introduction to venture capital 5th

8/10/2019 Introduction to Venture Capital 5th

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INTRODUCTION TO VENTURE CAPITAL

Venture Capital is a form of "risk capital". In other words, capital that is invested in a project (in thiscase - a business) where there is a substantial element of risk relating to the future creation of profitsand cash flows. Risk capital is invested as shares (equity) rather than as a loan and the investor requiresa higher rate of return" to compensate him for his risk.

The main sources of venture capital in the UK are venture capital firms and "business angels" - privateinvestors. Separate Tutor2u revision notes cover the operation of business angels. In these notes, weprincipally focus on venture capital firms. However, it should be pointed out the attributes that bothventure capital firms and business angels look for in potential investments are often very similar.

WHAT IS VENTURE CAPITAL?

Venture capital is equity financing provided by institutional investors that either manage a fund onbehalf of large institutions (usually pension funds and insurance companies) or have their ownproprietary pool of capital. Venture capital is raised in a series of stages or rounds. Venture capitalinvestors usually specialize in one specific investment stage. Each stage also has its own unique set of

parameters with respect to the: Operational progress that a potential investment needs to demonstrate Amount of capital a fund might invest in a given venture Investment time horizon (i.e., how longbefore the investor expects to get its money back) Investor return expectations (i.e., how much of the company will the investor expect to satisfy their

return requirements.

CONCEPT OF VENTURE CAPITAL

The terms venture capital comprises of two words that is, Venture and Capital. Venture is a

course of proceeding the outcomes of which is uncertain but to which is attended the risk or danger of

Loss. Capital means recourses to start an enterprise. To connote the risk and adventure of such afund, the generic name Venture Capital was coined.

Venture capital is considered as financing of high technology based enterprises. It is said that Venture

capital involves investment in new or relatively untried technology, initiated by relatively new and

professionally or technically qualified entrepreneurs with inadequate funds. The conventional

financiers, unlike Venture capital mainly finance proven technologies and established markets.

However, high technology need not be prerequisite for venture capital.

Venture capital has also been described as unsecured risk financing. The relatively high risk of

Venture capital is compensated by the possibility of high return usually through substantial capital

gains in terms. Venture capital is broader sense is not solely an injection of funds in to a new firms, it is

also an input of skills needed to set up the firms, design its marketing strategy, organize and manage it.

Thus it is a long term association with successive stages of companys development under highly risky

investment condition with distinctive type of financing appropriate to each stage of development.

Investors join the entrepreneurs as co-partner and support the project with finance and business skill to

exploit the market opportunities.


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Venture capital is not a passive finance. It may be at any stage of business/production cycle, that is

startup, expansion or to improve a product or process, which are associated with both risk and reward.

Thee Venture capital gains through appreciation in the value of such investment when the new

technology succeeds. Thus the primary return sought by the investor is essentially capital gain rather

than steady interest income or dividend yield.

MEANING OFVENTURE CAPITAL & PRIVATE EQUITY

Venture Capital/Private Equity; provides long-term, committed share capital, to help unquotedcompanies grow and succeed. If you are looking to start up, expand, buy into a business, buy out adivision of your parent company, turnaround or revitalize a company, Private Equity could help.

Obtaining private equity is very different from raising debt or a loan from a lender, such as a bank.Lenders, who usually seek security such as a charge over the assets of the company, will charge intereston a loan and seek repayment of the capital. Private equity is invested in exchange for a stake in yourcompany and, as shareholders, the investors' returns are dependent on the growth and profitability ofyour business. The investment is unsecured, fully at risk and usually does not have defined repaymentterms. It is this flexibility which makes private equity an attractive and appropriate form of finance for

early stage and knowledge-based projects in particular.

WHY VC?

The venture capital industry in India is still at a nascent stage. With a view to promote innovation,

enterprise and conversion of scientific technology and knowledge based ideas into commercial

production, it is very important to promote venture capital activity in India. Indias recent success story

in the area of information technology has shown that there is a tremendous potential for growth of

knowledge based industries. This potential is not only confined to information technology but is

equally relevant in several areas such as bio-technology, pharmaceuticals and drugs, agriculture, food

processing, telecommunications, services, etc. Given the inherent strength by way of its skilled and cost

competitive manpower, technology, research and entrepreneurship, with proper environment and policy

support, India can achieve rapid economic growth and competitive global strength in a sustainable

manner.

A flourishing venture capital industry in India will fill the gap between the capital requirements of

technology and knowledge based startup enterprises and funding available from traditional institutional

lenders such as banks. The gap exists because such startups are necessarily based on intangible assets

such as human capital and on a technology-enabled mission, often with the hope of changing the world.

Beginning with a consideration of the wide role of venture capital to encompass not just informationtechnology, but all high-growth technology and knowledge-based enterprises, the endeavor of theCommittee has been to make recommendations that will facilitate the growth of a vibrant venturecapital industry in India. The report examines.

The vision for venture capital

Strategies for its growth and

How to bridge the gap between traditional means of finance and the capital needs of highgrowth startups.


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ADVANTAGES OF VENTURE CAPITAL

Venture capital has a number of advantages over other forms of finance, such as:

It injects long term equity finance which provides a solid capital base for futuregrowth.

The venture capitalist is a business partner, sharing both the risks and rewards.Venture capitalists are rewarded by business success and the capital gain. The venture capitalist is able to provide practical advice and assistance to the

company based on past experience with other companies which were in similarsituations.

The venture capitalist also has a network of contacts in many areas that can addvalue to the company, such as in recruiting key personnel, providing contacts ininternational markets, introductions to strategic partners, and if needed co-investments with other venture capital firms when additional rounds of financingare required.

The venture capitalist may be capable of providing additional rounds of funding

should it be required to finance growth.

FEATURES OF VENTURE CAPITAL

i. High Risk

ii. High tech

iii. Equity participation & Capital gains

iv. Participation in Management

v. Length of Investment

vi. Illiquid Investment

High Risk

By definition the Venture capital financing is highly risk and chances of failure are high as it provides

long term start capital to high risky- high reward ventures. Venture capital assumes four types of risks,

these are:

Management RiskInability of management terms to work together.

Market RiskProduct may fail in the market.

Product RiskProduct may not be commercially viable.

Operation RiskOperation may not be cost effective resulting in increased cost decreased gross

margin.

High Tech


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As opportunities in the low technology area tend to be few of lower order, and high tech projects

generally offer higher returns than projects in more traditional area, venture capital investments are

made in high tech. areas using new technologies or producing innovation goods by using new

technology. Not just high technology, any high risk ventures where the entrepreneur has conviction but

little capital gets venture finance. Venture capital is available for expansion of existing business or

diversification to a high risk area. Thus technology financing had never been the primary objective but

incidental to venture capital.

Equity participation & Capital gains

Investments are generally in equity and quasi equity participation through direct purchase of share,

options, convertible debentures where the debt holder has the option to convert the loan instruments

into stock of the borrower or a debt with warrant to equity investment. The funds in the form of equity

help to raise term loans that are cheaper source of funds. In the early stage of business, because

dividends can be delayed, equity investment implies that investors bear the risk of venture and would

earn a return commensurate with success in the form of capital gains.

