Was PE too early for Sri Lanka?


The investment landscape shifted when Ironwood Capital Partners and a combination of NDB and US-based Zephyr launched Sri Lanka’s first private equity (PE) funds in 2014. Until then, few outside high finance had heard of PE or understood their role in backing businesses. Sri Lanka’s economy was then growing at 7-8%, in a flurry of post-war economic activity. Outlook for funds, with an expectation of 6-7% economic growth, was positive. Those assumptions were soon proven wrong. Th e Department of Census and Statistics re-based GDP indicators in mid-2015, giving a rude awakening that growth had been a mere 3.4% in 2013 and 5% in 2014. Growth has since continued to fall, recording 3.2% in 2018.

“There’s no hiding the fact that the whole macroeconomic situation has impacted the performance of companies, particularly revenue and profitability growth,” says NDB Zephyr Emerald Fund Managing Director Senaka Kekiriwaragodage.

PE funds invest in risk capital (usually a minority stake). They expect an annual return of over 20% when they exit an investment five years later, typically after a company goes public or a trade sale where the company is sold to a bigger business, or even back to the majority stakeholder.

Kekiriwaragodage says NDB Zephyr’s Emerald Fund investments are growing slightly slower, in the teen levels, as consumers have less disposable income than expected.

International funds including those with a long history in Sri Lanka and a good understanding of local challenges, including IFC, DEG, and FMO, have invested in the $42 million Emerald Fund. Hiran Embuldeniya, Managing Partner of the $20 million Ironwood Capital, backed by high-net-worth foreigners and local family businesses, is optimistic despite the apparent challenges.

“Financial markets may feel the pain of 3% economic growth, but SMEs (small and medium enterprises) could still achieve targets,” he says.

Ironwood has dual priorities; expecting its investments to perform well, it’s also eyeing favourable exits with buyouts from international heavyweights.

“An international investor may buy out with a 30% return, so anything is possible,” he said.

PE is an integral part of the startup ecosystem. While startups begin with investments from friends and family or angel investors, their ability to fund a valuation beyond $100,000 is limited. PE funding, on the other hand, can turn ideas into products, and help businesses accelerate growth.


As companies grow, they reach out to venture capitalists (VC) who occupy the space between angel investors and PE. Fewer than one in ten successful startups survive to reach the PE stage. With PE, companies, now well-established, optimise for a higher growth path. Both Emerald and Ironwood take board seats in promoting companies and appoint key personnel, such as the chief executive or chief financial officer.

Kekiriwaragodage and Embuldeniya agree that a poorly developed startup ecosystem is proving to be an enormous obstacle for growth of nascent PE.

Although new businesses abound, Sri Lanka lacks enough entrepreneurs with the vision to scale to reach regional and global heights, Embuldeniya says.

“The big success story continues to elude us,” he says.

Entrepreneurs are just 2.8% of Sri Lanka’s population, compared to 19.6% in Vietnam, 27.5% in Thailand, 11.6% in Bangladesh, and 7.5% in China, according to state data. Critics point their finger at the education system not sparking creativity or critical thinking, for most citizens preferring public sector jobs due to their disliking the hard work, and the fear of failure associated with entrepreneurship.

The 2019 government budget proposed loan interest subsidies for new businesses named Enterprise Sri Lanka. Embuldeniya lauds the initiative, but warns that it needs robust monitoring.

Kekiriwaragodage, meanwhile, stresses that the government’s role should be to ensure a level playing field for startups and established businesses. He highlights the advantages the old guard enjoys, like their close political ties and sometimes the avoidance of legal compliance and even dodging taxes. There are so few entrepreneurs, and even fewer funds to back them.

“It’s a chicken and egg situation,” Kekiriwaragodage says.

The angel investors are sparsely organised, and VC is limited to the $15 million Dialog Innovation Fund, managed by a telco. Some family-owned firms run VCs, but aren’t professionally-managed funds, according to Embuldeniya. These tend to be passive investors, and don’t seek out potential growth firms. Apparel firms are funding their own employees’ ideas with VC, but that remains narrowly focused on one industry segment.

The lack of upstream prospects for PE correlates to fewer investment opportunities. However, even some relatively established firms are unfamiliar with PE, mistaking them for debt financing.

“For instance, it’s different in India because there are so many PE funds. When we approach a company, they would already have been pitched by another PE fund so they would say ‘Okay, this fund was in last week giving me these terms, what are yours?’,” Embuldeniya said. Many are poorly capitalised, according to him, due to poor past financing choices. Some even have founding partners owning 50% of the shares, but who have parted ways years earlier.

“Still, they expect returns for their 50% shareholding, without contributing any work,” he said.

Firms are also resistant to follow the advice of PE funds. Owners who had built up the businesses feel that they should remain in control.

Sparks may start flying as early as the pre-investment stage. Kekiriwaragodage coaxes potential partners to up their compliance for greater market credibility and competitive access to finance. The fact that almost all Fortune 500 companies are publicly traded is one of his oft-used quotes.

“If growth is what you want, it’s impractical to remain private. We want companies that could go out and stamp out at least a regional presence, if not a global presence. If that’s the objective, then you can’t be a control freak and be averse of listing or admitting other investors.”

1Kekiriwaragodage has also seen his fair share of companies refusing to allow changes in the management structure as a PE firm advises. For some firms, lacking scale means they cannot afford the luxury to hire an all-star finance head or a marketing whiz. However, some companies have refused to further compliance with laws and regulations. In Kekiriwaragodage’s opinion, such firms raise a red flag.

