It was a marriage made in heaven. Eager Limited Partners (LPs) anxious to have an exposure to the next economic superpower (yes – this is the term we are using to describe India); together with General Partners (GPs) who could see the path (with potholes and all) to riches – the result has seen no fewer than 50 venture funds were setup in India over the past seven years.
From fabled venture capital firms on revered Sand Hill Road to the bluest of blue chip MNCs – and seemingly everybody in between – interest in Indian venture investments is high. As a result, we have seen the venture investments in recent years increasing: whether they are early-stage deals or public market deals; within technology or within sectors as diverse as wine.
We are still in the honeymoon period where the focus is on deploying available capital; but the outlook for reliable exits remains hazy. The honeymoon may be about to end. Observations on the Indian Venture Capital (VC) industry that follow could cause angst in the LP/GP community not quite unlike the pain you experience after eating Mumbai street food. Please do note – these comments are about the venture capital industry only (early-growth-late stage venture investments), and do not apply to the private equity industry.
Show me the money!
This line, from the script of the Hollywood film Jerry Maguire, pretty much sums it up. Entrepreneurs – and indeed, sometimes VCs – can forget that VCs are money managers, usually managing OPM (Other Peoples’ Money). And ‘OP’ usually expect to see a significant return on their ‘M’. In this case, ‘significant’ means much higher than what they would get from the equity markets.
How and when VCs are going to generate significant returns is a question that usually gets glossed over by the “but look at the 9% GDP growth for the next 10 years” argument. The lack of a vibrant M&A market in India really puts a dampener on VCs’ ability to generate significant returns. Large local companies are loath to pay any kind of premium for acquisitions. I don’t know whether this has to do with lack of IP in startups or lack of respect of IP at potential acquirers. MNCs would gladly acquire, but they are used to acquiring IP or large revenues, both of which are absent in the Indian startups. At this time, IPO is the most likely path to a meaningful exit. This implies that the time to exit is much longer and fraught with the vagaries of trying to list and maintain on the stock markets.
But, you may ask – why not just look at late-stage investments for a quick return? Well, the ticket size gets much bigger and more importantly, the valuations are so unreasonable, it’s not even funny. Sure, there will be some reasonably big hits, but the prospect of IPOs being the only viable exit option for the entire portfolio is a somewhat frightening thought.
Will LPs, and for that matter even GPs, have the patience for the longer exit horizon or the appetite for smaller returns? In a world that now moves at the pace of Twitter, Facebook and Foursquare, will the stakeholders be able to keep the faith?
I love my job, but …
Most industries require years and years of domain experience to get to the top post. But some venture capitalists in India don’t always have a great deal of investment experience before they get into this line of work. I am not questioning the ability of others to do their job, rather whether they may want to keep doing the job long-term. That may sounds like a rather ridiculous question – after all, why wouldn’t anyone want to continue doing a job that’s high profile, intellectually stimulating, pays well with the promise of more (if, Insha’Allah, the fund actually generates a carry).
Well, there are plenty of reasons why, especially for people with deep operating experience – this type of role is not always ‘hands-on’; it can mean working with a team that’s a fraction of what one has been used to; it can mean dealing with (sometimes) challenging entrepreneurs and co-investors; it means raising money from LPs every few years; it’s requires commitment 24x7; requires patience to see exits; it means living in India long-term – the list may go on.
As Paul Kedrosky’s research had pointed out, it takes a VC to invest $50 million and be in the industry for seven years to make a good VC – and not everyone has the patience or the aptitude to endure this. Bottom line, not everyone is cut out for this job. My sense is that in the near future, we may start to see churn in this industry where GPs move on, damn the promise of the carry. LPs have probably baked this into their assumptions, but too much of this won’t be a good thing for the industry.
What – our regulations are not clear?
Of course, no discussion on any topic in India would be complete without discussing the actions of the government. Are they going to help the startups/VCs, are they going to be neutral, or are they going to hinder?
Even if there were a clear answer to this question, we could manage, but the rate of policy changes here are more difficult to follow than Muralitharan’s deliveries. Do we want to encourage use of stock options? Do we want to continue STP? Do we want to make it easier to protect VC interests during the IPO process? Do we want to have a legal environment for speedy resolutions of investor startup conflicts (I should disclose here I, for one, and pushing for the latter) so that the legal documents do carry some weight and not just represent the hefty legal fees that we have paid?
While regulations haven’t become a big issue yet, some do note a feeling of being under a hanging sword which is going to be swung by someone who may not appreciate how important the industry is to India. The IVCA is working hard to educate and influence stakeholders and I wish them the best.
What’s the cumulative effect?
The above three factors, individually and combined, could seriously hurt future fund-raising efforts of current and new venture capital firms. Here are the implications for entrepreneurs:
1) Choose your investor(s) carefully. Make sure they have enough ‘dry powder’ to fund you in subsequent rounds, and don’t have any fund issues or team issues which may cause unnecessary distraction for management.
2) I would like to suggest – at the risk of being ridiculed by the entrepreneurs – that it’s better to go with a lower valuation from a stable VC fund than a higher valuation from a fund that has or is likely to develop issues.
3) Make an effort to understand the VC business. Entrepreneurs have a huge role to play in ensuring that the VC industry in India remains vibrant for a long time to come.
As with most things in our great country, there is a big gap between logical analysis and reality – or perception of reality – that unfolds. I truly hope that is the case here too and that the above factors don’t become huge issues over a short period of time. Here’s wishing that the honeymoon continues for a long time, more funds are created, more deals are funded, and more deals make it to big Rupee exits. Jai Ho!
(Pradeep Tagare is an Investment Director with Intel Capital India.)