From 1994 to 2001, India put the public equity market into shape. On the stock market, large firms are able to access bulk equity financing at a low cost. The success of the public equity market made a fascinating "vertical integration" possible. From roughly 2000 onwards, professional private equity (PE) funds have come of age. PE is now a key part of the financial ecosystem, and is likely to induce a significant acceleration of growth of the modern sector of the economy.

A PE fund selects a company for investment. It takes a large stake in it. It then works with the company over a 3-6 year horizon, pushing for very high growth of the company. In the end, it exits when the company goes for an IPO or is sold to a listed company. Growth and profitable exit are, of course, unpredictable: the PE fund bears high risk in this process.

Four terms require clarification: the public market, private equity, venture capital and hedge funds. The public equity market is about trading on the NSE and BSE. The market involves large-block transactions that are privately negotiated, generally involving unlisted companies. One element of this is venture capital, which generally focuses on early stage investments where the risk of failure is high.

Private equity funds are similar to hedge funds in two respects. In both cases, the investors are large and sophisticated; the general public is excluded so as to avoid regulation motivated by investor protection. And in both cases, compensation structures endeavour to align the interests of the fund manager with those of the investor - the typical fund manager invests a big fraction of his personal wealth in the fund, and gets a performance-linked fee. Private equity differs from hedge funds in that most hedge funds invest in liquid assets.

Internationally, venture capital is generally seen as being about investments in risky high-tech companies. But in India, the best use of capital is often investing in low-tech companies. We need world-class potato chip companies more than we require world-class computer chip companies. Hence, while PE funds in India have invested in high-tech, the bulk of money has gone into low-tech, as it should.

In India of old, starting a business could only be done by one of the 1,000 rich families owing to constraints on capital. PE has given a democratisation of entrepreneurship by setting up a new and meritocratic channel through which capital can be accessed. There are now myriad success stories of first-generation entrepreneurs who have built up Rs 100-crore (Rs 1 billion) and Rs 1,000-crore (Rs 10 billion) companies by getting capital and management support from PE funds. This is good for India because it increases competition, and speeds up the pace at which the economy reaches the frontier.

It appears that roughly 20 per cent of investments by PE funds are small stakes in listed companies. Another 20 per cent involves substantial stakes in listed companies. The remaining 60 per cent is invested in unlisted companies. In all cases, PE funds differ from mainstream FII investment in two respects: investment horizon and involvement. PE funds tend to look for large investment returns over long horizons. In this respect, investments by PE funds are more like FDI and less like FII investment. In terms of involvement, PE funds tend to play a hands-on role in the transformation of the company so as to achieve high growth. PE-backing seems to help CEOs learn how to become a big company faster and better.

A PE investment can be made only if there is a reasonable scenario of selling out at a good profit, which critically requires a well-functioning public market. The sequencing that appears to have come about in India is that from 1994 to 2001 the public equity market was knocked into shape. Once a successful firm could access capital from the public equity market at a good valuation, the PE industry sprang up as an upstream producer, applying a professional focus to aggressively growing companies which could be sold into the public market (either through IPO or by sale to an existing listed company).

While good data are hard to come by, the numbers are now significant. The gross investments of PE funds are estimated at $13 billion in 2006-07 and $20 billion in 2007-08. There are now roughly 250 PE funds operating in India. They may have investments in 1,500 companies. This means that the PE industry is now applying its professional incubation function upon a full 1,500 companies.

The investments in place today might generate 1,000 exits over the next four years. On average, the PE industry will produce one company per weekday! Some of these exits would be through an IPO; the others would involve sale to an existing listed company. In either event, this would give growth of the overall market capitalisation of India and grow the modern sector of the economy.

A key feature of PE funds is that they have a substantial shareholding in the investee company - sometimes even a majority stake. This is a sea change in the governance environment when compared with the usual Indian family run company, where the CEO has job security owing to owning over 50 per cent of the shares. PE funds, in contrast, exert substantial control, and sometimes even sack the CEO. This pressure helps to improve the performance of the company. Once the Indian listed space has hundreds of companies which have experienced a few years of PE investment, this would lead to an improvement in the corporate governance climate in the country.

Indian capital controls matter greatly. The bulk of the money coming into this field is from foreign investors, particularly after the mistakes of Budget 2007, which restricted tax passthrough for PE funds for domestic investors. Investee companies are now often planned out as a global business doing outbound FDI very early in the game. Sometimes, investee companies are being structured as offshore firms so as to avoid Indian capital controls. Global PE funds are setting up operations in India, and their ability to do so critically depends on an environment which is supportive to global firms operating branches here and moving money across the boundary. A strong effort is required, on solving mistakes of tax policy and capital controls, so as to enable private equity to impact on India's growth.