India: the new jewel in the investment banking crown?

India: A shortage of talent

WHEN HE STARES out of his office window in Mumbai, Brooks Entwistle has a superb panoramic view of the Arabian Sea. The weather is inclement, with India’s monsoon season in full swing, but the peninsula is still a breathtaking sight. The CEO of Goldman Sachs’s India business is a lucky man. He had better not get too attached to the view, though, as he won’t have it for much longer.

Entwistle’s office is a suite on the 10th floor of a five-star hotel in Nariman Point in Mumbai’s financial district. His residence there is temporary. The US firm will move into bigger premises later this year. The move is symbolic of Goldman’s new start in India as it waits for the green light from the regulators to begin its banking operations in the country.

For 10 years Goldman Sachs had built its business in India through a joint venture with one of India’s leading financial services groups, Kotak Mahindra Bank. Goldman held a 25% stake in two of Kotak’s subsidiaries, Kotak Mahindra Capital Company and Kotak Securities. Now it wants to go it alone. In March, Goldman parted formal company with Kotak, when the Indian firm bought out Goldman’s stake for a combined Re3.33 billion ($70 million). The two companies remain on good terms and entered into a business cooperation agreement for one year.

For Entwistle the rationale behind his firm’s decision to sell is simple. “India is no longer a market where you can be a small investment banking boutique,” he says. “You need to be able to provide a comprehensive range of services.” As a statement of its intent Goldman Sachs has announced that it plans to invest about $1 billion in India over the medium term, largely in private equity investments. “People are waking up to the India opportunity,” adds Entwistle.

No longer ignored

The country’s successful economic story, the unprecedented growth of India’s corporates and their burgeoning need for advisory and funding services, the increase in global capital flows to India, and the gradual evolution of its capital markets allied with the lightening of government regulation means that India is fast becoming central to any investment bank’s strategy.

ECM Listing on Indian Exchanges

Jan 01 to Aug 11

Source: Dealogic

“There are very few multinational companies where the CEO doesn’t have India on their radar screen. That also holds true for the financial services sector and especially the investment banking community,” says Pramit Jhaveri, head of investment banking in India at Citigroup. Just five years ago, he adds, the story was very different. For many of these banks India wasn’t as relevant. At Citigroup, investment banking in India accounted for less than 5% of the bank’s Asia ex-Japan IB platform. Today it’s about 15%. “India cannot be ignored,” agrees Paul Calello, chief executive of Credit Suisse Asia Pacific, which is also seeking to build its operations in the country. Like Goldman and Citigroup, Credit Suisse is not new to India. It had a strong presence in the 1990s but in 2002 the firm was forced to shut its brokerage business after the country’s stock market regulator suspended it for two years after allegations that it violated rules on price manipulation. Now that suspension has passed, Credit Suisse is ramping up its operations again as it strives to fill the one missing piece in its Asia jigsaw. “We have a long history of strong capabilities in India,” says Calello, “and we’re looking to rebuild our franchise.” Earlier this year it hired Mihir Doshi from Morgan Stanley to spearhead its efforts.

Lehman Brothers has also announced its intention to expand its activities and is sending one of its senior executives, Tarun Jotwani, co-head of the firm’s fixed income businesses in Europe, to head its India efforts.

“This is the most exciting, competitive environment in Indian investment banking” Hemendra Kothari, DSP Merrill Lynch

The rumour mill is also whirring with the possibility that RBS, Macquarie and GE Capital are applying for banking licences. If these institutions do arrive (which cannot be taken for granted as the central bank has not awarded a licence to a new bank in two years), they will enter one of the toughest investment banking markets in the developing world – one that not only includes the firms already mentioned but other foreign standalone businesses such as Barclays Capital, Deutsche Bank, HSBC, Rothschild and UBS among others; the tie-up banks JM Morgan Stanley and DSP Merrill Lynch; and independent local outfits such as Enam and ICICI, as well as Kotak. “This is the most exciting, competitive environment in Indian investment banking,” says Hemendra Kothari, chairman of DSP Merrill Lynch.

“Any country that has evolved like India has is bound to have a dynamic landscape, but from an investment banking and securities point of view it has never been as dynamic,” agrees Jhaveri.

End of the JV era

One big change taking place is the diminishing importance of the joint venture. Three prominent partnerships dominated the Indian investment banking scene in the late 1990s/early 21st century: Goldman’s tie-up with Kotak, JM Financial’s venture with Morgan Stanley and DSP’s partnership with Merrill Lynch.

