Investment banks enter startup funding space to diversify revenue streams

Bengaluru: New-economy boutique investment banks want the best of both the worlds when it comes to startups - advising them on raising funds while also investing in them. They are increasingly setting up micro-venture capital funds to diversify their revenue streams and capitalise on the rise in opportunities across various stages in startup funding to offset the seasonal nature of their advisory businesses.

Investment banks that have ventured into funding in recent years include Sprout Capital, Merisis Advisors and Dexter Ventures. Tech-focused IndigoEdge is looking to launch a $40-50 million fund to invest in 8-10 late-stage startups, two people familiar with the matter toldMint. IndigoEdge declined to comment.

One potential area for boutique investment banks lies in holders of employee stock option plans (ESOP) and early angel investors seeking to cash out.

“IndigoEdge's investment thesis is based on the fact that there are multiple small secondary blocks owing to ESOP holders and angels looking to gain liquidity. This does not interest large investors, and the founders do not want to go to wealth firms, thereby presenting an interesting opportunity," one of the people cited earlier said. “It is a function of knowing the company intimately, solving a problem for the founder with a potential for value creation to create a win-win for all concerned."

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Avendus was among the first funds to identify such an opportunity. It started as an investment bank and eventually stepped into funding to become a full-fledged financial services company. Besides its funding vehicle, it has a lending arm.

While boutique investment banks are able to widen their revenue streams, it also opens up more avenues for startups to raise funds with smaller cheques. However, venture capital and private equity firms are still the dominant investors in the space and boutique investment banks only come in on a smaller scale to help close a funding round.

Conflicts of interest

Bankers have noted that real value unlocking happens by staying invested in a company as its valuation compounds over time. This becomes even more significant when the company has raised capital and is advised by the same entity. However, such moves may come with limitations including potential conflicts of interest that need to be taken care of before advising and investing, especially in the same company.

Avendus, which recently advised Lenskart’s investors on a $200 million secondary round, is also an investor in the eyewear retailer through its investment arm Future Leaders Fund. With other similar examples in its portfolio, the fund takes a minority stake in companies with an average cheque size ranging from $10 million to $30 million, and typically targets sectors such as digital technologies, consumption, and financial services.

In such cases, the investment banks ensure that all legal disclosures are in place. To be sure, this trend is more common globally and even established Indian advisory banks such as IIFL and Kotak operate in both these areas.

This has now percolated to the smaller investment banks, which want to invest in some of the most valued companies that they have also advised. The logic is simple – the service offered by an investment bank complements that of a fund manager. Investment banks helping startups to raise funds at the right valuation face the same risks and carry out the same due diligence processes as the investors getting on board.

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“Essentially, an investment bank (IB) functions similarly to a venture capital firm during the preliminary stages of a deal. Given that both involve comparable time commitments, opportunity costs, and due diligence processes, it makes sense for the IB to invest as well to capitalise on future gains from the business," said Sumir Verma, founder and managing director of Merisis Advisors.

Merisis launched its Merisis Opportunities Fund in 2022, nearly a decade after establishing its investment banking unit. With a ₹100 crore fund, Merisis aims to execute 10-15 deals and exit some investments before raising its next fund early next year, projected in the range of ₹400-500 crore.

It has also invested in certain companies through its funding arm, with the investment banking mandate handled by its advisory team, but only at the point of deal closure. This approach allows Mersis to enter at the same valuation as other incoming investors and it serves two purposes: it reassures both incoming investors and founders that the banker shares the same valuation perspective, and it mitigates potential conflicts of interest for the fund's limited partners, who might feel uneasy if the firm invested earlier to secure a mandate.

Merisis’ first investment was in the Series A round of $6 million in Beato in 2022, which increased 2.5 times in 11 months with the Series B round of $33 million. Both the IB deals were run by Merisis. Its most recent investment was in Eggoz, which is not an IB mandate.

Many investment banks have already been investing in companies through their balance sheets for quite some time now. But setting up a fund is more of a formalisation of the process as they have a more predictable deal flow. These banks have benefited from the abundance of deals that came their way during the peak funding years of the pandemic, when capital was more freely available and created higher demand for their services.

Seasonal advisory role

Since then, funding levels have subsided as only companies with a demonstrated path to profitability have attracted investor interest. As a result, the advisory business became more seasonal. However, the advisory unit gives bankers a perspective into where growth and late-stage investors are looking to invest.

“We set up an early-stage fund to potentially identify early winners in the sectors we were advising (consumer and tech)," said Sunil Jain, who founded Sprout Capital in 2012.

Five years later, Sprout set up its micro-VC fund to invest about $100,000-500,000 in startups.

“Another incentive for IBs to set up a fund business is to build a fund-based income stream in addition to a fee-based income (advisory)," Jain added.

Also Read: Funding winter for startups likely to thaw this year

Dexter is also an investment bank with its own fund. While it typically advises through Dexter Capital and funds early-stage companies via Dexter Ventures, it has a thumb rule to never lead a funding round through its investing arm if it is also being advised by them.

It advised D2C startup The Pant Project and also invested in the company in June. Dexter’s funding arm, which came about seven years after the investment banking unit was founded in 2013, invests as a syndicate with Lets Venture and Anglelist.

Much like the others, Sprout and Dexter have separate teams that supervise the two divisions to avoid potential conflicts of interest. However, Sprout’s advisory service deals with companies from Series B and beyond, while the fund is focused on the seed to Series A stages of companies. Sprout has invested in companies including Pixis, Ripplr, advantageClub, while it has advised Ocean Beverages (Series B), Fashor (Series A) and Eggoz (Series B).

As the overall ecosystem matures, Merisis’ Verma anticipates an increasing trend of investment banks establishing their own funds, given the natural synergies between these two spaces.