‘For the private equity industry to scale in a significant way, some structural changes need to be made’

Abhaya Shrestha

Managing Partner, Lantern Hill Partners, New York City

Abhaya Shrestha, Managing Partner of Lantern Hill Partners in New York City, left Nepal in the early 90s with a scholarship to attend college in the United States. After graduating, he started his career working at a Wall Street firm, Morgan Stanley, in New York City. He worked on mergers and acquisitions and capital raises for Fortune 500 companies in the technology sector. “Back then, the internet was just getting off the ground and companies like Amazon and Yahoo were getting started - it was a fascinating time to be doing investment banking work for technology companies,” he shares. After a few years at Morgan Stanley, Shrestha moved to the private equity industry. He says he liked the idea of being an owner or stakeholder in a company rather than an investment banker or advisor. He then joined a firm called Behrman Capital which had approximately $2 billion in capital. Since then, he has spent more than two decades in the private equity industry, making several dozen investments in companies ranging in revenues from $50 million to $250 million. “The investments I have made have leveraged buyout transactions – purchase of controlling equity stakes in companies utilising some debt to finance a portion of the purchase price as well as equity investments to fund growth,” mentions Shrestha. These investments have generally been in the businesses services, technology, health care and specialty manufacturing sectors. Most of his investments have been in North America, but some have also been in Europe and China. In this edition of Business 360, we spoke to Shrestha who was on a short visit to the capital, about private equity and its importance in Nepal.

How would you define private equity in layman terms?

Private equity is the business of buying equity or shares of privately owned companies (as opposed to of publicly listed companies), then helping those companies increase the value of their equity, and then finally selling the equity stake in three to five years presumably at a higher value and thereby realising a gain. Private equity firms often buy a majority equity stake in companies (called portfolio companies once bought) and therefore become the controlling shareholder of the portfolio company, but private equity firms can acquire minority equity stakes as well. Portfolio companies can be in various stages of development, from startups to mature businesses. Private equity firms work to increase the value of their portfolio companies by doing things like helping them grow, develop new strategies or sales channels, or acquire other companies to create synergies. To buy equity in companies, private equity firms raise capital from banks, pension funds, wealthy individuals and others, and the managers of the private equity firm themselves also invest their personal capital into their fund. Private equity firms typically charge an annual management fee to their investors and portfolio companies, and also get paid by their investors a negotiated percentage of investment gains. If a portfolio company does not perform well, its private equity investor may be forced to sell its equity stake at a loss, so the investments can be risky. But in general, private equity firms work hard to help generate gain in the value of their investments and they do so in three main ways: growth, leverage and multiple expansion. The first way is helping the portfolio company grow through strategic initiatives like investing in product development and sales channels, buying other companies and merging them to create synergies, etc. The second way consists of financing a portion of the purchase price through debt, which has a lower cost of capital, and paying down debt over time thereby increasing the value of the equity. This is like buying a house with a mortgage and paying down the mortgage over time. The third way is by buying equity of a company at a price representing a certain multiple of the company’s earnings, and then selling the equity a few years later at a price that equates to a higher multiple of the company’s earnings. A company is typically valued as a multiple of its earnings (in some cases, as a multiple of its revenues). Let’s say, a private equity firm acquires a majority equity stake in a company at a price representing eight times the company’s earnings. Then, by executing strategic initiatives like opening up new sales channels, upgrading operations, expanding the product portfolio, restructuring the business to generate efficiencies, etc, the private equity firm will make the company more attractive to a buyer and may be able to sell its equity stake to the buyer at a price higher than eight times the company’s earnings. Private equity firms typically exit their investments after three to five years but can hold their investments for up to about ten years.

How important is the concept of private equity for a country like Nepal?

