'Enough time for venture and PE firms to adapt to GAAR'

Mahendra Swaroop, President of Indian Private Equity and Venture Capital Association, or IVCA, in an interview with BT's Taslima Khan speaks on the importance of venture funding, the challenges of dealing with startups and how the industry would be affected by GAAR.

How important is venture funding for an economy like India?
I think venture funding is extremely critical to kick-start any economy, not just emerging economies. It is the risk capital which seeds or encourages entrepreneurship. It is the only source of capital to support innovation apart from borrowings from friends and relatives which anyway is debt. The other source of debt is from banks which will never be forthcoming to fund new and innovative ideas.

Venture capital creates new industries. [If venture capital] hadn't been around, there would be no IT or telecom story in this country, especially IT. The entire internet industry exists today only because of VC funding.

Take us through the story of venture funding in India over the past 10 years?
India has attracted a lot of capital because the India story was hot.  You couldn't ignore India and people put in money. But the entrepreneurial ecosystem was not mature enough to absorb this amount of capital that fast. So between 2005-09, there was too much capital chasing too few deals. Today the industry has more than $200 billion as assets under management and for the last 10 years we have grown by 20 to 25 per cent. But India has the ability to absorb a whole lot more capital. The sad thing is that the ecosystem for absorbing this kind of high risk capital doesn't exist. There aren't enough entrepreneurs who have the knowledge of approaching this asset class. It is largely the tech and internet-based entrepreneurs who have the know-how to access us.
 
Future growth will depend on how the economy behaves. If the economy continues in the present shape, this growth will definitely slow down.

Is venture funding going predominantly into technology startups?
Very little actually. It is a complete myth that a majority of venture funding goes into tech ventures in India. Most of the funding actually goes into manufacturing and services like logistics, food processing and consumer facing industries like quick service restaurants. It is only that the media gets more excited to talk about tech ventures.  Tech ventures getting funding is a good story but a Haldiram getting funded is not. Risk capital is going in huge amounts in healthcare, education, clean technology and biosciences. If you look at the 2500 ventures that have been funded so far, the number of deals is balanced across all sectors. It could be higher in other sectors such as infrastructure because the ticket size is much bigger.

Most tech entrepreneurs are expats who have come back to India to start a venture. They have seen a similar model working elsewhere and want to bring it to India. So the comfort of an investor in putting in quick money into these ventures is there, because there is a certain model working elsewhere.  

But as far as manufacturing is concerned, creating a product and creating a market for the product is quite long drawn. These ventures need much more patience and handholding as opposed to an internet entrepreneur.

After ecommerce which sectors are going to be the next hot sectors?
It is very difficult to say which one will be the next hot sector. We are not a developed economy where demand and supply is satiated. In any sector you look at, India is underserviced. We have huge demand for any service.  But where opportunities are not an issue in this country, the issue is with availability with good entrepreneurs who can spot them and out put up an idea together to exploit it.

How many startups are seen by venture capitalists and how many actually get funded?
If you look at all early stage funding opportunities all funds collectively look at, it may run into several thousands. Any fund would look at 600-750 or a thousand-odd proposals a year. But the funding rate is actually very low. Maybe one in a thousand gets funded.

One reason is that, all sorts of proposals land up on your table, not all of them are bad but most of them are not in the areas that you want to focus on. The industry and the entrepreneur need to learn how to connect. In the US and more mature economies, the entrepreneur does a lot of research before he approaches an investor - what kind of ventures he has funded, his track record, expertise etc.

What are the challenges in dealing with startups?
There is no dearth of ideas. The Indian mind is as fertile or as quick in generating brilliant ideas. But what is lacking is the ability to execute and continuing passion about what they believe in. They get fatigued very fast. The problem with early stage Indian entrepreneurs is that they over- promise and under-deliver. Venture capital puts in money on future earnings and your growth is being tracked on a quarter-to-quarter or yearly basis. Even a positive or negative growth by 10 to 15 or 20 per cent is okay. But you cannot underperform by 30 to 40 or 50 per cent.

Are Indian entrepreneurs too skeptical about parting with equity?
Control is not the issue for a passionate entrepreneur. It is about creating wealth for the society at large rather than for himself. Seeing his venture grow is a bigger passion for him than his wealth growing. Even big ones that I have known won't mind owning 15 per cent of a billion dollar company. VCs love to support such passionate people.  A genuine entrepreneur who is passionate about his venture will part with equity. But that is a challenge because a traditional business house in the country believes in control. It is because they believe that their enterprise has to be inherited by family.