Participation in Management

Venture capital provides value addition by managerial support, monitoring and follow up assistance. It

monitors physical and financial progress as well as market development initiative. It helps by

identifying key resource person. They want one seat on the companys board of directors and

involvement, for better or worse, in the major decision affecting the direction of company. This is

unique philosophy of hand on management where venture capitalist acts as complementary to the

entrepreneurs. Based upon the experience other companies a venture capitalist advice the promoters on

project planning, monitoring, financial management, including working capital and public issue.

Venture capital investor cannot interfere in day today management of the enterprise but keeps a close

contact with the promoters or entrepreneurs to protect his investment.

Length of Investment

Venture capitalist help comprise grow, but they eventually seek to exit the investment in three to seven

years. An early stage investment may take seven to ten years to mature, while most of the later stage

investment takes only a few years. The process of having significant returns takes several years and

calls on the capacity and talent of venture capitalist and entrepreneurs to reach fruition.

Illiquid Investment

Venture capital investments are illiquid, that is not subject to repayment on demand or following arepayment schedule. Investors seek return ultimately by means of capital gain when the investment is

sold at market place. The investment is realized only on enlistment of security or it is lost if enterprise

is liquidated for unsuccessful working. It may take several years before the first investment starts too

locked for seven to ten years. Venture capitalist understands this illiquidity and factors this in his

investment decision.


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TYPES OF INVESTORS

There are five tiers of venture capital sources: angel investors, seed or early stage funds, growth stage

funds, late stage funds, and private equity/leveraged buyout funds.

Angel Investors

Angel investors are wealthy individuals who provide capital to fund concepts or very young companies

that need to complete prototypes or attract initial customers. They typically invest less than $1 millionper round and generally have long investment time horizons, often expecting to see their investmentcapital returned to them in a span of around 10 years. Angels typically are less concerned with theinitial valuation of a company and are more concerned with establishing a firms viability and its

potential to be a profitable firm on a large scale. Generally, angel investors want to invest in businessesoperating in industries that they personally know well. Some angels like to be highly involved in afirms management, while others will be mainly passive. Angels often invest alongside other similar

investors either through formal angel groups or through informal networks of similar individualinvestors.

Seed or Early Stage FundsSeed and early stage venture capital funds typically have less than $200 million of capital undermanagement and like to invest $1-$5 million in a particular company over several financing rounds.These funds tend to invest in companies that have at least built a working beta version of their mainproduct or service and have a few trial customers using it. Seed and early stage funds tend to be fairlyhands-on with their investments and actively seek to fill gaps in the companys management teamand business strategy. These funds usually expect to have a shareholder liquidity event within 5-7years. As with angel investors, early stage venture capital firms want to be within 100-150 miles oftheir investments so that they can more closely provide management assistance.

Growth Stage Funds

Growth stage funds usually invest in rounds of $5-$20 million for companies with proven businessoperations that need capital to accelerate market penetration. These funds usually have $200+ millionunder management. Growth stage funds do not frequently take an active role in the management of acompany, although they usually have a significant role on a firms board of directors. Th ese venturecapital funds are national in scope and are willing to invest in businesses anywhere in North Americaand occasionally abroad.

Late Stage FundsLate stage funds invest $20 million or more in mature, well-developed companies that seek significantexpansion capital or operational cushion. These companies are typically profitable and address largemarkets. Late stage funds often have more than $1 billion under management.

Private Equity and Leveraged Buyout FundsUnlike the funds discussed above, private equity funds (also referred to as leveraged buyout or LBO

funds) primarily buy existing shares in companies rather than invest in new shares. LBO funds are an

attractive means for shareholders to monetize their stockholdings, especially if a company is not

considering selling its shares in an IPO. An LBO firm may have as little as $200 million under

management or may be as large as $10+ billion. LBO funds invest in companies of all sizes although a

key consideration is profitability; LBO funds rarely invest in businesses that do not generate substantial


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positive cash flow. Typically an LBO firm will seek to acquire a majority position in a company, but

occasionally these funds will consider minority positions if a firm is large or is in a highly attractive

market.

HISTORY OF VENTURE CAPITAL

A venture may be defined as a project prospective of converted into a process with an adequate

assumed risk and investment. With few exceptions, private equity in the first half of the 20th centurywas the domain of wealthy individuals and families. The Vanderbilts, Whitneys, Rockefellers, and

Warburgs were notable investors in private companies in the first half of the century. In 1938,

Laurence S. Rockefeller helped finance the creation of both Eastern Air Lines and Douglas Aircraft,

and the Rockefeller family had vast holdings in a variety of companies. Eric M. Warburg founded E.M.

Warburg & Co. in 1938, which would ultimately become Warburg Pincus, with investments in both

leveraged buyouts and venture capital. Origins of modern private equity Before World War II, money

orders (originally known as "development capital") were primarily the domain of wealthy individuals

and families. It was not until after World War II that what is considered today to be true private equity

investments began to emerge marked by the founding of the first two venture capital firms in 1946:

American Research and Development Corporation. (ARDC) and J.H. Whitney & Company.

ARDC was founded by Georges Doriot, the "father of venture capitalism"(former dean of Harvard

Business School and founder of INSEAD), with Ralph Flanders and Karl Compton (former president

of MIT), to encourage private sector investments in businesses run by soldiers who were returning from

World War II. ARDC's significance was primarily that it was the first institutional private equity

investment firm that raised capital from sources other than wealthy families although it had several

notable investment successes as well. ARDC is credited with the first trick when its 1957 investment of

$70,000 in Digital Equipment Corporation (DEC) would be valued at over $355 million after the

company's initial public offering in 1968 (representing a return of over 1200 times on its investment

and an annualized rate of return of 101%).

Former employees of ARDC went on and established several prominent venture capital firms including

Greylock Partners (founded in 1965 by Charlie Waite and Bill Elfers) and Morgan, Holland Ventures,

the predecessor of Flagship Ventures (founded in 1982 by James Morgan). ARDC continued investing

until 1971 with the retirement of Doriot. In 1972, Doriot merged ARDC with Textron after having

invested in over 150 companies.

J.H. Whitney & Company was founded by John Hay Whitney and his partner Benno Schmidt. Whitney

had been investing since the 1930s, founding Pioneer Pictures in 1933 and acquiring a 15% interest in

Technicolor Corporation with his cousin Cornelius Vanderbilt Whitney. By far Whitney's most famousinvestment was in Florida Foods Corporation. The company developed an innovative method for

delivering nutrition to American soldiers, which later came to be known as Minute Maid orange juice

and was sold to The Coca-Cola Company in 1960. J.H. Whitney & Company continues to make

investments in leveraged buyout transactions and raised $750 million for its sixth institutional private

equity fund in 2005.

Early venture capital and the growth of Silicon Valley A highway exit for Sand Hill Road in Menlo


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Park, California, where many Bay Area venture capital firms are based

One of the first steps toward a professionally-managed venture capital industry was the passage of the

Small Business Investment Act of 1958. The 1958 Act officially allowed the U.S. Small Business

Administration (SBA) to license private "Small Business Investment Companies" (SBICs) to help the

financing and management of the small entrepreneurial businesses in the United States.

SAND HILL ROAD

During the 1960s and 1970s, venture capital firms focused their investment activity primarily on

starting and expanding companies. More often than not, these companies were exploiting

breakthroughs in electronic, medical, or data-processing technology. As a result, venture capital came

to be almost synonymous with technology finance. An early West Coast venture capital company was

Draper and Johnson Investment Company, formed in 1962 by William Henry Draper III and Franklin

P. Johnson, Jr. In 1962 Bill Draper and Paul Wythes founded Sutter Hill Ventures, and Pitch Johnson

formed Asset Management Company.