Nepal has achieved an annual growth rate of about 4-5% over the past decade which is decent particularly given some of the political instability in the country. But Nepal needs to grow significantly faster to keep pace with its South Asian neighbours and become competitive globally. Nepal also needs to change one of its main drivers of growth – remittance from Nepalis working outside the country which has contributed more than a quarter of gross domestic product in recent years. A remittance-driven growth model is highly vulnerable to economic shocks and unsustainable over long term due to talent flight and ensuing domestic shortage of human capital. In order to create sustainable and accelerated growth, Nepal needs high levels of investments in its industries and a strong capital market. Domestic public and private investments have historically been low. The government has tried to woo foreign investors by organising events like Nepal Investment Summits in 2017 and 2019, but FDI flow continues to remain low too, having recently plateaued at less than 0.5% of GDP and lagging behind most South Asian countries. Private equity occupies an important segment within the capital spectrum – it provides capital to companies from their startup stages through becoming mature businesses before they cross over to being publicly listed. In western countries, private equity is an important and growing segment of their economies. It has become a $2 trillion industry annually within the United States and Europe. A significant number of globally successful companies, from technology and e-commerce companies like Google and Amazon, to healthcare, manufacturing and services companies have been financed by private equity through various stages of their development. Over the past decade, India has seen a huge influx of private equity capital and the private equity industry there is burgeoning, helping many businesses grow and prosper. This same source of capital can be brought to Nepal at a significant scale and used as a catalyst to accelerate growth. If this capital source is not fostered in Nepal, startups and maturing companies will continue to be faced with debt financing as the primary and often only source of capital which can be severely limiting. In addition to providing capital, private equity firms support their portfolio companies in significant ways, bringing their experience and network to bear in helping their portfolio companies grow and become successful. If Nepal’s industries are to grow and compete internationally, I think attracting significantly more private equity will be quite important.

It hasn’t been very long since this concept was introduced to Nepal. How do you view its future?

During my present trip to Nepal, I have been pleasantly surprised to see a growing number of startups and maturing private businesses. It has also been interesting to see the private equity industry starting to take shape in the country with funds like Dolma actively investing in businesses. This is creating an important new source of capital for entrepreneurs and business owners as they seek to develop and grow full-fledged businesses, providing products and services that have the potential to compete not only domestically but in international markets as well. But as you noted, the private equity industry in Nepal is nascent and its reach and scale have so far been limited. For the private equity industry to scale in a significant way, some structural changes need to be made in areas such as regulations, enforcement, and infrastructure development. Without these changes, I think private equity will remain limited in Nepal and be unable to provide a meaningful link in its capital ecosystem.

How would you rate the ‘doing business’ climate of Nepal? What are the improvements required to not only attract FDI but domestic investments too?

Some improvements have been made over the past few years but the business environment is still not great. The main issues I see are government bureaucracy and graft, lack of judicial transparency and enforcement, subpar infrastructure, and an inefficient labour market with limited higher education and training. I think these factors continue to discourage entrepreneurship and sap investor confidence. The World Economic Forum’s Global Competitiveness Index of 2019 (prior to the Covid 19 pandemic) ranked Nepal 108th among the 141 countries studied (India ranked 68th, Sri Lanka 84th, Bangladesh 105th and Pakistan 110th). However, there are a number of ‘low hanging fruit’ reforms which can be implemented within a relatively short timeframe by a willing government. Some examples are streamlining government approval processes including creating and enforcing time limits on approvals and easing capital repatriation restrictions. There is room for much improvement, and they can and should be tackled with urgency.

"Nepali regulations require foreign investors to go through a lengthy approval process in order to invest in the country, a process that is often complex, opaque and discretionary. This should be streamlined. Multiple institutions are involved in investment policymaking and implementation, with some of these agencies having overlapping mandates causing regulations to be caught up in confusion and red tape."

What are some of the issues or agendas that the government has to immediately address in Nepal to attract Foreign Direct Investment?

