DEVELOPMENT OF THE INDIAN VENTURE CAPITAL INDUSTRY

By VRATA CHIGATERI 2006

A DISSERTATION PRESENTED IN PART CONSIDERATION FOR THE DEGREE OF MBA - FINANCIAL STUDIES

ACKNOWLEDGEMENTS

First and foremost, many thanks are due to Prof. Mike Wright, whose patient guidance and invaluable remarks have been vital in my carrying out the study in India and in the completion of the project. Secondly, thanks are due to the venture capitalists that participated in the study, for their valued contribution and comments, inspite of very busy schedules. I would like to gratefully acknowledge the financial assistance provide by Barclays Private Equity and Deloitte & Touche Corporate Finance to CMBOR (Centre for Management BuyOut Research). And finally, a warm thank you to my family and friends for their persistent support.

Responsibility for all errors and omissions is accepted.

Vrata Chigateri October 2006

TABLE OF CONTENTS

Summary...v

I. INTRODUCTION 1.1 Introduction1 1.2 Venture Capital..3 1.3 Importance of Venture Capital...4 II. METHODOLOGY 2.1 Research Methods...6 2.2 Data Source.6 2.3 Access.7 2.4 Questionnaire..7 2.5 Data collection and Analysis..8 2.6 Limitations..9 III. REVIEW OF INDIAN VENTURE CAPITAL INDUSTRY 3.1 History & Background..10 3.2 Recent Trends13 IV. DEVELOPMENT OF PRIVATE EQUITY AND VENTURE CAPITAL MARKETS 4.1 Literature review16 4.2 Framework.18 V. A COMPARITIVE ANALYSIS: INDIA & CENTRAL AND EAST EUROPEAN MARKETS 5.1 Introduction.20 5.2 Creation of Opportunities21 5.2 .1 Supply of Opportunities 5.2.1 (a) Growth and Expansion..22 5.2.2 (b) Privatisation..23 5.2.3 (c) M & A Market...23 5.2.4 (d) PIPE...24 5.3 Demand for PE and VC investments

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5.3.1 (a) Capital Scarcity.24 5.3.2 (b) Entrepreneurial Climate25 5.3.3 (c) Professional Managers..26 5.4 Infrastructure to Create Deals 5.4.1 (a) Favourability of Legal Framework...27 5.4.2 (b) Favourability of Tax system.27 5.4.3 (c) Intermediaries28 5.5 Realisation of Value29 5.6 Conclusion...30 VI. SYNDICATION 6.1 Introduction..32 6.2 Literature Review 6.2.1 Motives For Syndication-I.33 6.2.1(a) Finance based view.34 6.2.1(b) Resource Based View.35 6.2.1 (c) Deal Flow37 6.2.2 Motives For Syndication -II 6.2.2(a) Stage of Investment.38 6.2.2(b) Role in investment Lead / Non Lead..39 6.2.2(c) Partner Selection Criteria41 6.2.2(d) Specialists and Generalist Funds.42 6.2.2(e) Independent & Captive Firms.42 6.2.3 Syndication and the Monitoring of Investees42 VII.QUALITATIVE ANALYSIS OF SYNDICATION PRACTICES IN INDIA 7.1 Introduction...44 7.2 Motives for Syndication 7.2.1 Finance Based Motive45 7.2.2 Resource Based Motive..45 7.2.3 Deal Based Motive.46 7.2.4 Local and Foreign Firms46 7.3 Non-Lead membership 7.3.1 Finance Based Motive48 7.3.2 Resource Based Motive..48
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7.3.3 Deal Based Motive48 7.3.4 Local and Foreign Firms49 7.4 Partner Selection Criteria 7.4.1 Syndicating Out.49 7.4.2 Syndicating In..51 7.6 Role of Lead and Non-lead in Monitoring of Investees...51 7.5 Conclusion52 VIII. CONCLUSION 8.1 Development in the Indian VC Industry...55 8.2 Comparative Analysis between India and CEE markets..56 8.3 Syndication57 8.4 Implications...58 8.5 Conclusion.59 Appendix I...60 Appendix II..61 Appendix III.63 Bibliography66

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SUMMARY
Post liberalization, emerging markets and transition economies have become the most sought after destination for investment by venture capital firms. Governments have been undertaking radical regulatory changes in order to provide finance for the developmental phase of their economies.

Using a framework (Wright et al, 1993) to analyse and compare development between India and Central and Eastern Europe reveals that there are numerous factors that influence the development of the venture capital industry. As the rate at which institutions develop vary from country to country so does the level of development. An environment conducive for the growth of venture capital would need to have ample opportunities for investment along with legal and accounting support in creating deals. A thriving stock market and adequate liquidity in the economy will allow venture capitalists to realise their value.

In order to better understand venture capital behaviour in an emerging market scenario, the study presents an analysis of syndication practices in India. The results reveal that the economic conditions and internationalisation factors greatly influence the motives of firms to syndicate.

The study is presented based on a combination of interviews with venture capitalists and extensive desk based research and has significance for policy makers, venture capitalists and entrepreneurs. Policy makers need to make regulatory changes to encourage flow of funds from across the borders as well as from with the country. Venture capitalists entering the country need to be aware of the syndication practices of local firms in order to avoid ex-post investment decision managerial problems. While entrepreneurs by knowing the motives behind syndication, can leverage on the resources to enhance the value of the business.

CHAPTER 1

1.1 Introduction

The purpose of this study is to mark the trajectory of the Indian venture capital industry and to better understand venture capital behaviour and motives towards syndication in an emerging market scenario.

The venture capital industry took root in the United States and has since moved to Europe and very recently to the Asian Continent. The US has by far the most developed venture capital industry and venture capital backed firms have played a vital role in shaping the macro economic conditions of the country. Contributing annually to the tune of $1 trillion to the US economy, these firms are responsible for creating employment for over 12 million people (Bruton et al, 2005). The importance of a venture capital industry has been reiterated time and again. An OECD (2000) report considered it crucial in the success of high technology entrepreneurial firms and recommended that all countries adopt strategies to enhance its growth (Dossani & Kenny, 2000)

With developing markets like the United States reaching saturation point, venture capital firms are looking else where for investment opportunities. Emerging markets like China and India are considered ideal destinations, as their current development phase provide numerous opportunities for investment. The lack of understanding of venture capital operation and behaviour within a country would negatively influence the decision to invest. This would have a direct bearing on the level of activity, hampering the growth of the industry. Therefore in order to reduce the risks perceived by investors, research on the developing markets is a necessity.

India is a burgeoning economy and over the past decade, has been receiving tremendous global attention. Growth in emerging markets like India has been propelled by the governments taking firm steps towards economic liberalization (Hoskisson et al, 2000). Capitalizing on its labor cost advantage, a feature common to emerging economies, India has been able to leap frog from being just another fast developing economy to becoming a major emerging market. According to De Mattos et al (2002), over the next 20 years, India along

with China, Brazil, Turkey and Mexico is expected to become an economic center of the world. With GDP growing at the rate of 8% annually in the past three years (Reddy, 2006) and with the purchasing power of the middle class increasing, there is great demand for products and services. The Telecommunications and Banking sectors have seen tremendous growth along with Information Technology (IT) and IT Enabled Service (ITES) sectors.

A large body of literature exists on developed markets (Ooghe et al, 1991;Manigart et al, 2002;Wright et al, 1993,2003,2004a). Nevertheless, the venture capital industry is greatly influenced by institutional, cultural, and economic factors specific to a country (Wright et al, 2002a). Hence a need for focussed research on developing countries. Inspite of recent studies by Wright, Lockett & Pruthi (2002a, 2002b), Dossani & Kenny (2002), Pandey (1998) and others on the Indian sub-continent, it is still limited.

Ooghe et al, (1991) identify characteristics, which help in determining the maturity of the industry in a country. Along with non-participation by the government and the involvement of pension and insurance companies in investments, the level of deal syndication proves to be an important indicator.

Importance of syndication permeates to the deal level as it is a crucial strategic decision undertaken by firms in order to access skills of other firms and to enhance the value of their investments (Lockett & Wright, 2001). Extensive research in the practices of syndication in developed countries like US, UK and West European countries has been conducted. Research indicates that a similarity in syndication behaviour across west European countries is the result of a high degree of institutionalisation of the industry across these countries (Manigart et al, 2002b).

However, in contrast institutional factors are ever changing especially in the context of emerging markets (Hoskisson et al, 2000). Differences in institutional environment between countries would take time to bridge as the rapidity at which institutions changes occur, differ from country to country (Wright et al, 2004c). Therefore, the changes in institutional development would reflect in venture capital behaviour.

The study focuses on understanding the development of the Indian venture capital industry and the current trends influencing it. Using that as a backdrop the syndication practices in India are examined.

1.2 Venture Capital

Venture capitalists are investors who thrive in environments characterised by risk and information asymmetry. They provide finance in the form of equity to fledgling enterprises, which are high risk and high reward (Gompers & Lerner, 1998). Venture capital firms have adapted to the existence of information asymmetries by developing specialist skills in selecting and monitoring of the enterprises in which they invest (Amit et al, 1998). They seek a return for their specific and distinctive skills in identifying, investing in and monitoring new or radically changing firms (Wright& Robbie, 1998). Their contribution to early stage ventures is not limited to financial assistance. Venture capitalists provide a gamut of value enhancing services like intensive monitoring, management consulting and reputation capital, (Black & Gilson, 1998) which are crucial for start up companies to grow and mature. Sahlman (1990) defines venture capital as a professionally managed pool of capital that is invested in equity-linked securities of private ventures at various stages in their development.

