The growth momentum for private equity (PE) transactions in India remained robust in 2018, with venture capital (VC) and PE deals totalling a value of $26.3 billion, according to India Private Equity Report 2019, released by Bain and Company, in association with the Indian Private Equity and Venture Capital Association (IVCA).

The value of PE deals seen by companies across the spectrum in India in 2018 was at its second highest level in a decade and only marginally lesser than in 2017 when VC/PE deals totalling $26.8 billion were recorded. The small decline in deal value was despite deal volume rising for the second straight year with 2018 witnessing 793 VC/PE deals, compared to 700 in 2017.

“While the usual sectors such as banking, financial services and insurance (BFSI) continued to grow, investments also spurted in varied sectors like consumer/retail, healthcare and energy,” the report said. “Average deal size remained stable overall, even as deal size in consumer tech declined almost 30%. This was largely driven by the scarcity of consumer tech mega deals like the one we saw in 2017, such as SoftBank’s $2.5 billion investment in Flipkart.”

Consumer technology and BFSI remained the largest sectors when it came to attractive PE investments and accounted for 40% of the deal value in 2018. However, the quantum of PE capital flowing into the consumer tech space shrank to $7 billion in 2018 from $9 billion in the preceding year.

The top 15 deals accounted for 40% of the total investment value in 2018, which signals that most investors are valuing quality or over quantity when it comes to deal-making. The report pegs India-focussed dry powder (the amount of capital available for future deals) with VC/PE funds at $11.1 billion “indicating that high quality deals aren’t lacking capital.”

A crucial component of a healthy PE ecosystem is investors’ ability to exit their investment and make attractive returns. On this front as well, 2018 proved to be a good year that saw 265 exits totalling $33 billion. “Almost half of this exit value resulted from Flipkart’s sale to Walmart. However, even excluding the Flipkart exit, 2018 was one of the best years for exits in the last decade,” the report added.

An interesting trend that the report sheds light on is investors’ growing keenness to strike late-stage and buyout deals, as well as an increase in transactions that see PE players acquire majority stake in companies. Sriwatsan Krishnan, partner at Bain and Company and the author of the report tells Fortune India that investors have always preferred having a stake in companies that is strategically large enough for them to influence operational strategy by bringing their experience to the fore; and such deals were now being possible due to the relative maturity that a number of Indian companies have attained over the years.

In an interview with Fortune India, Krishnan says that he is bullish on his outlook for VC/PE investments in India in 2019. However, investors could turn cautious on certain specific sectors like non-banking financial companies (NBFCs), which have been suffering from stressed liquidity since the crisis at IL&FS broke out. Edited excerpts:

What is your outlook for VC/PE investments in India in 2019?

The outlook on Indian PE continues to be fairly strong for a number of reasons. The number of participating funds keeps going up over a period of time. Deals are seeing increased competition and there is massive interest in getting transactions done. The quantum of dry powder available means capital will get deployed. The general sentiment, driven by the attractiveness of Indian market from a growth perspective, as well as recent successful exits have given confidence to investors that it is possible for them to realise significant returns on their investments in five to seven years. The first quarter of 2019 (calendar year) has been pretty strong for PE investments. The second quarter has been a bit mixed, due to investors waiting and watching for the results of the elections to be declared.

Whether the quantum of PE investments in 2019 goes up substantially from where it was at the end of 2018 would also depend on some structural factors like stability of the capital markets and global cues around a potential economic slowdown.

The total value of PE deals hasn’t changed much between 2017 and 2018. What could be the areas of growth that can possibly lead to an increase in 2019?

A couple of sectors that have seen a lot of investments are BFSI and consumer internet. And these sectors will continue to see new investments. There are some nascent sectors where not much PE capital has flowed in till now, like health-tech and education-tech, and we expect a lot more capital to flow to these sectors going forward. There is also consumer retail in its traditional sense, which is getting a lot of attention from funds managers at present.

The report highlights that global pension funds and sovereign wealth funds are playing an increasing role when it comes to PE investments in India. Is the proportion of new PE investments made by these entities, compared to overall investments, expected to increase?

Yes, but no rapidly enough for it to be a significant shift. The proportion of deals done by the likes of pension funds, sovereign wealth funds and even some corporates has increased around five percentage points. But even now, 70-80% of deals continue to be done by the traditional PE funds.

The last couple of years were good for PE investors looking to exit their investments. Will we see this trend continue in the next two years?

Exits will continue but their success will depend on the markets, which is hard to predict. If the market stays more or less stable over the next 12-24 months, then the proportion of exits through public market, which is around 30-40%, will remain intact. Secondary exits depend more on the fundamentals of specific sectors remaining strong and that is true for sectors like consumer Internet, where more Indians are coming online to transact.

There is a progressive rise in late-stage and buyout deals, as well as PE players looking to acquire majority stakes in companies. What does that tell us about the market?

Early stage and growth capital deals are typically not for control of the company. PE players won't cut a cheque for $10-20 million and take majority control in a company because that entity is at a nascent stage and that amounts to effectively taking a massive venture risk.

The other thing to keep in mind is that funds have always been keen to acquire sizeable stakes in companies that gives them some measure of control. It could be for, let’s stay, a stake greater than 26% because that gives the funds ability to influence the company in terms of strategy and management. So the desire has always been there but the challenge has been on the supply side with the number of controllable deals remaining low.

But as companies mature and managements look for exits, the availability of deals where PE funds have the opportunity to acquire majority control is on the rise. In developed markets, the proportion of control and buyout transactions is higher and the Indian market is evolving in that direction.

The BFSI sector, including NBFCs, has attracted a lot of PE investments in the past. Do you see investors turning cautious on this sector in the wake of what has happened since the IL&FS crisis?

There has been a little caution on this sector. Investors are focusing a lot more on the quality of the books and assets of these companies. Some investors are also looking at such companies as an opportunity to buy into distressed lenders at low multiples and then look to turn around the business and make handsome returns. A couple of years ago, investors were betting on this sector due to the promise that these NBFCs held of addressing needs of potential borrowers—like individuals in tier II and III cities and small and medium enterprises—that the traditional banking channel couldn’t fulfill. But now there is a lot more focus on asset quality.

The report flags off rising valuations as a major concern for PE funds…

Investors continue to be bullish about the Indian market and want to make deals. But what bothers them is high valuations. Valuations have been fairly high in India and that is true for growth-oriented markets. Growth across sectors—be it BFSI and consumer Internet—has been really rapid and these companies have the potential to focus on one line of business today, but do much more of something different tomorrow which adds to incremental value. The other factor is competition. The number of active funds is going up every year and every deal these days sees more competition today than five years ago. These are structural factors in a market that is fundamentally attractive. We don’t see any reason for that to change. We think valuations will continue to be fairly punchy and there will be capital chasing those valuations.

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