Early last year, when the ongoing downturn in India’s start-up market was beginning to get serious, the central government decided to step in and fix what it saw as some key problems. One of those was the woefully small presence of a self-reliant, domestic venture capital industry. In January, as part of its ambitious Start-up India programme, it announced the Rs10,000 crore (roughly $1.5 billion) Fund-of-Funds for Start-ups (FFS) that would invest in local venture capital funds which would, in turn, back early stage start-ups. A little over 12 months later, FFS remains a bit of a non-starter.

Soon after it was announced, Rs500 crore (about $75 million) was allocated to the Small Industries Development Bank of India (Sidbi), the agency entrusted with managing FFS on behalf of the government, for fiscal year 2015-16. An additional Rs600 crore (about $90 million) was earmarked for the current fiscal year that ends in March. Out of the first tranche of Rs500 crore, only Rs129 crore ($19.2 million) has been sanctioned to venture capital funds.

The slow deployment isn’t for lack of interest among local venture capital firms. Rather, based on conversations Mint had with several fund managers, interest is quite high. “Raising a fund, especially in a market like India, is a huge challenge. There aren’t very many large domestic limited partners (or LPs, industry parlance for investors in venture capital funds) readily available. If the government as a LP is willing to commit 20-30% of a fund’s corpus, it’s a huge leg-up for a first-time fund," says Manish Singhal, co-founder of Bengaluru-based pi Ventures which is in the midst of raising a $30 million maiden fund. He declined comment on whether the firm had applied for an allocation from FFS.

Mukul Singhal, co-founder of Pravega Ventures, seconds that view. “Remember, this (venture capital) is a very high entry-barrier business. The costs of starting up are not trivial. Plus, even if one has prior track record in the business, getting institutional investors on board isn’t easy for a first-time fund," he says. Delhi-based Pravega is raising a $30 million debut fund and is in line for an allocation from FFS. “Due-diligence by LPs is tougher in the case of first-time funds. A sanction letter from the government certainly helps with credibility," says Anil Joshi, co-founder of Mumbai-based Unicorn India Ventures which is raising a $15 million maiden fund that is also in line for a commitment from FFS.

What’s become a thorn in the side of firms such as Pravega, Unicorn and pi Ventures is the investment restrictions that come along with FFS. By mandate, FFS can only invest in venture capital funds that are registered with the Securities and Exchange Board of India under the AIF (Alternative Investment Funds) regulations. Such venture capital funds can raise capital from FFS on the condition that they invest only in start-ups that are in compliance with the criteria prescribed by the department of industrial policy and promotion (DIPP). That means the start-up must be at most five years old at the time of raising capital from a FFS-backed venture capital fund. Further, the venture capital fund cannot make follow-on investments in an existing portfolio company if it crosses the five-year mark by even a day.

In a nutshell, the terms laid down by FFS strike at the core operating principles of the venture capital business. A venture capital fund will typically participate in successive funding rounds in a portfolio company for a few reasons. One, it would want to prevent its equity stake from being diluted when a new investor inevitably brings in fresh capital in the next funding round. It is important for venture capital funds, especially those that invest at the seed and Series A stages, to continue to hold a meaningful stake in a start-up through its life cycle in the interest of harvesting profitable returns later. Two, during a downturn, when money and new investors are scarce, the existing investor may have to pony up more capital to keep a portfolio company afloat. “Funds have their follow-on strategies and can’t take a chance that by the time they invest again it (the start-up) may or may not be a start-up as per government rules," says Ashish Fafadia, chief financial officer at Mumbai-based venture capital firm Blume Ventures. Blume raised a $60 million second fund in October 2016 and part of the corpus came from the India Aspiration Fund, a smaller fund-of-funds that was set up by the government in 2015 and is also managed by Sidbi. It did not apply for funds from FFS.

Three, remember FFS brings in only a portion of a venture capital fund’s total corpus. The rest has to come from other LPs such as family offices, banks, pension trusts and HNIs (high networth individuals). The investment restriction is an unfair imposition on those LPs. “The restrictions could be meaningless for other limited partners and may become a bottleneck in the fundraising process," says Sateesh Andra, co-founder of Hyderabad-based venture capital firm Endiya Partners which raised a $26 million maiden fund in January. Like Blume, part of the corpus came from the India Aspiration Fund and it didn’t need to approach FFS for this fund.

