India’s venture capitalists have a new benefactor—the government.

Last Saturday, Prime Minister Narendra Modi announced that the central government would create a fund of funds that would invest in private venture capital funds. Part of a bunch of measures that constitute the action plan for the government’s Start-up India initiative, the fund of funds’ proposed 10,000 crore (about $1.5 billion) corpus will be deployed in tranches of 2,500 crore over a period of four years.

The government’s ambitions of turning limited partner to venture capital funds has drawn sharp criticism from several quarters. The primary gripe is whether it is prudent, even proper, on the part of the government to invest taxpayers’ money in venture capital funds, which will in turn invest in enterprises that carry a high risk of failure.

Incidentally, the idea of a fund of funds isn’t new. Finance minister Arun Jaitley had earmarked 10,000 crore for a fund of funds nearly 18 months ago in the Union Budget 2014-2015. The fund of funds announced on Saturday is a reiteration, rather a repackaging of the July 2014 budget proposal with some clarity on how it will be structured and managed.

The fund of funds will invest in venture capital funds registered with markets regulator Securities and Exchange Board of India (Sebi). This is designed to stimulate the growth of the domestic venture capital industry, which is practically non-existent at present. The country’s venture capital industry, which consists of foreign firms such as Sequoia Capital, Accel Partners and Matrix Partners, and home-grown firms such as Kalaari Capital, Nexus Venture Partners and Helion Venture Partners Llc, currently raise more than 90% of their capital from foreign institutional investors, commonly known as limited partners.

There’s no doubt that it is important to encourage the growth of a domestic venture capital industry that is not overwhelmingly dependent on foreign capital. There are two key reasons. One, firms backed by foreign capital tend to gravitate towards start-ups that replicate business models that have been successful in the US, or in other developing markets. Their limited partners are understandably more comfortable with that strategy. This is why the consumer Internet sector, for instance, gobbled up more than half the venture capital invested here over the past few years. The fund of funds aims to fix that imbalance by specifically investing in funds that will, in turn, invest in sectors such as health, education, manufacturing and agriculture.

Two, the dependence on foreign capital makes firms here vulnerable to the ups and downs of those markets. While the Indian venture capital market is not currently strapped for capital and India remains an attractive investment destination for global limited partners, even a tremor in the US economy or venture capital market could trigger a major upset here.

However, just the creation of a 10,000 crore or $1.5 billion fund of funds will not spur the growth of a local venture capital industry. To begin with, the size of the corpus itself is minuscule in the context of the demand. Remember, the fund of funds will deploy 2,500 crore, or under $400 million, every year. Last year alone, venture capital investments in India stood at about $1.8 billion, according to data compiled by Chennai-based Venture Intelligence.

Then, there’s the matter of actually being allocated funds. The government intends to contribute up to 50% of the stated corpus of a Sebi-registered venture capital fund. But, it will only bring in that 50% after the Sebi-registered fund has already raised commitments from other investors for the balance 50%.

Now, raising the balance 50% would have been simple enough if Sebi-registered venture capital funds had access to a large pool of domestic institutional capital. They don’t. Pension funds are currently not allowed to invest in the asset class. Banks and insurance companies are allowed to but their investment limits are capped at 10% of the overall corpus of a Sebi-registered venture capital fund.

The only sources of domestic capital currently available to venture capital funds are HNIs (high net-worth individuals) and family offices. Neither is incentivised enough, through tax concessions, to put meaningful money into play in venture capital funds. Domestic venture capital funds, therefore, have no option but to raise capital from overseas investors. Even that is not easy because of a complex regulatory framework. As a result, most domestic venture capital funds have to adopt a dual fund structure (in which capital raised from foreign investors is parked in a separate offshore fund).

The government, to be fair, is looking into these issues. An advisory panel set up by Sebi and led by Infosys founder N.R. Narayana Murthy has just submitted a report suggesting reforms to make the fund-raising environment for venture capital funds more conducive.

Until that happens, however, the launch of the fund of funds at this juncture is more a case of putting the cart before the horse.

And, it certainly isn’t the most efficient use of taxpayers’ money.

Snigdha Sengupta is a freelance journalist in Mumbai and founder of StartupCentral. She contributes stories on private equity and venture capital to Mint.

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