The terms venture capital and private equity are understood differently in the UK and in Europe. Private equity refers to the investments made by wealthy individuals and financial institutions in both private and public equity and in Europe forms a part of venture capital financing (Jeng & Wells, 2000). In the US a distinction is made between the two where, Venture Capital refers to seed, start-up and expansion capital, and private equity refers to management buy-outs.

Venture capital and traditional corporate finance although similar on the basis of tools used in decision-making of investments are distinctively different due to existence of information asymmetry in VC and the lack of it corporate finance (Wright and Robbie, 1998).

1.3 Importance of Venture Capital

The importance of venture capitalists and the impact they have on the economy has been emphasized time and again by academic research. The value addition that venture capitalists bring to their portfolio company is a direct result of the specialist skills and expert advice they provide along with equity capital.

Black & Gilson (1998), in their study of the U S venture capital industry, have noted that firms which began with venture capital backing have gone on to play a significant role in shaping the macro economic landscape as they matured, especially in emerging sectors like biotechnology. Also venture capitalists are known to take an active role in identifying or bird-dogginginnovative entrepreneurs. By partnering with these exceptionally talented entrepreneurs, they achieve what Timmons and Bygrave (1986) call an acceleration effect . That is the collaborated efforts of both parties; take innovations to commercial maturity and social utility at a far greater velocity than a firm would alone.

The benefit of a developing venture capital industry translates into an increase in employment. Timmons and Bygrave (1986) highlight the correlation between high technology firms, financed by venture capitalists and the enormous growth in employment. Megginson s (2001) substantiates the effect on employment by drawing from data in the NVCA and EVCA showing how an increase in capital invested in portfolio companies also increased employment. Megginson and Weiss s (1991) study of venture capital certification, reflect that the participation of venture capitalists helps in taking younger company to an IPO (Initial Public Offering) and at the same time attracts prestigious auditors, underwriters to participate and elicits greater interest from institutional investors. Therefore, venture capital participation helps in enhancing the economic topography of a country.

Having briefly considered the meaning and importance of venture capital the following chapters are dedicated to understanding the development and growth of the Indian venture capital industry and syndication behaviour therein. The chapters are structured as follows. While Chapter 2 lays out the methodology adopted for the study, Chapter 3 presents a review of the Indian venture capital Industry and brings to the foreground recent trends. Chapter 4 is a literature review on the factors for development of a venture capital industry and presents the framework for analysing the development of an industry. While Chapter 5 covers a
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comparative analysis on the development of the venture capital industry between India and Central and East European (CEE) region, chapter 6 and 7 are dedicated to syndication and an analysis of syndication behaviour in India. The final, chapter 8 cover a summary of the finding in the previous chapters and also throws light on the implication this study has for policy makers and practitioners alike.

CHAPTER 2 RESEARCH METHODOLOGY

This dissertation is written towards a larger project on the emergence and significance of Venture capital financing in developing economies of Central and Eastern Europe and Asia that is currently being conducted by the Centre for Management Buy-Out Research (CMBOR), Nottingham University. The project is undertaken as my interests matched with the larger concerns that the project was dealing with, namely the development of venture capital in the Indian sub-continent at a macro-level and the motives for syndication at a deal level.

To be able to gather detailed information on the venture capital industry in India this study has drawn from a mixture of research methods. This chapter details the research methodology adopted, data collected and the limitations of the study.

2.1 Research Methods

The study employs a combination of primary and secondary data. Data was collected using both an interview method and a questionnaire. The questionnaire allows for a structured set of questions addressed towards the aim of research to be gathered. Further, an interview provides a medium to get full range and depth of information. It also lends an opportunity to build a relationship with the interviewee. The target group for the data collection were the venture capital and private equity firms in India.

2.2 Data Source

In order to identify the population for the study the Indian Venture Capital Association (IVCA) and the Asian Pacific Equity Bulletin, 2005 were used. The two sources were chosen, as they would provide the most updated information of firms currently operating in India and more importantly provide name and position held of individuals who could be contacted. The IVCA was able to provide contact details of its members. The list required filtering as it included advisors, legal consultants and academic individuals. The Asian Equity Bulletin

provided details of the top 300 VC firms in the Asia-pacific region. The two data streams were combined and carefully sorted in order to avoid duplication and select only those firms that met the bill of the target group. Finally the total number of firms that could be used for the study was 43.

2.3 Access

To gain the co-operation and participation of the various firms it was decided to communicate with them via a fax or an e-mail introducing and explaining the purpose of the research. The introductory letter spoke of the purpose and importance of the research and also promised confidentiality of participantsidentity and responses, other than in a collective form. Wherever e-mail details of managers were available they were contacted through the electronic route and the rest were communicated via a fax. All firms were contacted by the last week of July 2006. Follow up calls were made in July and in August 2006 post the initial contact requesting for a telephonic interviews. The population of firms are spread across various cities, and given the paucity of time and intent to contact as many firms as possible, it seemed feasible to choose telephonic interview over personal interview. However, for reasons of convenience only firms located in Bangalore City were requested for personal interviews. In the process of making contact it was realised that some firms were not in operation and therefore could not be reached. Amongst those who could be reached three firms refused participation due to time constraint. The appropriate persons in many firms could not be reached due to their busy schedules and unavailability. Follow up calls were made on a regular basis in subsequent weeks to explore participation by the firms. Nevertheless, using a reference system proved useful in gaining interviews. The time available for the study was limited; however, data from 11 [Appendix I] firms was successfully collected. Personal interview with two firms in Bangalore City could be arranged, while eight firms agreed to telephonic interviews. One firm preferred to reply electronically to the questionnaire.

2.4 Questionnaire

As this project formed a part of larger study by CMBOR, a combination of questionnaires used in previous studies conducted in the UK and European countries was used. As data gathered on the same parameters would allow for within and cross-country comparison.

The questionnaire was structured into 3 parts. In order to gain an overall understanding of the company, the first section was dedicated to gathering general background information of the firms. The second section looked at the control and coordination of foreign firms operations in India. The final section focussed on Motives for Syndication. A total of 13 main questions with 150 sub-questions covered various topics of syndication. The complete questionnaire was 12 pages long.

2.5 Data collection and Results

The interviews over the telephone contrary to intuition lasted for three quarter of an hour on an average, allowing sufficient time for communication between the interviewer and interviewee. Time was not much of a restraining factor as the need of ample time of the interviewee was communicated at the time of fixing of the appointments. Brief notes were made after each interview. This helped in getting a deeper understanding of the venture capital industry and enabled detailed and active interaction with interviewees as the project progressed. The 2 personal interviews lasted for just over an hour, although the same time length as the telephonic interview, all areas of research could not be exhaustively dealt with. However, as a rapport was built during interview seeking and during the course of the interview, they subsequently agreed to filling out the questionnaire. In both these cases the use of a voice recorder was not found problematic.

The composition of firms based on the preferred stage of investment and size of funds managed is as follows:
No. of Stage of Investment Early Stage Expansion, Development and Late Stage Firms 5 6

No. of Size of Funds Managed < $50mn $50 mn-$350mn > $350mn Firms 5 5 1

The analysis in the following chapters is based on qualitative and desk based research.

2.6 Limitations

The approach adopted for the survey does have certain drawback. Telephonic interviews, to a certain extent hinder in the communication and understanding of questions between the interview and interviewee. Also, it is not as effective a channel for relationship building with respondents as is a personal interview. The limited sample size of data does not allow for a quantitative approach to be presented. While qualitative approach has its benefits it is limited to the extent that individuals can interpret it differently.

CHAPTER 3 REVIEW OF THE INDIAN VENTURE CAPITAL INDUSTRY

Venture capital in India has been in receipt of governmental impetus over several decades. (Pandey, 1998) But, the structural changes in the legal and tax systems along with improvement in general economic conditions have propelled India into the foreground of international venture capital and private equity markets. Transfer of know-how from leading venture capital markets like the US, has allowed for a steep learning curve (Dossani & Kenny, 2002).

3.1 History and Background

In the Indian context, supply of capital for establishing risk and start-up capital is centuries old, usually made available through family members, relatives and friends (Pandey, 1998).

But, modern venture capital in India was started in the late 1980s with the World Bank taking keen interest in the economic liberalisation of the country. Through regulatory changes, state controlled banks were allowed to start venture capital arms. The World Bank, responsible for the transferring of technology research and development from the state to private hands also helped in the setting up of four public sector financial institutions (FIs) by lending $ 45mn.The FIs selected were those of Andhra Pradesh and Gujarat state governments, Canara Bank a leading nationalized bank and ICICI (Industrial Credit and Investment Corporation of India) a development financial institute. A portion of the finance was also channelized towards training of personnel to support the industry (Dossani & Kenny (2002).

According to Dossani & Kenney (2002), management lacking in experience and regulations that mandated sectorial investments, beleaguered the first phase (period from1986-1995) of venture capital in India. Governmental interference enhanced the risk of an already risky business. Regulatory hurdles like high taxes and lack of finances from pension or insurance companies proved a challenge for mobilising funds. (Pandey, 1998) Conditions in India until recently were not encouraging for the growth of entrepreneurship and risk capital. Bank loans
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were still the primary source of finance in spite of some companies facing problems in availing of credit (Smolarski et al, 2005).

With the Securities and Exchange Board of India (SEBI), gaining statutory powers in 1992, a series of reforms were set in motion. SEBI reduced the minimum percentage of shares required to be listed to 20%, mandated quarterly reporting and allowed companies to buyback shares (Wright et al, 2002 b). While there were a few reforms brought about in 1992, the general legal and regulatory framework was not conducive for the growth of venture capital.