It is commonly noted that the first venture-backed startup is Fairchild Semiconductor (which produced

the first commercially practical integrated circuit), funded in 1959 by what would later become

Venrock Associates. Venrock was founded in 1969 by Laurance S. Rockefeller, the fourth of John D.

Rockefeller's six children as a way to allow other Rockefeller children to develop exposure to venture

capital investments.

It was also in the 1960s that the common form of private equity fund, still in use today, emerged.

Private equity firms organized limited partnerships to hold investments in which the investmentprofessionals served as general partner and the investors, who were passive limited partners, put up the

capital. The compensation structure, still in use today, also emerged with limited partners paying an

annual management fee of 1.02.5% and a carried interest typically representing up to 20% of the

profits of the partnership.

The growth of the venture capital industry was fueled by the emergence of the independent investment

firms on Sand Hill Road, beginning with Kleiner, Perkins, Caufield & Byers and Sequoia Capital in


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1972. Located in Menlo Park, CA, Kleiner Perkins, Sequoia and later venture capital firms would have

access to the many semiconductor companies based in the Santa Clara Valley as well as early computer

firms using their devices and programming and service companies.

Throughout the 1970s, a group of private equity firms, focused primarily on venture capital

investments, would be founded that would become the model for later leveraged buyout and venture

capital investment firms. In 1973, with the number of new venture capital firms increasing, leading

venture capitalists formed the National Venture Capital Association (NVCA). The NVCA was to serve

as the industry trade group for the venture capital industry. Venture capital firms suffered a temporary

downturn in 1974, when the stock market crashed and investors were naturally wary of this new kind of

investment fund.

It was not until 1978 that venture capital experienced its first major fundraising year, as the industry

raised approximately $750 million. With the passage of the Employee Retirement Income Security Act

(ERISA) in 1974, corporate pension funds were prohibited from holding certain risky investments

including many investments in privately held companies. In 1978, the US Labor Department relaxed

certain of the ERISA restrictions, under the "prudent man rule,"thus allowing corporate pension funds

to invest in the asset class and providing a major source of capital available to venture capitalists.

1980s

The public successes of the venture capital industry in the 1970s and early 1980s (e.g., Digital

Equipment Corporation, Apple Inc., Genentech) gave rise to a major proliferation of venture capital

investment firms. From just a few dozen firms at the start of the decade, there were over 650 firms by

the end of the 1980s, each searching for the next major "home run". The number of firms multiplied,

and the capital managed by these firms increased from $3 billion to $31 billion over the course of the

decade.

The growth of the industry was hampered by sharply declining returns, and certain venture firms began

posting losses for the first time. In addition to the increased competition among firms, several other

factors impacted returns. The market for initial public offerings cooled in the mid-1980s before

collapsing after the stock market crash in 1987 and foreign corporations, particularly from Japan and

Korea, flooded early stage companies with capital.

In response to the changing conditions, corporations that had sponsored in-house venture investment

arms, including General Electric and Paine Webber either sold off or closed these venture capital units.

Additionally, venture capital units within Chemical Bank and Continental Illinois National Bank,

among others, began shifting their focus from funding early stage companies toward investments in

more mature companies. Even industry founders J.H. Whitney & Company and Warburg Pincus began

to transition toward leveraged buyouts and growth capital investments.


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PLAYERS IN VENTURE CAPITAL INDUSTRY

There are following group of players:

Angels and angle clubs

Venture capital funds

o Small

o Medium

o Large

Corporate venture funds

Financial service venture groups

PLAYERS IN PRIVATE EQUITY

The Organized Private Equity market consists of four players:

Issuers

It refers to the companies that cannot raise or have opted to raise capital through the private

equity market for various reasons like to develop new product and technologies, to make acquisition or

to strengthen the balance sheet.

Intermediaries

It refers to the fund under management. Typically 80% of the global private equity investment is

managed by the funds on the limited partnership model. Other intermediaries like Small Business

Investment Companies (SBIC's) accounts for a marginal share of private equity market.

Investors

A wide variety of people invest in private equity funds. Public and corporate Pension Funds accounts

for 40% of global capital outstanding. Endowment Funds and wealthy individuals, each accounts for

approximately 10% of outstanding. The other investors include insurance companies, investment banks

and non-banking financial corporations.

Agents and Advisors

With the coming up of various private equity funds, the role of agents and advisors are all more

important. They act as information disseminators. They perform two functions:


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They identify the potential private equity funds, evaluate them and provide information to

investors.

They help funds raise capital. They often negotiate the terms on behalf of their clients to obtain

better terms.

LIFE CYCLE OF PRIVATE EQUITY

Fund Raising

Since, the partnerships have finite lives, the private equity managers who serve as general partners

must regularly raise new funds in order to stay in business. In fact, to invest in portfolio companies on a

continuing basis, managers must raise a new partnership once the funds from the existing partnership

are fully invested. The fund raising- investment cycle last from three to five years.

The fund raising is very time consuming and costly exercise, involving presentations to institutional

investors and their advisors that can take from two months to well over a year depending on the general

partners' reputation and experience. To minimize their fund-raising expenses, partnership managers

generally turn first to those that invested in their previous partnerships. In addition, funds are often

raised in several stages, referred to as 'closings', to get a favorable evaluation of the fund by those that

have already committed.

General Partners prefer investors that have a long-term commitment to private equity investing.

Because past investors are most familiar with a general partner's ability, general partners face greater

difficulties when experienced investors withdraw from the market. For instance, insurance companies

drastically reduced their commitments to private equity in 1990 owing to concerns among the public

about insurance companies financial condition. More recently, IBM, a major corporate pension fund

investor, withdrew from the private equity market as part of a broad reduction in pension staff.

Selecting Investment

The success of private equity funds depends on the selection of right kind of investment. Generalpartners rely on relationships with investment bankers, brokers, consultants, lawyers, and accountants

to obtain leads; they also count on referrals from firms they successfully financed in the past.

Economies of scale apparently play an important role in deal flow: The larger the number of

investments a partnership is involved in, the larger the number of investment opportunities it is exposed

to.


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They exercise due control by dominating the board of portfolio companies. Even in minority

investments, they appoint atleast one member on the board. The other methods can be through

acquisition of voting rights and by controlling the additional finance requirements of portfolio

companies.

The degree of involvement varies with the type of investment. Involvement is greatest in new

venturesfor which the quality of management is viewed as a key determinant of success or failure

and in certain non-venture situationsfor which improving managerial performance is one of the

primary purposes of the investment (for example, leveraged buyouts). For these two types of firms,

private equity investors typically are also majority owners, so the investors have even greater incentive,

as well as authority, to become involved in the company's decision making. Even when the degree of

involvement is lowestfor example, when a partnership is a minority investor in large private or

public companiesgeneral partners may spend as much as a third of their time with portfolio

companies. A partnership rarely is a completely passive investor; an exception is the case of

syndication, when other partnerships may allow the lead investor to take the active role.

Exiting Investments

Private equity professionals have their eye on the exit from the moment they first see a business plan.

