When Ajay Piramal enters the VC world

I was surprised to see the headlines announcing Ajay Piramal’s entry into the Indian venture capital industry, with a $50 million investment as the lead limited partner (LP, an investor) of Montane Ventures. Ajay Piramal is one the country’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 focused in early stage investing (Seed and Series A) which is just the right, though a 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 and $150 million, which will adequately address “significant agency costs” linked to such funds. It is well documented that the diametrically opposite objectives between the GP (the fund sponsor ) and the LPs (the investors) in terms of size of the fund (and therefore recurring percentage-based management fees) remains the largest booby trap for the uninitiated investor.

Not a great idea The trouble is that the economics of VC investing for a pure play VC fund simply does not work out and it is only a very few funds which 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”.

In terms of sentiment (read hype), India is today at a peak. Valuations are at unsustainable levels with promoters and entrepreneurs demanding — and getting — later round investments at stratospheric multiples, irrespective of the soundness of business models and cash flows. Most consumer-facing startups are using later-round funding to literally buy customers 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 startups in India and while 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 very lucrative exits recently and fresh funds, are queering the pitch for most VC funds in India.

The economics behind it Let us have a quick look at the basic economics with some real numbers. Helios, Sequoia, etc., have funds of an average size of $600 million. At 2 per cent, management fees for seven years — $84 million of committed expenses.

At an average of 20 per cent stake per portfolio company, it would imply a post money valuation of $ 3billion for all portfolio companies in aggregate.

Early stage companies worldwide have high mortality, and research indicates that only one in 20 companies translates to a multi bagger and returns the value of the entire fund at approximately a 40x multiple.

If the fund is to generate at least the hurdle rate (below which the fund manager makes no carry) of just 10 per cent internal rate of return or IRR, it would imply an exit of that one multi bagger company at $6 billion valuation!

Assuming no dilution after the initial round of financing, this would translate to the fund encashing $1.2 billion at 20 per cent 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 per cent 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 per cent.

Tough times The opportunity for making such returns is easily available in public financial markets 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 a year after listing. And what matters is what the total fund delivers and not just the handful of much publicised “winners”.

The risk of fund managers exiting to start their own fund in between the 7-year period after fund raising (a recent disturbing trend, eg: Helios) is a risk we have not even quantified. Given this, one finds it difficult to justify a VC fund in the current environment.

One can understand Piramal and other successful entrepreneurs with deep pockets wanting a play on the exciting startup eco system, but most people prefer to play the evangelist role by selectively investing in specific ideas and mentoring talented founders.

Azim Premji, Ratan Tata, NR Narayana Murthy, Nandan Nilekani and other visionary corporate leaders have taken this route and refrained from founding a pure play VC fund.

Those who have, like NS Raghavan (Infosys founder ) are in the process of winding up the funds (eg: Ojas Ventures). I suspect this is only because of the distorted economics of such funds.

Despite some derisking that Piramal has done in the structure of the fund, it would be interesting to watch the outcome of this venture and only time will tell whether this too is a multi bagger investment opportunity he spotted much before most of us.

Or did even a seasoned, mature investor like him fall prey to a speculative urge?

The writer is a Sloan Fellow from the London Business School. He also manages a PE fund

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