Government of India, SEBI and CBDT (Central Board of Direct Taxes), all three bodies, were responsible for the regulation of Venture funds. Different regulations were applicable to foreign and domestic venture capital firms. The foreign funds had lesser regulatory pressure. The overseas firms, which were registered in Mauritius under the Double Taxation Avoidance Treaty and operating in India, were subject to minimal tax. The Indian firms had to apply to CBDT to avail of any tax benefit. The reporting of foreign firms was to the Government of India while domestic firms had to register with SEBI. (Wright et al, 2002b)

Certain guidelines laid down by SEBI also proved restrictive. Investees could invest a minimum of Rs. 0.5 mn, a restriction, which deterred small inventors and, 80% of funds were to be invested in early stage investment or listed securities in the case of financially sick companies. There were also sectoral restrictions for investments. (Wright et al, 2002a)

Realising the importance of venture capital investments for the development of industry and business in India, SEBI formed a committee. The Chandrashekar Committee on Venture Capital in 2000 (Chandrashekar, 2000) put forth certain recommendations with intent to bring about changes in the regulatory and institutional environment, creating conditions favourable for a faster development of the venture capital industry.

The major recommendations were: (Wright et al, 2002b; Chandrashekar, 2000) Need for a nodal regulator A tax pass through in order to avoid double taxation of gains, Tax exemption for all foreign VC s regardless of their being registered in Mauritius

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 Flexibility in investments ceilings and sectoral restrictions Relaxation in listing requirements for IPOs Registration of foreign venture capital firms with SEBI to allow for smooth investment and divestment requiring no additional regulatory approval. Domestic pool of resources to include Banks, Mutual funds, Insurance and Pension Funds

Since then, amendments to the Venture Capital Funds Regulations of 1996 have been made, relaxing restrictions on domestic VC firms. SEBI has been made the nodal regulator. The Foreign Venture Capital Investor Regulations of 2000 (FVCI) has been able to bridge the difference between foreign and domestic firms, allowing both to invest up to 75% (earlier set at 80% for domestic) of the investable funds in unlisted equity shares or equity linked instruments. Restriction of domestic firms investing in financial services has since been lifted. The amount, foreign and domestic firms can now investment, in one investee has been increased by five percent to 25%. And Mutual funds are now allowed to invest in venture funds within a stipulated ceiling. (Pruthi et al, 2003; Singhvi, 2001)

In 2003, SEBI revisited the regulations pertaining to the venture capital environment in order to address issues raised by the industry. The Lahiri Committee (2003) was constituted for this purpose. The committee along with putting forth new recommendations also stressed on those which were recommended by the earlier Chandrashekar Committee and which had not been incorporated. The suggestions put forth were on operations, legal and foreign exchange matters. Amendments in 2004 to the FVCI Regulations of 2000, further loosen controls.

Some of the amendments were (Lahiri Committee, 2003; Amendments to FVCI Regulations, 2004) The lifting of the one-year post IPO listing lock-in which could be earlier availed by banks and mutual funds but not venture capital funds. As this did not allow for venture capital firms to take advantage of an exit opportunity post the one-year of an IPO listing, it had proved a major deterrent. The Real Estate Sector, which was not earlier opened for investing was opened.

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 Atleast 66.67% (Earlier 75%) of the funds were now to be invested in unlisted equity shares or equity linked instruments and the remaining in listed. This change helped in VC firms to seek a return in a shorter time frame and helped in channelising funds to the late stage financing.

3.2 Recent Trends

Pandey (1998) defines venture capital in the Indian context as investment in the form of equity, quasi equity and conditional loans made in new and unlisted high-risk or high-tech firms started by entrepreneurs. The venture capital funds in India can be demarcated into four categories. Three which are directly sponsored by the state; bank sponsored funds, state financial corporations and financial institutions, controlled by public sector banks and the fourth category comprising of private sector firms and foreign and privately held funds.

Wright et al (2002a) and Lockett et al (2002) throw light on the Indian VC industry being dominated by early stage investments. Distinctly different from the US market (1999 data) where less than 30% was invested in early stage funds whilst the Indian market (1997 data) had two-thirds of the value of funds in early stage investments.

An examination of Alyward 1998, data on venture capital financing stages (Appendix III, Figure 1) reiterates that in India entrepreneurial ventures were the main source of deals, but the opening up of the economy and undertaking of reforms has greatly changed the landscape of the Indian VC Industry.

Since 1995 India has seen the entry of foreign firms in the private equity space. Regulatory reforms to the Foreign Venture Capital Investor Regulations in 2000, has further widened the channel for foreign private equity firms. In 2003, India had $ 2.8 million as total funds under management a growth of over 300% from 1998 (Smolarski et al, 2005). The number of firms operating in India has grown from 11 in 1994 (Dossani & Kenny, 2000) to 82 in 2004(Asian Venture capital Guide, 2005). Alyward (1998) while analysing trends of emerging markets draws attention to lower risk, lower return ; later stage finance being more prevalent than early stage finance in Asian
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countries. Foreign firms entering into new emerging markets invest in the later stages of Private equity, as there is lesser risk. Also the size of funds considered in the US market and other developing markets as venture capital, falls under the quasi-private equity investment in India. The IT bust is responsible for lesser opportunities in the early stage ventures, forcing firms to look for opportunities in the late stage (Planning commission, 2006). Hence, there are a large number of firms concentrating on the later stages of investment.

Also a look a the various stages in investment show that, the management buy-out market is fairy young in India with only 5 deals successfully completed in 2005 (Appendix III-Figure 4). The growth and expansion stage along with PIPE (Private Investment in Private Equity) deals jointly comprise of 76% of the total deals (Asian Venture capital Guide, 2004). PIPE deals are gaining prominence since early 2000. Fund sizes are larger in late stage investments and as there is a dearth of very large growth capital investment opportunity, firms are looking towards PIPE deals. A venture capitalist elaborated the point as under The reason you see large firms doing business in the listed space is because in the unlisted space there are not many firms which have an appetite for growth capital in the range of say 100 million, very few

Widespread late stage finance also indicates a ready stock market allowing for exit opportunities (Alyward, 1998). The maturity of the Indian stock markets can be assessed by the size of deals. For example in 2005, Warburg Pincus sold a major portion of their stake in India s cellular giant Bharti Tele Ventures for a whopping $ 560 million. Not only was it the biggest deal India had seen till then, but also, the market absorbed the shares in 26 minutes.

A recent report by the Planning Commission (2006), Government of India shows that the primary source of funds between 2002 and 2005 was from overseas institutional investors (Appendix III-Figure 3).

As a venture capitalists who was interviewed pointed out Purely Indian fund are a dying breedin the industry as a whole, I don t have the statistics to back it as there are no reliable statistics in

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India, but I would say 60-70% of the funds earmarked for PE are foreign funds

Globalisation of the venture capital industry has seen a marked increase in cross border activity beyond the developed economies of the west (Patricof, 1989). Wright et al (2002a) show the internationalisation phenomenon in India by studying risk assessment and information between foreign and domestic firms in India. The entry of foreign firms into emerging markets will help in developing of venture capital markets and at the same time reduce costs of the learning process. Internationalisation also influences the behaviour of firms.

Therefore, in recent years there has been a shift in the emphasis from early stage investment to later stage investment. Internationalisation is evident with the growing number of funds coming in from overseas and a large presence of foreign firms in India. The government has been keeping their hand on the pulse of the industry and have been making consistent regulatory changes to facilitate the entry of firms.

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CHAPTER 4

DEVELOPMENT OF PRIVATE EQUITY AND VENTURE CAPITAL MARKETS

4.1 Literature Review

The US has the most developed venture capital market in the world (Lockett et al, 2002). Having originated in the US the industry moved on to Western Europe and then emerging markets in Continental Europe and Asia. The saturation of developed markets and radical regulatory reforms undertaken by developing nations (Wright et al, 2005) has enabled development of newer markets of venture capital. Alyward, (1998) recognizes globalization as the phenomenon driving development of new markets.

An entrepreneurial culture, a legal system that provides protection to the investor, an encouraging government, a labor market rich with engineering talent, a non-penalizing tax

regime, and the existence of an IPO Industry for the realization of value are characteristic common to develop venture capital industries like Britain, Switzerland and Israel (Megginson, 2001). Similarly Jeng & Wells (2000) also identify factors that impact venture capital growth highlight non-rigidity of labour market, IPO as an exit route, macro economic conditions and government programmes

Dossani & Kenny (2002) argue that a set of supportive condition, and not necessarily optimal condition need to be present for the development of a venture capital industry. As and how the industry emerges, it would induce a climate that would foster further growth and expansion moving slowly towards the optimal conditions required for the industry to thrive. They lay emphasis on the cultural, legal, institutional and personnel factors. Studying the development of the Indian venture capital market I M Pandey (1998) identifies various steps in the developmental process as being: An initial impetus by the government, an internal context that comprises of doing away with bureaucratic hurdles and improving competency and commitment of a management team, an external context of innovative financial mechanisms
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adaptive to the external environment and finally providing of value added services to sustain the venture capital activity.

Although similarities in the functions of venture capitalists exist, their behavior and business practices are greatly influenced by institutional, legal and cultural factors (Lockett et al 2002, Wright et al 2002a). The importance of legal and institution factors have also been emphasised by Cumming & Fleming (2002). Black and Gilson (1998) argue that for the existence of a robust venture capital industry, a well-developed stock market, which allows for firms to exit via an IPO, needs to be prevalent. Gompers & Lerner (1998) focus on the importance of macro economic conditions which influence venture fundraising. A fast growing economy may posses more opportunities for entrepreneurial ventures thereby increasing demand for VCs.

