The Four Stages of Divinity an Investor can Reach

From happenings at the 9th annual summit of the Private Equity & Venture Capital Association of India (PEVCAI) by ASSOCHAM.

There are four stages of divinity an investor can attain in the eyes of an entrepreneur. Right before making that first investment, the investor is God to the entrepreneur. The entrepreneur is waiting with baited breath to have The Mighty Hand bless him with a large warchest.

Once the same investor puts in money he loses a bit of his divinity. God is demoted to a lesser stage of deity hood, maybe a demi god status. If the same investor puts in more money in the same startup, then the entrepreneur considers the investor with even less deference. And at the last stage of divinity, the jig is up. By the time the investor tries to exit the startup, the entrepreneur will be treating God as a mere mortal.

“Do you agree with me?” asked Annurag Batra, chairman and editor-in-chief of BW. PE investor Arvind Malhan, partner at New Silk Route Partners laughed, “It’s either a man-God relationship or on second thought maybe it’s more like a marriage.”

Things start with a honeymoon and then start to sour. Even in the private equity industry. In the last ten years, 120 billion has been invested, about 65 billion dollars has been returned, which is not good enough.

Arvind continued, “To give an overall view of exits, the reality is that PE industry of India has grown tremendously in the last decade. And now it’s an industry which is investing about 15 – 16 billion dollars a year. Before that investment totalled a quarter of that. But it’s still not enough to generate healthy returns to us.

We have seen a large amount of capital raised between 2005 and till the financial crisis in 2007. Subsequently through the last government, when the macro wheels of India slowed down there was a shutdown in the deals that would give us an exit. In 2013 and 2014, we had less than 5 IPOs a year. Post Modi’s election there was a recovery in the IPO market, we had about 21 IPOs in 2015, 25 IPOs in 2016. It’s a significant increase but it’s still far less than what you need for an economy and an asset class our size.

The industry is deploying about 16 billion dollars of capital a year. That’s roughly a 1000 transactions a year. Last year which was the best year for exits, we had about 200 exits happen. So we are doing 5 times more deals than exits. The right benchmark is what companies did we invest in 5 years ago because those are the companies that are making exits today. We were doing 500 – 550 deals. So one in 3 of those companies has exited, but that’s still not enough to give us ROI. 40 percent are thru IPOs. This needs to go up by a factor of 2 or 3. Rest should be strategic sales, PE sales and buybacks as a last resort.”

The poor ROI in the market is one of the biggest challenges PE investors face in the country. Here are more of the sticky points delved into by a gathering of PE movers, shakers and policymakers. 

Ecommerce investors haven’t had successful exits. Why?

Pankaj Makkar, managing director at Bertelsmann India Investments said, India is a hypercompetitive market. We don’t have any entry barriers for companies coming and setting up shop here, I suppose that’s the dark side of increasing the ease of doing business. For any sector, ecommerce, digital media, whichever, we would have roughly about 7 to 8 players in each segment. In telecom we had 14 players at one point.

By virtue of too many players competing for market share even in a fairly large market like India, even if you divide it among 7 to 8 players, the share won’t be large. And that is not good for the investors backing those companies. You will have to do a ‘land grab’ or spend crazy amounts of money discounting goods if you’re an ecommerce business. It’s a wastage of money.

In about 2003, I remember hearing from a fellow investor that we were spending too much money on marketing, that we should be spending this on infrastructure development of the country or the next generation of towers and technology.

That is a beast we have to acknowledge in India. Hypercompetitiveness.

There are certain business models that are winner take all or winner takes most of the market. Now ecommerce is that kind of beast where in most countries only one or two players have won. If 10 people start the race and we know if only 1 or 2 can win, there will be 8 bad exits for every 2 winners.

So investors have to keep in mind that it’s not all the time that investors will be the number one or two player in this rat race. To be honest it’s an investor’s fault, it’s our fault for making such big bets in such a risky market.

Messy entrepreneur – investor battles

Ashley Menezes, partner at ChrysCapital Advisors LLP answered said, Before we decide to invest in an entrepreneur we make sure there is a meeting of minds. Everyone is good to you in good times. Can an entrepreneur be good to you and your agreement in bad times? We have had over 60 exits. We have never had a major dispute with the entrepreneur. And the fact of the matter is the entrepreneur shouldn’t have to go back on the share agreement you sign; if an entrepreneur tries to fight the terms saying “oh that wasn’t my interpretation of the terms”, it’s going to take you 15 years of court cases and we have only 10 years to get returns back to our investors.

Unless there is an alignment of interest at the stage of investing itself, where the entrepreneur thinks of you as your partner, where you are able to add value to the entrepreneur, don’t invest. It’s part of an investor’s responsibility to build a relationship with the entrepreneur where the company can be grown to give more returns than contractually agreed to. I think that kind of relationship will be developed only as the industry grows.

India should really ease up on complicating tax laws for PE exits

Tushar Sachade, partner at PwC India said, "As a fund manager, you play the role of a facilitator. Because you are managing assets of other people. That also means your appetite for risk is near zero. When it comes to India, tax and legal processes for exits is significantly higher in India. The buyer will be extra conservative on terms of the sale and the seller (the party attempting to exit the company) will always try to push for as much as they can get.

These negotiations always get complicated in India because of the legal and policy framework. So it will be conducive for investments and exits in India if the government can provide clear regulations to navigate these exit negotiations. For example, there are many funds today that use Mauritius, if these funds have a tax certificate of indemnification then there is no need for these funds to further present indemnification warranties. Reality is, even today when these funds with the proper certification try to sell, the buyer will still insist that there be an indemnity. Why is there a need to insist for indemnity? Because the buyers and sellers of company equity are not sure that at the ground level of working with tax officers, that the Supreme Court’s decision will be respected or not or whether more demands will be made to comply with.

The government wants to help but investors should be ready for any curveballs

The ambiguity and unpredictability of policymakers were highlighted when Dr Subhash Chandra Pandey, additional secretary and financial advisor, DIPP said, “One of the top priorities of the DIPP is investment promotion, facilitation and hand holding. And to create an investor friendly climate.

To promote startups, we also want to inculcate a culture where all exits do not become barriers to re-entry. And that every case is examined on its merits. So free entry, free exit subject to prudential regulations. And no change of rules of the game. These are some of the essential principles guiding our efforts in easing policy in entries and exits of a business.”

Then later Dr Pandey said, “On the business community’s expectations on taxation on the legal environment, I would like to explain things in a lighter vein. Even if you strike a deal and the environment is at room temperature, don’t expect the environment to be at room temperature when you’re trying to make an exit. Take this environment of taxation and environment as one that can change unexpectedly, due to unforeseen circumstances. The only legitimate expectation is that “I will not be unfairly singled out if and when there might be changes in the environment.””