An exit is the means by which a fund is able to realize its investment in a company by -

an initial public offering

a trade sale

selling to another private equity firm

a company buy-back

If a fund manager can't see an obvious exit route in a potential investment, then it won't touch it. A key

part of the investment strategy shall be to develop a clear thesis on exit routes, along with the

entrepreneur/promoter clearly understanding the investment horizon. As general partners have an

obligation to return the capital to limited partners within a specified period of time based on contractual

agreement, so they should maximize the profits by applying the appropriate exit strategy.


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WHAT ARE THE STAGES OF VENTURE CAPITAL INVESTMENT?

There are five distinct stages of venture capital funding: start-up stage, seed or early stage, growthstage, late stage, and Buyouts and Recapitalizations.

Start-up StageNewly formed companies without significant operating histories are considered to be in the start-up

stage. Most entrepreneurs fund this stage of a companys development with their own funds as well asinvestments from angel investors. Angels are wealthy individuals, friends, or family members thatpersonally invest in a company. Angels are the most common source of first round funding fortechnology businesses and angel rounds usually less that $1 million. They often will back companiesthat are at the concept stage and have a limited track record with respect to customers and revenue.These investors tend to invest only in local companies or for people that they already know personally.

Seed or Early Stage

Seed or early stage rounds often involve investments of less than $5 million for companies that havepromising concepts validated by key customers but have not yet achieved cash flow break-even.Organized groups of angel investors as well as early stage venture capital funds usually provide these

types of investments. Typically, seed and early venture capital funds will not invest in companiesoutside their geographic area (usually 100-150 miles from the VCs office) as they often actively workwith management on a variety of operational issues.

Growth StageGrowth stage investments focus on companies that have a proven business model and either are alreadyprofitable or offer a clear path to sustainable profitability. These investments tend to be in the $5-20million range and are intended to help the company increase its market penetration significantly. The

Start-up stage

Second

Growth stage

Seed capital Early stage

Later stage


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pool of potential venture capital investors is very robust for growth stage investments, with firms acrossthe United States willing to participate in investment rounds at this stage.

Late Stage

Late stage venture capital investments tend to be for relatively mature, profitable companies seeking toraise $10+ million for significant strategic initiatives (i.e. investment in sales & marketing, expansionoverseas, major infrastructure build-outs, strategic acquisitions, etc.) that will create major advantages

over their competition. These opportunities are usually funded by syndicates of well-establishedventure capital firms who manage large funds.

Buyouts and Recapitalizations

Buyouts and recapitalizations are becoming more prevalent for mature technology companies that are

stable and profitable. In these transactions, existing shareholders sell some or all of their shares to a

venture capital firm in return for cash. These venture capital firms may also provide additional capital

to fuel growth in conjunction with an exit for some or all of the companys existing shareholders.

THE VENTURE CAPITAL INVESTMENT PROCESS

The venture capital activity is a sequential process involving the following six steps.

I. Deal origination

II. Screening

III. Due diligence

IV. Deal structuring

V. Post-investment activity

VI. Exit

Deal origination

In the generating a deal flow, the VC investor creates a pipeline of deals or investment opportunities

that he would consider for investing in. deal may originate in various ways. Referral system is an

important source of deals. Deals may be referred to VCFs by their parent organization, trade partners,

industry association, friends etc. another deal flow is active search through networks, trade fairs,

conferences, seminars, foreign visits etc. intermediaries is used by venture capitalist in developed

countries like USA, is certain intermediaries who match VCFs and the potential entrepreneurs.

Screening

VCFs, before going for an in depth analysis, carry out initial screening of all projects on the basic ofbasic of some broad criteria. For example, the screening process may limit projects to areas in which

the venture capitalist is familiar in terms of technology, or product, or market scope. The size of

investment, geographical location and stage of financing could also be used as the broad screening

criteria.

Due diligence


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Due diligence is the industry jargon for all the activities that are associated with evaluating an

investment proposal. The venture capitalists evaluate the quality of entrepreneur before appraising the

characteristics of the product, market or technology. Most venture capitalists ask for a business plan to

make an assessment of the possible risk and return on the venture. Business plan contains detailed

information about the proposed venture. The evaluation of ventures by VCFs in Indian includes;

Preliminary venture to establish prima facie eligibility.

Deal structuring

In this process, the venture capitalist and the venture company negotiate the term of the deals, that are

amount form and price of the investment. This process is termed as deals structuring. The agreement

also include the venture capitalists right to control the venture company and to change its management

if needed, buyback arrangement specify the entrepreneurs equity share and the objectives share and the

objectives to be achieved.

Post investment activities

Once the deal has been structures an agreement finalized, the venture capitalist generally assumes the

role of partner and collaborator. He also gets involved in shaping of the direction of the venture. The

degree of the venture capitalists involvement depends on his policy. It may not, however be desirable

for a venture capitalist to get involved in the day -today operation of the venture. If a financial or

managerial crisis occurs, the venture capitalist may intervene, and even install a new management

team.

Exit

venture capitalist generally want to cash-our their in five to ten year after the initial investment. theyplay a positive role in directing the company towards particular exit routs. A venture may exit in one of

the following ways:

there are four ways for a venture capitalist to exit its investment:

Initial public offer (IPO)

Acquisition by another company

Re-purchase of venture capitalists share by the investee company

Purchase of venture capitalists share by a third party

Promoters buy-back

The most popular disinvestment route in India is promoters buy-back. This route is suited to Indian

conditions because it keeps the ownership and control of the promoter intact. The obvious limitation,

however, is that in a majority of cases the market value of the shares of the venture firm would have

appreciated so much after some years that the promoter would to be in a financial position to buy them

back.


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In India, the promoters are invariably given the first option to buy back equity of their enterprise. For

example, RCTO participates in the assisted firms equity with suitable agreements for the promoter to

repurchase it. Similarly, Confine- VCF offer an opportunities to the promoter buy back the shares of

the assisted firm within an agreed period at a predetermined price. If the promoter fails to buy back the

shares within the stipulated period, Confine-VCF would have the discretion to divest them in any

manner it deemed appropriate. SBI capital markets ensures through examining the personal asset of the

promoters and their associates, which buy back, would be a feasible option. GV would makedisinvestment, in consultation with the promoter, usually after the project has settled down, to a

profitable level and the entrepreneur is in a position to avail of finance under conventional schemes of

assistance from banks or other financial institutions.

Initial public offers (IPOs)

The benefits of disinvestments via the public issue route are improved marketability and liquidity,

better prospects for capital gains and widely known status of the venture as well as market control

through public share participation. This option has certain limitation in the context. The promotion of

the public issue would be difficult and expensive since the first generation entrepreneurs are not known

in the capital markets. Further, difficulties will be caused if the entrepreneurs business is perceived to

be unattractive investment proposition by investors. Also, the emphasis by the Indian investors on short

term profits and dividends may tend to make the market price unattractive. Yet another difficulty in

India until recently was that the controller of capital issues (CCI) guidelines for determining the

premium on shares took into account the book value and the cumulative average EPS till the date of the

new issue. This formula failed to give due weight age to the expected stream of earning of the venture

firm. Thus, the formula would underestimated the premium. The government has now abolished the

capital issues control Act, 1947 and consequently, the office of the controller of capital issues the

existing companies are now free to fix the premium on their shares. The initial public issue for

disinvestment of VCFs holding can involve high transaction costs because of the inefficiency of thesecondary market in a country like India. Also, this option has become far less feasible for small

ventures on account of the higher listing requirement of the stock exchanges. In February 1989, the

government of India raised the minimum from Rs 10 million to Rs 30 million and the minimum public

offer from Rs 6 million to Rs 18 million.