Wright et al (1993) analyze the development of private equity markets in US, Western Europe, by focusing on the key factors that influence the various stages in the venture capital process, i.e. Generation of opportunities, Infrastructure to complete deals and Realization of value. Using the same criteria, Wright, Kissane and Burrows (2004a), show how structural changes in generation of opportunities, infrastructure in completing deals and opportunities for realization of gains have been responsible for the development of the US and Western European markets. They also apply the framework in analyzing the development of the markets in Hungary, Poland, Romania and other Central and East European Countries.

The final goal of the venture capitalist is to liquidate their holding in the portfolio companies. The different ways, in which the venture capital firms exits are through an IPO -Listing on a stock exchange for the first time; a trade sale - acquisition by a strategic partner, Buybackentrepreneur buys out venture capitalists share, Secondary sales- sale of venture capitalists share to other firms or VC s and receivership (Wright & Robbie, 1998, Cummings and Fleming, 2002

An exit is important both for the venture capitalists and the investee company. According to Black & Gilson (1998), as companies mature the financial and non-financial services provided by the venture capitalists loose efficiency advantage. In order to recycle the investor capital firms look towards exiting and reinvesting in fresh portfolio companies. It also acts as a route to exit from lemon investments. For entrepreneurs, exit of a venture capitalist is a
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route to regain control of the company. An exit through a trade sale produces synergic gains while an exit through an IPO has the potential for a higher valued exit price (Black & Gilson, 1998). Jeng and Wells (2000) note the importance of IPO s as being strong drivers of investing and play a more important role for late stage investments vis--vis early stage investments. Murray (1994) talks about the second equity gap faced by early stage ventures, as these companies may prove too small an acquisition for concerns that are on the look out for building on economies of scale or scope. The trade sale is suitable to firms which have growth opportunities and which require outside capital. The IPO route to exit is uneconomical to most entrepreneurial ventures as it involves direct and indirect costs and would be more advisable to high growth firms with changing technology, that are seeking equity.

Cummings and Fleming (2002) consider the impact of legality on the choice of exit route. Examining samples from Asian emerging markets, they conclude that a high legality index is more likely to result in an acquisition or an IPO exit, while a low legality index would result in buyback exits. The liquidity conditions available for exit are critical for venture capitalists investment decision. Cummings et al (2005) define liquidity risk as a VC not being able to successfully exit and hence forced either to sell equity at a discounted price or stay invested in the venture. Stock market liquidity has strong links with the number of IPOs and trade sales. Stock markets apart from reflecting general economic conditions also affect the flow of capital into the industry.

Entrepreneurial firms in developing venture capital market relocate entrepreneurial firms in the US. Their characteristics allow them to find additional funding and exit routes at in the US (Cummings & Fleming, 2002).

4.2 Framework

The development of a VC market is influenced by the existence of certain vital conditions. Wright et al (1993) conceptualized a framework in analyzing the management buy-out and buy-in (MBO, MBI) markets that laid emphasis on the generation of opportunities, Infrastructure to complete deals and Realization of gains by investors.

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In order for a venture capital industry to take seed and thrive, apart from market-level determinants of supply and demand of opportunities, a mechanism to help materialize these opportunities into deals and finally into value need to be present.

Economic growth and expansion, privatization reforms or changes in the structure of traditional business present opportunities of investment for private equity firms. And at the same time demand for venture capital funding is created when there is a widespread entrepreneurial culture or scarcity of capital to help in rapid development. While these factors provide opportunities for investment, a combination of elements lends support enabling an opportunity to convert into an investment. A feasible infrastructure supported by conducive legal and tax structure and also the presence of intermediaries and advisories proficient in accounting, finance and legal practices are vital for this phase. Finally, for the creating of value an exit opportunity needs to be present. A well functioning stock market to enable exits via a flotation and sufficient liquidity to permit for trade and secondary sale exits would define the required environment for this stage.

The various levels of the different parameters influence the degree of development of the venture capital industry within a country. This framework breaks down the various stages in the investment process from supply and demand of deals to final realization of value. Therefore, it helps in providing a detailed analysis of the factors and conditions key to the shaping of a venture capital industry. Hence, it is well suited for tracing the development of the industry within a country. The sectioning of the framework also helps in a cross-country comparison.

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CHAPTER 5

A COMPARITIVE ANALYSIS: INDIA & CENTRAL AND EAST EUROPEAN MARKETS

5.1 Introduction

Using the framework put forth by Wright et al (1993) for analyzing the development of a private equity market and also drawing from the characteristics put forth by Megginson (2001) a comparative analysis of the development of the CEE and Indian, venture capital and private equity market is presented.

Fast growing countries of Asia and Latin America, due to widespread liberalization and adoption of market-based policy have been termed by the International Finance Corporation as emerging economies . Parallelly, with the fall of communism in 1989, numerous rapidly growing economies in Central and Eastern Europe (CEE) have emerged, referred to as transition economies. As these countries are also committed to liberalization and encouraging private enterprises, they are also considered emerging markets (Hoskisson et al, 2000) An emerging market is defined as a country that satisfies two criteria: a rapid pace of economic development, and governmental policies favoring economic liberalization and the adoption of a free-market system. (Arnold & Quelch, 1998 as quoted by Hoskisson et al, 2000, p.249)

Academic literature has addressed cross-country comparisons amongst European countries and also between Europe and Asian countries like Japan (Alyward, 1998; Wright et al, 2005).

However, the comparative analysis between transition economies like Romania, Poland and Hungary that form a part of the CEE region with an emerging market economy like India is of particular significance in understanding the factors influencing the development of venture capital industry. Firstly, venture capital took seed in both countries in the late 1980s,

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providing for a similar time frame for analysis. Secondly, while the background for the seed and growth of venture capital are startling different for both countries, the transformation process has been the result of institutional, legal and regulatory changes. The comparison reiterates that the institutional differences between countries take longer to diminish as the pace of change of institutions differ from country to country (Wright et al, 2004c).

Development in CEE markets: In Central Europe, during early 1990 s privatisation of the state owned enterprises heralded the development of the private equity market. Post the fall of communism in the late 1980 s, countries of Central Europe along with restructuring of legal, trade and banking policies looked at liquidating state owned enterprises. The newly embraced capitalist model attracted FDI, creating opportunities for deals and also liquidity in the markets to help in the realisation of gains for the ventures. Hand holding by Western European countries and the US, through the creation of funds like the Polish American Enterprise Fundand Enterprise Fund provided a smooth channel for the transfer of both capital and skills. In Poland, the largest of the CEE states, divesting the 200,000 small enterprises of the state in the sectors of retails and services created opportunities in the early and growth capital stages. For Czech Republic, the private equity industry took time to formulate, primarily being driven by the entrepreneurial ventures backed by a pool of talented industrial engineers. Romania on the other hand leveraged on its low cost labour and attracted foreign investment creating opportunities for deals and investments (Wright et al, 2004a). Most of Central European countries post the communist regimes have undergone varied scales of economic crises due to the sudden changes in the economic and political climate. Although the conditions required for a thriving private equity market are in place, there is still scope for improvement. As these countries are fast becoming a part of the European Union, need for homogeneity in the business, legal and regulatory practices across Europe would drive conditions to become akin to those of Western Europe, ploughing a path for a vibrant private equity industry in CEE.

5.2 Creation of opportunities

Gompers and Lerner (1998) describe the supply of venture capital as the willingness of investors to participate in venture capital funds and demand for venture capital as the desire of entrepreneurs to attract investments for their firms and at the same time Jeng & Wells (2000)
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throw light on how the existence of IPO as an exit route affects the supply and demand for finance.

With the saturation of developed markets, a large numbers of venture capitalists are turning towards emerging markets. The developing markets with recent reforms to their regulations and increase in their economic activities have become a hot bed of economic activity and an ideal destination for venture capitalists (Wright et al, 2002a; Gompers & Lerner,1998).

5.2.1 Supply of Deal opportunities

5.2.1 (a) Growth and Expansion

Regulatory changes have a positive impact on economic activities, and a fast growing economy allows for entrepreneurial opportunities and start up ventures (Gompers and Lerner, 1998). Such has been the case for both the CEE region and India.

In the CEE region, the fall of communism saw majority of private equity activity in the form of privatization deals. Due to the shift into the market-based economy and the presence of a supportive entrepreneurial environment new venture capital firms were set up. While this was in the beginning of the 1990 it is only in the past few years that the investments are materializing into exits. India s current economic condition provides an environment conducive for venture capital investment. A fast growing IT and ITES off-shoring business is expected to grow from its current size of $ 40 billion to $140 billion by 2014. GDP has been growing at the rate of 8% for the last 3 years (Chaddha, 2006). Disposable income in the hands of the growing middle class is creating a demand for new products and services. Mobile subscribers in India have moved up from 5mn to 70 mn in past 3 years. Number of credit cards in circulation have move up from 1mn to 50 mn in past 5 years. The need for infrastructure has presented opportunities for investments in Rail, roads power and airports (Chaddha, 2006).

In 2005, some of the leading sectors that attracted venture capital investment were IT & ITES, Hotels & Resorts, Banking & Financial Services, Healthcare & Life sciences, Engineering & Construction amongst others (Appendix III, Figure 5).
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5.2.1(b) Privatisation

While privatisation in the CEE region is now nearly complete, it was the major source of supply of deals post communism. The bulk of opportunities came from the privatisation of State Owned Enterprises (SOEs). In Hungary out of the 1850 SOEs 1200 of them were privatised by 1998 while in Poland out of the 8000 SOEs those in important industries were privatised by 2003 (Wright et al, 2004a).