The government isn’t unaware of these problems. “It (the government) has taken note and is working on modifying some of the terms and conditions. It’s a matter of two-three months," says Saurabh Srivastava, founder of Delhi-based angel investors group Indian Angel Network. Srivastava serves as an external expert on the Sidbi investment committee that vets applications for FFS. Mint reported in January that DIPP is taking steps to overhaul FFS and may allow venture capital funds to invest half of the corpus in later stage start-ups, i.e. start-ups that are more than five years old. It may also relax the norm that such funds can invest only in start-ups that have annual revenue of Rs25 crore or less.

What cannot be denied is that out of all the initiatives that have been outlined under the Start-up India programme, FFS is the centrepiece. Access to capital at the seed and Series A stages, when a start-up has barely launched its product or service, can make the difference between life and death. Now, it may be argued that in recent years, the availability of venture capital hasn’t really been a constraint in India. While the number of venture capital firms active in the country is small at 20-odd at the most, they have consistently been able to raise successive funds over the years. The funds have also gotten bigger with each year. For instance, last year, just three of the largest firms active here—Sequoia Capital India, Nexus Venture Partners and Accel India—together raised more than $1 billion in new funds.

But Sequoia and Accel, both local franchises of Silicon Valley firms, do not need the support of a government-backed fund-of-funds. Their parent partnerships in the US enjoy deep relationships with and access to global LPs, which have a long tradition in investing in the venture capital asset class. These include public pension trusts such as CalPERS (the California Public Employees’ Retirement System), rich university endowments such as Harvard Management Co. Inc., a vast population of family offices, and banks and financial institutions. Such institutional investors form the bedrock of the venture capital industry globally. In India, in the absence of a meaningful base of domestic institutional LPs, home-grown firms such as Nexus Venture Partners, Helion Venture Partners and Blume Ventures have also had to rely on foreign capital. By rough industry estimates, nearly 90% of the venture capital that is invested in India every year comes from overseas.

Why is that a problem?

Two reasons. One, since most of the capital comes from markets such as the US and Europe, any ups and downs in those economies can impact the inflow of capital here. For instance, if the US Federal Reserve were to increase interest rates significantly— it raised the benchmark interest rates to a range between 0.5% and 0.75% in December and further hikes are expected this year—it could have a bearing on venture capital allocations to India by foreign LPs. Two, venture capital funds backed by foreign capital, whether they are Silicon Valley franchises or home-grown ones, tend to gravitate towards start-ups that replicate business models that have been successful in those markets because their LPs are more comfortable with those models. A good example would be the handful of copycat e-commerce firms that have absorbed enormous amounts of capital over the past six-seven years and are yet struggling to turn profitable.

In making sovereign capital available to local venture capital funds, the government hopes to compensate, to some extent, for the absence of local LPs. Indeed first-time funds often have to depend on HNIs to muster the initial tranche of capital from their personal networks. Pravega’s Singhal, for instance, expects to raise the first tranche of his fund almost entirely from HNIs. Last week, Bengaluru-based Stellaris Venture Partners, which is raising a $100 million maiden fund, signed on commitments worth $50 million. While institutional investors such as software services company Infosys Ltd and Sidbi are part of the investor mix, as many as 50 HNIs have co-invested in the fund. Stellaris co-founder Ritesh Banglani declined to comment on whether the fund has applied to FFS. There’s nothing wrong with raising money from HNIs but having too many on board comes with its own set of problems, the least of which is managing the expectations of a large and unwieldy set of investors.

The government also hopes that with time, encouraged by FFS, local banks and insurance companies, family offices and corporates will invest more meaningfully in the venture capital asset class. The larger presence of domestic institutional capital in local venture capital funds, in turn, may encourage such funds to back businesses that are more India-appropriate and, in the long term fetch better returns for investors. With more home-grown venture capital funds in play, backed by local LPs, the next downturn, when it comes, may be less painful to bear for start-ups.

Everything, however, depends on how quickly the government moves to resolve the problems with FFS and restore confidence that Start-up India is more than grand rhetoric.

Snigdha Sengupta is a consulting writer with Mint. She contributes stories on venture capital and private equity.

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