How have Indian startups been faring in terms of generating returns for your Limited Partners?
It has been a challenge. Some of the businesses have grown but they have not reached a scale where they are exit ready.  Intrinsically, the business could be valuable but the market is not putting that kind of value into the business because of macroeconomic issues. Exits get governed by the intrinsic value that you create but encashing that exit has to have extremely favourable and enabling macroeconomic situations. So most of the funds are maturing or are in an exit mode at the wrong time.

The tragedy of Indian venture capital has been that they came in when the industry was not mature - that is the microeconomic conditions were unfavourable, and exits are coming in when the macroeconomic situations are unfavourable.

But on an average I will say that venture capital deals have seen early teen or early double-digit returns. Some of the big ticket investments ranging from 20 to 30 million dollars are giving and will continue to give very good returns. But the smaller investments ranging from three to four million dollars won't give returns if these ventures haven't been able to raise a second round. In that case they will have to be written off.  

Can we compare China and India in terms of returns?
I think we are at a stage where we should not compare China with India. Whereas returns in China are in on the higher 20s, we are in the lower 10s.

Will GAAR impact venture investments?
It would have impacted venture investments, if it were implemented immediately. But now that it has been deferred by a year, there is enough time for venture and private equity firms to adapt to the requirements of GAAR.  I don't think GAAR is a bad thing to have. All countries have it and I don't think that venture capital or private equity ever want to avoid tax.

What was the whole confusion about?
The problem was that GAAR provisions surprised everyone.  Limited Partners raise money on certain assumptions, say, for example, a certain fiscal environment they will be investing in. You can't change that environment or the rules of the game midway. The industry was not opposed to GAAR but was not prepared for it. We were also concerned that GAAR should not override an already existing treaty. If there is a treaty between Mauritius and India, no one can override that. GAAR was trying to override certain treaty arrangements between various jurisdictions. Now they have clarified that they will not override the treaty, and also now you have an year's time to adapt to the conditions posed by GAAR, there should be material presence in the jurisdiction you are operating in, your books should be maintained there, your board meetings should happen there, your accountant should be resident there. We are all fine with this.

What kind of transactions can be put to GAAR?
If you are investing in any venture here, the money is foreign. We source the money from foreign entities or LPs pooled overseas in a jurisdiction like Mauritius or Singapore. So it is a foreign company investing in an Indian asset. When they exit the venture, that exit or transaction happens abroad. So it is an Indian asset being sold or traded abroad. Hence it is covered under GAAR. So the selling of shares of the company which happens abroad will be subjected to GAAR. These exit transactions can be put to 20 per cent capital gains tax; they can also treat it as income. The Indo-Mauritius treaty does not allow for this taxation and so it cannot be taxed.

Do investors still believe in the India story?
I am a firm believer in the fact that the India story is not dead. No one can deny that we are still growing at six and half per cent, whereas the US and Europe are growing at low single digits. Pecking orders may change one year and may catch up next year. So allocations may go up to Brazil or Russia or Indonesia, but how much capital can these countries absorb as opposed to India? India will come back again and again.

Confusion in legislation is good for the long term. At least it is debated. It's not like China that a regulation comes in and you just have to abide by it. Our experience at IVCA has been extremely good. The government has been extremely open minded and understanding.  We are a new asset class and they don't know how the whole ecosystem operates. But we spoke to them on how we support innovation, what are our expectations of returns, we sit on the boards, we want our returns only at the end of five to seven years, we are willing to write off. We are not like a nationalised bank that we ask the entrepreneur's mother or father to become guarantors. We take more risk than the entrepreneur takes actually. If the venture loses, the entrepreneur probably loses three years of his life. But we may lose 30 million dollars as well. Our track record gets affected and I cannot go back to LPs and raise another round.

What is the way forward for venture capital in India?
There has to be a drastic change in mindset of [graduates] from IITs and IIMs - from aspiring to become employees to becoming employers. There is a very slow change happening which is much slower than the availability of capital. If you wanted to start off in the 70s or 80s, there were no funds available. But now there is no dearth of capital. There is a dearth of entrepreneurs.