The present government, although democratically elected and striving to foster a measure of economic transparency that would be unthinkable under China’s authoritarian regime, seems ambivalent about shedding all of its barriers to foreign ownership. The bureaucratic tangle has become an embarrassment within the country, especially since the publication last year of Governance and the Sclerosis That Has Set In, a book by Arun Shourie, a former World Bank economist and the country’s privatization minister from 2000 to 2004. Shourie’s scathing account includes his recollection of a yearlong wrangle he witnessed during which steel ministry officials debated whether it was ever appropriate to use red or green ink to sign documents.
 

TOP VIEW Although some of the Indian government’s economic liberalization efforts have stalled, there have been moves to give foreign investors better access to the property sector and to spur entrepreneurial enterprises generally. Investors willing to pay the high costs of entry are likely to reap significant rewards in the next decade, not necessarily from the much maligned outsourcing companies, but from technology, consumer products and infrastructure projects demanded by India’s growing number of domestic wealth holders.

Nevertheless, Singh, a pro-reform politician who is credited with ushering in the current environment of economic transformation during his stint as India’s finance minister in the 1990s, has seen his popularity decline since he became the country’s chief executive last May. Singh’s government has only been able to push through a few measures, such as raising foreign investment ceilings in telecommunications, banking and property. The communist parties that support his government stiffly oppose such liberalization. His slow progress has been reflected in the performance of the Bombay Stock Exchange’s Sensex index, which has risen only 31 percent in the first year of his government, compared to 127 percent in his first year as finance minister, when he initiated his reforms.
 
Former investment banker Norman Prouty, who has lived and worked in Bangalore since the late 1990s, was also a cofounder of ICF Ventures. In that capacity he has helped to launch a number of entrepreneurial ventures in India, and he clearly feels that there are significant opportunities for investors: He has invested millions of his own capital into an ICF fund that he has incorporated in Mauritius. India imposes capital gains taxes on foreign investors, so nearly all investment funds incorporate in the small island off the coast of southern Africa, which has a tax treaty with India that grants exemptions to this levy. ICF claims to offer its investors average annual returns above 35 percent—slightly more than the average annual return for an Indian private equity fund—and is so successful that the principals anticipate limiting the next round of funding only to previous participants.

Homegrown Wealth
The expectation that the economy will grow by at least 7 percent this year, despite Shourie’s “sclerosis,” attests to the success of the technology sector and the growing pool of wealth it has generated. The services sector, including telecom and IT outsourcing, has been responsible for close to half of the 6.5 percent average annual growth rate over the past three years. But the greatest upside in the decade ahead is likely to be found in industries that address the development of the domestic infrastructure and consumer market. The manufacturing sector is expected to grow by 8.9 percent this year, with 90 percent of its output aimed at the domestic market, according to government figures.

“Investors have an opportunity to really capitalize on India’s evolution from an export-based outsourcing boom to a more indigenous growth story in infrastructure and consumer products,” says Kammy Moalemzadeh, a managing partner in the New York–based investment firm Arcadia Investment Partners, who has put several million of his and his investors’ dollars into private equity in India since 1999. As in China, private equity has become the most popular route for wealthy investors who are willing to shoulder the substantial risks of betting on unproven companies in return for the possibility of doubling their money in three to 10 years. Whether the private equity sector’s steroidal performances of recent years can continue is debatable, however. “India has seen a dramatic run-up in the last five years when it was discovered by foreign capital; that happens only once,” argues Ashish Dhawan, a senior managing director of ChrysCapital Investment Advisors, a private equity firm with offices in New Delhi and Palo Alto, Calif. The firm’s best picks have returned as much as 500 percent.

The Singh government is trying to attract money to modernize a country in which so many vast stretches are trapped in the developing world.

ChrysCapital has invested $450 million via two funds that targeted back-office outsourcing, financial services and consumer services companies in the early growth phase. The firm has been careful about picking companies in these rapidly ascending sectors that boast excellent management teams. Dhawan considers his holding in a leading training company that will return only 10 to 12 percent a disappointment, and it does have an aura of failure when held up against an investment in a back-office firm called Spectramind that returned six times its original investment in just two and a half years.
Dhawan takes a conservative view of his firm’s recent success, attributing most of it to the overall investment climate. “While macroeconomic changes began in the early 1990s,” he says, “microeconomic changes, such as the dramatic growth in entrepreneurs’ aspirations, a global mindset and improved corporate governance, make India extremely attractive.” ChrysCapital is not currently raising capital, but might launch a round near the end of 2005.
 
Indian hedge funds are generally more appropriate for investors seeking less volatility than those who can bear the risks of private equity. But, as in China, India lacks a sophisticated derivatives market, so investors must trust their capital to fund managers who seek to take directional bets in a market that trades heavily on rumors and relationships and is light on regulation, with little opportunity to hedge. Those with nimble, highly focused strategies have done well. Jon Thorn, managing director of the India Capital Fund, a London-based hedge fund with $150 million in assets, has seen some triple-digit returns since January from investments in small-cap manufacturing companies. He recently announced that the fund will reduce its holdings in export-driven sectors such as software and pharmaceuticals, which he sees as vulnerable to a U.S. slowdown, and focus on domestic consumption-driven sectors.