METHODS OF VENTURE FINANCING

Venture capital typically available in three forms in India, they are:

Equity:All VCFs in India provide equity but generally their contribution does not exceed 49% of the

total equity capital. Thus, the effective control and majority ownership of the firm remains with theentrepreneur. They buy shares of an enterprise with an intention to ultimately sell them off to make

capital gains.

Conditional Loan:it is repayable in the form of royalty after the venture is able to generate sales. No

interest paid on such loans. In India, VCFs change royalty ranging between 2% to 15%; actual rate

depends on other factors of the venture such as gestation period, cost flow patterns, riskiness and other

factors of the enterprise.


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Income Note:it is a hybrid security which combines the features of both conventional loan and

conditional loan. The entrepreneur has to pay both interest and royalty on sales, but at substantially low

rates.

Participating Debenture:such security carries charges in phases. In the start up phase, before the

venture attains operations to a minimum level, no interest is charged, after this, low rate of interest is

charged, up to a particular level of operation. Once the venture is commercial, a high rate of interest is

required to be paid.

Quasi Equity:quasi equity instruments are converted into equity at a later date. Convertible

instruments are normally converted into equity at the book value or at certain multiple of EPS, i.e. at a

premium to par value at a later date the premium automatically rewards the promoter for their initiative

and hand work. Since it is performance related, it motivates the promoter to work harder so as to

minimize dilution of their control on the company. The different quasi equity instruments are follows:

a) Cumulative convertible preference shares.

b) Partially convertible debentures.

c) Fully convertible debentures.

Other financing methods:a few venture capitalists, particularly in the private sector, have started

introducing innovation financial securities like participating debentures, introduced by TCFC is an

example.

PRIVATE EQUITY AND VENTURE CAPITAL ASSOCIATION IN INDIA

Indian Private Equity and Venture Capital Association (IVCA) is the oldest, most influential andlargest member-based national organisation of its kind. It represents venture capital and private equityfirms to promote the industry within India. It seeks to create a more favourable environment for equity

investment and entrepreneurship. It is an influential forum representing the industry to governmentalbodies and public authorities.

IVCA members include leading venture capital and private equity firms, institutional investors, banks,corporate advisers, accountants, lawyers and other service providers to the venture capital and privateequity industry. These firms provide capital for seed ventures, early-stage companies, later-stageexpansion and growth finance for management buyouts/buy-ins.

IVCAs purpose is to support the examination and discussion of management and investment issues inprivate equity and venture capital in India. It aims to support entrepreneurial activity and innovation aswell as the development and maintenance of a private equity and venture capital industry that provides

equity finance. It helps establish high standards of ethics, business conduct and professionalcompetence. IVCA also serves as a powerful platform for investment funds to interact with oneanother.

The Association stimulates the promotion, research and analysis of private equity and venture capital inIndia, and facilitates contact with policymakers, research institutions, universities, trade associationsand other relevant organisations. IVCA collects, circulates and disseminates commercial statistics andinformation related to the venture capital industry.


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PRIVATE EQUITY: AN INTRODUCTION

Private Equity is a broad term denoting any investment in an asset class consisting of equity securities

in operating companies that are not publicly traded on a stock exchange. More accurately, privateequity refers to the manner in which the funds have been raised, namely on the private markets, as

opposed to the public markets. Investments in private equity most often involve either an investment of

capital into an operating company or the acquisition of an operating company. It is typically a

transformational, value-added, active investment strategy.

1.1 PRIVATE EQUITY FIRMS

Private equity firms invest in companies at various stages of their development ranging from their very

beginnings to their demise. PE firm is an investment manager that makes investments in the private

equity through a variety of loosely affiliated investment strategies including Leveraged Buyout,

Venture Capital and Growth Capital.


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Private equity firms, with their investors, will acquire a controlling or substantial minority position in a

company and then look to maximize the value of that investment. In turn they receive a periodic

management fee as well as a share in the profits earned (carried interest) from each private equity fund

managed.Private equity firms generally receive a return on their investments through an IPO, a merger

or acquisition, a recapitalization.

1.2 WHY PRIVATE EQUITY?

Capital to a company is like life in human body. The companies engaged in the traditional line of

business procure necessary financial capital from the public issues, financial institutions, commercial

banks, mutual funds, lease financing, debt instruments, hire purchase etc. But the companies face great

difficulty while raising capital for newly floated companies as at the initial stages of the business the

risk is very high and the return is uncertain.

Similarly, small-scale enterprises (SSE's) are also unable to raise funds because it is highly risky

venture, are less profitable and do not possess adequate tangible assets to offer as security. So, they

have two options left- either to raise capital through IPO or to obtain loans. But most of the SSE's are

unable to fulfill the listing requirements in terms of sales and minimum size of share issues. Moreover,

common investors hesitate to invest in such companies even though the growth rate is high because of

high degree of risk involved. As far as loans are concerned, lenders charge relatively high rate of

interest to compensate for the high degree of risk involved.

The spectacular success of companies like GE, Microsoft, Federal Express, Infosys and Reliance give a

sense that new venture creation is a sign of future productivity gains. So how such companies shall be

financed? The Private Equity market is an important source of funds for new firms, private middle-

market firms, firms in financial distress, and public firms seeking buyout financing. Over the last 15

years it has been the fastest growing market for corporate finance as compared to bond market and

others. Today the private equity market is roughly one-sixth the size of the commercial bank loan and

commercial paper markets in terms of outstanding, and in recent years private equity capital raised by

partnerships has matched, and sometimes exceeded, funds raised through initial public offerings and

gross issuance of public high-yield corporate bonds.


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1.3 TYPES OF PRIVATE EQUITY

Private Equity investments can be divided into the following categories:

1. Leveraged Buyout

A leveraged Buyout (orLBO or highly-leveraged transaction (HLT) or bootstrap transaction) refers

to a strategy of making equity investments as part of a transaction in which a company, business unit or

business assets is acquired from the current shareholders typically with the use of financial leverage.

The companies involved in these transactions are typically mature and generate operating cash flows.

Leveraged buyouts involve afinancial sponsor agreeing to an acquisition without itself committing all

the capital required for the acquisition. To do this, the financial sponsor will raise acquisition debt

which ultimately looks to the cash flows of the acquisition target to make interest and principal

payments. Acquisition debt in an LBO is often non-recourse to the financial sponsor and has no claim

on other investment managed by the financial sponsor. Therefore, an LBO transaction's financial

structure is particularly attractive to a fund's limited partners, allowing them the benefits of leverage

but greatly limiting the degree of recourse of that leverage. This kind of financing structure leverage

benefits to an LBO's financial sponsor in two ways:

The investor itself only needs to provide a fraction of the capital for the acquisition, and

The returns to the investor will be enhanced (as long as thereturn on assets exceeds the cost of

the debt).