I think the first issue to address is regulations. The government has introduced a number of laws to attract domestic and foreign investment over the past few years including the Foreign Investment and Technology Transfer Act (FITTA) and Public Private Partnership and Investment Act. While these legal reforms are helpful, they do not go far enough. There are many issues that need further reform but let me talk about a few of them here. Nepali regulations require foreign investors to go through a lengthy approval process in order to invest in the country, a process that is often complex, opaque and discretionary. This should be streamlined. Multiple institutions are involved in investment policymaking and implementation, including the Department of Industry, Investment Board Nepal, Nepal Rastra Bank (NRB) and the Industrial and Investment Promotion Board, with some of these agencies having overlapping mandates causing regulations to be caught up in confusion and red tape. Furthermore, within the federal government structure, the licences, permits and the inspection processes are affected by many layers of government. These also need to be reformed and simplified. The scope of investors’ repatriation rights in Nepal falls short of international standards. Even though Nepali law does not require prior approval for the repatriation of foreign investment, in practice, it is subject to dual approvals by NRB and the Department of Industry, with no prescribed time period within which these approvals will be provided. If there is compensation received as a result of the resolution of disputes or indemnification claims, Nepal’s repatriation rights do not explicitly guarantee repatriation of payments obtained as a result of such dispute resolutions. These need to be reformed. And all of this has to be handled perhaps by a single agency, with time limits imposed on the agency’s review and approval process so that processes don’t get caught up endlessly in red tape. The second and related issue that needs to be addressed is the country’s judicial framework and enforcement of laws, together with the elimination or reduction of graft. The existing judicial process in Nepal does not provide enough protection to investors to make them comfortable with making large investment bets in the country. A strong set of investor rights, including asset protection and enforcement processes, needs to be implemented. For example, as far as I know, there are no mechanisms in Nepal’s laws to settle disputes between foreign investors and the state. Dispute settlement measures included in the FITTA regulations only pertain to disputes between investors and industry participants. This needs to be amended to add a mechanism to settle disputes between investors and the state, preferably via an independent international arbitrator. In essence, a modern investment law that adheres to international best practices concerning approval of FDI, investor protection, repatriation, dispute resolution, etc and a strong judicial process to enforce them is extremely important to inspire investor confidence and cause higher inflows of capital into Nepal.

"Enabling people of Nepali origin who have immigrated to other countries to have dual citizenship will increase their engagement with Nepal as well as encourage them to invest more in the Nepali economy. Providing dual citizenship helps maintain a strong link between Nepal and NRNs, and also provides a higher level of security, both real and perceived, for NRNs’ economic engagement with Nepal, which will likely encourage this population to be an increasingly important part of foreign direct investment in the country."

A number of years ago, I worked on an investment in a manufacturing business in China. While we were operating the business, a regulatory issue came up regarding an economic development zone permit held by the owner of the manufacturing facility that we had leased. We approached the local authorities regarding the issue, and I was pleasantly surprised how expeditiously and seamlessly the matter was resolved, allowing us to continue focusing our energies on managing and growing our business. Such an environment is highly encouraging for businesses and investors. In contrast, I read about an instance in Nepal when an approval sought by a company from the Ministry of Industry for issuing shares to reinvest in expanding the capacity of a manufacturing operation stalled for more than a year. As far as I know, a lot of approval processes comprise rent-seeking behaviour by government officials, with approvals stalled until unofficial payments are made. According to a study by Transparency International, in 2021 Nepal ranked 117th in the global corruption index out of 180 countries. Nepal needs to improve on this and similar metrics to attract more investments into the country. The third issue that I think the Nepali government needs to address, or continue to address, is infrastructure. Infrastructure availability, in areas like energy, transportation, and utilities (water supply, waste management, etc), is of course necessary for industries to operate and grow. Nepal ranks low in infrastructure availability compared to other countries in South Asia. The 2018 Logistics Performance Index of the World Bank ranked Nepal 114th in the global ranking of 167 countries. Poor infrastructure is a key area that hampers investor comfort and appetite for investing in Nepal. It is estimated that investment in infrastructure needed over the next decade is around 10-15% of GDP. I think the private sector, including private equity, can play an important role in infrastructure development through public-private partnerships. I’d like to mention two other points on this topic. The Nepali government needs to do better in attracting and retaining a strong and efficient labour pool in order to continue to promote a business enabling environment and attract investments. Emigration and migrant workers have created pockets of labour shortage in many sectors of Nepal, and the skill level and productivity of its labour force have been depleted due to Nepal’s labor export. The productivity of the Nepali labour force is lower, and its wages higher compared to other South Asian countries. While labour relations have improved over the past few years, Nepal continues to have rigid labour laws that hamper companies’ ability to adapt to changing market environments in the face of high costs and administrative burden. This needs to be changed. Until Nepal’s capital markets are sufficiently developed to support a strong flow of capital to industries and enable investors to be able to both invest and exit their investments with relative ease through the aforementioned improvements in regulations, judicial enforcement, infrastructure and labour availability, private equity as an industry will be unable to scale in Nepal.

What are the sectors you personally feel that Nepal needs to emphasise for long-term sustainable development?

In an increasingly globalised and technology-driven world, focusing on sectors of competitive advantage is important for a country to find and maintain its footing in the global economy. Based on what I’ve seen, I think the technology, energy, tourism and agriculture sectors, or niches within these sectors, are areas where Nepal can utilise its competitive advantages and develop strong competencies.

