Bangalore: Early stage venture capital (VC) investors have competition from a new league of investors: social funds. Start-ups are increasingly turning to the half-a-dozen social investors active in the country as their return expectations are lower and investment horizons longer, say VC firms.

Social funds support entrepreneurs who work on ideas that have a social impact and are aimed at improving the lives of the underprivileged.

Do-good policy: Nexus India Capital’s Singhal says start-ups could overstate potential social benefits in order to raise cheaper capital. Abhijit Bhatlekar / Mint

In social investments, which include healthcare, water purification, education, microfinance institutions and other firms working for financial inclusion of the poor, returns are measured on the basis of the impact the offering has on the life of the targeted clientele.

These funds typically seek returns of 8-15% over seven-nine years, while conventional VC firms expect 20-30% in five-seven years. VC firms back companies with strong, finacially viable business ideas and outlook, with expectations of high returns.

“These social funds would make capital cheaper. If you can show some social benefits, you can get cheap capital," says Sandeep Singhal, managing partner at Nexus India Capital, an early stage VC investor. Singhal says the desire to raise cheaper capital could prompt start-ups to overstate the potential social benefits they are capable of creating.

Among social sector investors, Aavishkaar India Micro Venture Capital Fund had the highest number of deals in 2009 with 11 investments. In the VC space, Nexus was the most active investor with seven deals.

Investors who back firms that cater to the poor say their return expectations are based on what a promoter offers on the basis of the firm’s business idea. “Which investor would refuse a company which offers social impact as well as internal rate of returns (IRRs) of 25%?" says Varun Sahni, director, Acumen Fund India, a social investor. “The companies we invest in have low margins...They can’t give IRRs of 30% in three years," he says. “We take all this into consideration."

Investment bankers point to another reason for the increasing preference for social funds. Bangalore-based Viedea Capital Advisors Pvt. Ltd has mandates from an education firm and a clean technology firm for raising funds from social investors.

“The reason they cite is that their business idea will be easier to sell to a social investor," says Deepak Srinath, co-founder of Viedea. “Promoters believe it is easy to convince social investors."

For promoters looking to raise small sums, social investors are a handy alternative.

Baskar Babu, chief executive of Pune-based Suryoday Micro Finance Pvt. Ltd, wants to raise $5 million (Rs22.35 crore) from social investors in his second round of fund raising. “The requirement of $5 million is not big enough to bring typical VC investors. At this stage, we want someone who can stay invested for a longer time," says Babu, who earlier raised capital from Aavishkaar.

Start-ups turn to social funds for their understanding of the business model rather than just cheap capital, says Vineet Rai, chief executive of Aavishkaar Venture Management Services. “Capital is never cheap. It depends on what a company is offering."

Rai says there is vast disparity between the capital requirements of early stage firms and funding supply in India. “We need over 300 $100 million funds in India," he says.