In India the privatisation process began with the opening up of the economy in the early 1990s. While privatisation has been able to generate funds for the Indian government and has been an important reason for the flow of FDI into the country, the first private equity backed privatisation concluded only in 2003 with Actis investing $60 mn in Punjab Tractors (Punjab Tractors Case Study, 2003). While there are still opportunities for privatisation, opposition by the leftist party who are a part of the current coalition government has to a great extent dampened the government s privatisation agenda.

In contrast to the CEE market, privatisation has not been a major source of deals in India, but if there are changes in governmental decisions there are still opportunities for deals.

5.2.1(c) Mergers & Acquisitions market

Wright et al (2004b) use mergers and acquisitions (M&A) activity as a benchmark to assess the level of private equity in the CEE region.

The M& A scene in the CEE have seen a consistent growth, inspite of drop in activity in the US and worldwide to the tune of 40% and 30% respectively. A report by CMBOR (2004) expects intra CE M&A activity to increase following EU membership. The restructuring of markets would allow for consolidation of various sectors.

In India too the M&A scene is on the rise. Indian firms are not only acquiring within the country but also abroad. Indian firms made 24 overseas acquisitions worth US $ 800 million during the first six months of 2004 (PWC Report, 2005a). Within the country, PE firms have been active in the Technology, Telecommunication and Banking sectors with 2004 seeing
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deals like Francisco Partners investing $50 mn in Office Tiger a business process outsourcing provider and West Bridge Capital Partners and Tamesak Holdings investing $ 35 mn in ICICI one source, another BPO service provider (PWC Report, 2005a). The future forecast is expected to be brighter with regulatory changes in FDI being brought about and firms like Tamesak Holdings announcing funds of $ 200 mn for the power sector.

5.2.1 (4) PIPE

Private Investment in public Equity is investment made in publicly listed companies by PE firms with an intention of raising future equity and also allowing for a ready made exit route. The market for PIPE investments in CEE is substantial (Wright et al, 2004b). In India nearly 50% of the deals amounting to 35% of value made in 2005 were in PIPE. With Bharti Tele Ventures and I-flex being examples (Venture Intelligence India, 2005).

5.2.2 Demand of Private equity

5.2.2 (a) Capital Scarcity

CEE being a fast developing area is in need of both public and private equity funding. The region is currently under served. As the growing and restructuring firms require capital to expand they and are as they are not in positions to service debt capital there is potential for this gap to be filled in by private equity finance (Wright et al, 2004b).

India too being an emerging economy is cash hungry. A major sector, which is expected to attract funds, is the infrastructure sector that is looking at changes in airports, roads, railroads, ports, hotels along with power and water. But a report by the Emerging Market Private Equity Review (EMPER) (2006) considers the climate in India to be overheating . With a ten-fold increase in funds within a short span of 2 years, private equity managers believe there is more money chasing deals resulting in higher valuations. This is mainly due to a strong increase in fundraising within India and also the growing presence of global players. There has been a starvation of cash for early stage ventures of late as 2005 has seen only 4% of the value of funds across 25 deals.

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5.2.2 (b) Entrepreneurial Climate

In CEE the entrepreneurial climate grew in tandem with privatisation post the fall of communism. The need for products and services created opportunities for early and start up ventures. Countries of Western Europe, namely Germany and Spain are averse to the sale of private businesses and maintain a tradition of family succession. The communism regime has not allowed for the basis for such a tradition therefore CEE entrepreneurs are only in the past decade been building their wealth. Bruton et al (2005) highlight that the status given to entrepreneurs in the US is higher when compared to Continental Europe. The low status given to entrepreneurial ventures and the negative implications attached to a failed venture is a major deterrent for people in CEE counties to start-up firms.

There are now successful entrepreneurs to act as role models for other managers, like Akos Erdos, a journalist turned entrepreneur in Hungary and Mariusz Lukassiewicz, the founder of Lukas Bank in Poland.

The Indian sub continent is no stranger to entrepreneurial culture. Indian businesses can be categorised into family run business conglomerates and traditional small enterprises. Small and medium enterprises have been given attention by governmental forces ever since India gained independence in 1947(Dossani & Kenny, 1998). In order to have an entrepreneurial culture a string of opportunities needs to be present. In India this constant flow is presented by the Information Technology industry (Dossani & Kenny, 1998). Since the 1950s well educated Indian Engineers have travelled to the US and have worked in high technology firms with many of them gaining success in Silicon Valley. As the Indian technological industry began to spring up in India, the Non-Resident Indians (NRIs) returned and started firms. Leveraging on the networks they had built over the years they advanced the entrepreneurial climate in India.

Out of the 2.2 million English-speaking graduates each year 250000 are engineers and 40000 are MBAs. The entrepreneurial ecosystem is well supported by networking organisations like TiE (The Indus Entrepreneur), set up by Silicon Valley expatriates and NASSCOM (National Association of Software and Services Companies)(Chaddha, 2006). This ecosystem is also being nurtured by the numerous educational institutes, like the Indian Institute of

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Management, Bangalore that have dedicated studies and research towards development of entrepreneurial culture in India.

5.2.2(c) Professional Managers

CEE has seen a steady increase in the number of middle level managers. Western trained managers returning to their home countries along with home bread managers having learnt on the jobs over the past decade have resulted in a vast pool of talent for private equity firms to drawn on. Investment by top tier firms from western countries has helped in managers learning and practicing western commercial principles.

The EU membership has increased transfer of capital and labour across borders. The CEE countries have seen Poland alone receive an FDI $ 65 billion between 1990 and 2002. With a growing population working for western firms, there would be greater exposure to the working culture of the west. Professional management education has also seen a steep growth. Numerous top universities in the west and institutions like George Soros CEU Graduate School of Business, at home are training executives in western practices. In India during the 1960 s with help from the Ford foundation the IITs (Indian Institute of Technology) were set-up. These elite institutes along with other institutions produce some of India s finest engineers (Kenny & Dossani, 1998). Similar leagues of institutions have been set up for management training called the IIMs (Indian Institute of management), which help in feeding the growing middle and top management levels in organisations.

Similar to the events in CEE, the entry of foreign firms has helped in Indian managers learning and practicing western corporate finance techniques. A study on the Indian venture capital industry by Wright et al (2002a) reflects only up to 8.9% of the employees in foreign venture capital firms are foreign nationals. Also there was no difference in the domestic and foreign firm managers within India in relation to background expertise in technology and consulting. This clearly reflects quality of Indian management and the reliability placed on them by global players.

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5.3 Infrastructure to complete deals

Wright et al (1993) in their framework for the development of an MBO-MBI market stress the role that intermediaries like investment bankers, accounting firms and lawyers play in identifying and structuring deals as accounting and auditing rules differ from country to country and influence the valuation of companies.

5.3.1 Favourability of legal framework

Studies by La Porta Lopez- de Silans, Shleifer and Vishy(1998, 2000) have found that common law countries have stronger legal protection for shareholders when compared to countries which have Civil law(As quoted in Bruton et al, 2005). Venture capitalist decision to invest as a minority shareholder in their portfolio companies is greatly influenced by the legal protection provided (Bruton et al, 2005). Hence, legal protection provided also influences the way in which the industry in a country develops. The US, UK, Singapore and India are considered as following the Common / English form of Law (Wright et al., 2004b). India following common law therefore reflects the favourability of the legal framework as it is tuned towards the protection of shareholders interests.

Regulatory changes have been undertaken under the recommendation of both the Chandrashekar Committee (2000) and Lahiri Committee (2003). A recent report by the Planning Commission, (2006) has recommended suggested that necessarily changes be made to the Companies Act to incorporate perpetual preference shares, thereby giving share holders greater protection at the time of liquidation.

In CEE continuous reforms and revisions have been undertaken to make possible commercial and private equity investments (Wright et al., 2004a). The EU Accession countries are focussing on improving their judicial infrastructure for easy convergence with the Western economies.

5.3.2Favourability of Tax system

A major driving factor, which has stimulated private industry in CEE, is the change in the tax structure. In most countries there has been a change in both personal and corporate tax. In
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Poland the corporate tax rate is expected to change from 27% in 2003 to 19%. This would obviously encourage future investment and wealth creation (Wright et al, 2004a).

In India there has been tremendous tax benefits given to venture capital firms. Domestic venture capital firms received tax benefits under the Income Tax Act 1961 (ITA). Under Section 10(23FB) of the ITA income earned by a VCF set up to raise funds and to invest in venture capital undertakings is exempt from tax provided it is registered with SEBI. For foreign venture capital funds there is no specific tax exemption. But they can avail of tax benefits via the Double Taxation Avoidance Treaty between India and Mauritius by registering in Mauritius and operating in India. Capital gains earned by residents of Mauritius are exempt from tax in India (Shah & Ajinkya, 2005). This makes it attractive and also a favoured route for private equity players investing in India.

5.3.3Intermediaries

Opening up of the economy also saw entry of international professional service firms both in CEE and in India.

Elite firms like Deloitte, Ernest & Young, KPMG, Linklaters, and BCG have opened shop in the Warsaw, Prague, Budapest as well as Mumbai and New Delhi amongst other cities. Firms like Clifford Chance service Indian companies based out of Singapore.

Consultancies, Legal and Accountancy firms from developed countries like the US and Europe have brought with them western culture and practice, educating local staff and clients. While the CEE region legislations have been passed to create limited partnerships and similar structures, in the Indian scenario although Chandrashekar Committee recommended this option in 2000 (Chandrashekar, 2000), it has not been implemented as yet.

