A Larger Domestic Capital Pool Is What India Needs
The corrections in 2022 were quite natural and required. However, it also led to the segregation of the mindsets of long-term value creation vs short-term valuation
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The Start-up ecosystems are a pillar of our country's growth and economic development. India has seen rapid growth and development in all aspects. As per reports, India saw a staggering jump in the number of start-ups in just six years, going from 471 in 2016 to more than 84,000 in 2022 recognized by the Government which has reported the creation of more than 8.5 lakh jobs as on November 2022.
The recognized startups are spread across 662 districts of the country with at least one from all 36 States and UTs. Thanks to the start-up India initiatives led by the government and the noteworthy introduction of the AIF regime in 2012, the unprecedented deployment of robust, patient, and high-risk capital into Indian entrepreneurs, our country has minted 107 unicorns (startups with valuations of $1 billion or more) with a total valuation of over $340.79 billion, as of 7 September 2022. Most of these unicorns are in the services sector, which contributes over 50% to India’s GDP. All these figures testify that the start-up ecosystem is one of the most prominent drivers of growth in the Indian economy.
There are some challenges attributable in part to current global macroeconomic conditions, however, I believe, if India’s GDP grows in real terms by 8.0-8.5 per cent per annum for the next 25 years, India will be a 25 trillion economy.
While India celebrated the creation of 107 Unicorns at the end of 2022 and 47 unicorns in the year 2021 alone, we at IvyCap Ventures have always focused on the concept of Dragons (The creation of value in the portfolio companies in such a way that one company itself gives the exit value of more than the entire fund).
When we exited our Fund 1 stake in Purplle last year, creating India’s first Dragon in any Venture capital fund portfolio, we did not have even a single unicorn in our portfolio. This approach has helped us create superior cash returns (not just paper returns) for our investors.
We have been fortunate to receive support from over 25 Indian financial institutions, most of whom have invested across our funds. We have seen the Indian Venture Capital ecosystem evolve from the time we started IvyCap Ventures in 2011 and have contributed to building the Indian VC ecosystem. The Government of India has taken many proactive measures to support the growth of start-ups in India.
The launch of Initiatives such as Startup India and invest India have accelerated support for Indian startups- several programs have been implemented over the years under these initiatives to support entrepreneurs, build a robust start-up ecosystem, and transform India into a country of global job creators rather than just job seekers.
From facilitating access to capital, filings for the protection of intellectual property rights, tax incentives, easing of public procurement, and enabling regulatory reforms to access international fests, all efforts are being made by the Government in supporting the Indian startup ecosystem. The government has also brought in a lot of initiatives to ease out and attract investment to flourish the start-up ecosystem in India, 3rd largest in the world with 100+ unicorns.
To name a few:
o Supporting the reduction of the corporate tax rate from 30% to 22%
o Reducing LTCG for unlisted shares
o Implementing structured AIF regulations in 2013
o Making the positive move toward solving Angel tax issues
o Creating multiple pockets of Fund of Funds to invest in the VCs
All these efforts are helping start-ups in many ways. However, if India wants to achieve its growth targets, there are still huge gaps that the Government should consider at the earliest. There is also a huge need to unleash domestic capital into the start-up by initiating policy initiatives favoring that.
Presently, the taxation system discriminates in favor of investments in public markets rather than private investments. Investors investing in unlisted securities provide necessary risk capital, which is critical for the success of start-ups and companies in their growth phase given their relative inability to access capital markets. One of the issues is that investors see more value in the listed space from a taxation perspective. If we look at countries like the UK, the government provides taxation benefits on investment in unlisted entities. The amount can be offset against your taxed income, why should India not encourage this? Both for the short-term and long-term tax regimes.
While a lot of reforms have been brought into the ecosystem, in order to encourage long-term capital generation, a smooth and frictionless tax environment is needed which is based on the following principles - Consistency, Certainty, and Collections. The tax policy should, therefore, be simple and easy to understand, uniform, and revenue neutral. Accordingly, from domestic risk capital providers’ perspective, it is suggested to take further steps in the reform of the tax framework by introducing uniformity in the taxation of unlisted securities and public market securities. This would bring all financial instruments at par from a tax perspective and ensure that investment allocations are made on the basis of the perception of risk and return rather than being driven by tax outcomes. We recommend that parity should be brought for listed and unlisted securities for domestic investors. We have tabulated below the period of holding to be considered as long-term under the current regime and the proposed recommendation –
We also recommend making changes in the regulations of the fund management structure to ensure India becomes an attractive investment destination. These primarily center around the direct and indirect tax structure and the securities regulation act. The government should look at forming an expert committee to look into these aspects. Have hundreds of professionally managed fund-of-funds attracting institutional capital, which will help mobilise greater capital across the economy.