As a percentage of the purchase price for a leverage buyout target, the amount of debt used to finance a

transaction varies according the financial condition and history of the acquisition target, market

conditions, the willingness of lenders to extend credit (both to the LBO's financial sponsors and the

company to be acquired) as well as the interest costs and the ability of the company to cover those

costs. Historically the debt portion of a LBO will range from 60%-90% of the purchase price, although

during certain periods the debt ratio can be higher or lower than the historical averages.
http://en.wikipedia.org/wiki/Leveraged_buyouthttp://en.wikipedia.org/wiki/Leverage_%28finance%29http://en.wikipedia.org/wiki/Financial_sponsorhttp://en.wikipedia.org/wiki/Nonrecourse_debthttp://en.wikipedia.org/wiki/Return_on_assetshttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Financial_sponsorhttp://en.wikipedia.org/wiki/Interest_coverage_ratiohttp://en.wikipedia.org/wiki/Interest_coverage_ratiohttp://en.wikipedia.org/wiki/Financial_sponsorhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Return_on_assetshttp://en.wikipedia.org/wiki/Nonrecourse_debthttp://en.wikipedia.org/wiki/Financial_sponsorhttp://en.wikipedia.org/wiki/Leverage_%28finance%29http://en.wikipedia.org/wiki/Leveraged_buyout


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2. Venture capital

Venture capital is a broad subcategory of private equity that refers to equity investments made,

typically in less mature companies, for the launch, early development, or expansion of a business.

Venture investment is most often found in the application of new technology, new marketing concepts

and new products that have yet to be proven.

Venture capital is often sub-divided by the stage of development of the company ranging from early

stage capital used for the launch of start-up companies to late stage and growth capital that is often used

to fund expansion of existing business that are generating revenue but may not yet be profitable or

generating cash flow to fund future growth. Entrepreneurs often develop products and ideas that require

substantial capital during the formative stages of their companies' life cycles. Many entrepreneurs do

not have sufficient funds to finance projects themselves, and they prefer outside financing. To

compensate the risk of failure, venture capitalist's seeks higher return from these investments. Venture

Capital is often most closely associated with fast growing technology and biotechnology fields.

3 .Growth capital

Growth capital refers to equity investments, most often significant minority investments, in relatively

mature companies that are looking for capital to expand or restructure operations, enter new markets or
http://en.wikipedia.org/wiki/File:Leveraged_Buyout_Diagram.png


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finance a major acquisition without a change of control of the business. Companies that seek growth

capital will often do so in order to finance a transformational event in their life cycle. These companies

are likely to be more mature than venture capital funded companies, able to generate revenue and

operating profits but unable to generate sufficient cash to fund major expansions, acquisitions or other

investments. The primary owner of the company may not be willing to take the financial risk alone. By

selling part of the company to private equity, the owner can take out some value and share the risk of

growth with partners.

4 .Distressed and Special Situations

Distressed or Special Situations are a broad category referring to investments in equity or debt

securities of financially stressed companies. The "distressed" category encompasses two broad sub-

strategies including:

"Distressed-to-Control" or "Loan-to-Own" strategies where the investor acquires debt securitiesin the hopes of emerging from a corporate restructuring in control of the company's equity;

"Special Situations" or "Turnaround" strategies where an investor will provide debt and equity

investments, often "rescue financing" to companies undergoing operational or financial

challenges.

5 .Mezzanine capital

Mezzanine capital refers to subordinated debt or preferred equity securities that often represent the

most junior portion of a company's capital structure that is senior to the company's common equity.

This form of financing is often used by private equity investors to reduce the amount of equity capital

required to finance a leveraged buyout or major expansion. Mezzanine capital, which is often used by

smaller companies that are unable to access the high yield market, allows such companies to borrow

additional capital beyond the levels that traditional lenders are willing to provide through bank loans. In

compensation for the increased risk, mezzanine debt holders require a higher return for their investment

than secured or other more senior lenders.

6. Secondaries

Secondary investments refer to investments made in existing private equity assets. These transactions

can involve the sale of private equity fund interests or portfolios of direct investments in privately held

companies through the purchase of these investments from existing institutional investors. By its

nature, the private equity asset class is illiquid, intended to be a long-term investment for buy-and-hold

investors. Secondary investments provide institutional investors with the ability to improve vintage


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diversification, particularly for investors that are new to the asset class. Secondaries also typically

experience a different cash flow profile, diminishing the effect of investing in new private equity funds.

Often investments in secondaries are made through third party fund vehicle, structured similar to a fund

of funds although many large institutional investors have purchased private equity fund interests

through secondary transactions. Sellers of private equity fund investments sell not only the investments

in the fund but also their remaining unfunded commitments to the funds.


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1.4 THE STAGES OF PRIVATE EQUITY

Private Equity investments can be classified into:

Seed stage Financing provided to research, assess and develop an initial concept before a business has

reached the start-up phase

Start-up stage financing for product development and initial marketing.

Expansion stage financing for growth and expansion of a company which is breaking even or trading

profitably.

Replacement capital Purchase of shares from another investor or to reduce gearing via the refinancing

of debt.

The above stages can be explained by the diagram which is shown below -:


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1.5 ADVANTAGES OF PRIVATE EQUITY

Investing in a private equity fund has a lot of advantages compared to other investment areas; here are

some advantages of private equity for not only investors but also the companies that private equity

firms acquire:

Advantages for Investors:

By definition, private equity firms work outside the public eye and do not have to follow the

same transparency standards that public firms and funds must adhere to. This allows private

equity firms to reform the companies without the constraint of having to report quarterly to the

SEBI, ROC or similar distractions.

Private equity firms generally perform very rigorous due diligence on potential investments. By

utilizing a team of researchers the private equity firm is able to identify most risks that would

not otherwise be found.

The management receives carried interest, a portion of the profits, so managers and their staff

are motivated to produce good results to investors. Although carried interest is often criticized

for taking money from the investors, it is a very big incentive for managers.

Economic Scenario-

India is one of the fastest growing economies in the world, with enormous growth potential in manyindustries. This means that capital requirements are high, translating into an ideal hunting ground

for PE funds.

Abundance of skilled labor

India offers a huge advantage in the form of its highly talented and skilled labor pool, which can

lead to the success of the firms in which investment is made through the private equity route. The

funds are not just bullish about the businesses in India but have also grabbed a fair share of highly

rated managers like Vivek Paul, Rajeev Gupta, Avnish Bajaj, Akhil Gupta, and Nikhil Khattau. PE

funds are invariably on the lookout for high profile managers, not only to manage their own funds

but also as their representative on the board of companies in which they have invested.

Success of several sectors


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India has firmly established itself as the worlds IT superpower with almost all major software

development companies having an Indian development centre. It is also becoming the the hub of

back office operations, and a leading provider of BPO and KPO services. This has led to greater

confidence in the future growth potential of Indian companies.

Mature Financial markets

Capital markets have stabilized in the recent past with regulators like SEBI keeping a firm watch on

the market development. This means both increased opportunities as well as an easier and painless

exit route for PE funds. The emergence of entrepreneurs in India who consider PE their full time

occupation is also a positive sign. Besides, there are well established corporate houses diversifying

their surplus investment, as a strategy for their assets allocation, through PE funds without

involving themselves directly in the operations of target companies.

Successful M&As-

A recent spate of mergers and acquisitions has given rise to yet another way of exiting from Indian

companies for private equity investors.

Successful track record

The first generation of private equity players have realized significant success in the last several

years. For instance, Warburg Pincus earned huge returns out from its investments in Indian

companies like Bharti Telecom.

