Past imperfect, future tense

In an attempt to adapt to the changing economic scenario, venture capitalists (VCs) have modified investment policies to make fewer investments, and even there, in late-stage and profitable companies. But all this has come at a cost. VCs are now being labelled risk-averse ‘fund managers’ and the industry is being written off as ‘virtually dead’ and non-existent. What is the Indian VC really up to? Deepika Janardhan finds out

There is serious money to be made in sectors like pharma and retail, says pravin gandhi

Pravin Gandhi doesn’t seem to like the term ‘risk-averse’. The director of Infinity Ventures, one of the earliest venture funds in India, which also figured in Forbes’ list of 50 VC firms worldwide ‘that have been particularly active in the past year’, would probably prefer to substitute the term with risk distribution. “You can’t ask a VC to jump off the fifth floor and then call him risk-averse because he’s afraid to jump. Investing in a start-up today while having to meet investor expectations is not feasible.”

Gandhi speaks for several other Indian VCs who’ve burnt their fingers in the tech meltdown and are now trying to alleviate the risks involved in the investment business.

The dot-com boom and concomitant bust is a textbook example of how venture capitalists (VCs) worldwide foundered, subsequent to investors blindly pouring money into venture capital funds hoping to reap quick returns. While very few investors have actually made money, several others have shut shop. Some wait for the US economy to pick up and an intrepid few continue to invest.

However, this wasn’t what VCs had in mind when they launched new funds in the late 90s, when they were just opening up to the potential that was India. Impressed by India’s software services prowess, global funds pumped millions of dollars into the industry in the first few years. The Indian Venture Capital Association’s (IVCA) estimate of VC fund commitments is said to be $5 billion. Investor confidence was infectious and the business of venture capital caught on in India.

The number of new VC funds launched shot up from nine in 1999 to 45 in 2000 (Source: Indian Venture Capital Yearbook). VC investments grew from $20 million up to 1996 to $150 million in 1998. Investments peaked in 2000 at $750 million, but the downfall was becoming evident when investments declined to $409.5 million in 2002.

However, the picture seems to have brightened a bit. Come 2003, VC investments are already said to have touched $400 million and are expected to touch $650 to $700 million by the year-end.

The new VC

The economic slowdown has forced many a VC to take a few investment lessons, even if it has been at the cost of entrepreneurs. “The Indian VC has got smarter. Across the board, VCs are laying down stringent timelines for RoI. While the Indian VC earlier played the role of ‘follow the leader’ to their counterparts in the West, now a lot more diligence is involved,” says Sunil Purushe, CEO of angel-funded Myzus Technologies. While everyone earlier was all for investing in early-stage companies at abnormal valuations, today they look for revenue visibility. VCs now want to see a customer list with reputed names on it. Valuations have become more realistic and historical methods of determining a company’s value, like the company’s critical achievements, have come back into the picture.

But in their attempt to recoup investments, are VCs trying to dodge the risk factor involved while investing in a company? In an article that appeared in Fast Company, Daniel L Burnstein, managing partner at Millennium Technology Ventures, calls this trend a shift in the venture capital paradigm—where VCs prefer to invest in fewer companies, in later stages, in new sectors, and in companies that are profitable from the start. According to him, the portfolio approach that VCs followed earlier (where if a firm makes 10 investments, and one of these is a success but the rest fail, the profitable one will take care of the nine losses) does not work anymore.

Sector-wise distribution of VC/private-equity investments in 2002-2003

Instead, what is happening now is that VCs prefer to make fewer investments or just try to salvage existing investments.

While VCs are allowed the defence that they need to find worthwhile companies to invest in, many are questioning this emergence of the so-called ‘risk-averse’ venture capitalists.

Says Harish Tibrewala, president of Homeindia.com, an online retailing company that has chosen to stretch existing funding until new funds are brought in, “In India, we have just borrowed the term venture capital. What we have here are fund managers managing money that big international banks have put aside to invest in companies that are profitable.”

Angel investor Mahesh Murthy scoffs at the lack of venture funds willing to invest risk capital in start-ups, but adds, “This is not necessarily a bad thing. To be a venture capitalist, one must have operational and management experience—very few Indian VCs had this. Most come from a financial background and are hence only able to add value at a pre-IPO or during-IPO stage—so, the right people have migrated to the right levels. There is a gap at the start-up funding stage, and it is slowly being filled by individual investors with operational experience who are performing the roles that VCs traditionally do.”