Lockett et al, (2002) highlight that inspite of radical changes in regulations; there are disparities in Accounting Standards between developed countries and India. Amongst Asian countries, Singapore and Hong Kong find themselves with developed levels of Accounting Standards than India.

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5.4 Realisation of Gains

In Europe, post the developments of new stock markets in the mid 1990s were small and medium firms allowed to list, allowing them an exit opportunity (Dossani & Kenny, 2002).

An increase in the numbers of IPOs and trade sales reflects improved levels of liquidity in the stock markets. Wright et al (2004a) opine that the liquidity levels of CEE stock markets are moving closer to those of developed countries. Wright, Kissane and Burrows (2004a), point out that in spite of difficulty in exit environment during 2002, there was an increase in the number of firms exiting in the form of IPOs. Data from EVCA for 2001- 2002 shows that nearly 15% of exits in CE were in the form of IPOs.

Sale to strategic partner was a primary route of exit in 2001 and 2002 for CEE countries, accounting for nearly 1/3 of the exits. A growing M&A market is evidence of this continuing to be a practical route of exit.

The Securities and Exchange Board of India was instituted as part of the financial reforms in 1991 to regulate the stock markets. The loosening of reforms allowed the number of listed companies to grow to 9877 by March 1999 (Dossani & Kenny, 2002). A crucial reform for this massive growth in numbers was the removal of the profitability criterion. Unprofitable companies were allowed to register in order to provide an exit route to investors. Many of the high technology firms used this window for registering on the stock market.

Data available on the Indian market reflects 43 exits in 2005. But the numbers of IPOs in 2005 were 17; accounting for nearly 40% of the total number of exits wile the remaining 17 were a combination of secondary sales and buyback by promoters 2004 saw 6 IPOs (Venture Intelligence India, 2005) .The total number of divestments and exits in 2002 and 2003 were 178 and 215 (Asian Venture Capital Guide, 2005).

The M&A market in India although flat between 2002-2004 saw 195 deals valued at $2.8 billion in the fist half of 2004, a Private Equity transaction deal accounting for 21% of the value (Majumdar, 2005).

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The year 2005 saw what media labelled spectacular exits via the secondary and trade sale routes four of which were worth $ 500 mn. Some of the cases were Actis and AIG exited investments in BPL Communications selling their stake at $1.56 Bn to Essar Group. CVC International having invested $ 4 mn in 1992 in I-flex solutions, sold its share to US based Oracle Corp. for $ 593 mn. Warburg Pincus exited from publicly listed Bharti Tele Ventures, a telecom services company for an overall $ 1.4 bn for 19% stake which it had acquired for only $ 292 mn in 1999.

Many Indian companies are co-based in the US, primarily in the ITES sectors, allowing for them to exit in the US market either through a Trade sale or an IPO. (Knowledge@wharton, 2006)

Exit numbers in India do not match those of countries in the CEE. The CEE region had 561 exits between 1998-2002; the reason attributed to private equity firms exiting from the privatisation deals in the early 1990s. While privatisation has given the CEE an edge in exit numbers, the infrastructure to support large number of exits like a well developed stock and mergers and acquisition market are in place in India.

5.5 Conclusion

Although private equity and venture capital activity are at different levels in the two regions, it is evident that the growth and development of the industry has been fostered by seismic changes in their institutional factors.

Looking at the supply and demand factors that enable development of a venture capital industry, growth and expansion of the economies have been crucial to both regions encouraging FDI. Privatisation of state owned enterprises played a key role in CEE along at the same time sowing the seed of entrepreneurial spirit. In India however, the entrepreneurial

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climate and the impetus by the government was responsible for fostering the venture capital industry. The mergers and acquisition markets are well developed in the CEE regions and are still developing in India. A developed M& A market is needed as it provides a conduit for deals, whilst various sectors are consolidated due to market restructuring. The EU membership for the CEE region has allowed for ease in transfer of capital and labour across borders. Professional managers trained in the west have returned to their home countries in the CEE region and India. Western firms entering these regions have trained local staff in the western skills and practices. Both, in India and the CEE professional management institutions have been responsible for providing middle and top level executives to the industry.

Harmonizing legal, tax and market policies to be in tune with other EU countries has enable the faster development of the infrastructure required to complete deals. While infrastructure is in place, it is not as developed as that of the CEE region. Reforms are still underway with the government introducing new laws to foster venture capital investments. Internationalization has allowed for foreign accounting and legal firms to set up shop in both the regions.

A well-developed stock market and liquidity in the economy enable venture capital firms to realize their gains in various exit routes like IPO or a trade or strategic sale. In India, loosening of bureaucratic controls with regard to lock in of investments for a year, post IPO has encouraged firms to use the flotation exit route.

The CEE has all the relevant structures in place, in India the structures are still shaping up. The level of venture capital activity is far greater in the CEE than in India. Institutional factors are constantly changing, especially in relation to emerging markets (Hoskisson, 2000), and as the rate of development differs from country to country there is a difference in the development of the venture capital industry (Wright et al, 2004c). This is illustrated in the difference between the development levels in India and the CEE region.

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CHAPTER 6 SYNDICATION

6.1 Introduction

VC firms operate in a niche area of finance, laden with risk and information asymmetry. The specialised skills in selecting and monitoring of their portfolio companies give them a competitive advantage over conventional financial intermediaries (Amit et al, 1998). But, in order to diffuse the high risk posed by such investments, venture capitalists resort to an array of strategies, of which syndication of deals is an important one. (Wright & Robbie, 1998)

Syndication is the coming together of two or more venture capitalists in providing necessary productive resources of capital and information to an enterprise, with intent of sharing the resulting payoffs. (Wilson 1968:119 as read in Lockett & Wright, 1999).

Syndication of investments in venture capital is different from syndication of firms for the public sale of securities. While, information asymmetries exist prior to venture capital investments, underwriters, in the sale of public securities determine the demand for the shares prior to sale.

Inspite of the existing ex-ante and ex-post problems of inter-firm linkage, a large number of the venture capital firms resort to syndication of deals. Ooghe et al (1991), draw a relation between the maturity of a venture capital industry and the level of syndication at country level. Countries with a more mature market tend to have a higher level of deal syndication. This is also in tune with studies in the US and European market which reflected Syndication of deals to be common. While data on the US reflects over 60% of VC investments were syndicated in 2000, European and UK data reflect 30% and 13% of investments were syndicated respectively (Manigart et al, 2002a).

There has been research conducted in the US, UK and European countries about syndication practices. As institutional, legal, economic and cultural conditions influence the activities of a
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venture capital industry, (Manigart et al, 2002) the various studies have reflected different patterns in syndication behaviour.

According to Sahlman (1990), venture capitalist looked at staged investments as a control mechanism, as they would not want to contribute a bulk of money to one investment, capital being a precious resource. While staged investments or financial contracting reduces moral hazard problem, syndication as a control mechanism solves both moral hazard and adverse selection problems (Smolarski et al, 2005). This would imply syndication to be a better form of control mechanism.

The purpose of this study is to ascertain the motives behind syndication of deals in an emerging market context and see how the characteristics of a firm like age, stage and sector of investment preference as well as geography, influences the decision of syndication. It brings to the fore ground the different motivations that influence a lead or a non-lead investor at the same time looking at motives which influence a foreign or a domestic investor to syndicate or co-invest.

Approach to the study is based on presenting theoretical perspectives found in the existing literature followed with a qualitative analysis of the data collected.

6.2 Literature Review

Syndication has been the subject of research and study for academicians, predominantly in the western and developed economies. The literature review brings out the theoretical aspects at two levels. First, a review of the general motives for syndication and second, the factors that influence syndication when venture capital firms are divided into several sub-groups.

6.2.1. Motives for syndication-I

A review of literature throws many competing views on motives for syndication. Motives behind syndication can be broadly classified into those relating to traditional finance theory, resource based theory and access to future deal creation (Lockett & Wright, 2001; Manigart et al, 2002a). While early research reflect the rational behind venture capital syndication as the need for risk avoidance via risk sharing and leveraging on resources capabilities of peers,
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Lockett & Wright (1999) highlight the importance of deal flow as an important motivator for syndication. They also examine resource base view of syndication under the need for information under ex-ante and ex-post decision-making stages.

6.2.1(a) Finance based view

Risk is an integral part of venture capital investment and VC firms look for means to overcome the same. The intension of investors is to maintain a good return whilst reducing risk. As venture capital firms invest in a portfolio of companies, a parallel can be drawn with a portfolio of stocks. The Portfolio Diversification Model classifies risk of investments into unique/systematic risk and market/unsystematic risk. Unique risk is the risk associated with the firm, and can be minimised by choosing to diversify the portfolio. On the other hand market risk is an uncontrollable factor, influenced by macro economic trends and therefore cannot be controlled (Brealey & Myers, 2004). In contrast to publicly held investments, private investments by venture capitalists allow for reduction in firm level or market risk. This can be attributed to venture capitalists taking active part in day-to-day management of portfolio companies (Lockett & Wright 2001). Syndication of deals allows for firms to invest in a variety of portfolio companies thereby reducing the overall riskiness of the investments.

Also, finance as a resource is precious and has limited availability. This being the case, a diversified portfolio, which can be achieve through syndication of deals will not only prove to reduce the overall riskiness of the investments but would enable better utilisation of the resources. Thereby, providing capital for other cash needs of the firm.

The performance of portfolio companies would also impact the ability of the firm to raise future funds. Firms resort to diversification of portfolio or syndication of investments so that they do not under perform their peers (Lerner, 1994).

