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September 11, 2005

While IT services cos. are acquiring overseas, product firms are getting acquired by foreign firms

This week, I contributed to an article on M&A in India's IT services sector in the The 451 techDEALMAKER. I'm posting below some of my responses to a well compiled list of questions from The 451 Group's Fred Linden.

What trends do you see in M&A involving India-based technology and communications companies?
While product/IP-driven companies based in India are finding willing buyers and investors among foreign companies (examples include the recent Oracle-I-flex deal and Flextronics’ string of acquisitions in 2004), services-focused firms are capitalizing on the booming capital market to acquire overseas companies.

Based on the successful exits, technology-focused VC firms are now more bullish on backing product/IP-driven firms rather than IT services firms (except for niche/specialized players).

Within services, it has been quite fascinating to witness how much more rapidly the Indian BPO services sector grew and matured – including in terms of attracting M&A interest from overseas firms - compared to the IT Services sector.

Are there factors besides the ample supply of competitively priced and well-educated knowledge workers driving the tech sector growth in India?
The sheer numbers in terms of trained manpower is a factor that no other country - except probably China - can match. The strong Indian diaspora in the US - common to Israel and China as well – is another source of strength. With salary levels on the rise year-on-year, the availability of sufficient “been there, done that” management experience and the comfort with English of even the entry-level programmer are what will keep India ahead of China in the IT services space.

What's driving India-based IT companies to look abroad for investment opportunities?
An extremely conducive capital market – both domestic and global for Indian companies - is making the financing of acquisitions much easier. Whether it is a local IPO, overseas equity issues (like GDR and ADRs), convertible debt (like Foreign Currency Convertible Bonds) or Private Equity funding, Indian companies are spoilt for choice in terms of options to finance their overseas acquisitions. The Indian government too has liberalized the rules for companies making overseas acquisitions and recently also relaxed limits placed on Indian banks to finance these acquisitions.

What's driving foreign-based companies to buy India-based IT operations (besides the obvious - the low cost of highly qualified labor)? How do other forms of direct foreign investment in the Indian IT sector (JVs, local branch offices, etc.) compare?

Recent deals seem to indicate a preference among foreign firms to acquire Indian firms with specialist/niche capabilities rather than generic service providers.

Would it be correct to say that the focus of India-based IT is shifting from IT business services/systems integration (2003 & 2002) to IT outsourcing and software development?

My understanding, as someone who tracks the IT Services industry mainly from a deal perspective, is that while the larger firms continue to play across the spectrum, mid-sized firms are choosing – if not forced - to specialize. Offshore software testing services has been a new area of growth for the mid-sized players and based on their success, the larger players – who earlier did not pay to much attention to this opportunity – are growing their practices in this area.

Our data suggests that India-based IT companies over the past four years have been increasing the size of their foreign acquistions rather than making more of them (although just in the past couple of months there have been an upswing in activity). Can you confirm this trend toward larger transactions, and what would explain it?

While I’m not sure there is a conscious move towards doing larger deals, given the challenges of integrating cross-border acquisitions – motivating and retaining the existing team, cultural issues, etc. – it makes sense for Indian IT vendors to go in for fewer deals - and consequently ones that are significant sized - so that management bandwidth is not spread too thin. Also, given the strong performance of the Indian stock markets, it makes sense to use the opportunity to do larger deals now.

Our data suggests that the size of IT acquisitions in India by foreign companies has not been growing over the past four years. Meanwhile, the activity level (number of deals) has been growing. Can you confirm this trend toward quantity over size, and what would explain it?

Each foreign firm entering India makes a “build versus buy” decision. Over the last few years, most Global IT Services firms have entered the country and opted to create their own delivery presence rather than acquire generic local IT services firms. The process for setting up an India Development Center (IDC) is relatively smooth (so there is no significant entrenched advantage that a local firm enjoys here). Plus the foreign firms have been able to hire local management talent – usually by hiking salaries significantly.

The acquisitions have been reserved for adding niche capabilities – like BPO (IBM-Daksh), vertical specialization (Flextronics-HSS), etc.

What recent international deal involving a tech company based in India do you find most interesting?

Apart from the recent Oracle-I-flex deal, which has received wide publicly, I found the way in which Singapore-based contract electronics manufacturer Flextronics has rapidly emerged an active acquirer of Indian technology companies to be quite fascinating. The company moved swiftly to invest in most of the leading communications software companies in India in 2004: it acquired FutureSoft and Deccanet Designs and invested $226 million to acquire the 55% stake held by News Corp. in publicly-listed Hughes Software Systems. As part of the company’s plans to make India its global center for technology products design, Flextronics has also led a $10 million investment in chip design firm inSilica and acquired multimedia technology firm Emuzed.

Arun Natarajan is the Editor of TSJ Media, which tracks venture capital activity in India and Indian-founded companies worldwide. View sample issues of TSJ Media's Venture Intelligence India newsletters and reports.