The venture capital and private equity industry Essay Example
The venture capital and private equity industry Essay Example

The venture capital and private equity industry Essay Example

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  • Published: June 15, 2018
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Journal of Indian Business Research Emerald Article: Venture capital and private equity in India: an analysis of investments and exits Thillai Rajan Annamalai, Ashish Deshmukh Article information: To cite this document: Thillai Rajan Annamalai, Ashish Deshmukh, (2011),"Venture capital and private equity in India: an analysis of investments and exits", Journal of Indian Business Research, Vol. 3 Iss: 1 pp. 6 - 21 Permanent link to this document: http://dx. doi. org/10. 1108/17554191111112442 Downloaded on: 24-09-2012

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The organization is affiliated with COPE and collaborates with Portico and the LOCKSS initiative for preserving digital archives. *Related content and download information are accurate at the time of download. The current issue and full text archive of this journal can be found at JIBR 3,1 Venture capital and private equity in India: an analysis of investments and exits. The authors of this article are Thillai Rajan Annamalai and Ashish Deshmukh from the Department of Management Studies at the Indian Institute of Technology Madras in Chennai, India.

The venture capital and private equity (VCPE) industry in India has grown significantly in recent years, becoming the third largest worldwide for investments between 2004-2008. However, there is limited academic research on this industry in India. This paper aims to address this gap by examining recent trends in the Indian VCPE industry.

Traditionally, studies on VCPE transactions have focused on specific aspects of the investment lifecycle, such as investments, monitoring, or exit. In contrast, this study takes a comprehensive approach by analyzing the entire investment lifecycle from initial investment to eventual exit. The analysis is based on 1,912 VCPE transactions involving 1,503 firms between 2004-2008.

The findings reveal that most VCPE investments took place during the late stage of financing and many years after the investee firm's incorporation. These investments were also characterized by their short duration. Furthermore, factors like industry type, financing stage, region of investment, and type of VCPE fund could predict the type of exit.

The significance

of this research paper is to emphasize key areas for ensuring sustainable growth in the industry, particularly by increasing early stage funding opportunities to guarantee a strong pipeline of investment options for late stage investors. It is crucial to view VCPE investments as long-term commitments rather than quick decisions. To achieve this, having a robust domestic VCPE industry is important, as it allows for longer-term investment in portfolio companies. Keywords in this research paper include venture capital, equity capital, India, investments, and financing.

The growth of the Indian VCPE industry has been remarkable in recent years, making it one of the top choices for venture capital and private equity investments. While the concept of VCPE investment existed in the country since the 1960s, significant growth in the industry occurred after the economic reforms in 1991. Before that, most VCPE funding came from public sector financial institutions and exhibited low levels of investment activity. However, in recent years, there has been a rapid increase in VCPE commitments and investments in India.

During the period 1990-1999, India was ranked 25th out of 64 based on venture economics data, with various VCPE funds raising $945.9 million for investments in India. However, over the next decade (2000-2009), India's ranking improved to 13th out of 90 countries, with the funds raising $16,682.5 million for investments in India. The information is from the Journal of Indian Business Research Vol. 3 No. 1, 2011, pp. 6-21, published by Emerald Group Publishing Limited (ISSN: 1755-4195). The authors acknowledge the financial support provided by the Indian Council of Social Sciences Research and IIT Madras for this research.

M. B. Raghupathy and V. Vasupradha are

recognized for their assistance in this research, along with the remarkable increase in investments made by different VCPE funds over the past decade, which amounted to a 1,664 percent growth rate. This positive trend is even more evident in the most recent five-year period from 2005 to 2009 when India ranked 10th out of 77 countries and various funds raised $15,073.6 million for VCPE investments in India. Comparatively, during the previous five-year period of 2000-2004, funds raised experienced a growth rate of 837 percent.

Between 2004 and 2008, the Indian industry underwent significant expansion and became the third largest in terms of investments globally[1]. In this period, VCPE funds initially invested $1.8 billion in 2004, which then rose to $22 billion in 2007 before declining to $8.1 billion in 2008[2]. Additionally, VCPE investments in India increased from comprising 0.4% of GDP in 2004 to over 1.5% of GDP by 2008 (Annamalai and Deshmukh, 2009). The subsequent section presents the objective of this paper[3].

The paper's third section discusses the data set and sources of data used for analysis. Section 4 is then divided into six sub-sections, which cover round wise analysis of investments, time of incorporation and financing stage, intervals between funding rounds, investment exits, duration of investment, and a statistical analysis of investment duration and type of exit. Lastly, Section 5 provides a summary of the paper. The overall objective is to fill the research gap on VCPE that aligns with the industry's growth.

