C Opportunities in India: Transitions into an Organized, Digital and Mobile Economy

This fall, we visited India, as guests of an Asian focused private equity fund of

funds manager our clients invest with. This is the second trip the manager has

taken us on; in 2015 we had an eye-opening visit to China with their team. This

year, the manager thought it would be a particularly interesting time to take

clients to India, given the country’s growing importance to investors as a leading

growth engine of the world economy. In 2016, India made headlines for being

the only major economy which grew over 7%; GDP growth for the year was 7.1%,

outpacing China’s 6.7% growth. Yet, 2017 growth has been slower than

expected, many say due to transitional challenges of reforms and issues in the

agricultural sector. The most recent statistics, however, show that growth has

picked up again. India is expected to continue to be the leading growth

economy of the world for the next few years, outperforming its long-time rival

in the region, China, and significantly outpacing the rest of the world (See Table

1)1.

During our trip, we met with several General Partners of private equity and

venture capital funds, key economic advisors to the government, and

management teams of portfolio companies in a variety of sectors. Throughout

these meetings, four themes were consistently touched upon as opportunities

for investors: 1) India’s transition into an “organized” economy; 2) the rise of M-

Commerce; 3) the move to a digital economy and 4) growing elite and affluent

consumer segment.

2016 2017 2018 2019 2020 2021 2022

India 7.1 6.7 7.4 7.8 7.9 8.1 8.2

China 6.7 6.8 6.5 6.3 6.2 6 5.8

United States 1.5 2.2 2.3 1.9 1.8 1.7 1.7

World 3.2 3.6 3.7 3.7 3.7 3.8 3.8

North America 1.5 2.2 2.2 1.9 1.8 1.8 1.8

South America -2.6 0.6 1.6 2.3 2.5 2.5 2.5

Western Europe 1.8 2 1.8 1.6 1.7 1.6 1.5

Eastern Europe 1.1 2.6 2.4 2.2 2.2 2.2 2.2

Asia and Pacific 5.3 5.5 5.4 5.5 5.4 5.5 5.4

Middle East 5.7 1.3 2.8 2.9 2.9 3 3

Africa 2.1 3.5 3.7 3.6 3.9 4.1 4.2

Source: International Monetary Fund

Table 1: Real GDP growth (Annual percent change)

The Thinking Man’s Approach

October 2017 | Series #54

Ignacio Pakciarz, CEO Ilina Dutt, Analyst

Summary

For more on how we are positioning our portfolios, please contact your investment advisor or email: ideas@bigsurpartners.com

December 2017 2

1. Transitioning to an “organized” economy

Despite strong economic growth, India’s economy remains highly “unorganized” – full of small scale

private enterprises which are not registered with the government. As unregistered entities these

enterprises1 avoid taxes and regulation. They operate without any oversight, and make doing

business for their compliant counterparts difficult. This contributes the India’s low position (100 out

of 190 countries ) in the World Bank’s Ease of Doing Business (and last year it ranked 130 out of

190).2 These unorganized companies pay workers below minimum wages, usually on a daily basis,

without any employment protection. About 90% of India’s work force is in the unorganized sector,

and only 1.5% of Indians pay personal income tax (as opposed to 58% of the population in the US or

60% in the United Kingdom).3

Perhaps the most crucial component to India’s growth story has been the country’s measures to

transition into a more “organized” economy. This will increase tax collection and thus government

revenues; the Goods & Services Tax Reform (GST) is expected to help boost GDP from 1-2% annually.

Formalizing the economy will also increase compliance, transparency, and productivity as

businesses will follow the rule of law; this will also encourage foreign entities to increase investment

and operations in India. Some of these reform measures are highlighted in Table 2 below, and should

help to secure and sustain a higher economic growth rate over the long term.