Advantages for Company:

Private equity managers are paid very well and so it is easy to attract high caliber, experienced

managers that tend to perform very well. The same goes for lower level employees at private

equity firms, they tend to be the top young business school graduates. This helps the company

to utilize best talent in the industry without shelling out even a single penny from its pocket.

PE helps a company to prepare for stock market listing (IPO) as the exit route of investment. It

opens up enormous opportunities for companies to raise funds. The continuous scrutiny by

stock market participants, SEBI & ROC facilitates efficiency improvement and proper strategic

decisions.


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PE helps those companies which cannot raise money from the market. By private equity

company get money from the investors, which help in the growth of the company.

DISADVANTAGES OF PRIVATE EQUITY

Disadvantages for Investors:Difficult to access for small & medium investors-

private equity Limited Partnership funds may only be marketed to institutions and very wealthy

individuals; in addition the minimum investment accepted is usually more than 1mn.

Relative illiquidity

Private Equity funds normally invest in a unlisted space and they find it difficult to exit the

investment at their wish, since it require concentrated efforts to find a suitable investor for unlisted

company. Even in the listed space, the impact cost remains very high due to sheer magnitude of

scale.

A long term investment perspective is necessary to achieve gains for a private equity investment

programme because the investment programme depends on the company growth. It depends on the

gap between entry and exit of the investor.

Political condition

India, being divided into a number of states, causes an investment decision to be affected by

politics. Changes in regulation and infrastructure development are often sidelined due to friction

and conflict between the state and the federal government.

Competition from China

China is a direct competitor of India and most of the private equity investors, eyeing the Asian

region, draw a comparison across both the countries to decide where their money should be parked.

The new state-ofthe- art airports in China bear a stark contrast to the abysmal conditions of the

terminals in Indias main cities.

High costs


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private equity managers charge relatively high fees for managing capital committed by external

investors (generally around 2%) and, if the fund performs well, take a sizeable proportion

(generally 20%) of realised returns in excess of investment hurdle rates.

Disadvantages for Company:

It is a lengthy process since private equity managers conduct detailed market, financial, legal,

environmental and management due diligence, which could take several months before they

make final decisions on investing.

Entrepreneurs have to give up some of their companys shares to a private equity investor, i.e.

control. Because investor have some control over the company, so it is not easy for the

entrepreneur to take decision independently. He have to take advice of the investor to takedecision and it causes delay in the process.

The private equity managers have control over the timing of a sale of (a part of) the business.

Lack of promotion in investment across sectors - PE funds are being channelized into only a

few sectors like IT, infrastructure & real estate and telecommunications, to the exclusion of the

remaining industries, desperately in need of funds for growth.


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CASE STUDIES

GMR Infrastructure is the infrastructure company of the GMR Group, a family-run conglomerate.

GMR infrastructure has interests in airports, energy, highways and urban infrastructure. It began

operations by setting up power plants and initiating road projects. Management, at the time of the PE

investment, was reputed to possess excellent project management skills, having built infrastructure

projects on time and within budget.

In March 2004, IDFC PE invested USD 22.5 million for a 15 percent holding in GMR Energy, the

energy holding company that IDFC PE and GMR decided to create. This was the first example of

aggregating infrastructure SPVs into a corporate structure that facilitated a possible IPO at an earlier

date. The funds were used to build the companys third power plant.

At the time of the investment, GMR Infrastructure owned a contract to build a new airport at

Hyderabad, but had no prior airport experience. IDFC PE decided to partner with GMR to bid for the

restructuring of the Delhi and Mumbai airports. This would be the second investment of IDFC PE in

the GMR Group. IDFC PE helped bring in Fraport as a strategic partner for the bid. This was the first

time that a PE fund participated directly in a bid for an infrastructure project. Key executives from

Manchester airport and Cranfield University were signed on as professionals to help prepare the bid.

INFRASTRUCTURE COMPANIES

GMR INFRASTRUCTURE


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GMR Infrastructure went public in 2006 and IDFC PE played a key role in the pricing of the IPO.

IDFC PE sold its investment in GMR Energy for a stake in GMR Infrastructure before the IPO.

IMPACT OF PE ON GMR INFRASTRUCTURE

IDFC PE focused its efforts on improving corporate governance, brand building, helping the company

access strategic partners and advisors that would help it win and execute projects, and helping the

company build domain knowledge in new sectors of entry. It also assisted with the pricing of the IPO.

The management of GMR Infrastructure notes that it benefited greatly from the PE investment. As a

senior executive noted: IDFC PE investment was not an investment but a relationship which resulted

in a harmonious value-added partnership. The management notes that the companys growth rates

were substantially higher after PE funding, with an impact of at least 10 percent additional revenue

growth per annum. According to the management, PE fulfilled their expectation of being helpful during

a phase when the company was not ready for public equity, rather than being a substitute for public

market funding.

Interestingly, IDFC PE decided to invest in GMR Energy because the investees model of building

infrastructure agglomerations rather than stand-alone investments in particular sectors made sense. This

deal thus showed how infrastructure investing in India can be structured to suit PE.

CONSUMER COMPANIES

MERU TAXI(earlier known as V Link Pvt. Ltd.)


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V-Link, the operator of Meru Taxis, began as a Mumbai-based operator of taxicabs in 2006. Prior to

Merus launch, cabs could not be reserved over the phone. The company owned a license from the state

to operate radio taxis, but lacked funds for expansion.

The PE firm, IVF, invested INR 2 billion in VLink in 2006, and took a majority holding, enabling the

introduction of the Meru brand. Apart from enabling scale, IVF brought in professionals. IVF

facilitated the recruitment process, attracting high-end talent from reputed companies, including global

organisations. It also created the franchising model based on a study of similar systems globally,

focused on air-conditioned cabs fitted with high technology, including data terminals and GPS systems

in each Meru cab. IVF also helped V-Link raise debt to purchase vehicles, standing in as guarantor.

Meru expanded by enrolling franchisees from the existing owners of taxi licenses. The company also

added operations in Hyderabad, Delhi and Bangalore. By March 2010, the company operated over

4,000 cabs, with plans to expand to 10,000, thus consolidating its position as the largest taxicab

operator in India.

For better comfort of the passengers and to keep up with the changing times Meru has been upgrading

its technology regularly. Recently, the company installed an Oracle ERP system, implemented by

Accenture, which makes Meru Cabs the first radio cabs service company in the world to implementERP systems.

As recognition of the pro-active and holistic approach to IT adoption and the seamless alignment of IT

with the business strategy, Meru Cabs once again won 'NASSCOMCNBC IT User Award 2009' for the

second time in a row.

IMPACT OF PE ON MERU

IVFs investment in Meru was unusual for PE because of the relatively early stage at which funds were

committed. The taking of a majority holding was also not typical of India, though more akin to the

western model. The difference with the western model was that the management of Meru was retained

and strengthened. Thus, Meru was a test-bed of two new business ideas: whether investing in an idea at


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such an early stage made sense; and whether control the of existing management by the PE firm would

work.

The impact on Meru is evident. The Meru brand has become synonymous with airconditioned radio

taxis. Without PE investment, the companys professionalisation and development trajectory would

undoubtedly be slower; technological sophistication would likely have been lower, as well. The

combination of these two factors is that Meru is not just the largest taxicab operator in India, but its

most technologically sophisticated.