Local Flavor
As in China, a U.S. investor hoping to gain access to India will need to turn to fund managers or financial advisors who go there often and hear directly about investment opportunities and establish relationships. Indeed, the local stock market is not open to foreigners; those wishing to trade must prove Indian ancestry dating back to a great-grandparent.

Dushyant Pandit, managing director of Tocqueville Asset Management in New York, is a wealth advisor with an Indian investor license who can move private client money into the Indian stock market. He recommends that investors, whether in private or public equity, look only to industries in which India has a proven competitive advantage. “The banks,” he says, “are not the best in Asia.” A better bet, according to Pandit, is the pharmaceutical industry, where India is not only producing many drugs for the domestic and foreign markets at a low cost but also increasingly becoming a source of innovation at manufacturing plants that are approved by the U.S. FDA. He believes information technology also holds long-term promise, as Indian engineers and scientists are increasingly finding opportunities to start companies and develop new products on their home turf. “IT outsourcing, despite the cry in the U.S., is sort of played out,” he says. “Now the companies with technical knowledge are packing it into their own software products.”

Pandit sees less promise in India’s domestic automobile industry, despite a 41 percent earnings rise this past year at Tata Motors, a separately listed division of India’s largest privately owned conglomerate, the $14.25 billion Tata Group. Tata introduced its first India-designed car in 1997, and now has a 16 percent share in the domestic car market. Still, says Pandit, the quality of India’s automobiles “does not compare with Honda, Toyota or the Korean carmakers.”
 
Foreign investors who want to take smaller or more liquid exposures than those available via private equity or hedge funds might consider buying stocks in some of the large-cap Indian multinationals listed overseas. The offerings on foreign exchanges are fairly limited: There are only about two dozen split between the NYSE and Nasdaq, including four hybrid companies such as Cognizant and Kanbay, which were founded by Indians but incorporated in the United States. There are also about a half dozen on the London Stock Exchange. Plowing through the accounting and other paperwork required by the Securities and Exchange Commission, ironically enough, often seems too onerous to Indian companies, as is meeting U.S. governance requirements.

Yet in spite of the sluggish Indian index, the track records of individual large-caps that have ventured overseas have impressed in the past year, especially the stocks of bellwether software services firms—Infosys Technologies (INFY), up 71 percent; Wipro (WIT), up 42 percent; and Satyam Computer Services (SAY), up 26 percent. These firms continue to project 30 to 40 percent growth in annual profits.
 

India has seen a dramatic dramatic run-up in the last five years when it was discovered by foreign capital; that happens only once.

Investing in American Depository Receipts (ADRs) is simple. As large-caps that have passed SEC muster, those listed in the U.S. offer a reasonable amount of transparency and potential for growth—but there is a catch. The ADRs of Indian companies traded on the NYSE command a fairly sizable premium compared to shares traded on Indian exchanges. The premium for Infosys is 30 to 40 percent. The price difference is explained by U.S. investor demand, relative valuation, market risk and absence of an arbitrage opportunity (because U.S. investors cannot participate in the Indian exchanges, they cannot arbitrage the difference in the prices). Infosys and other large companies have recently attempted to address such shortcomings—and improve their global branding—by moving stock directly to the U.S. In May, Infosys’ offering of 14 million ADRs boosted its trading liquidity on Nasdaq from 21 million shares to 35 million and pumped its ambitions of entering the Nasdaq 100 by 2006.

Property Rights and Wrongs
The demand for both commercial and residential real estate is booming. But foreign investment remains a daunting proposition. Real estate transactions were not open to foreigners until this past March. Now foreigners can own property outright, but only parcels of 10,000 acres—nearly 16 square miles—or more. These might encompass office parks, resorts, even special economic zones for low-tax offshore production.

Perhaps a more pragmatic way for foreign investors to participate is through a professionally managed, diversified capital pool. Funds specializing in the booming hotel sector include Brooke International Fund, Dalmia Capital Fund, Indian Real Estate Opportunities Fund and the Merlion Fund of Temasek Holdings. A number of Indian banks, including ICICI Bank and HDFC Bank, are contemplating floating real estate venture funds open to foreigners. Bear in mind that all the funds above are new, and must be approached with caution. A number of international property advisors, including Jones Lang LaSalle, Cushman & Wakefield, Knight Frank and CB Richard Ellis, have offices in India to counsel foreign investors on regulatory issues.

Many private equity funds and real estate funds are eyeing opportunities in large infrastructure projects. The Singh government is trying to attract money to modernize a country in which so many vast stretches are trapped in the developing world. Large cities are currently making do with airports that appear more like American Greyhound bus stations with runways, as well as with traffic-clogged roads and acute energy shortages.

Infrastructure experts estimate that India needs $55 billion to upgrade its railways and airports, $75 billion to meet its energy needs and $25 billion to develop telecommunications infrastructure. With its fiscal deficit, India has no choice but to look to domestic and foreign investors to fund and improve infrastructure—another reason why the government is eager to do away with red tape. If the liberalization program can continue to reduce barriers to outside investment, foreigners can prepare to reap the rewards for building the foundations of a country poised on a fresh growth wave. 

Saritha Rai is a Bangalore, India-based business writer.