The model succeeded for a while but now seems too limiting to work in the long term. “If you go back to the mid-1990s, joint ventures had a certain rationale as India’s markets were evolving,” says S Ramesh, chief operating officer of the investment banking division at Kotak. “Over the past 10 years that has changed. The time has now come for local and global banks to chart their own history in India.”

“Joint ventures haven’t really provided much value to shareholders in terms of bottom-line profitability,” says Calello. “Margins are very tight. The demands of the joint venture partners are extremely high. The economics have traditionally favoured the local partners.”

Now that Goldman and Kotak have cut their cord and Merrill Lynch has increased its stake in its tie-up to 90% from 40%, only Morgan Stanley’s partnership with JM Financial can be considered a proper joint venture (in January SBI Capital Markets and CLSA entered an investment banking alliance but there has been no transfer of equity).

JM Morgan Stanley, which began operations in April 1999, is run through four different companies. The first, which focuses on corporate finance, capital raising and advisory work for Indian companies in both domestic and international capital markets, is 51% owned by JM Financial and 49% by Morgan Stanley. The two firms also operate in the areas of retail distribution and fixed income securities through two wholly owned subsidiaries, JM Morgan Stanley Retail Services and JM Morgan Stanley Fixed Income Securities respectively. The final company, JM Morgan Stanley Securities, which operates in institutional equity sales and trading supported by research for both Indian and foreign institutional investors, sees Morgan Stanley hold a 51% stake and JM Financial 49%. “We are the only joint venture left in India – we are unique,” says Nimesh Kampani, chairman of JM Morgan Stanley.

Kotak’s buyout of Goldman Sachs and Merrill Lynch’s increase in its stake in DSP have fuelled speculation that a change in structure at JM Morgan Stanley will follow. Rival bankers suggest that Morgan Stanley is struggling to know what to do: to buy out JM Financial will prove costly as Merrill Lynch found out after it paid $500 million for its additional 50% stake. At the same time, if Morgan Stanley wanted to sell to JM Financial it might not reap its full reward because of local regulations. In India, a foreign bank needs the consent of its former local partner if it wants to continue competing in the same industry as a standalone entity. The former local partner, therefore, is in a good position to negotiate. Rumour has it that’s how Kotak was able to buy Goldman Sachs’s 25% stake for such a relatively low price. To some observers Morgan Stanley strategy appears to be stuck.

JM Morgan Stanley declines to comment on the speculation. Undoubtedly, it remains one of the country’s outstanding investment banks, especially in M&A and international equities. It might prove the exception to the new rule.

Size matters

Still, others remain unconvinced about the general merits of the joint venture structure in India’s increasingly sophisticated investment banking landscape, especially as size matters more than ever. “Capital requirements are big. The need for risk appetite and capital base is important. So there’s greater flexibility in being independent and in building your own business,” says Raju Shukla, managing director of investment banking at Barclays Capital.

Barclays is putting its money where its mouth is – it has invested $300 million of capital in India, half of which was committed in March. It is not alone: Citigroup, for example, has $2.8 billion of capital already invested, HSBC has more than $1 billion committed, while UBS is rumoured to be investing $200 million. This money is being devoted across all product lines; not just M&A and capital markets activity. UBS, for example, is seeking a commercial banking licence that will allow it to get into wholesale banking – including selling derivatives products, extending guarantees, offering FX products and providing an onshore private banking platform. Credit Suisse wants to offer asset management and private banking as well as securities products. Goldman Sachs is applying for separate licences that will allow it to act as a merchant bank, a broker dealer and an asset manager, as well as other licences that will allow it to act as a financial advisor. Every bank is carving out its niche areas of expertise.

Relationship building

Much effort is also being spent on developing strong corporate relationships. Relationship building might seem a nebulous concept but is perhaps more critical in India than in most other countries. Naturally the local institutions have an advantage, whether they are independent or in a partnership. DSP Merrill Lynch has worked with nearly 1,000 companies, according to Kothari. But global banks need not despair – many Indian companies increasingly want global banking services.

An important development in M&A over the past year is the growth of in-house teams within Indian corporates, whose job is to identify potential targets and analyse any opportunity quickly. Knowing who these people are will be critical to any investment bank’s success. Strong relationships, after all, lead to the holy grail for banks: repeat business. “If you seek to build a partnership with a client that pays off in getting repeat business, then that’s more important than adding clients on a one-off basis,” says Shukla.

That holds true across all product lines. In the equity capital markets, for example, local institution Enam has repeatedly won business from companies such as Infosys, Reliance and Zee because it established a relationship with them when they were small private outfits. Enam executed a small private offering for Infosys to its shareholders in 1992 when the IT firm was largely unknown. The success of that deal led to Enam participating in Infosys’s IPO, its first American depositary receipt and other offerings.