Previous studies have investigated different aspects of the Indian VCPE industry. Some researchers, including Pandey (1996, 1998), Verma (1997), Dossani and Kenney (2002), and Singh et al.

(2005), have examined its development and current status. Others, like Lockett et al. (1992), Subhash (2006), and Ippolito (2007), have conducted cross-country studies that include India. There has also been survey research specifically analyzing VCPE industry practices in India, as shown by Mitra (1997), Vinay Kumar (2002, 2005), Vinay Kumar and Kaura (2003), and Mishra (2004). Additionally, there are case studies focusing on VCPE investments in India, such as the work by Kulkarni and Prusty (2007).

The main goals of this paper are twofold. Firstly, it aims to address the lack of research on the VCPE industry in India during its growth phase from 2004 to 2008. Previous studies focused either on periods prior to 2004 or did not cover the entire growth phase. To bridge this research gap, this paper will concentrate on recent trends in the Indian VCPE industry.
Secondly, it seeks to analyze the complete investment lifecycle, encompassing both investments made and their eventual exit. While separate studies have been conducted on investment decision making, structure, valuation, and venture exits, this paper intends to provide a comprehensive analysis of the entire investment lifecycle.
In summary, this paper's primary contribution lies in its holistic examination of the investment lifecycle.

This paper aims to provide insight into lesser-known aspects of the Indian VCPE industry, including the characteristics of investee firms during VCPE investments, the duration of these investments, and how investors exit. The ultimate objective is to gain a comprehensive understanding of the Indian VCPE industry to promote a policy environment that encourages its growth. This study analyzes VCPE investment transaction data from 2004-2008.

The analysis period was selected for two reasons. Firstly,

it coincided with a period of significant growth in the industry and India's emergence as a major destination for VCPE investments. This makes studying the industry's growth an intriguing topic for researchers. Secondly, practical considerations were also taken into account when determining the period. Before 2004, there was insufficient data on VCPE investments in India that could be utilized for research purposes. Hence, the study commenced in 2004 when data became accessible.

The study aimed to analyze transactions for a period of five years, taking into account annual fluctuations and aligning with the complete financial cycle in global markets. This cycle typically involves significant growth followed by decline. To gather data, information was collected from multiple sources including Venture Intelligence India[3] and Asian Venture Capital Journal[4] databases. Combining the data from both databases created an extensive dataset for analysis.

The data set was reviewed for data repetition and any duplicate data points were removed first. Then, if there was any discrepancy in the information provided for the same deal, its accuracy and correctness were verified independently using other sources like newspaper reports and company websites. If the required information was not available in these databases, it was separately obtained from the websites of the respective companies. It should be noted that due to the absence of a comprehensive database on Indian investments, creating such a data set required significant effort.

The comprehensive data set developed provided various details on VCPE investments and exits in India from 2004 to 2008. It included 1,912 transactions involving 1,503 firms during this period. Out of these, 1,276 firms had only investment transactions, while 129 firms

had only exit transactions. The remaining 98 firms had both investment and exit transactions. To enable a more detailed analysis, the investments were classified into ten industry categories and four financing stages based on the lifecycle stage of the investee firm and investment objectives. Exits were categorized as initial public offerings or mergers and acquisitions/trade sales.

In terms of the round-wise analysis of investments, firms seeking VCPE investments typically receive them in multiple rounds. Previous studies have offered several explanations for this phenomenon. Gompers (1995) suggests that the staging of capital infusions allows venture capitalists to gather information and monitor firm progress while maintaining the option to abandon projects at periodic intervals.

According to Admati and Periderer (1994), it is crucial to have the option to abandon a failing project because entrepreneurs will continue to pursue it as long as they receive capital from others, and the threat of abandonment incentivizes them to maximize value and meet goals. Neher (1999) suggests that multiple rounds of financing can resolve potential conflicts between entrepreneurs and investors, as previous rounds establish collateral to support later rounds. The stage of financing is determined by investment objectives and timing, while the round of financing indicates the number of instances of venture capital and private equity investments in the company. For example, Round 1 financing is the first instance of the company receiving investment, but it may not always occur at an early stage. Depending on the company's lifecycle and investment objectives, Round 1 financing can occur in any of the four financing stages. Similarly, multiple rounds of investment can occur within the same stage. In a particular funding round,

there may be multiple investors jointly investing in the company.

When multiple VCPE investors invest together at the same time, it is considered one investment round. Similarly, if an investor makes multiple investments in the company at different times and valuations, each investment is viewed as a separate funding round. Funding rounds are regarded as separate if there has been a significant gap in time since the last financing round and/or the investment occurs at a different valuation than the previous round. Figure 1 shows the results of analyzing VCPE investments by funding round.