VCs, a.k.a private equity players

Take a glance at VC investments in the last couple of years and you know what makes the entrepreneur community in India an unhappy lot. Take, for instance, funds raised in 2001, when India ranked as the third most active VC market in the Asia Pacific region (excluding Japan) with investments of $937.03 million. Almost half of this amount was allocated to telecommunications service provider Bharti Tele-Ventures, which garnered a whopping $460 million. In 2002, India stood second in the Asia-Pacific region, fetching $409.5 million in volume, that is 22 percent of the total of $1.9 billion, according to data collected by Thomson Venture Economics. Here again, of the $409.5 million, it was Patni Computer Systems that soaked up $107 million from General Atlantic Partners and GE Asia Pacific Technology Fund.

There is a future for the Indian VC industry, but it will take some time to establish a significant presence, says Ash lilani

While the investment scenario is picking up—albeit tardily—the fall in start-up investments is worrying industry observers, because it slows down the creation of new entrepreneurs. While you would still find an odd BPO start-up with some takers, the chances of a product company clocking a good deal is unheard of in this scenario. Says Purushe, “It’s never been tougher to convince the investor that an unexplored business potential is worth tapping into. Investors are more likely to invest in an already implemented and successfully running business model, despite the promoter being financially involved.”

“Entrepreneurs are realising that the Indian VC movement is in advanced coma, if not early rigor mortis. They know there is little or no money out there—and are already willing to bootstrap their plans and start off with little or no funding, instead of waiting for a cheque to hit the bank before they start any work,” says Murthy.

VCs, at their end, have realised that starting a company involves far too much risk than helping a company grow. And until a time when they start yielding substantial RoI from existing companies, which would cover any risk that a start-up may bring in, you can expect the trend of low investments in early-stage companies to continue.

And that could take quite some time. But Indian Venture Capital Association (IVCA) president Saurabh Srivastava does not find any reason to panic: “Many VC funds have burnt their fingers by their exuberance in funding early-stage companies without a mature management or a decent business plan. Predictably, they are now adopting this approach, which has swung the other way to extreme caution. The pendulum will swing back to the middle over the next 12 to 18 months. There is nothing unusual about this. This has happened before and will happen again.”

Q3 results this year corroborate Srivastava’s confidence. Early-stage investments made a comeback with two Chennai-based healthcare BPO services firms—Rev IT Systems and Secova eServices—raising around $2 million each.

BPO continues as front-runner

In the meantime, though one can find the willingness to invest once again, the most prevalent deals are private equity or BPO and non-IT sectors.

VCs welcome companies in software services and BPO almost exclusively because these are companies that already have significant revenue traction or come with impeccable corporate parentage and therefore provide higher returns, and involve lesser risk. Moreover, the possibility of acquisitions by larger companies provides good exit routes.

Accordingly, BPO companies garnered $103 million in 2002 and $120 million in 2003. Of the few VC funds that have made money, most had invested in BPOs. For instance, Chrysalis from Spectramind and Transworld, e-Ventures from Customer Asset. (Wipro acquired Spectramind and Customer Asset was acquired by ICICI OneSource)

Mahesh Murthy hopes US VC-funded companies will bring a new level of experienced venture capitalist to Indian shores

And while investors—in their search for fail-safe investment sectors—continue to invest in BPOs, many fear that product and technology companies are being bypassed.

“A BPO start-up getting funds today is still a possibility (especially if it’s backed by a rich existing Indian group), but if you’re a product company starting in India today, it will be almost impossible for you to get funds in today’s scenario,” says Ravi Lekhrajani, vice president at IDEA.

Says Kumar Shiralagi, director, Strategic Investments, Intel Capital-South Asia, “BPO is a very attractive proposition for VCs from a risk perspective. On the plus side, BPOs are bringing in a lot of investors to India, thereby creating a positive investor ecosystem, but on the negative side, it does take away bandwidth from product companies.”

But it’s not that VC funds have lost their appetite for technology. Shiralagi notes that many Indian and US VCs have approached Intel Capital, which decided to continue to focus on early-stage technology companies, and expressed interest in investing in tech and product companies.