HSBC’s investment bank is also very much a relationship driven model. The investment bank’s ability to leverage the goodwill generated from its corporate bank, and vice versa, gives it an advantage over the monoline investment banks. For example, its presence as one of the underwriters to Jet Airways’s IPO led to the bank becoming that company’s core broker.

All the leading local and international houses are deepening their client coverage. Some, of course, have more resources than others. Citigroup, for example, has more than 50 people covering 800 clients that it brackets as tier one. Of these, 200 corporates receive what the bank calls dual coverage – continuous investment and corporate banking service. The rest receive regular general corporate banking but specialist investment banking only on an opportunistic basis. “That way we are extracting maximum operating leverage within our given resources,” says Sanjay Nayar, chief executive of Citigroup India. The bank is also broadening its coverage of middle-market names, companies with about a $400 million market capitalization. Getting the product/coverage balance right is Citigroup’s biggest challenge but Nayar believes the bank has one of the most complete franchises in India.

Global push

Banks are jostling for position for good reason. Local companies are becoming more confident and tapping into global liquidity pools. Indian M&A is at unprecedented levels, with more than 40 overseas acquisitions already this year, totalling more than $1.9 billion. India’s recent economic success is being reflected at a corporate level. “Companies are becoming more global on the back of recent economic growth,” says A Rajagopal, head of Indian equity capital markets at UBS. “That’s really the driver.”

“Indian industry has matured,” says Vishakha Mulye, chief financial officer and treasurer at ICICI Bank, India’s biggest private sector bank. “Corporates have scale and technological know-how to compete internationally. Therefore they are either looking for tie-ups or acquisitions abroad.”

Companies across a number of sectors are venturing overseas, including pharmaceuticals, IT, biotech, energy and industrials. Recent examples include Dr Reddy’s Laboratories’ $571 million acquisition of German pharmaceutical Betapharm in March and Ranbaxy Laboratories’ forays into Italy, Romania and Belgium. Far from fearing global competition, many Indian companies are now embracing it.

Equities depth

Much of this corporate expansion is being financed by surplus cash. But this will change. “All companies are growing much faster than before and their capital expenditure needs are building up,” says Kothari. This will lead, he adds, to a greater reliance on other financing techniques, such as equities or leveraged finance.

“Venture lending is a brand new idea in India” Sanjay Nayar, Citigroup

At present, the ability to use equity to fund overseas expansion is limited. Shares listed on the local market don’t have capital account convertibility, while shares listed abroad through GDRs and ADRs tend to be illiquid. The government, however, is moving towards opening the capital account, albeit in a gradual manner. When that happens that will be a boost to the domestic market. Until then, the domestic market can still be a fruitful avenue for raising money for companies with home-grown needs. Over the past three years, equity issuance by Indian companies, especially on local exchanges, has blossomed. Last year, for example, there were 144 equity listings on Indian exchanges, according to Dealogic. This compares with just 53 in 2004. This year the figure is 104 listings so far, and this despite the turn in sentiment towards equities. As for international equities, so far Indian companies have made 59 listings, according to Dealogic.

Bankers expect the trend towards local issuance to continue. “Clearly, the domestic market is deep now, and we have seen many large – $1 billion plus – transactions from India in the last three years,” says Rajagopal. “International issuances will continue to play an important role, especially in products such as convertible bonds and real estate investment trusts, for which there is no domestic market yet. But surely these will also develop in the future.”

Transparent market

Although the Bombay Stock Exchange is small by international standards, it is transparent and sophisticated. Settlement is conducted on a T+2 basis (in New York it’s still T+3). Ticket sizes are becoming bigger, with billion-dollar equivalent deals no longer exceptional. In April, for example, Reliance Petroleum raised Re54 billion through an IPO, the public part of which was 51 times oversubscribed. In the same week Citigroup and JM Morgan Stanley handled the largest ever Indian block trade to help Indian Oil Corporation, the country’s largest refiner, sell a 1.92% stake in Oil and Natural Gas Corporation for Re36.72 billion .

In the short term supply will be affected by the continuing fallout of the BSE’s big wobble in May and early June, when it lost 30% of its value in just over a month, although it has since recovered somewhat. “For companies that are attractively valued, there is enough appetite,” says an investment banker at Enam Financial Consultants, though he adds: “Expectations of issuers have to be realistic.” In particular, investors will be much more selective towards mid-cap and small-cap companies, which enjoyed such success in the recent bull market. “From an IPO perspective, confidence needs to first get established through the larger attractively valued issues and only if that is sustained will we see an appetite emerge for small- and mid-cap issues,” adds the banker.