What are the major differences in opening and operating a business in the developed world and in Nepal?

In the United States where I have spent the most of my professional career, regulatory hurdles and processes for starting and operating a business are pretty minimal. You can register a company within a few hours through electronic filings. The market for raising capital is also well developed and efficient. There is a robust private equity and debt sector as well as a highly liquid and accessible public equities and debt markets. Of course, the systems and markets in the US are not perfect, but they do provide entrepreneurs and business executives relative ease in starting and running their businesses. If there are disputes, there is a well-worn, perhaps too well worn in some regards, judicial system with processes laid out for dispute resolution. There is strong infrastructure and labour force in place. All this creates a highly attractive environment for entrepreneurs and businesses owners to start and build business as well as for investors to invest in them. The biggest challenge for entrepreneurs and business executives consists of developing and marketing products and services that can compete successfully in a highly competitive market environment. The companies that succeed in this environment are often world class businesses that bring significant value to their customers as well as shareholders and contribute to economic growth. The business environment in the US is perhaps the most efficient in the world and it is no wonder that a lot of businesses are created and developed in the US. Nepal needs to move quite a bit across each of these areas to create a similarly enabling environment of entrepreneurship, investment and growth.

There are different definitions of what actually constitutes a startup. How would you personally define it?

I think of a startup as a company that is anywhere between the stages of developing a product or service supported by an investment from its founders or external parties, through to the stage where the company is proving out its business model and establishing a steady volume of customers and stream of revenues. Once a company has proven out its business model, established a steady customer base and is generating stable revenues, I consider the company to have moved out of its startup phase and become an established business.

What are the three fundamentals that a young entrepreneur needs to be aware of when starting a business?

First, figure out as clearly as possible what the unmet market need is that the business would seek to satisfy. Second, build outstanding products or services that not only satisfy unmet market needs, but also create enthusiastic fans of your products or services. I am an investor in a business right now whose aim every day is to turn all their customers into ‘raving fans’ and keep them that way. Third, constantly seek and evaluate market feedback, and be willing to change and adapt the business based on market needs. Markets are fluid, particularly in today’s age of technology and innovation, and keeping your finger on its pulse and constantly adapting to changes within it is extremely important. If you don’t do this, your business can and will most likely become obsolete or irrelevant sooner or later.

There have been talks about dual citizenship for NRNs for many years now with no substantial result. If the government does provide dual citizenship, how will it benefit Nepal and the NRNs?

There are reportedly 3 to 5 million Nepalis living and working outside the country excluding India, and this trend of exporting Nepali labour continues. A portion of Nepalis working abroad, particularly those with higher skill levels and wages, have immigrated or will immigrate to the countries where they have found employment and economic livelihoods. As we know, the Nepali diaspora has been an important source of foreign reserves and economic growth for Nepal. I think enabling people of Nepali origin who have immigrated to other countries to have dual citizenship will increase their engagement with Nepal as well as encourage them to invest more in the Nepali economy. Providing dual citizenship helps maintain a strong link between Nepal and NRNs, and also provides a higher level of security, both real and perceived, for NRNs’ economic engagement with Nepal, which will likely encourage this population to be an increasingly important part of foreign direct investment in the country. Also, Nepal will need to increasingly compete globally as economies across the globe continue to be more and more intertwined. Providing dual citizenship to NRNs can enable Nepal to transfer skills back to the country from abroad at a much greater scale and help the country compete globally. India for instance, is already seeing this in significant numbers. A growing number of Nepalis who have established companies in other countries have started investing in and building companies in Nepal. Enabling them to have dual citizenship will accelerate this trend.

On a closing note…

The private sector is an important part of the Nepali economy, and it has been heartening for me to see a growing number of startups and established private businesses in Nepal. I think the country is near an inflection point in the growth of its private sector. A much higher level of investment is needed to scale Nepal’s private sector and enable businesses to bring themselves up to global competitive standards and contribute to Nepal’s economic growth. Attracting private equity capital both from abroad as well as domestically at a much larger scale through the creation of an attractive investment environment could set Nepal on the path of stronger growth and global competitiveness, essential for the country to prosper in an increasingly interlinked and dynamic world economy. READ ALSO:

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