1 International Monetary Fund. World Economic Outlook: Real GDP Growth. October 1, 2017. Accessed November 30, 2017. http://www.imf.org/external/datamapper/NGDP_RPCH@WEO/OEMDC/ADVEC/WEOWORLD/CHN/IND. 2 Business Today India. “Ease of Doing Business rankings: India makes highest-Ever jump to rank 100 out of 190 countries.” Business Today, Living Media India Limited, 1 Nov. 2017, www.businesstoday.in/current/economy-politics/ease-of-doing-business-rankings-india-rank-world-bank-100/story/262976.html. 3 Express News Service. “90% Indian workforce in unorganised sector deprived of welfare schemes, says, Justice T S Thakur.” The Indian Express, 12 Apr. 2015, indianexpress.com/article/cities/chandigarh/90-indian-workforce-in-unorganised-sector-deprived-of-welfare-schemes-says-justice-t-s-thakur/. 4 Economic Times, Morgan Stanley

Table 2: Major Indian Reform Measures

Reform Measures Update and Status

Goods & Services Tax (GST) Reform

-GST is the biggest tax reform since India’s independence in 1947. Once fully implemented it could help increase GDP growth by 1-2% per annum4 -GST in India is a comprehensive, multi-stage, destination-based tax that will be lived across the supply chain -GST will lead to an unified tax structure across the nation

Demonetization -The Government of India on November 8, 2016, announced the Demonetization of all INR 500 and INR 1000 banknotes -86% of the currency under circulation was rendered invalid

Digitization -Pro digital initiatives undertaken, such as e-KYC through a 12 digit unique identification number -Rural inclusion in the financial sector through launch of Unified Payment Interface and Bharat Interface for Money app

FDI regulations -in 2016, the government relaxed Foreign Direct Investment regulations in many key sectors, including insurance, defense and railway infrastructure

India banking reforms -New bankruptcy procedure will facilitate faster recovery of bad debts -21 new small bank and mobile banking licenses issues in the last 2 years

December 2017 3

Our fund of fund manager pointed out that while reforms will be a positive catalyst for growth across

the economy, they have identified two investment opportunities which will directly benefit: Mid-

Large Growth Equity and Buy-Out strategies.

The first companies to benefit from an organized economy will be well-established mid to large size

companies. They are poised to gain market share from the unorganized sector, as they have the

resources and the “culture of compliance” to seamless adjust to the initial complexities of adopting

reforms. They will also see some of their smaller competitors lose their pricing advantages, because

these firms will now be taxed under the GST Reforms.

We heard about these themes directly when we visited the Godrej Group, headquartered in Mumbai.

This conglomerate was founded 120 years ago and operates in consumer products, appliances, real

estate, industrial engineering, security and agricultural products. We met Nisa Godrej, Executive

Chairperson of the Godrej’s Consumer Products business (and fourth generation member of the

family). Nisa talked about the company’s frustrations in trying to operate in the most rural (and

often poorest) parts of India. The company’s consumer business started selling many of their

personal care goods, such as toothpaste and shampoo, in small disposable packets meant for daily

use (as this is all many of these rural workers, paid in daily wages, can afford). Even in a space like

consumer products where branded products should dominate, in rural markets, unorganized players

are almost as large as the organized players. Nisa told us that the business has had difficulty because

these unorganized players offer stockists higher margins.5 They can offer these higher margins, she

explained, because they don’t pay tax or compliance costs, they don’t compensate workers fairly,

and they don’t follow health and safety standards for the ingredients of their products. Godrej’s real

estate group faced similar dynamics in rural areas; in bids for projects, local unorganized players

who exploited workers and disregard standard safety procedures were winning bids.

As reforms become implemented, compliant and well-established companies, like Godrej, will be

beneficiaries. We met with a few mid-large growth equity managers who have already seen upticks

of profitability as reforms start to be implemented. Buy-out managers have also seen an increase

in deal flow as sector consolidation is on the rise. Companies are looking to merge and build their

market share. The buy-out managers we met have all expanded their internal operating team, and

the leading managers have brought in star professionals from multi-national corporations who can

help their portfolio companies scale operations.