IMPACT OF PE ON THE INDUSTRY

Meru took considerable risk in creating the Meru brand. This is because the cost to users is regulated

by the state and does not differ between taxicabs. Meru relied on achieving a certain scale of operations

that would justify the extra costs of airconditioning and IT-enabled services.

Having succeeded in this effort, Merus impact on the industry is becoming evident in the shift to me -

too services offered by individual operators and the rise of competing franchises.

HEALTHCARE COMPANIESPARAS

PHARMACEUTICALS


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Paras Pharmaceuticals is one of Indias leading OTC healthcare and personal care companies, with a

track record of introducing successful branded products. Its two leading brands, MOOV (a pain

relieving ointment) andDCold (a cough syrup) are both in the top 10 OTC brands in India. Personal

care products are among the fastest growing consumer segments with a growth rate in recent years at

14 percent. Paras has grown faster and expects to grow by 25 percent in FY 2010-2011.

Actis, a PE firm, invested USD 42 million in 2006 for a minority stake, raising it to a majority

shareholding in 2008, which they continue to hold. Actis rationale for the initial investment was based

on Paras ability to create strong brands in niche, fast -growing areas. They were impressed with the

companys ability to compete effectively against global organisations with innovative products; for

example, the success ofMOOV in a market dominated by market leaderIodex (a Glaxo brand).

Actis view of Paras noted above is shared by itspromoters. As a key company insider commented: A

company goes through three stages: incubation, implementing the initial vision and

professionalisation. At the second stage, the team needs to be willing to take risks and follow the

founders vision. Professionals are likely to be too risk-averse to do so as failure would hurt their

longterm career prospects. At the third stage, once the vision has been implemented, professionals need

to take charge.

It was at that third stage that Paras sought Actis as a PE investor to enable the transformation to a

professionally-run company. In fact, the money was the minor part of the transaction in a sense, since it

was used primarily to buy out the promoters holding rather than to be infused into the company (the

company was already cash rich). Paras required the PE firm to possess a deep understanding of the

industry as well as understand the company, both of which Actis possessed. As a company insider

notes: PE is expensive money: it should only be used if it comes with other benefits.

PE backing provided the company credibility as a professionally run-organisation and there was an

influx of younger, highlytrained talent that replaced family recruits. Paras recruitment of the best

quality professionals led to positive impacts on operational management with a greater focus on

efficiency, tighter financial controls, brand leveraging and an improved marketing and distribution

strategy.


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The transformation of Paras from a familyrun to professional company faced the challenges of cultural

transformation and was not a simple task but accomplished by focusing on these key areas and showed

clear results. EBITDA margins rose from 20 percent prior to PE funding to about 30 percent

afterwards. Subsequent to the Actis investment, the company has also expanded internationally,

especially in the Middle East and North Africa.

IMPACT OF PE ON PARAS

As is evident from the above, Actiss impact

was transformative in the sense of changing

how the company was run, while being

supportive of a quality that was already

ingrained, that of conceptualising and

developing a range of high-margin products

that could successfully compete with large

players, many of which are global

organisations.

Actis achieved its transformation by getting to

know the company, and then bringing in talent

in selected areas that were critical for raising

margins and enabling the efficient introduction

of new products, while retaining the innovative

core intact.

Among the many positive effects was a change

in practice in procurement, governance and

reporting, thus enabling a stronger brand being

built. As a result, revenue growth rates rose to

40 percent and gross margins rose by 10

percent. Actis also supported the strategic shift

in sales and distribution networks; as well as

international expansion.


The investment shows that a domestic company can succeed while competing with global

organisations. Although there are other successful examples, such as Dabur, Paras is a special case of

achieving this through professionalising a family-run firm in a credible way, with a majority of non-


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family ownership, while retaining the benefits of incorporating the initial promoters into the core

management structure.


Higher education, a recent growth leader in India, is a difficult field for PE investment owing to the

legal requirement that providers of degree-granting institutions are not permitted to earn profit. It is

estimated that, despite the industrys growth rate in technical fields of over 40 percent per annum

between 2005 and 2009, PE investments are less than USD 300 million.9 PE has, therefore, looked to

fund ancillary services that leverage brand names. Given the newness of the private higher education

sector, MULs success in using PE funds to finance for-profit services established a paradigm that was

earlier set for the K-12 sector by Educomp.

Shriram Transport Finance (STF), Indias largest commercial vehicle finance company, was

established in 1979. As of March 2010, the company runs 479 branches and service centers offering

finance for purchasing commercial vehicles, including trucks, three-wheelers and tractors. The

company also offers ancillary services, including working capital and a cobranded credit card. The

company has been consistently profitable for several years. For the financial year ended March 2009,

EDUCATION

MANIPAL UNIVERSALLEARNING (MUL)

FINANCE

SHRIRAM

TRANSPORT FINANCE


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STFs revenue was INR 36.9 billion and PBT was INR 2.9 billion. It employed 12,500 persons. The

company has been quoted on the stock exchanges for several decades. As of March 2010, its market

capitalisation was INR 91.6 billion.

The truck financing business at the time, and even as of 2010, was fragmented and high-cost due to the

risks and transactions costs of lending to unorganised, single-truck owners. STF catered to this market

but was also beginning to access the organised borrowers that were coming into play as the trucking

business became more organised in India. These factors had enabled STF to perform well in a

regulatory environment that was significantly more favourable to banks than to NBFCs. However, the

company was undercapitalised at the time of receiving the PE investment.

The company subsequently received multiple rounds of PE investment. In 2005, PE firm Chrys Capital

invested USD 30 million for a 17 percent holding in STF. It exited in 2008-09. Global PE major TPGinvested USD 100 million in 2006 and, as of 2010, remains an active investor. TPG was interested in

the financial sector in India, but the banking regulations prevented it from buying a large holding in a

regulated bank. TPG was attracted by STFs stability in terms of customers and credit -ratings, in the

midst of the NBFC meltdown at the time. STF further attracted TPG because of its reputation of

integrity, efficient management and customer loyalty.

The first PE funds were used by STF to integrate its regional operations and control them from its

home base in Tamil Nadu, as well as to consider international expansion. The second round of

investing, from TPG, brought in high standards of credit evaluation and corporate governance. TPGs

portfolio of Asian finance firms, such as First Bank, Korea, provided it with the experience to establish

these stronger standards. These were needed as the management was largely promoterdominated,

which made credit rating agencies and investors somewhat cautious. Also, their securitisation business

was relatively undeveloped.

Helped by better practices, STFs portfolio, which was at USD 1 billion in assets when TPG invested,

had risen to USD 6.5 billion by 2010.


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IMPACT OF PE ON STF

PE initially enabled a national strategy, when Chrys Capital invested in STF. Till then, STFs four

regional entities operated independently. Thus, in the words of a company insider: Chrys Capital

provided capital during the growth phase of STF.

TPGs investment transformed the company through better internal management practices and

corporate governance. The same insider notes that, where Chrys Capital enabled growth, TPG added

value. TPG helped in improving the credit rating of the company and developing the companys

securitization business. TPG, therefore, is an example of a PE investor with deep pockets and

experience in running financial firms in Asia and elsewhere bringing these advantages to STF.10


STF is the countrys largest player in commercial vehicle finance. The primary impact of the PE

investment on the industry was to begin the transformation of the business from a fragmented, money-

lender dependent business to a more organised business.

introduction to venture capital 5th

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