IDFC Private Equity – From the ground up

For years now the India market has been a financial hotspot second only to China in terms of both growth rates and buzz. And yet India’s booming economy, which grew at a staggering 9.7 percent last year, is hampered by a critical bottleneck ? vastly underdeveloped infrastructure. The country’s needs span every sector: roads, ports, airports, power. In its 2006-2007 annual report, India’s Planning Commission revealed that the country needs at least $350 billion (€240 billion) for infrastructure over the next five years. ICICI Bank puts the number closer to $500 billion.

India has long been aware of this problem. In 1997 the government created the India Development Finance Corporation to act as a commercial lender to assist infrastructure projects. The government of India initially owned 40 percent of the equity of IDFC, and financial institutions, foreign investors and multilateral agencies held the remaining 60 percent. The corporation is listed on both the Bombay Stock Exchange and the National Stock Exchange. The IDFC’s initial capitalization was $530 million, and the corporation has since lent more than $465 million.

?No one believed in infrastructure at that time, and it was difficult convincing people that they should invest in a fund like ours.?

India’s government and its central bank have set up a number of other entities to address the infrastructure issue, including Infrastructure Leasing & Financial Services and the India Infrastructure Finance Company. It is not always easy to discern how each differs from the others, and the government has been accused by some of creating institutional clutter rather than addressing the country’s needs.

But where the abovementioned institutions are primarily lenders, IDFC Private Equity is tasked with increasing the flow of private capital investment into the sector. To this end, IDFC brought in Luis Miranda in 2002.

Miranda had experience in both banking and private equity. Before setting up IDFC Private Equity, he was a partner at New Delhi-based ChrysCapital, and before that he was part of a team that set up HDFC Bank, India’s largest private sector bank.

When he set up IDFC Private Equity, Miranda wanted to do things differently than the typical infrastructure player might. For one, he looked for people with a private equity background, not a project finance background, for his team.

?We realized that we wanted to bring in people who did not have project finance experience, but rather had private equity experience, because project finance people invariably tended to focus on ?How do I ensure that I get my capital back??? Miranda said.

?Whereas we wanted to look at all these deals from a private equity perspective and focus on ?How do I multiply the value of my investment??? Miranda started out with a team of five, which has since grown to 12. But the investment team is just one arm of IDFC Private Equity’s network, whose structure Miranda believes gives the firm a competitive advantage. The firm is advised by a board of directors that includes executives from JPMorgan Chase, Tata Industries, Mphasis EDS and Infosys, as well as a ?Senior Expert Council? of infrastructure experts which Miranda calls ?the wise men? of the firm.

And then there is the connection with IDFC itself, which gives IDFC Private Equity access to an even larger set of experts, and indirectly, access to resources and people in the government.

?The network of IDFC puts us in a unique position in terms of understanding the space and closing deals,? Miranda said.

IDFC Private Equity

Buying businesses, not assets
Industry experts describe two models of infrastructure investment. There are those who buy assets, and those who buy companies. Because of the requirements of its private equity partnership structure, IDFC Private Equity adheres to the latter model. Investing asset by asset is too risky, and building a project up from the ground takes too long for a limited-life fund, in which the GPs must return their sponsors’ capital within 5 to 7 years, not 10 to 15 years.

?We could invest in a single power plant, but there are significant risks,? Miranda said. ?If the project was delayed we would not be able to make the returns we expect. If the plant was too small for us to exit through an IPO or a sale to a strategic buyer, that would impact our exit valuation.?

?We realized that we wanted to bring in people who did not have project finance experience, but rather had private equity experience, because project finance people invariably tended to focus on ?How do I ensure that I get my capital back?? Whereas we wanted to look at all these deals from a private equity perspective and focus on ?How do I multiply the value of my investment??

Instead, IDFC primarily looks at aggregation plays, where assets are bundled together to reach a critical size and limit the firm’s exposure. IDFC also invests in established, family-owned businesses looking to jump start the next stage of their growth. The firm targets returns of between 15 percent and 20 percent, an ambitious aim in a sector where returns are usually capped at around 10 percent.

The firm’s acquisition of GMR Infrastructure followed this strategy play by play. IDFC first acquired several power plants operating under the name GMR Energy in March 2004. The firm then acquired four airport projects and six road projects, combined them under an infrastructure holding company, then flipped the power assets into the holding company. GMR Infrastructure had an initial public offering in August 2006. IDFC has recently exited its investment completely, earning around a seven times return.

In recent years, the IDFC’s appetite for risk has increased a bit, however. The company has made some single asset plays, a few greenfield start-ups and several privatization bids. One example of IDFC taking on more early stage deals was its successful bid to develop the gas grid for the state of Andhra Pradesh. IDFC approached the state’s chief minister, YS Rajashekhara Reddy, in 2004 with a proposal to develop the large gas finds in the Krishna-Godavari basin area. Today IDFC owns 48 percent of the Krishna Godavari Gas Network, and plans to extend the gas grid to every district in the state by 2008.

?This is an example of an early stage deal which we would not have done when we started off, but based on our experience in our earlier investments and our risk appetite today, we are comfortable taking this type of deal into our portfolio,? Miranda said.

The road ahead
Despite the influx of new capital and competition, IDFC believes there is plenty of untapped opportunity still to be found in India, as long as one can stay a few steps ahead of the herd. The firm recently made its first deal in the water management sector, a $9 million investment in a family-run water treatment, waste water and effluent treatment project manager Doshion. Miranda also said he finds the rural sector promising, in particular produce operations.

?India is the second largest producer of fruit and vegetables in the world, but there is a significant amount, about 25 percent, of the produce that is currently wasted in the production process,? he said. ?There is clearly an opportunity there.?

There are problems to be confronted as well. Debt financing remains an issue. Long-term debt is not widely available, making it impossible to secure debt financing that matches the tenure of an asset’s concession. Consequently debt must be reprised periodically or projects must be refinanced after 10 years or so, Miranda said, all of which makes planning cash flows difficult and hurts an investment’s internal rate of return.

But as the infrastructure buzz spreads around the globe, the firm should have little trouble fulfilling its mandate of bringing private capital to India. LPs in the US and Europe are finally picking up on the opportunities in the sector, Miranda said. The firm’s returns are starting to speak for themselves. And the government of India continues to be supportive of infrastructure investment in both word and deed.

IDFC Private Equity’s original mandate may no longer be an issue. There are currently at least six private equity funds in the market specifically dedicated to infrastructure investment in India. Giants like The Blackstone Group and Global Infrastructure Partners have taken an interest in the sector. Is IDFC worried about being bid out of its home territory? ?India’s a large country,? Miranda said blithely. ?There will be different deals for available for different people.?