How venture capital investors in India manage risk
Academic literature as well as practitioner accounts have identified the two strategic investment approaches of specialization and syndication
Venture capital fund managers, venture capitalists or VCs, for short, are financial intermediaries who use their reputation, knowledge capital and network to source and evaluate risky, yet attractive investment
opportunities, fund them and turn them into great businesses.
They are expected to have the ability to deal with the risk inherent in investing in inexperienced entrepreneurs who are building businesses on which limited information is available. VCs are believed to have the know-how to turn such start-ups into valuable enterprises.
Absent such professional fund managers, entrepreneurs with high potential would be starved of funds. Equally, investors would be denied the opportunity to participate in those high-risk, high-reward enterprises.
How do VCs go about playing this part? Academic literature as well as practitioner accounts have identified two strategic approaches: specialization and syndication.
Specialization means that fund managers focus their investment activity on a small set of industries where they believe they possess deep expertise. Alternatively, they focus on enterprises in a certain phase of growth, such as seed stage, early revenue stage, expansion and so on.
Deep expertise, coupled with sound judgement, enables fund managers to deal with high levels of uncertainty more effectively than a generalist might.
Syndication involves sharing the funding opportunity with other investors. It helps in two ways. One, it limits the risk for the fund manager by reducing the investment exposure per transaction. Second, it brings in complementary expertise available with other members in the syndicate.
Academic discourse would give the impression that these are mutually exclusive approaches that are contrary to each other in nature. Practitioners tend to view the two as being mutually complementary approaches that individual fund managers resort to opportunistically.
In order to understand the extent to which fund managers specialize by industry sector or stage of funding, we analysed data relating to 7,924 transactions, consummated by 205 funds managers that had made at least 10 investments over the past 19-odd years.
Given the limited reliability of the data available, we worked with the number of investments made by fund managers instead of analysing the amount of funding provided.
The data indicates that the concentration of individual sectors in the portfolios of various funds varies a great deal. The maximum concentration in a single sector was as little as 10% of the number of companies in the case of some of the funds, while there were a few funds that had all their investments in one sector. This wide variation might appear to suggest the absence of sectoral specialization.
A closer examination indicates, though, that a third of the fund managers had 40% of their investments concentrated in one single industry and two thirds had 25% of their investments in one sector. Thus, at an aggregate level, the industry does seem to specialize to a fair degree.
It would be reasonable to surmise that given the investment in knowledge capital that is required for specialization, VCs need to have a minimum scale in order to specialize. The data, however, does not indicate such a relationship between the number of investments in the portfolio and the level of sectoral concentration.
On the syndication front, across all the funded enterprises, the average number of investors increases from the first round to the sixth round of funding. It appears that as an enterprise grows and it raises more and more capital, incumbent investors are roping in more co-investors into the syndicate.
At an aggregate level, the Indian industry seems to follow a combination of specialization and syndication. At the same time, many individual funds probably choose one stance over the other consciously.
Given the limited data that the industry shares, one can only reasonably speculate about what drives fund managers’ choice between syndication and specialization.
One, the Indian VC industry invests across a wide spectrum of industrial sectors, unlike its American counterpart. Even our broad classification of industries results in 23 sectors. Second, unlike the larger VC markets where the labour market for fund managers is both broad and deep, talent in the Indian VC industry is still accumulating gradually.
Taken together, it means that the supply of deep expertise to the Indian VC industry is probably limited, both in terms of sectors as well as the stage of evolution of the enterprise. In the absence of expertise, fund managers syndicate.
For the development of a healthy early-stage ecosystem however, the availability of specialized investment capabilities is essential. Given the nature of the risks involved and their need for post-financing support from the investor, syndication cannot be a substitute for mitigating risk in early-stage investments.
Does either of syndication or specialization lead to better portfolio returns over the other approach? That is another question altogether, which cannot be answered with the data presently available. As incurable optimists, these authors believe that ignorance on that front has to be viewed as bliss.
G. Sabarinathan and Shrinitha Thiyagarajan are, respectively, an associate professor at IIM- Bangalore, and a student at NIT Trichy.
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