How Sophisticated Investors Were Hurt in India

The first rule of investing is buy assets cheap and sell them high, but a recent report shows that some professional investors in India bought at the market’s peak and haven’t yet been able to cash their investments in.

Of the $103 billion invested by private-equity funds in India since 2001, consulting firm McKinsey & Co. estimates that more than a quarter was invested at the peak of the market, in 2007 and early 2008. Since then, India’s economy has slowed, companies haven’t grown as rapidly as expected, and the Indian rupee has lost a quarter of its value against the dollar.

The result: private-equity funds made an average annual return of 7% before fees between Jan.1, 2007 and Dec. 31 2013, while a comparable return of the S&P BSE Sensex during this period was around 11%, according to McKinsey. In other words, an individual investor who bought a fund tracking the Sensex would have made better returns than investors with a private-equity portfolio.

“The party ended just…when everyone had put a lot of money to work,” said Vivek Pandit, a senior partner at McKinsey’s Mumbai office.

Private-equity investments made before the boom–between 1998 and 2006–fared better, with a 21% return. A comparable return for the Sensex in that period was 18%.

Funds don’t publicly disclose returns, so McKinsey’s estimates are based on a study of more than 600 transactions.

Such private-equity funds have been investing in India selectively since 1998, but they dived in headlong post 2007, when they saw the stock market soaring. The Sensex more than doubled in the two years ended Dec. 31, 2007.

But investing at the market’s peak meant that funds paid steep prices.

Two-thirds of all private-equity investment in India over the last 15 years was made when the Sensex was trading at a higher level than historical valuations, according to McKinsey. In comparison, in China, private-equity funds paid higher-than-average prices for only half of their investments, according to McKinsey.

In India, the high prices meant that funds needed to sell their investments at even higher prices to make good returns.

But the country’s economy slowed from around 9% in 2007 to around 5% in 2012.

India’s inflation was also rising, eating into the profits of companies and lowering their valuations, said McKinsey.

The economic slowdown affected sectors like real estate and infrastructure, where many private-equity funds had invested chunks of money.

The Indian rupee collapsed by nearly 25% against the dollar between 2008 and 2013, further eroding gains for private-equity funds, which are typically dollar based.

“You had a perfect storm,” said Mr. Pandit.

The deteriorating conditions meant that many private-equity funds weren’t able to sell or exit many of their investments in order to book profits.

Between 2001 and 2007, a private-equity fund got out of an investment within an average of three years but by 2013, the average holding period for an investment rose to nearly six years, according to McKinsey.

Private-equity funds typically have a life of around seven years, meaning they should return their investors’ money by the end of this period.

McKinsey estimates that, of $51 billion invested in India between 2000 to 2008, only a third of the investments have been exited so far.

New investors have been unwilling to commit money to these funds. Private equity funds in India raised $29 billion between 2009 and 2013–less than half the amount they had raised between 2001 and 2008.

Mr. Pandit expects the outlook for India’s private-equity industry to improve. He said fund managers are no longer willing to pay high prices for investments, and that, combined with a potentially improving economy, could boost their returns.

Meanwhile, global pension funds and other investors who put money into private equity remain positive on India, though with lower return expectations.

“The opportunity to earn 14%, 15%, 16% is still attractive” to them, said Mr. Pandit.