Syndication not only helps in reducing risk but also in enhancing returns. Research by Brander et al (2002) (As read in Pynna,(no date)) have noted that syndicated investments have a higher rate of return than stand alone investments due to the value added hypothesis .

Hence, syndication is a means through which firms can increase returns and spread risk by diversifying their portfolio.
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6.2.1(b) Resource Based View

A firm is considered to be a bundle of tangible and intangible resources. The resource based view suggests that in order for a firm to gain competitive advantage, it seeks factors of production or resources. Inter firm linkage can be viewed as a firms attempt to overcome its lack of competitive resources. Via this route a firm gains access to resources which not only create value but which would other wise be time consuming and costly to build (Ahuja 2000).

As venture capitalist specialise in the selecting and the monitoring of investments, they would look towards reducing any specific risk arising ex-ante (Selecting of investments) or ex-post (Monitoring) investment decision (Manigart et al, 2002a).

Specialisation allows venture capital managers to accumulate knowledge in their preferred investment stages, thereby reducing the uncertainty and risk pertaining to such investments (Manigart et al, 2002c). Also, venture capitalists possess knowledge in the areas of technical innovation and emerging sectors, which would influence future strategic investment decisions (Bygrave, 1987). Other venture capitalists that lack such specialist knowledge seek to leverage on such specialisation and strategic information by entering into co-invested deals.

Lockett & Wright (2001) point out syndication by a group of firms, which are specialised in the same area of investment, would result in superior selection of investments.

Another important reason for diversification of portfolio is the existence of information asymmetry. The existence of information asymmetry in venture capital investments makes them more risky than stock market investments.

Information, a key resource plays a different role in ex-ante and ex-post management decisions. (Lockett & Wright, 1999)

Reducing uncertainty in the ex-ante decision function (selection of investments) can be overcome by a second opinion of other venture capitalists would result in the superior selection of investments (Lerner, 1994). Also, the willingness of another important venture capitalist to invest in a firm would reflect the potential the firm holds, thereby influencing a
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lead investor s decision in investing. Lerner supports this view with empirical data from the biotechnology industry that reflects that experienced venture capitalists choose to syndicate with partners with the same level of experience as themselves in the first round and with lesser-experienced partners in the following rounds. Syndication allows for pooling of the analytical resources of a venture capital firms resulting in better selection of investee firms (Lockett & Wright 2001).

The problem of information asymmetry is overcome only ex-post the investment decision (Lockett & Wright 2001). Stock market investors have an advantage of liquidity that a venture capitalist does not have (Sahlman 1990). In order to be able to divest from lemon investments venture capitalist resort to control strategies on a deal-to-deal basis. Staging of investment rounds allows VCs to exit from bad investments while syndication allows dispersing of the risk (Gompers, 1995). In case of late stage investments, where a managerial structure is already in place, there is less information asymmetry and therefore less risk. This reduces the need for syndication. But later stage firms choose to syndicate with later firms in order to leverage on financial resources, as the investments in later stage are larger (Lerner, 1994).

Gompers (1996) highlights the effect reputation has on attracting capital. Experienced or reputed VC investment also enhances the value of firms for subsequent rounds of financing (Lerner, 1994). Reputation and investment styles have been found to be important when venture capitalists seek partners or syndication (Lockett & Wright, 1999).

Venture capitalists use networks to share information on the portfolio companies in which they invest. They use channels like venture capital associations and trade associations as platforms to exchange information. Bygrave (1987) identifies, syndication of deals and seats on boards of the investee firm as two vital ways in which firms network. Syndication brings forth other networking related benefits. Firms get access to expertise, contacts and capital resources amongst others.

In order to provide future funding to venture capitalists, institutional investors assess the ability and skill of the venture capital firm. As the performance of portfolio companies would reflect the skills, managers indulge in window dressing . That is divesting from funds that have not performed and purchasing shares in firms whose shares have been appreciating.
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They also resort to investing in later rounds of financing in promising firms (Lakonishok et al (1991) As read in Lerner J, 1994). VC Firms to access such promising ventures for later round financing resort to syndication.

Firms need to resort to syndication in order to access resources to increase returns and decrease risks.

6.2.1 (c) Deal Flow

Access to a larger number of potential deals enables a venture capital firm to cherry pick their investments. The venture capital industry is influenced by economic factors and is cyclical in nature (Gompers & Lerner 2000). Economic downturns impact the number of deals available to venture capitalists. Deals directly influence the returns of the company and hence, Syndication is an avenue providing VCs with access to deals during times of scarcity. The quantity of deals for investment may influence the quality of investments undertaken by the firms. Also, active deal seeking activity is not without costs (Wright & Robbie, 1998) consequently; deal flow reciprocation is instrumental in minimising the deal seeking expenses to a certain extent and beneficial when deals are hard to come by.

When firms choose to syndicate, they is an implied expectation that there would be a reciprocal gesture by the other firms to do the same, there by maintaining a steady flow of deals for the venture capitalists even when the deal has not been initiated by the venture capital firm (Lockett & Wright, 2001). Firms investing in early rounds of financing resort to syndication in later rounds with an intention that the syndicating colleagues would reciprocate the offer with their deals (Lerner, 1994). Converse to an economic downturn, there may be Too Much money chasing too few deals (Gompers & Lerner 2000). An increase in the flow of venture capital with out an increase in opportunities would raise competition levels leaving fewer returns for a venture capital firm. A constant deal flow as a result of syndication will help in the firms to improve its performance. Hence, syndication is a means through which firms can increase deal flow

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6.2.2 Motives for syndication-II

Syndication motives cannot be viewed in isolation. The difference in strategies, investment objectives and resource availability are reasons for the heterogeneity in the venture capital industry as a result, VC firms tend to focus on different stages, sizes and market technologies (Timmons & Bygrave, 1986). Therefore, being a heterogeneous group their attitude and behaviour towards syndication would be varying. Specific characteristics of the venture capitalists, like the age, preference of investment stage and country of investment impact the importance levied on the various motives of syndication.

6.2.2(a) Stage of Investment

A study conducted by Lockett and Wright in 2001 on the UK VC Industry, reflects motives for syndication are different for early and late stage investors.

Elaborating on the heterogeneity of venture capital firms put forth by Timmons and Bygrave (1986), Elango et al (1995) bifurcates firms into sub-groups. Firms are categorised by the preferred stage of investment i.e. firms which had in their portfolio, investments which are in the early stage of their development and firms which had investments in all stages of development.

The preference for a particular stage of investment would bare an influence on syndication:

Financial Perspective Risk associated with early stage firms is higher as they invest in high growth, emerging markets products. Hence the need to diversity portfolio risk is high for the early stage firms (Elango et al, 1995). Later stage firms prefer greater industry diversification, (Gupta & Sapienza, 1992) and therefore would have a well-diversified portfolio reducing their need to syndicate. The low risk involved in late stage ventures in also highlighted in the fact that they seek lower returns when compared to firms in the early stage (Elango et al, 1995).

The size of funds tend to be larger for firms investing in the later stages MBO/ MBI (Lockett and Wright, 2001), than those in early stages. As later stage deals invests into firms, which

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already have a management structure and an established market in place, reduced information asymmetry reduces the associated risk.

Hence the need to syndicate for financial reasons is more compelling for firms in early stage investments than those that invest in later stages.

Resource based perspective The value-enhancing role that a venture capital firm plays is, bringing managerial experience, intensive monitoring and a channel to expand business networks to a company. Later stage investments already have managerial skills and a well-developed supplier and customer networks. As early stage investees do not have such skills more handholding from the venture capital firm is required.

Deal Flow Perspective Lockett and Wright (2001) concluded their study of the UK venture capital industry by stating that the importance of deal flow as a motive to syndicate was the same for both early and later stage investments. Manigart et al (2002b) argue that as early stage investments tend to focus on a narrower area of investment than later stage investments a need to have a continuous stream of deals would be more important for early stage firms to resort to syndication. However, their study of 5 European countries supported the conclusion of the UK study, of being equally important for early and later stage investments.

Therefore early stage and late stage investors lay the same importance on syndication with intent to increase deal flow.

6.2.2(b) Role in Investment -Lead / Non Lead

The role a partner in a syndicate plays also influences the motive to syndication. Manigart et al (2002b) in their study of syndicate deals across Continental Europe saw that the financial motive was the most important driver for syndication than either Resource based or deal flow motives. Where as syndication in the US was primarily driven by resource-based motives where firms intending to leverage on resources, enhance networks and at the same time increase deal flow.

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Lockett &Wright (1999) examine the reasons of firms syndicating in and syndicating out of deals. Syndicating in referring to the decision of firms to join a syndicate in a non-lead role and syndicating out referring to the decision of firms to join a syndicate in a lead role.

Finance based motive The role of lead or non-lead within a syndicate is on a deal-to-deal basis. Wright and Lockett (2003) use equity stakes in a syndicate as a measure to identify what role a partner plays in a syndicate and what resources they contribute. Lead venture capitalists are responsible for identifying and coordinating the deal and hence would want a larger portion of the equity. Inter firm linkage requiring not only a desire to form links but also the attractiveness to be a potential partner (Ahuja, 2000). A lead venture capitalists is seeking to reduce risk by portfolio diversification (Manigart et al 2002), and would be contributing to the syndicate by bringing resources like market and industry knowledge along with skills of selecting and monitoring investees.