Non-IT sectors and cross-border deals

Having realised the risks involved in putting all their eggs into the IT basket, neophyte VCs are sizing up non-IT sectors like FMCG, media and entertainment. Check out Indian VC investments in the latest quarter. According to reports collated by TSJ Media, as much as $180 million was invested in the period from July to September 2003. Non-IT sectors like food and media garnered almost $99.1 million and the rest of the investments found their way into

BPO companies. “The July-September quarter marked a significant departure from the trends observed in the past several quarters. The Warburg-Radhakrishna Foodland, ICICI Venture-Tata Infomedia, StanChart-NDTV deals, and CDC’s buyout of the Punjab government’s stake in Punjab Tractors, showed the willingness of private equity funds to look beyond the IT and BPO services sectors,” says Arun Natarajan, editor, TSJ Media. While the StanChart-NDTV deal didn’t really take off due to regulatory issues, it does point to the growing preoccupation in media companies.

Says Gandhi of Infinity Ventures: “There is serious money to be made in sectors like pharma and retail, among others. That’ll be the message at TiEcon this year.” The investor is also excited about the fact that TiEcon 2003 will see a number of international investors coming to India to explore investment opportunities. Gandhi also hopes that besides TiEcon, the retreat organised by TiE Silicon Valley at Goa for charter members from across the world, will be a potent platform for exchange of ideas and opportunities.

Since the market for Indian IT companies is still outside India, as it does not offer a large enough market, cross-border deals appear more attractive. Avenues for exit in the Indian market are also fewer and far between as opposed to the global market. “India is not the most attractive market at this point for a large number of investors. But there are sophisticated investors who appreciate the underlying value creation possibilities out of India. These funds are typically seeking out cross-border plays similar to the larger international private equity players,” says Sanjay Anandram of Jumpstartup. Firms like Jumpstartup and Westbridge Capital Partners are looked at as survivors in the cross-border VC arena that are doing very well and have a promising future.

But what about the future of tech start-ups? Entrepreneurs might also be steamed up about most VCs running away from domestic ventures while scampering for cross-border companies. But Murthy is optimistic: “The blind trend-followers are staying home. To me, an entrepreneur starting off in a down market is always more credible than somebody trying to make the leap when the going is good.”

And until a time when VCs loosen their belts for early-stage start-ups, entrepreneurs—like Tibrewala, who got funding from a group of high net worth individuals—might end up exploring other avenues for funds, like banks, instead of approaching VCs. Besides, start-ups could also do well by making pitches to domestic venture funds, like Sidbi Ventures, which continues to invest in small and medium enterprises (SMEs).

Future prospects

In the meanwhile, we can only wait for the economy to pick up. “Though the Asia-Pacific market has been categorised as one of the high opportunity, high growth markets in the world, it is usually one of the first to be hit by a US slowdown,” says Madhurima Das of PriceWaterhouseCoopers. Understandably, most VCs we spoke to expect the VC market to recover only when the US markets start looking up, which could be anytime around 2005.

Entrepreneurs and VCs alike could also come up with innovative themes for funding. Gandhi suggests lower dependency on the US by starting to explore non-US countries for opportunities, such as China and Europe. “Investors could investigate ventures that capitalise on China’s hardware competency along with India’s competency in software.”

The improved secondary market sentiment [the Sensex has already breached the 5000 mark]—subject to there being no longer term correction—could well result in a few significantly profitable exits (e.g. BPO companies, larger privately held software services companies being acquired or possibly going public) that could lead to VCs investing more aggressively and to new funds being raised, remarks one industry analyst.

This could also lead to VCs looking at sectors that are in dire need of funding and guidance, like media, entertainment, and Internet and communication technologies. Says Murthy, “I believe the power of the Internet has been growing through these supposed ‘bust’ years, and the opportunities to create a globally impactful business are riper than ever before. Consumers and enterprises are spending more money online. The Internet is back—if only people would notice.”

Conclusion

VCs in India and worldwide, in an attempt to please investors or for fear of failure, seem to have forgotten what venture capital means—wealth available for investment in new or speculative enterprises. Hopefully, organisations like TiE and international institutions like the Silicon Valley Bank could help speed the process of establishing and conducting global business through their connections. “In time, this activity will translate into broader pick-up in the industry, but it will take time,” says Ash Lilani of Silicon Valley Bank.

deepika@expresscomputeronline.com