What will the secular move towards greater local issuance mean for investment banks? Clearly in the short to medium term, Indian securities houses will continue to have an edge, especially as there is a heavy retail aspect to local equity offerings. Up to half of all shares are typically placed in retail and rich individuals’ hands.

International banks are beginning to address the lacunae in their strategy. Citigroup, for example, is launching its retail brokerage from October 1. Those that don’t have the resources to follow suit can always develop a network of local brokers. “I suspect there will be a trend of opportunistic alliances,” says Rajagopal. “If India becomes a big market, then most players will want a broad presence and without diluting their autonomy.”

Moreover, the other half of the allocation goes to local and international institutional investors that are registered with Sebi, the national regulator. Domestic players, such as Enam, Kotak and ICICI, have demonstrated that they have strong local and foreign institutional investor relationships but, in general, global banks will feel much more confident about competing in this sphere.

Still, to provide a comprehensive equities underwriting service in India’s markets, investment banks will need both global and local, and institutional and retail distribution capabilities.

Dwindling popularity

One issue that international banks will have to face up to is the prospect of a dwindling in popularity of two of their more profitable equity products: international convertible bonds and GDRs. Between early 2004 and May this year both flourished.

Convertible bonds proved an attractive funding alternative to cash for companies as they expanded overseas. The instrument fitted the bull market perfectly – such was the strong appreciation of their stock prices that dilution was not a big concern for company executives. Funds could be accessed at attractive terms. If the bonds got converted, the issuer paid no coupon. If they didn’t convert, then the borrower got access to relatively cheap debt. Hedge funds in the UK and Asia proved a very receptive audience for the product.

“It will be a long time before an investment bank makes $300 million–plus profits in India” Naina Lal Kidwai, HSBC

Almost all leading international banks made hay during the convertibles boom, especially Barclays Capital, Citigroup, Morgan Stanley, JPMorgan and Deutsche Bank. The problem now, of course, is that sentiment towards equities has soured and global interest rates are on a tightening cycle. “It will be interesting to see how many issuers will have the ability to redeem their convertible bonds in case conversion into equity remains unattractive through the tenor of the bonds, particularly for smaller companies,” says the Enam banker. As for GDRs, their popularity was simply a function of local laws. Regulation stipulated that if an Indian company wanted to do a follow-on offering domestically, then institutional investors would have to enter a 12-month lock-in period. As overseas listings had no such constraints, it made sense for issuers to place GDRs instead. Now, though, the Indian authorities have levelled the playing field and, as the GDRs had limited liquidity, there’s little rationale to issue them. That’s a big shame for the international banks, which could make up to 3% in fees on GDR issues.

Debt despair

Although India’s equity markets are flourishing, the same cannot be said of the local bond markets. “The debt markets are still not deep enough nor the yield curve long or continuous enough to suggest we have the right structure,” says Naina Lal Kidwai, chief executive of HSBC in India, who was the first Indian woman to graduate from Harvard Business School. “We need more depth and variety, and the structure of the market is still heavily regulated.”

The local corporate bond market is at the fledgling stage, to put it kindly. Primary issuance has stagnated at between $10 billion and $13 billion over the past five years, while daily trading volumes are a pathetic Re500 million. It’s certainly in India’s interest to kick-start the market, especially given the country’s massive infrastructure needs, and a specialist committee has been set up to identify just how that can be achieved.

With potential opportunities in international bond issuance also limited because of regulations, withholding tax, and India’s split investment-grade rating, banks are instead focusing on less conventional forms of debt finance to make their money. The emphasis is on innovation.

“What’s clear is that companies are not just looking for financial capital but intellectual capital too and strong risk management advice,” says Gunit Chadha, chief executive of Deutsche Bank in India. “The vanilla corporate debt market locally is small but you can address a corporation’s needs through alternative products.”

Alternative finance

In the field of risk management, for example, companies are now actively managing their FX, commodities and interest rate exposures. Managing these risks can be a profitable avenue for banks.

As for debt products, the hybrid market is one to look out for. In July, the Reserve Bank of India gave the green light for Indian banks to raise tier 1 and upper tier 2 capital in the international markets. Indian banks are enjoying unprecedented loan growth and their need for capital is strong. In August, UTI Bank became the first Indian bank to take advantage of the relaxation in the rules, with a successful $150 million upper tier 2 capital issue. Barclays Capital, Citigroup and Deutsche Bank acted as lead managers. The 15-year non-call 10 bond generated $1 billion of demand. ICICI followed UTI’s lead with a perpetual hybrid tier 1 transaction and State Bank of India is expected to follow shortly.

