Long on PM Narendra Modi, Carlyle says India to offer best PE returns in the world.

MUMBAI: Modinomics has just found one of its biggest cheer leader in Carlyle.

The world's second largest private equity fund has ranked India as the most attractive investment destination in the whole world, offering the highest expected returns on incremental capital over the next 4 years. Such views run contrary to the popular narrative of India being largely a difficult market to make money for PE investors - exacerbated by a lethal combination of over regulation, demanding local promoters, frothy valuations, limited exit options, macro-economic headwinds and a volatile currency.

In a first-of-its-kind note to its investors, specifically on India, Carlyle's director of research Jason Thomas has said that after India formally assumed the mantle of the world's fastest growing economy in 2015 from China, it will continue to outpace the latter by about 1% this year and the gap between the growth rates of two is likely to widen over time. "The most optimistic forecast for 2016 GDP growth in China (7%) matches the most pessimistic forecast for India," Thomas wrote to Carlyle's limited partners last month.

This will largely be on account of India offering the world's highest returns on investment. Quoting IMF data, 'returns on incremental capital in India to average 24.7% per year between 2016 and 2020', Thomas points out, "these returns are about 2 times the global average of 12.5% and 1.7x faster than the 15% return forecast for Emerging Market economies on the whole" and adds, "With an investment rate equal to roughly 30% of national income, Indian trend GDP growth is expected to average 7.5% annually through 2020."

The productivity of capital is high, feels Thomas, thanks to a large supply of low-cost labour, abundance of IT talent and entrepreneurs that contribute to rapid productivity growth, favorable demographics, improved quality of public institutions, and the small existing capital stock. "High expected returns on investment are, of course, a key determinant of the attractiveness of various markets. There are many other factors as well: risk, valuations, the level of competition for acquisitions, availability of financing, exit market liquidity, etc," he told ET in a subsequent interaction.

While elaborating on the co-relation between GDP growth and returns on investments, Thomas argues that it depends on how the growth is generated. If it comes from excessive investment and overbuilding like it is in China, returns are generally low because excessive investment depresses the return on capital. Conversely, when GDP growth comes from high real returns on incremental capital, financial returns tend to be high as well. "India's GDP growth comes primarily from high returns on incremental capital, as India's investment share of GDP is about 30%, very close to peers and far below some Asian economies that experienced unsustainable growth. Indeed, most evidence suggests investment rates in India could increase substantially without diminishing returns," he points out. For example, new capex in Indian power generation should relax supply side bottlenecks and increase the yield of existing capital as it will catalyse overall production of goods and services. Similarly, technology investments to create digital infrastructure for healthcare, financial services and internet commerce would have a wider rub off.

Emphasising on the importance of structural reforms even in a pluralistic democracy to sustain the growth accelerator, Thomas points out "that rarely do they form the basis of actual public policy." He however remains hopeful that "with Modi, India elected a leader willing to make precisely these structural reforms as centrepiece of his domestic policy."

As a firm, Carlyle have been long on India in recent times like some of its other PE peers like Blackstone and KKR. According to industry sources, it has invested the highest amount in 2015 in a single year since setting up its India operations in 2000. As of December 31, 2015, The Group has invested approximately $1.5 billion of equity in more than 30 transactions via its Asia growth and buyout teams. Sources close to Carlyle peg this year's number to be even higher. "We believe India is likely to outperform global markets in the current economic environment. The world is starved for growth, which makes economies like India especially attractive" asserts Thomas. Plans are also reportedly on to raise a new billion dollar PE fund to invest in Asian growth companies. Founded in 1987 in Washington, D.C., Carlyle manages $183 billion worth of assets, according to its website. Roughly one-third of those assets are managed by its private-equity team.

Overall PE investments in India have also grown 81.2 % in the last calendar year to $10.89 billion compared to $6.07 a year ago, according to data compiled by Thomson Reuters.

"2015 has been the best year ever for PE in terms of deal value and volume of investments. It was characterised by large ticket action in sectors like e-commerce, financial services and pharmaceuticals. It also saw the highest number of exits recorded in a year with the value doubling as compared to the year before. We expect the momentum to continue," said Amit Khandelwal, National Director Transaction Advisory Services at Ernst & Young.

While growth at this pace is surely impressive in the global average of just 3%, Thomas feels there is no reason India should settle for "just" 7.5%. "With effective wages one-tenth of the U.S. level, a capital stock one-third the size of China's, and a large pool of underemployed labour, India could absorb a significant increase in fixed investment with no diminution in returns, he said.

Putting political setbacks in state polls or reforms like GST in perspectives, Thomas is of the opinion that foreign investors in India's stock market seem to have overestimated the speed at which structural reforms could be implemented. Yet, the pessimism implied by recent out-flows seems out-of-step with underlying fundamentals.

After flocking to India following Modi's election, foreign investors have recently become more lukewarm on the country's prospects. Broad Indian stock indexes rose by over 40% in the 12 months following the 2014 election victory, but have since fallen by nearly 18% from their 2015 highs. In the last 1 year leading foreign institutional investors have sold Indian equities worth Rs 90,000 crore after buying almost Rs 1.07 lakh crore in the preceding year. Post this year's budget though, the buying momentum has gradually picked up despite lacklustre corporate numbers.

"The reform agenda proceeds, albeit at a slower pace than many observers initially contemplated, and new monetary policy targets have reduced the risk of a confidence-sapping rise in inflation that hits financial savings and the currency. India's hour on the global macroeconomic stage has arrived. Investors should take notice," Thomas adds.