“During initial discussions, we gauge how promoters react to these ideas. That would also be why we wouldn’t invest in a company.”

The terms of management and a slew of exit strategies are then hammered out in the shareholder’s agreement. However, some companies had flouted exit deals, due to poor valuations at the end of agreements in the distant past.

Valuations frequently cause friction between a promoter’s PE funds. “It’s as much a rational exercise of numbers as an irrational exercise of the owners’ emotions,” Embuldeniya says.

Proceedings heat up when the promoter eyes its own buyback of the PE shares at exit. The lackluster performance of listed company share prices due to weak economic growth and profitability also dampens PE and discourages listing as an exit strategy, Kekiriwaragodage says.

Continuous political and policy instability, along with a string of natural disasters, had hit investor confidence and growth until 2018. Sri Lanka also has a twin deficit, with high foreign debt repayments that will peak in 2022. Sri Lanka is now in an election year, which may bring more considerable uncertainty to the economy.

The Easter Sunday bombings, which in addition to the loss of life and uncertainty, will erode $1.5 billion in earnings from tourism, as arrivals peter out. Both Emerald and Ironwood are indirectly exposed to the tourism industry due to their investment in laundries, whose main B2B clients are hotels.

The funds had early aspirations to invest directly in hotel infrastructure backing investments. Later, they decided that capital-intensive business, with longer terms of repayment, would not fit the 10-year cycle, although Emerald is thinking of entering the budget hotel space. As growth slows, Kekiriwaragodage says companies will expand at a moderate pace, reducing the need for further capital. Embuldeniya said PE funds now have to work harder to identify potential companies and grow them. In his opinion, the relative nascence of PE is working in its favour.

“If there were more funds out there, it would have been even harder in the current climate and would have affected the entire industry.”

While Ironwood has already completed its $20 million investments, Emerald has only disbursed $15 million, which is around a third of the fund. Despite the macroeconomic situation, Kekiriwaragodage is expecting to meet his 2020 target for full deployment.

“There are 3 projects in the pipeline with $7-8 million in investments. A few transactions haven’t moved to a due diligence state. However, this year, we’re looking to invest around $10-12 million,” he said.

Ironwood, meanwhile, is expecting to start its second fund of $50 million. It will follow a similar strategy as the first one in exposure; industries with strong correlations to the overall economy like finance, consumer goods, and food & beverage. Tourism, healthcare, education and tech are also attractive as defensive investments (not strongly linked to GDP growth) and will carry over as legacies, with export as a new focus area.

Ticket sizes for the new fund will be as large as $5-7 million, compared to the earlier $2-5 million range.

Emerald is diverging from this view. Established to invest around $2-5 million per pop, Kekiriwaragodage is now looking for investments even below $1 million, invading VC space.

“With the recent rupee depreciation, even medium-sized investments have become small in dollar terms,” he said.

Most of these investments would be in tech, where asset values are low but have the potential to quickly scale. Embuldeniya does not find such a strategy appealing, due to higher costs and the time required to identify and vet the stars from among the dozens of startups and then managing them. The industry focus for growth investments would remain the same for Emerald, with exports to hedge against rupee depreciation, in addition to tourism and tech. Kekiriwaragodage is particularly eyeing Sri Lankan FMCG and power firms looking to enter South Asia and Africa. It is also looking to finance mergers and acquisitions.

“In a billion rupee valuation for acquisition, we might back a big company putting in Rs600 million by financing the rest,” Kekiriwaragodage says. Although this may take away from Emerald’s objective of growth, the fund will attempt to choose acquisitions that have the potential to generate future growth.

One area where Emerald has seen a myriad of such opportunities is in banking and finance. Emerald is also witnessing space to invest in companies looking to restructure their finances and retire debt, in an environment where interest rates are high and banks are becoming conservative in their lending due to weak macroeconomic fundamentals, including a surge in bad loans.

Given Sri Lanka’s low growth, was PE too early to enter the country? Embuldeniya has mixed feelings. “Compared to emerging and advanced markets, we are late, but compared to some frontier markets, we are early,” he says.

However, Embuldeniya opines that PE should inject between 0.1% and 1% of GDP in funds annually to an economy. At the lower end, this amounts to $80 million annually. In contrast, Emerald and Ironwood together represent just $72 million in investments over a 5-year period, or just under $15 million annually.

Kekiriwaragodage says that PE is essential for Sri Lanka to grow and compete in the global market. If Sri Lanka is to become a global financial hub with the Port City, as the government hopes, PE should become a key player, he says.

He pushes for tax breaks as a solution for economic growth. Income from dividends from investments are taxed at 28%, or even higher, for some industries such as finance.

“If the government wants to encourage PE and VC investing, don’t worry about the fund. Worry about taxing the company,” Kekiriwaragodage says.

3He envisions such a setup being as useful in generating growth financing as the low-interest Enterprise Sri Lanka loan scheme. Both experts, however, suggest it would take longer for robust PE growth in Sri Lanka. Embuldeniya explains that most investors are currently investing in PE funds, which service the entire region. To commit funds for a single country such as Sri Lanka, they would observe whether the initial PE funds were successful and to what extent the winning management team was diluted for subsequent funds. As Kekiriwaragodage reminds, better growth would not hurt the prospects of PE.