There is just too much money chasing too few quality start ups in India and, whilst Piramal's entry into the VC industry is good news for entrepreneurs, it is not necessarily the best for the investor in VC funds
I was surprised to see the headlines this morning announcing Ajay Piramal’s entry into the Indian Venture Capital industry with a $50 million investment as the lead LP of Montane Ventures. Ajay Piramal is one of India’s most savvy investors and his investing record speaks for itself. Notwithstanding the media frenzy which will invariably follow, I am not too sure if this time his call is not a trifle speculative in nature.
The fund is focussed on early stage investing (Seed and Series A) which is just the right, though crowded, space. Most of the value creation of VC funds is in the Seed and Series A stage and then, to a limited extent, in the Series C stage. The size of the fund too is adequately placed at between $100 million-$150 million range to adequately address the “significant agency costs" linked to such funds. It is a well-documented fact that the diametrically opposite objectives between the GP (the fund sponsor) and the LPs (the investors) in terms of the size of the fund (and therefore recurring percentage based management fees) remains the largest booby trap for the uninitiated investor. But so far so good for Montane Ventures.
The trouble is that the economics of VC investing for a pure play VC fund beyond a certain size simply does not work out and only a few consistently make money.... and that too is a function largely of the sentiment cycle and not necessarily only due to the ability to spot the “next big thing".
Sentiment (read market hype, irrational valuations and excess VC funding) in India, like in technology investing globally, is today at its peak. Valuations are simply at unsustainable levels with promoters/entrepreneurs demanding, and getting, later round investments at stratospheric multiples.....irrespective of the soundness of business models and cash flows. Most consumer facing start ups are using later round funding to literally “buy" customers by offering unsustainable levels of discounts and not by creating robust business models which will stand up to the sharp scrutiny of public markets when VCs eventually exit. Besides, there is just too much money chasing too few quality start ups in India and, whilst this is good news for entrepreneurs, it is not necessarily the best for the investor in VC funds. The likes of DST Global, Sequoia, Tiger Global and Soft Bank with recent lucrative exits and fresh funds are queering the pitch for most VC funds in India.
Let us have a quick look at the basic economics with some real numbers. Helion, Sequoia, etc have funds of an average size of $600 million. At 2% management fees for seven years, that is $84 million of committed expenses. At an average of 20% stake per portfolio company, it would imply a post-money valuation of $3 billion for all portfolio companies in aggregate. Early-stage companies, world wide, have high mortality and research indicates that only 1 in 20 companies convert to a multibagger and returns the value of the entire fund at approximately a 40x multiple. For those with interest in detail, the actual data dispersion is as follows ( 65% : nil, 20% : 1x-3x, 8% : 3x-5x, 7% : >5x ). If the fund is to generate at least the hurdle rate (below which the fund manager makes no carry) of just 10% IRR, it would imply an exit of that one multibagger company at $6 billion valuation! Assuming no dilution post the initial round of financing, this would translate to the fund encashing $1.2 billion @ 20% stake in this winner with a multiple of 40x. How many $6 billion exits or IPOs have we heard of in India? None!
And do remember, at the fund level, this only implies an IRR of 10% over a seven-year period.....without the committed fees of $84 million that the fund manager rakes in irrespective of performance. If this is included, as it should, the IRR reduces to only 9% ! Opportunity for making such returns are easily available in public financial markets (especially in the small to mid cap segment) with full transparency and instant liquidity unlike private, totally illiquid investments in a VC fund of a 7-10 year tenure.
Of course, there will be the occasional Flipkart, Snapdeal etc.... but here too, the “real" value will emerge only one-year post listing. Groupon today quotes at 15% of its IPO price on Nasdaq. And the day is not far when India too will adopt the recent global trends of investors marking down the value of the investments in unlisted portfolio companies. Snapchat and Dropbox have been marked down recently by as much as 25% by Fidelity in the US. Besides, what matters finally is the returns the total fund delivers and not just a handful of the much publicised “winners". The risk of fund managers exiting to start their own fund in between the seven-year period post fund raising (a recent disturbing trend, eg: Helion) is a risk we have not even quantified.
Given this, I find it difficult to justify a VC fund in the environment we are in. I can understand Mr. Piramal and other successful entrepreneurs with deep pockets wanting a play on the exciting start up ecosystem ...... but most prefer to play the evangelist role by selectively investing in specific ideas and mentoring talented founders. Azim Premji, Ratan Tata, N.R. Narayana Murthy, Nandan Nilekani and other visionary corporate leaders have taken this route and refrained from founding a pure play VC fund. I suspect this is only because of the distorted economics of such large funds which has been described in some detail above,
Despite some derisking which Mr. Piramal has done whilst structuring the fund, it would be interesting to watch the outcome of this Piramal venture and only time will tell whether this too is a multibagger investment opportunity he spotted much before most of us. Or did even a seasoned, mature investor like him fall prey to a speculative urge in what is largely a con game from an investor’s perspective?
Prabal Basu Roy is a Sloan Fellow from the London Business School and a Chartered Accountant, the author presently manages a PE fund and has formerly been a director and group chief financial officer in various companies.