Another area attracting attention is distressed debt. “The market is still nascent,” says Shukla. “A lot has happened on the regulatory side and there is now far greater flexibility.” No one is certain on how big India’s bad debt problem is, with some estimates putting the total at between $60 billion and $70 billion. What is clear is that India has the third-highest level of non-performing loans in Asia, after Japan and China.

Rule changes last year mean that foreign investors are now able to buy stakes in asset reconstruction companies, created to help dispose of banks’ bad debt. Last month, Barclays announced that it was in talks to buy a 10% stake in distressed asset firm, Asset Reconstruction Co of India Ltd (Arcil). A unit of Citigroup also holds a 4.4% stake in Arcil, which bought bad debts worth about Re211 billion from various banks in the year to March 2006.

Business potential also lies in helping corporate restructurings. “There are opportunities across the board, not just in buying distressed debt cheap and in getting good recovery rates,” says Shukla. “A lot of companies are turning their fortunes around, so restructuring opportunities are far greater.”

Another form of alternative financing that could take off is venture lending or principal debt investing. “This is a brand new idea in India,” says Nayar. It involves banks making unsecured loans to high-growth companies with some kind of equity kicker attached. Citigroup, for example, made such a loan to a biotech company recently. This type of business will complement Citigroup’s existing principal investing activities on the equity side.

Indeed, principal investing is becoming a catch-all phrase in India. Specialist players such as Temasek and Warburg Pincus have already made strides in private equity in the country. Now the leading banks, especially Goldman Sachs, are following suit. “The ability to aggressively commit capital will be a differentiator,” says Entwistle. Investors will need to be flexible but the opportunities are there.

All to play for

The emergence of these products should ensure that India remains an exciting market in the years ahead and there’s the promise of more to come. Structured finance products such as CDOs, CLOs, asset-backed securities and mortgage-backed securities have yet to develop. Leveraged finance is still very much in its infancy – there has only been one LBO in India, and there’s little indication of any more soon. No one is trying to reinvent the wheel but the process of developing financing techniques will be gradual.

Bankers will need to be patient but there is all to play for. There is potential to grow profits, albeit from a relatively low base. “It won’t surprise me if we all grow our profits by at least 40% a year for the next three years in investment banking,” says Kothari.

Still, India is not as a lucrative an investment banking market as China, for example. “It will be a long time before an investment bank makes $300 million-plus profits in India,” says Lal Kidwai. She reckons that average profit is about $50 million a year, and Entwistle estimates that the entire fee pool across M&A, equities and debt is only about $375 million.

Of course, that pool will grow as the markets grow but in the meantime some banks might decide eventually to shut up shop and leave, especially when times get tough, as has happened in the past. “It won’t be possible for everyone to survive,” says Jhaveri. “How can everyone have a market share that results in profits? It will be interesting to see how those under pressure will react.”

Question marks can be placed against each type of model: the international-local ventures, the standalone global players and the independent local banks. Newer entrants, in particular, could struggle and it will take at least three years for them to make their presence felt. The question is: will they be given that leeway?

“The answer will differ according to the outlook of each firm,” says Ramesh. “Some will have a three-year outlook, others five years and others 10 years.”

Another banker is less convinced. “Foreign banks are fair-weather friends,” he says. The foreign banks, of course, dismiss this as a caricature. They, in turn, say that the local banks lack the global reach to properly service India’s leading companies. Only time will tell who is proved correct.

The global banks will also have to tread carefully with the regulators. Despite the relaxation of many laws, India is still a difficult market to negotiate. Last month Credit Suisse got another ticking off when Sebi suspended the firm for one month for “omission to observe the code of conduct”, a judgement related to trades executed more than six years ago. The Swiss bank is not alone in getting its fingers burnt in recent years. In May 2005, UBS was banned from issuing participatory notes and other offshore derivatives instruments for one year after the Swiss bank failed to cooperate in an investigation by the regulators into market manipulation. Last month, the regulator slapped a Re10 million fine on Citigroup for issuing derivatives on Indian securities to a firm prohibited from investing in India.

Success for banks will depend as much on keeping their noses clean as anything else. Reputations can diminish quickly. But if these hazards can be avoided, then rich rewards could lie ahead. “There’s no question that this economy will be in a capital formation stage over the next 10 years,” says Jhaveri. That’s the overriding message that’s driving every investment banker in India.