How private equity industry can play a crucial role in development of SMEs

By Mukul Gulati & Pankaj Raina

The Small and Medium Enterprise (SME) segment accounts for 45 per cent of India’s total industrial output and 40 per cent of total exports. However, companies operating in this segment face significant challenges in raising financing for growth and working capital needs.

Access to traditional bank financing is often not available due to lack of collateral or due to limited operating history. Traditional banks in India are reluctant to lend to this segment because credit appraisal is difficult, reliable financial information is not available and smaller loans are less profitable.

There have been some encouraging recent developments in the area of SME debt finance. Some new generation Non-Banking Finance Companies are beginning to fill the void left by banks. These NBFCs leverage modern IT systems and make credit appraisal decisions based on deep understanding of business verticals and local markets. The upcoming launch of payment banks is expected to increase the availability of credit for small businesses. However, the financing gap for SMEs is so significant ($520 billion based on IFC estimates) that it will take several years to plug this hole.

The situation is even more challenging on the equity side. SMEs have limited access to third-party equity capital, and lack of equity capital prevents management teams from making long-term investments in capital expenditure and Research & Development. This is where the private equity industry has a crucial role to play.

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Local and global VC funds are providing significant amounts of equity financing to early-stage businesses in India, particularly ecommerce related businesses. Alongside the growth in venture and seed capital funds, a large community of angel investors is also emerging. Early and venture stage investments have consistently accounted for a dominant share in overall PE activity, constituting 46 per cent of the total deal volume in 2014. Notwithstanding the highly optimistic valuations in the ecommerce sector, the early-stage investment ecosystem in India is well positioned to serve the financing needs of new ventures in the tech space. On the other end of the spectrum, global private equity funds and large domestic funds remain attracted to India’s longterm growth prospects and are active funders of large deals. These funds are active in various areas including buyouts, structured financing and growth financing of large corporations. In addition large businesses have the option of accessing capital via IPOs and follow-on financing.

However, small and mid-sized businesses outside the technology sector are having a tough time raising equity capital. Growth capital investments, defined as transactions of $5 million to $20 million, have declined as a percentage of overall deals. By our estimate, there are less than 10 PE funds operating in India which specialise in SME growth investing.

This is grossly inadequate for an economy of India’s size and growth trajectory. As a result, the PE/VC industry in India is beginning to resemble a dumbbell with robust activity in the VC and large PE space and a very skinny middle represented by SME growth capital funds.

There are several emerging sectors with strong potential that could benefit from growth capital. These include areas such as food and agricultural production, engineering design and services, pharmaceutical contract research, and specialised manufacturing. The absence of equity capital in the SME segment not only deprives these businesses of an important source of long-term capital, but also contributions to governance, business development, and access to global best practices that PE funds can provide. The reason for the shift away from growth to venture investing is partially explained by current global trends. Global VC investors have identified India as the next big internet market, and the recent growth of etailers in India has been impressive. As a result, a lot of private capital allocated to India is going to ecommerce companies.

The other reason for the decline in growth capital investments is supply related. There are simply not enough funds targeting this space. Growth capital is hard work. Small and mid-sized businesses require significant operational intervention in order to scale up. The PE business is still in its early days and most teams have limited operating experience. As PE teams in India develop more operating expertise, we believe that their ability to execute successful growth capital investments will increase.

(Gulati is cofounder and managing partner of Zephyr Peacock, a private equity firm focused on SMEs; Raina is an associate at Zephyr Peacock )

This article is a reprint from The Economic Times, November, 2015 (Link here.)

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About Zephyr Peacock India

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Zephyr Peacock India seeks to make private equity investments targeting India’s fast growing small and middle market corporate segment. In addition to providing capital, Zephyr Peacock seeks to add value to our portfolio companies by leveraging its global relationships in the international corporate and financial markets. The Fund’s management team, based in Bangalore and New York, combines local and international private equity expertise and has many years of investment and operating experience.