The findings show that 82 percent of the VCPE investments were in Round 1, which refers to the initial investments made in the company. Only 18 percent of the total investment was attributed to follow-on investments. It is evident that investments decline significantly as subsequent funding rounds take place. This could be due to the fact that most of the investment occurred in the later years of the study period [5], suggesting that there may not have been enough time for the next round of investment.

Based on the research, VCPE investments may occur during later stages of a company's lifecycle. At this point, the company no longer needs extra funding to reach a critical size for an IPO or finding a buyer. This can be explained by the grandstanding theory (Gompers, 1996), which states that VCs prefer to exit their investments earlier. Furthermore, this trend may indicate that companies receiving initial investment did not perform well enough to attract further investment from investors.

Further research is needed to fully understand this pattern. Table I reveals that out of

1,503 companies, there were a total of 1,912 rounds of funding received by companies in different industries. This indicates that on average, each company received 1.27 rounds of funding.

Table I also shows that most firms only received one round of VCPE investment. Figure 1 supports this finding by showing that during the years 2004-2008, 82% of the total VCPE investments were for Round 1. Additionally, only 13% of companies obtained two rounds of funding and less than 5% of all companies receiving VCPE investments during this period got more than two rounds.

The distribution of second-round funding across various industries remains mostly consistent with Round 1 investments except for the financial services sector. However, our analysis does not find any clear pattern indicating certain industries' greater success in securing Round 2 investments.

A significant number of funded companies are in the fields of information technology (IT) and information technology-enabled services (ITES). These sectors make up 24 percent of all funded companies, 24 percent of those receiving initial funding, and 25 percent of those securing multiple rounds of funding. This suggests that while IT and ITES companies are acknowledged as drivers for growth in India, they have not achieved as much success in attracting repeated rounds of funding compared to firms in other industries.

Financial services companies account for 10 percent of all funded companies, with 9 percent having one round of funding and 15 percent having multiple rounds. This indicates that financial services companies have a higher success rate in securing additional investment. There are several reasons behind this trend. Firstly, larger funding requirements may necessitate multiple rounds of funding. Additionally, companies that have

already received initial funding may possess a strong performance history, making them attractive for further investment rounds. Furthermore, the Indian financial services industry was experiencing growth during the study period, which made it enticing to investors. The institutional and regulatory aspects associated with private equity investing in India might have also influenced the decision to pursue multiple rounds of funding due to procedural issues related to foreign investments in certain sectors. Further research is needed to identify the specific factors impacting the number of funding rounds.

Industries that require more capital typically undergo multiple funding rounds. Among the ten industry categories, engineering and construction as well as manufacturing sectors are highly capital intensive. However, the proportion of companies in these industries receiving additional funding is not higher than those getting first-round funding. In fact, the percentage of manufacturing companies obtaining extra financing is lower compared to their initial round. This trend has several possible explanations that need further research.
One potential reason is that companies in these sectors receive venture capital and private equity (VCPE) funding later in their lifecycle, eliminating the need for subsequent rounds of financing before offering an exit to investors. Another possibility is that their asset-heavy nature allows them to secure debt funding, reducing reliance on additional VCPE financing. It is widely acknowledged that VC investments usually happen early on in a company's existence.

At the early stage, companies face difficulties in obtaining funds from traditional sources and therefore turn to alternative sources such as venture capitalists. Table II presents our analysis findings, which show the time gap between incorporation and the funding stage. These results highlight important trends: usually,

early stage funding should happen within a few years of company establishment. However, our analysis reveals that 17 percent of firms receive their early stage funding even after ten years of incorporation.

In India, the majority of funding for early stage companies happens within one to three years of incorporation. However, a significant number of companies continue to receive early stage funding even up to their fifth year. This implies that VCPE investors in India are hesitant to invest in the earliest stages of company development. Growth stage investments typically occur between five and eight years, which is considered reasonable. However, it is worth noting that the second highest percentage of growth stage funding takes place after 15 years since incorporation. This phenomenon requires further examination to determine if it stems from investor reluctance or if these companies simply aren't ready for VCPE funding in their early years. It's possible that these companies have explored alternate funding options such as family, banks, or friends before seeking investment from VCPE investors.

The table presents the financing stages and their corresponding time since incorporation. The analysis of VCPE deals for different financing stages over time since the establishment of investee companies indicates a consistent increase in late stage investment deals. It is worth mentioning that more than 50% of these late stage deals occur in companies with a history of over 15 years.

The previous findings are reaffirmed, indicating that VCPE investors typically invest more in companies that have a longer operating history and are of sufficient size. It is possible that these companies receiving late stage funding were initially supported financially by a larger

business group. Additional research is needed to understand the factors leading up to firms receiving late stage investment.

