Indian Venture Capital Industry: An insider perspective, Bangalore

The Indian Association of Investment Professionals (IAIP) organized the Speaker Event, Bangalore on April 5^th 2013, wherein Venkatesh Peddi, Vice President IDG Ventures India, discussed multiple aspects on the Indian venture capital industry.

Starting with a background on the industry, Venkatesh elaborated on phases of businesses where the investment firms focus on – venture capital firms (VC) invest in the company’s formation stage; private equity (PE) refers to investments during the company’s growth phase and leveraged buy-out refers the purchase of equity of a mature company funded with high levels of debt. He highlighted the phenomenal growth of the Industry from around $40 million a decade ago to about $1 billion in 2011. The Industry is expected to invest about $1 billion in 2013 but the expectation is masked with concerns about the uncertainty in the Indian political scenario and other country specific issues. Though investments made in dollar terms were large in the PE industry, the number of investments was comparable to the Industry.

Historically, it has been observed that there is a very low probability of a start-up being successful and profitable. As such, a VC firm looks towards multiplying its investment by supporting the organization at pre-early stage and early stage in its growth into fairly large organizations at a rapid pace, thereby, increasing the profitability of their portfolio.

Salient features of the Indian VC Industry:

According to an accepted theory, the continuous growth of a country’s gross domestic product (GDP) is catalyzed by creation of new firms which add value. On a comparative note, the contribution from Industry (manufacturing) as a percentage of India’s GDP is smaller compared to the ratios in China or the USA. Considering that India’s GDP is on a growth trajectory, the Industry is expected to grow at a rapid pace.

VCs in India are biased toward technology companies with 68.0% of investments made in this sector. Other sectors include healthcare and education accounting for 9.0% and 7.0% of total investments respectively. Further, majority of technology investments have been attracted by the Internet companies.

Structure of VC Firms:

The two key participants in the Industry value chain are limited partners and general partners. Each participant has a distinguished role in creating value. Limited partners entrust the general partners with their money and general partners assumes responsibility of investment decision-making. Tax incentives play a very critical role as far as the structuring of funds is concerned.

As a compensation for the efforts to manage day-to-day activity of these investments, general partners are normally entitled for 2.0% fixed fee and 20.0% profit sharing structure. To elaborate, the structure can be described as the general partner earns 20.0% of profits exceeding a benchmark return (could even be preferred return of 8.0 percent) for the limited partners. The 2.0% fees is aimed at reimbursing expenses incurred in finding opportunities, travel, salary costs, etc.

Some facts of the Indian VC Industry:

Venkatesh then explained the evolution of a company from a start-up eco system in an economy. The start-up ecosystem has been developing very well in India and the eco-system has transformed rapidly in the last three to four years. The transformation of the Industry over the past few years has been  phenomenal. He said incubators, angel investors and seed investors have developed significantly in recent years, especially so in Bangalore. He highlighted the importance Bangalore has placed from a VC investment perspective, where the city has accounted for about 40.0% of start-ups. Incubators, angel investors and seed investors have formed a support system for new ideas and helped develop the Industry in a very big way.

There were about 1200 to 1300 start-ups in India. Of the 184 exits in the Industry, the technology sector accounted for about 137 of them. From a breakup of the nature of exit, 61.0 percent of exits were strategic sales, 16.0 percent were secondary sales, 12.0 percent initial public offerings and 11.0 percent were buybacks. The average return on data available for analysis is about 5.3 times the initial investment for 67 exits. The frequency of big exits such as makemytrip.com is critical for the health of this ecosystem. Considering the young nature of the Industry, these were promising results.

Describing the timeline of VC funds, Peddi mentioned that the duration of a VC fund is typically about 10 years. Further, the fund has a buffer of two more years to accommodate investments which have not yet been exited. In general, the fund has a period of 3 or 4 years as the ‘deployment period’, the period to allocate all funds and the exit time frame for the fund is set as the 10th year. For investments which the firm does not exit within the 10th year, the general partner usually negotiates with the limited partners for an extension for closure of the fund.

Critical success factors:

Management team was the biggest driver of Venkatesh’s investment decisions. Domain expertise, entrepreneurial leadership background, ability to attract talent, chemistry between the founders, promoter investment in the venture (based on age and other factors), cultural backgrounds, educational background etc. played a big role in his decision making process. Other VC specific criteria such as portfolio composition, fund phase, timeframe of returns, background of partners of the fund, winners from existing portfolio play a crucial factor as well.

Most of the investment decisions are driven by these VC specific factors. Entrepreneurs assessing their inability or ability to attract capital must account for these factors as these factors determine to a large extent where capital flows.

Speaking about valuation, Peddi noted that discounted cash flow was impossible as there usually are no revenues and definitely no cash flows in the investments analyzed by the VCs. On an average he looked at about 130 opportunities before he invested in one and the norm in the Industry was about 100 to 1.

Career in a VC Industry:

Finally Peddi talked about careers in the Industry. Top level executives in a VC firm usually have an entrepreneurial background. The Industry attracted talent with functional expertise, banking background, and most positions at higher levels emphasized access to an already available network. At the junior levels, opportunities largely attracted talents from consulting, banking, domain expertise and start-up expertise in India.

Contributed by: Abhimanyu JL, Hareesh Mothi, CFA and Deepak Mundra, CFA

Photographs by: Abhimanyu JL