Bangalore: The economic downturn has affected India’s venture capital (VC) firms because the companies they have invested in are performing below expectation, thus pulling down their internal rate of return (IRR).

Time for pragmatism: Subrata Mitra, partner, Accel Partners. Experts say the internal rate of return may continue to fall for at least another six months as revenue generation for portfolio firms may take more time.

IRR is the average annual rate of return received by investors over the life of their investment. It is a key indicator used in assessing the quality of investments.

VC firms, which typically seek an IRR of 25-30%, managed to garner just 15-20% in the past six-eight months, according to Deepak Srinath, director and co-founder of Viedea Capital Advisors Pvt. Ltd, an investment bank.

This decline, VC firms say, will result in portfolio companies taking an additional 12-18 months to reach revenue targets that trigger exits.

General partners (GPs), or private equity managers, are now under pressure from limited partners (LPs), or those who invest in VC firms, for early exits, even if that means lower returns.

“As many LPs themselves are getting impatient due to lack of venture returns, many are strongly recommending to GPs to opt for an exit in the near term of 6x or 7x (six or seven times of the investment) instead of a longer-term exit at a 10x or 20x," says Mohanjit Jolly, executive director, Draper Fisher Jurvetson India.

Generally, VC investors have an exit horizon of seven-eight years, which could come about either through an initial public offering or strategic sale of stake.

Investors say another problematic issue is that quite a few companies were funded at high valuations. On top of this, some of these had to raise capital during the slowdown in the past year. As a result, expectations of return on investments have fallen significantly.

“Exits getting pushed are a worst case scenario for an investor," says an investment adviser on condition of anonymity, due to company policy on speaking with the media. “LPs can take drastic steps like locking capital, thereby constraining further capital infusion."

Indian companies have also not been as capital-efficient as most VC firms had earlier anticipated, these investors say. Kanwaljit Singh, managing director, Helion Venture Partners, says investors have been forced to recalibrate expectations on the market situation and how a business will turn out.

“Mid-last year, we may have been bullish on something," says Singh. “Today, we are more pragmatic about it." Singh, however, adds that these changes are market-driven and the situation may change. In a muted market, even exit options are limited.

“It is not even clear who potential acquirers may be for some types of companies now, and that may add another dimension to the problem," says Subrata Mitra, partner, Accel Partners. Experts say IRR may continue to fall for at least six more months as revenue generation for portfolio firms may take some more time.

Reviving IRRs is difficult at present, says Viedea Capital’s Srinath. “Early-stage companies are struggling to generate revenues," he says. “It will be very difficult to give such returns." Those looking at late-stage deals are also finding it difficult to make investments as stock prices are up significantly, thus making it difficult to ensure high returns.

“Structured deals could be very interesting in the current market as it is hard to price private deals based on inflated public market multiples," says Sohil Chand, managing director, Norwest Venture Partners India, adding that a structured deal offers the investor good downside protection if the market corrects itself and the promoter makes a neat profit if the market stays at current levels.

However, the challenge in such deals is ensuring due diligence on such listed companies, given the restrictions on access to information not available to the public, he says.