Comment by Ramki — February 11, 2007 @ 11:40 pm

  6. finally vodafone got it..but while thinking on it..will vodafone be able to convert hutch into their own brand..idea did that with escotel after about one year..but hutch is not a small player like escotel..and the brand created by the ad..the dog..i don’t think vodafone will be able to revamp the hutch completely..and today i read in paper that arun sarin also thinks the same..it will take minimum five years to completely brand hutch as a vodafone..

    Comment by Visakh — February 15, 2007 @ 5:35 pm

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