2. The Rise of M-Commerce

Smart phone use has exploded in India. Now about a quarter of the Indian population (321 million

people) are mobile phone internet users. This has coincided with explosive growth in “M-commerce”

or mobile commerce, defined as buying or selling goods or services with the use of internet/cellular

data via a wireless handheld device6. This year retail m-commerce sales are on track to be about

5 “EquityMaster: Consumer Products” Equitymaster.com, 10 July 2009, www.equitymaster.com/research-it/sector-info/consprds/index-jul09.asp. 6 “11 key differences between E-Commerce and M-Commerce.” M commerce blog - SimiCart, 27 Nov. 2017, www.simicart.com/blog/differences-between-e-commerce-and-m-commerce/

December 2017 4

$17 billion (USD), up from $6 billion in 2015. By 2020, they are expected to be about $38 billion (see

Graphic 1).7

Every early-stage venture capital (VC) manager we visited touted m-commerce as a wave of the

future for Indian technology based companies.

We met the founder of a food delivery app,

which allows consumers to order a variety

of cuisines from their mobile phones.

What’s differentiates about this company

from its competitors is that it owns and

operates its different food brands. It’s

not just a delivery service; the company

has four different food brands, in Italian

cuisine, Indian cuisine, “healthy” cuisine

and “tea and snacks” cuisine. None of these

brands have storefronts; instead all the food

is made and delivered from central kitchens.

These brands only sell to customers via the

mobile delivery app, Owning all stages of the process allows the company to keep 100% of the

margins. The company reports serving 15,000 customers per day orders and has now expanded to

16 cities since its launch in late 2014. In the last year, they have reported 20% growth per month in

sales and are launching new food brands and expanding locations for their central kitchens.

Another VC manager we visited made an investment in an e-wallet start-up, which has now become

the leader of mobile payments in India. The company has had a partial exit, and is reportedly

currently trading at a multiple on invested capital of 65 times. This e-wallet start-up was founded

by former employees of eBay, PayPal and Oracle in Silicon Valley. We saw this trend at many of the

VC managers and portfolio companies we visited – some of the Indian diaspora of Silicon Valley

who worked for star technology companies have brought their knowledge and experience back to

India. VCs in India clearly benefit from this experienced talent pool, and on our trip we met early

employees from Google, Facebook, Uber, as well as seasoned investors from leading Silicon Valley

VC firms such as Sequoia and Andreessen Horowitz.

3. Moving to a Digital Economy

As part of the reform efforts, the Indian government has created several game changing “pro-

digital” policies, primarily for identity, banking and mobile services. This includes the Aadhaar

program, an initiative issuing all Indians a unique identity number based on biometric and

demographic data. It’s been estimated that about 80% of the population have been issued Aadhar

7 “Mobile phone internet users in India 2022 | Statistic.” Statista, Aug. 2017, www.statista.com/statistics/558610/number-of-mobile-internet-user-in-india/.

0

5

10

15

20

25

30

35

40

2015 2016 Est. 2017 Est. 2018 Est. 2019 Est. 2020

Re

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in b

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Graphic 1: Retail M-Commerce Sales in India from

Source: Statista

December 2017 5

cards.8 Another initiative is the Bharat Interface for Money (BHIM), a mobile app launched by the

government at the end of 2016. The app can be used on all mobile devices, and supports all major

Indian banks, and allows the user to transfer money instantly between two bank accounts of any

two parties.

These types of digitization efforts will help reduce transaction and on-boarding costs for businesses,

as well as add accountability for customers. Many of the venture managers we met see this as

paving the way for additional opportunities in fintech and marketplace. It also opens up the rural

consumer segment as technology increasingly penetrates in the rural areas.

Suryoday is a company benefiting from these digitization advancements. The company started as

a micro finance organization, but in January 2017, Suryoday launched as a small finance bank. We

met with the CEO, Mr. Baskar Babu in his office in Mumbai. He explained to us that with Aadhar, his

bank could now lend to rural village people who he previously couldn’t do business with because

they had no means of identification.

