Depending on the impact of demonetisation, certain sectors may get into consolidation mode and M&A activities may increase, which, in turn, may provide exit opportunities for the existing PE investments.
On November, 8, 2016, the Prime Minister of India, announced demonetization of 500 and 1000 rupee denominated bank notes with effect from November, 9, 2016. After the initial shock, attention soon shifted to its possible impact on the Indian economy. While there are mixed reactions on its impact, there is no denying that this event shall have significant ramifications on the ways business is conducted in the sub-continent. To understand the impact properly one has to consider the fact that the Indian economy is largely cash driven. From manufacturing to retail, from banking to micro finance, there are several sectors which are heavily cash dependent. As these sectors will be hit, growth prospects of target companies may be revisited and private equity funds may take a re-look at fresh investments as well as where the existing investments are headed. Similarly, depending on the impact of demonetisation, certain sectors may get into consolidation mode and M&A activities may increase, which, in turn, may provide exit opportunities for the existing PE investments.
Please see below a snapshot on how some of the sectors may be hit from demonetisation and possible PE and M&A activities in such sectors, while highlighting how the relevant regulations may aid/discourage such activities:
E-wallet business seem to be the biggest beneficiaries as India goes cashless! Valuations are likely to increase and correspondingly, private equity (“PE”) investments are likely to increase in such ewallet companies and payment platforms. Having said that, experts are also cautioning what lies ahead in these sectors, when the currency flow returns to normal.
In India, the payment system and settlement system are regulated by the Payment and Settlement Systems Act, 2007 (PSS Act) and the relevant regulations thereunder. A person wishing to commence or operate a payment system in India need to take permission from the Reserve Bank of India (RBI). Recently, 100% foreign investments in other financial services (which would include a payment and settlement system service) has been allowed subject to compliance with the regulations prescribed by the respective sectoral regulator (RBI in this case). This is in contrast with the earlier set of regulations, which may have required a foreign investor to interface with two set of regulators.
Given the current regulatory position and given the positive impact of demonetisation, overall, this sector is likely to see heightened interest from foreign investors (PE as well as strategic).
Other financial technology companies (other than e-wallet companies) are also likely to be beneficiaries of the cashless movement.
Their regulatory position is similar to that of e-wallets in so far they have to deal with the RBI only and 100% foreign investment is allowed; however, please note that in financial services activities which are not regulated or partly regulated by any financial sector regulator or where there is lack of clarity regarding regulatory oversight, foreign investment will be allowed up to 100% after taking permission of the government.
Given the current regulatory position and given the positive impact of demonetisation, this sector is also likely to see heightened interest from PE investors and correspondingly, higher valuations! However, as mentioned above, experts also caution about the road ahead in this sector, when the currency flow returns to normal.2
This has been mixed bag – pure play online retail platforms such as Amazon and Flipkart are reported to be bracing for drop in sales as cash on delivery declines; however, they are hoping that this will be beneficial in the long run5. Other players which combine e-wallets with retail platforms such as PayTM has seen a substantial jump in gross merchandise value.
Online retail platforms have also been hit by the recent change in foreign investment norms, which allows 100% foreign investment in an e-commerce entity which, amongst others, does not exercise any ownership over inventory/goods sold through its marketplace and need to cap its total sales from one vendor at 25%. This position has forced a couple of e-commerce entities to rework their existing businesses, including their abilities to provide discounts on the products sold through it. Given these developments, pure play online retail platforms are likely to be hit, with foreign investments declining. This, in turn, may force consolidation in this space with increase in M&A.
Since both are cash heavy sector, wholesale and brick and mortar retail have been heavily hit and footfalls have been dwindling. Foreign investment in both single brand and multi brand retail is already quite regulated – only 49% foreign investment is allowed in single brand retail without government approval and only 51% in multi brand retail with government approval, and is further subject to various conditions – demonetisation has badly affected this space. Consequently, while 100% foreign investment is allowed in wholesale (subject to compliance with certain conditions), it has also been severely affected. PE investments are likely to decline; however, this space may see some consolidation as valuations become realistic.
B2C logistics space seem to have been severely hit on account of demonetisation as it is one of the most cash dependent sectors. While 100% foreign investment is allowed, given its dependence on cash and as a fallout of impact on e-commerce sector, wholesale and brick and mortal retail, this sector is hit immediately as well.
As a consequence of impact on retail and in absence of informal capital, manufacturing also has taken a hit may push the promoters to look for alternatives like private equity. Alternatively, this sector may see some consolidation as well.
Since real estate sector relied heavily on informal pool of capital and cash, this is likely to take a severe hit. In short to medium term, investments in this sector is likely to dwindle. Allied sectors such as paints etc., are likely to be hit as a consequence and valuations may become attractive, which, in turn, may lead to consolidation.
As a consequence of impact on real estate sector, cement sector is likely to face a down turn as well. The recent amendment to the Mines and Minerals (Development and Regulation) Act, which, amongst others, allows transfer of mining leases granted otherwise than by way of auction, coupled with likely sobering of valuation, is likely to help consolidation in this sector.
While the banks and financial institutions seem to be raking in money with deposit numbers rising every day since 8th November, a consequence of huge money flows in the banks has been diversion of time and resources from other parts of business (such as credit) to deposit and exchange of notes. In addition, if the impact on other sectors is negative, the default rates on the existing credit lines may rise – this may be particularly true in case of micro finance companies. Overall, while there may be short term disruptions, the banks are likely to gain as a wide array of population use banks. Foreign investments in the banks are tightly regulated and only 49% investment is allowed freely; however, based on the long-term view, foreign investment will be attracted and the sector may also see some M&A activities (even at premium).
While we have covered some of the key sectors, this move will affect every sector of the economy in one or another. The jury is still out whether it will have a long term benefit to steer the Indian economy in the right direction, this move, coupled with the existing regulatory regime, is likely to force all financial and strategic investors to take a serious re-look at each of their existing and proposed investments in the respective sectors.
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