Approximately 75% (541 out of 722[6]) of deals involve companies that have been operating for more than five years. Around 60% (429 out of 722) of VCPE deal investments are made in firms that are at least eight years old, confirming previous findings that VCPE funds in India prefer investing in companies with a proven track record. This investment trend is notably significant in India, but it may also be similar to other emerging economies such as Brazil (Ribiero and de Carvalho, 2008).

The majority of VCPE investments in India are classified as PE investments rather than VC investments, which typically target early stage companies. The average time gap between Round 1 and Round 2 funding is approximately 13.69 months, while for Round 2 to Round 3 funding it is around 10.1 months. The median values for these intervals are respectively 12.17 and 11.17 months, indicating a relatively balanced distribution of time intervals between funding rounds.

Figures 2 and 3 demonstrate the distribution of time intervals between funding rounds, revealing that deals are evenly spread out in the early stages with slightly higher frequency around the mean value but become less common as they progress further.

It should be noted that considering it takes about three to six months from initial investor meetings to secure an investment, the short time gaps between funding rounds hold significant importance.

The provided table displays the percentages of investments in various industries such as financial services, telecommunications and media, transportation and logistics, ranging from 8.46% to 17.13%.

Figure 2 illustrates the number of VCPE deals

in India over a specific timeframe. The duration between Round 2 and Round 1 investments is divided into different intervals lasting from three to thirty-six months, with fewer deals occurring as the duration increases.The text implies that multiple financing rounds undertaken by a company may indicate continuous emphasis on raising capital, potentially harming business operations. Additionally, research indicates an increasing pattern of more frequent financing in India.

It is surprising that the company's funding has not increased with each round as expected, which would typically meet their needs for a longer period of time. This discovery even takes into account higher cash burn rates as the company grows. When comparing intervals between funding rounds in various industries, it is observed that the engineering and construction sector experiences the longest gap between initial and subsequent funding rounds. Additional research is necessary to explore potential reasons for this trend, which could be attributed to these industries' capital-intensive nature.

They raise significant amounts that assist companies in maintaining operations for an extended time. Additional funding can be obtained from sources like debt. Finances can also come from operational cash flows. However, the time gap between the second and third investment rounds in this sector is the shortest, possibly due to the pre-IPO nature of funding. Venture exit research has been limited in this area (Gompers and Lerner, 2004).

The VCPE investor must sell their investment within a specific timeframe to recoup their investment and generate profit. It is crucial for investors to have access to favorable ways of swiftly selling their investments when assessing potential investments. Several options exist for selling VCPE funds, such as

IPOs, selling shares on the secondary market, management buyouts, and liquidation. However, the predominant methods employed in the Indian VCPE markets are IPOs and trade sales through M.

A total of 252 exit events were recorded during the period from 2004 to 2008. Among these, 84 events were IPOs and the remaining 168 events were M. This implies that the ratio of exits for IPOs to M is exactly 0.5, indicating that an exit by M is twice as probable as an exit by IPO. However, a fascinating trend emerges when examining this ratio across different industries. Except for engineering and construction, as well as transportation and logistics sectors, the ratio consistently remains below 1. Companies in these sectors typically have high capital requirements with a large asset base and heavily rely on the Indian market.

The VCPE sector has different exit strategies depending on company size and industry. Larger companies with higher revenues or assets often choose to go public through an IPO. On the other hand, sectors like computer hardware, IT and ITES, and healthcare prefer to exit through mergers (M). These industries have a low ratio of IPO-M exits, less than 0.4, indicating their preference for M exits (Figure 4).

The choice of exit strategy is also influenced by the state of the capital markets. Figure 5 shows the ratio of IPO-M exits in each year during the study period. The overall ratio for the five-year period ending in 2008 is 0.5 but varies depending on market conditions. It ranges from 0.3 to 0.6 for most years except for a significantly higher ratio of 0.8 in 2006 due to a

flourishing IPO market in India (Figure 5).

Lerner (1994) found that IPOs are more likely when equity values are high and that capital markets affect how long it takes for an investor to exit. Figure 6 illustrates how the average number of rounds varies over time for both types of exits.

The variations in the number of rounds of VCPE funding before IPOs are significant. Specifically, during the years 2006 and 2007 when the capital markets were active, there were fewer rounds of funding before IPOs compared to other years. On the other hand, the number of rounds of funding before an M has been consistently increasing over time, suggesting a greater requirement for size before exiting through an M. However, it is particularly interesting to consider companies that exit from other means.

The conditions in the capital markets do not have a significant effect on M's circumstances. However, if the conditions are favorable, companies can benefit.

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