Doing business with rural customers has

been made easier thanks to mobile

payment options which allow customers

to pay from their phones, so they can

avoid traveling each month to make

payments. Suryoday’s strategy is to

target rural women, and give loans to

groups of four or more of them. The social

pressure to pay the loans helps ensure

solvency and after successfully paying a

group loan, the women can apply for

single loans.

We met with a woman who had taken out both group and single loans. She used the single loan to

buy better equipment for her small snack shop, which she said helped her increase sales by 5 times

per day. Once this loan is repaid, she will take another one to open a second small snack shop in

her village. Pictures of the Suryoday branch we went to are found above.

4. Growing Elite and Affluent Consumers

Growing consumption in India has been a theme managers have been talking about for the last few

years. Many of the early stage venture managers we met were investing in start-ups catering to the

elite and affluence segments of the market, which in the next several years and expected to double

in size from 8% of the population (2016) to 16% of the population (in 2026), see Graphic 2.

8 “UIDAI claims that 1.05 billion Aadhar cards have been issued so far, 20 crore Indians still to enroll.” Tech2, 29 Sept. 2016,

www.firstpost.com/tech/news-analysis/uidai-claims-that-105-billion-aadhar-cards-have-been-issued-so-far-20-crore-indians-still-to-enroll-3689571.html.

Suryoday Financial Literacy Center in

Mumbai

December 2017 6

Many of these managers had experience working in start-ups in the US which were catering to

equivalent segments of the market and are trying to bring similar products and services to India.

We met with Droom, a company founded by an entrepreneur who had previously lived in Silicon

Valley and had worked with many different e-commerce businesses. Droom is an online marketplace

for buying and selling new and used cars, scooters, and bikes, and remains the only player in this

space. Droom is now the fourth largest e-commerce company in India (in terms of gross

merchandise volume).9 The quick growth of Droom and demand for this type of service

demonstrates the power of the growing affluent/elite consumer in India. Incidentally, the founder

told us that in response to customer demand, Droom now offers a “Vintage” category which sells

high-end collectible Mercedes, Jaguars and other luxury cars. They site also just launched a private

plane category.

One of the venture managers we met brought in Furlenco, whose business model is based upon

these changing income dynamics. One of the consequences of growing affluent and elite consumers

has been young working professionals leaving their family home and renting their own apartments.

Furlenco saw an opportunity to rent modern designed, moderately priced, and good quality

furniture to Indian millennials for their “starter” apartments. Users pay Furlenco a monthly fee to

rent furniture, appliances and accessories by piece (from beds to microwaves to table lamps) and

also by pre-set packages by room (a complete queen size bedroom or a living room, for example).

Furlenco has grown its operation to six cities in India, and expects to be profitable in early 2018.

After Furlenco’s presentation, the venture manager who brought them in told us that they are

increasingly seeing start-ups catering to the affluent Indian millennial.

9 “About Droom.” Droom: First Mobile Marketplace to Buy & Sell New & Used Automobiles, droom.in/about.

December 2017 7

5. Conclusion

A key tenet of our investment philosophy is identifying the right themes that will shape the markets

we invest in. In complex markets where we have less familiarity, such as India, we look to find

managers that are focusing on long term fundamentals as opposed to the markets “flavor of the

day” – and seek to pick management teams with strong track records and alignment of interest.

The four themes highlighted in this piece coincide with investment opportunities in mid-large

growth equity, buyout and early-stage venture segments of the Indian private equity landscape.

Our strategy for investment in India remains unchanged; the majority of our exposure comes from

our Asia dedicated fund of fund manager. The team has the resources, relationships, access and the

“boots on the ground” to evaluate the opportunities in India and greater Asia. The manager

combines this local Asian presence with a Western approach (they are headquartered in San

Francisco and the founding partners are Harvard MBAs) and an American governance style of

transparency that fits BigSur.

December 2017 8

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