The start-up economy will benefit domestic capital investment in Indian startups, and the country stands to benefit in multiple ways. Domestic Capital is an important and resilient source that provides high returns to domestic investors and is an important tool of Government policy. At the same time, VC/PE investing can be used to channel funds for diversification providing a safe and well-governed route for funds. VC/PE Industry has provided risk capital of over ₹23 Lakh Crore ($ 311 Bn) since 2015, investing in more than ~4,200 companies. VC/PE Funds provide long-term and high-risk capital to a wide variety of ventures at all stages of their evolution, creating stability and entrepreneurial capability.
Despite headwinds originating from global trade, geopolitical factors, and significant domestic concerns over credit availability and the slowdown in growth, the Indian VC/PE industry has continued to repose its faith in the ‘India story’, investing a record high for the third year in a row. Global VC/PE funds are now earmarking a sizeable share of their capital pie for India, but over 85 per cent of funds earmarked for India are still pooled in overseas jurisdictions. About 60- 70 per cent of FDI comes through private equities. In such a scenario, there is a growing need for increased participation of domestic capital making its way into the Indian startup ecosystem primarily through the venture capital and private equity route to boost innovation and technology-enabled business in the country.
Both the industry and the policymakers have put in a significant effort over the last few years to evolve a regulatory and tax regime that helps AIFs attract more capital for our nation's growth. The continued support from the government with required policy changes for the ecosystem by 2025 will help AIFs make investments of USD 100 Billion into startups and create US $ 1 trillion in value. This will help incubate 100,000 startups and scale around 150 Unicorns. Domestic Capital is an important and resilient source that provides high returns to domestic investors and is an important tool of Government policy. At the same time, VC/PE investing can be used to channel funds for diversification providing a safe and well-governed route for funds.
India needs to promote the local asset management industry and encourage domiciling of funds in India. From the current private capital AUM size of USD 450 bn, private capital AUM should be USD 2 Tn (at least 10% of GDP) by 2047. India needs to create 1-1.5 crore (10-15 million) jobs per year for the next decade to provide gainful employment to its young literate population. Accelerating innovation-driven entrepreneurship and business creation through Start-ups is crucial for large-scale employment generation. There is a need to support their journey into larger enterprises so that substantial benefit accrues to the economy.
Currently, the primary contributors to the overall domestic capital come from individual investors, HNIs, and family offices, though the participation of institutional capital has been quite less. There are much larger capital pools in India, which are yet to be unlocked or tapped into. IvyCap Ventures is the only and the largest venture capital fund that manages over INR 4500 Crores of domestic capital primarily raised from Indian institutions. However, there is a need to make changes in the regulations to encourage these 6 major capital pools 1) Insurance companies 2) Institutions 3) Pension funds 4) Family Offices 5) Corporates 6) individuals.
In India, the biggest success story has been the SIDBI funds of fund for startups, which has created a large number of new fund managers, but also need more growth funds as just venture fund is not enough.
Insurance Companies: From the insurance companies, the amount allocated for private capital is only about 1-1.5%. This limit should be increased to 3 to 5X. We also need to do a long-term alignment with their investment horizon
Pension Funds: In the case of pension funds, broad rules have been framed, at the operational level, Pension Funds still don’t have clarity on how to go about investing in AIFs. They also may not have created the required capabilities to assess such investment opportunities.
Institutions: Large financial institutions in India should be encouraged to channel a proportion of their investible surplus into domestic funds. As per the RBI guidelines, the banks assign a risk weightage of 2.5X in the investment made in PE and VC funds. Banks should be allowed to allocate a minimum of 5-10% of their capital to be invested in AIF I and II. This would bring in the much-needed additional domestic capital for start-up investments.
Family offices: Most of the family offices are looking to make direct investments in startups and are very keen to co-invest in Ventures Capital funds. There is a need for the creation of an enabling structure for the same. There is an opportunity to rationalize the co-investment structures to encourage more family office capital into the start-up ecosystem.
Corporates: Many corporates are setting up their own Venture Capital Funds, accelerators, and M&A teams. While this is a great news for start-ups, there is also an opportunity to channelise their CSR funding into VC funds.
Individual: Currently an individual can invest a minimum ticket size of 1Cr, and there are speculations that this ticket may be increased further to up to 5Cr. Given the experience of investors investing in the start-up ecosystem, there is an opportunity to introduce the investing experience as part of the definition of qualified investors to avoid minimum investment criteria as a roadblock for investments in Venture Capital.
Expectations from 2023
The year 2021 was a boom year from a capital availability perspective for startups. The corrections in 2022 were quite natural and required. However, it also led to the segregation of the mindsets of long-term value creation vs short-term valuation. This process may continue until mid-2023 when we will start seeing the dry powder of over 20Bn dollars starting to get deployed more proactively. While this may cause further stress for 6-8 months for startups that are struggling, it’s a huge opportunity for investors like us, to select the best long-term winner during this time. With that objective, we are looking to deploy a substantial part of our USD 250 million of our fund 3, in 2023.
Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house
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