PE buyout deals generate highest returns: McKinsey

India is finally beginning to show its potential as a viable private equity investment destination. Exits from private equity (PE) investments in India grew tenfold to $10.8 billion in 2017, since 2009. In fact, 48% of all exits since 2003, by value, took place in the past three years. The average returns on exited investments have risen to 22% (2012–2014 vintage) from 8% (2006–2008 vintage), according to global consulting giant McKinsey & Co's latest report Indian private equity: Coming of age.

This is definitely the much needed good news for the Indian investment ecosystem. While over $97 billion have been invested by PE firms (excluding real estate and venture capital) in the country since 2003, till about three years ago it was widely believed India was not showing enough profitable exits and high returns. The 2015-17 vintage is, however, changing that belief.

“Sales to strategic buyers account for almost a third of exits (measured by value) from 2015 to 2017. This finding underscores the influence private-equity investors wield over exit approaches and timing to capture value, reposition portfolio companies as attractive acquisition targets, and steer other owners and investors through an exit process. Buoyant markets have recently facilitated sales to the public. These sales grew 1.5 times from 2015 to 2017 compared with 2011 to 2014,” according to the report.

McKinsey analysed the two dominant strategies in Indian private equity—buyout and minority stakes for growth investment—in a range of deal sizes. Buyouts earned the highest return, with median returns at 21%. Growth capital investments ($25 million to $99 million) offered median returns of 18%.

“During the period from 2015 to 2017, one-quarter of investment was in buyouts, up sevenfold in value from the period from 2009 to 2011. This shift reflects changes in both demand and supply. Investors had an increased appetite for control and took advantage of a growing number of buyout opportunities as promoters restructured portfolios, divested noncore businesses, or cashed out,” according to the report.

As general partners (or GPs, who operate the fund) are becoming owners of businesses, rather than minority investors, they are beginning to recalibrate their organisation and talent models and rewrite their playbooks. Hence, they are investing in specialised operations capabilities and partnering more closely with experienced industry professionals. Twenty-eight of the 30 most active funds in India either have an in-house operating team or regularly engage senior industry professionals as advisers or partners, according to the report. Their involvement includes activities such as assessing management, hiring staff, cutting costs, and developing growth capabilities.

From 2015 to 2017, more than three-quarters of deal value was driven by deals worth more than $100 million, according to the report. The number of deals in this category grew, as did the size of the largest deals. Eight deals were greater than $500 million from 2015 to 2017, compared with only four in the previous six-year period

Private-equity investments in India broadly focused on six sectors: consumer, financial services, healthcare, IT/business process outsourcing (BPO), machinery and industrials, and telecommunications. These sectors have grown steadily over the past nine years and collectively account for 83% of investment from 2015 to 2017— up from 44% from 2009 to 2011.

PE-backed companies are also showing better performance. Over a seven-year period, businesses backed by private equity raised revenue and profit, on average, 27% faster than their peers. When measured on revenue growth alone, businesses backed by private equity outperformed their peers in every sector, and they out-earned them on EBITDA growth in six out of ten sectors, says McKinsey.

“The search for alpha—superior returns vis-à-vis benchmarks—is of course the holy grail of private-equity investing, but it is being supplemented by a desire for “consistency at scale.” The industry appears to be succeeding, as businesses with private-equity backing typically grow faster than industry averages,” says the report.

In the meantime, the good run is expected to continue and both deals and exits are expected to pick up in the next 12 months.

"Strategic investors and sovereign / pension funds together with East Asian investors have been more prolific in the Indian markets owing to the focus on the stressed assets and the consolidation in the tech enabled businesses - the late growth / growth investors have been a bit muted over the last year or so, but with the IPO market slowing down I expect traditional PE deal momentum to pick up in the next 12 months,” says Sanjeev Krishan, private equity and deals leader, at consulting firm PwC India.