Resources based Motive The resource-based motive for firms in a non-lead is more significant than for firms in a lead role. Firms which are lacking in experience and information choose to be become non-leads in syndicates as they can over come their disadvantage (Wright & locket 2003). In the case of young ventures, lead investors play a significant role in providing external contacts and managerial advice, allowing them scope to develop their internal efficiency and external position (Gupta & Sapienza, 1992). Converse to theoretical assumptions, a study conducted by Lockett & Wright (1999) on the UK industry shows that firms in a non-lead role do not find the lack of experience, be it in industry, sector or a new geography more important a reason to syndicate than having experience in the various areas.

Syndicating with firms that have a reputation amongst venture capital networks adds to a firm s own credibility. Reputed venture capital firms would not want to tarnish their reputation and hence would want to syndicate with reliable partners, thereby reinforcing the non-leads legitimacy (resource) (Manigart et al 2002b).

Deal Flow Motive The argument put forth by Manigart et al (2002b) is that a constant deal flow would be important for either syndicate partner. Empirical data from their survey of European venture
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capitalists reflect that deal flow is an equally important motive for both a lead and non-lead to syndicate.

Therefore we can state that financial motive is more important for Lead Investors, while Resource based motive is more important for Non-lead investors. The Deal flow motives are equally important for both, lead and non-lead investors.

6.2.2(c) Partner Selection Criteria

There is limited literature on the partner selection criteria in the syndication of venture capital firms.

But, previous research in the area of joint ventures has reflected that partner selection is an important component in the venture decision-making process. As the partner contributes skills and resources, they would influence the competitive performance of the venture. (Glaister & Buckley 1997)

Selection criteria, in the case of joint ventures, is divided into task related and partner related. Task related criteria comprising of access to markets, distribution channels amongst other whilst partner related criteria emphasises trust and reputation. (Glaister & Buckley, 1997)

Although equity joint ventures and syndication of venture capital deals are similar as partners taking equity stakes in an investments and the profit earned is determined by the performance of the firm. But they are also different as in the case of syndication a new management is not created. The limited similarity proves to be a drawback for applying the finding on the syndication of venture capital firms. (Lockett and Wright 1999, Wright & Lockett, 2003)

Lockett & Wright (1999), theorise that the criteria for selecting a partner would be directly influenced by the motives to syndicate a deal, which would fall under financial, resource based or a deal based motive. They also recognise and highlight the importance of factors that would translate into congenial working amongst partners, trustworthiness, reputation regarding investment style and experience of previous dealing, to partner selection.

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6.2.2(d) Specialists and Generalist Funds

Jungwirth and Moog (2004), draw a distinction within the group of venture capitalists based on differences in knowledge. Specialists are those who possess knowledge in specific industries while generalistsfunds have only a basic know how of funding a financing ventures. Specialisation allows for these firms to access limited deals. In the case of generalists, the lack of knowledge hinders in the selection of deals. Hence, there is a greater need for, deal flow for specialists and at the same time industry specific knowledge for generalists. Therefore the motive for syndication for specialist funds is to gain access to deal flows while for generalists it is gain knowledge based resources allowing for better selection of deals.

6.2.2(e) Independent & Captive Firms

The source of finance for the two sets of firms is different. The captive firms receive finance from parent firms while independent firms raise capital from a range of sources. As independent Firms depend on external sources of finance their motives for syndication are finance driven when compared to captive firms.

6.2.3 Syndication and the Monitoring of Investees

The structure of syndicated deals is such that there is one lead investor, with the other investors taking on non-lead roles. Although this relation of lead and non-lead is on a deal-todeal basis, it created a principle and agent relationship for any given investment resulting in the classic agency cost. Jensen & Meckling, 1976 (As read in Wright & Lockett 2003) consider agency cost arising in any circumstance which requiring collaborated effort. In order to control costs arising from the agency problem Wright & Lockett (2003), highlight the importance of the structure of contracts and management of investees.

Lead investors are responsible for bringing the deal together. They ensure greater control by taking a greater stake in the equity. Overall, it is the investment agreement that spells out the rights of the various parties of the syndicate (Wright & Lockett 2003).

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Ineffective management of the investees in the ex-post decision-making process will increase coordination costs. Although it is the investment agreement that defines the right of the lead and non-lead parties, it is the actual interaction with investors that will influence the amount of information received.

While non-lead managers may have access to certain specific information, lead managers have access to accounting and management information. This (Wright & Lockett, 2003) can be attributed to the higher frequency of formal and informal contact leads managers have with the investee firm, than non-lead managers.

Research clearly reflects that firms undertake syndication due to financial, resource and dealbased reasons. But each motive of syndication when taken separately has an influence on other motives of syndication.

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CHAPTER 7 QUALITATIVE ANALYSIS OF SYNDICATION PRACTICES IN INDIA

This chapter presents a qualitative commentary on the syndication practices in India. Here an attempt is made to draw parallels with views of venture capitalists and academic literature and surveys to gain better insight into venture capital behaviour.

The chapter is presented as follows: Section 7.1 provides a brief introduction on the current syndication scenario in India. Section 7.2 gives an analysis of the motives for syndication. Sections 7.3 7.5, address the topics of non-lead, partner section and monitoring of invitees respectively. Section 7.6, the final section concentrates on presenting the results of the analysis.

7.1 Introduction

A snap shot of the top 81 deals made in 2005 show, 18 of them were through syndication (Appendix II). While this shows that syndication is not new to the Indian sub-continent, a Venture Capitalists remarked Syndication is still too large a term to use in the Indian context, as growth capital usually is done independently

While there are insufficient statistics (as not all deal are announced) to plot syndication activity, there are adequate deals to provide us insight into the factors that influence firms to syndicate.

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7.2 Motives for Syndication

7.2.1 Finance Based Motives

Lockett & Wright (2001) have found the dominant motive to syndicate between UK firms is finance based. The same is true of Indian firms. Irrespective of the stage in which they invest, the finance motive proves to be an important reason to syndicate.

Large firms that invested in late stage reason that the large size of deal in proportion to available size of funds is an important criterion as is the need to disperse financial risk. Early stage ventures found the need to diversify risk as well as access to additional rounds of financing as important. In contrast a large early stage investor did not find additional rounds of financing a reason to syndicate, owing to size of funds he had access to. An investor who focussed on multilateral investment, but whose funds size is smaller claimed I don t mind looking at co-investors if the deal size is too huge

This reflects that firms in later stages also look at syndication to access funds over and above the diversification of risk. This would be in consonance with Lockett & Wright s (2001) result where only firms that focussed on MBO/MBI investments did not find the deal size pertinent enough to prompt syndication.

7.2.2 Resource Based Motives

According to Jungwirth and Moog (1994) generalists VCs seek to syndicate in order to gain resources while specialist funds syndicate to enhance deal flow. In the Indian scenario, VCs who invest in all stages/ or generalists do want to encash on the resources of other syndicate partners. While these firms have sufficient managerial expertise they wanted to syndicate with firms that have technical capabilities. As quoted by an officer in a late stage VC firm Managerial skills not as important as the technical expertise

Contrary to Jungwirth and Moog (1994) findings, the need for managerial resources or access to specific skills in order to manage the investment is more important than increase deal flow
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for the specialist funds investing in early stage. Firms lay more emphasis on the need for resources they lacked than increasing deal flow to seek a syndicate partner.

7.2.3 Deal Flow

While the importance of deal flow and the benefits of having a steady flow of business is acknowledged, venture capitalists do not considered it to be more important than resource based motive or finance based motive to syndicate deals. The importance of deal flow as a motive can be understood by the reaction of a venture capitalists Deal per se is not an issue

While the research of Lockett &Wright (2001) on the UK venture capital market show that deal-based motive was more important than the resource-based motive for syndicated out deals, and the same was found by Manigart et al in (2002a) for France in turns out that in the Indian context it is not so. This is because of the number of deals available to venture capitalists. A venture capitalist elaborated this point by highlighting As far as deal flow is concerned there is enough for all, occasionally we do cross arms

Deal-flow takes relevance when competition levels are high (Lockett & Wright, 1999). Given there are sufficient deals for the firms operating in India currently; the need for deal flow does not take precedence over resource-based view for syndication. The emerging market is characterized by an increase in commercially oriented firms there by supplying a string of private equity opportunities (Wright et al, 2004).

7.2.4 Local & Foreign Firms

The factors that are important for local/domestic firms to syndicate with other local firms and foreign firms are different. The reason venture capitalists want to syndicate with foreign firms is for both finance and resource based motives. Co-investment between two or more domestic firms on the other hand is purely for financial motives. To quote a venture capitalists reasons for choosing a local firm vis--vis a foreign firm:
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 Local partner. it would be purely financial, risk sharing and deal size Some venture capital funds are in Rupees and some in Dollars . This also influences the choice of syndicating out deals to foreign VCs. Foreign firms choose to invest in firms whose offices are incorporated in the US and have back offices in India. With value driven in the US a venture capital firm with rupee funding, investing in the back office operations in India would not prove to be profitable. As a local venture capitalists explained . Well I can t invest with foreign firms it will leave me with bread crumps

While most domestic firms in India have foreign currency or mixed currency funds, this problem is with the smaller venture capital and government affiliated firms. However, the smaller venture capitalists do not fall under the radar of foreign firms.

The late stage investments in India are dominated with foreign players along with a few strong domestic players. Foreign firms prove to be ideal syndicate partners for both financial and resource based reasons. Local firms investing in all stages considered syndicating on the basis of technical expertise that foreign firms provided over and above the financial reasons. While early stage ventures considered resources in relation to deal being outside their specialised industry or outside the stage of investment.

The need to seek secondary approval of either a foreign or domestic player to invest in a deal was not considered highly important by most venture capitalists.

Access to networks to enhance deal flow were a low motivator when syndicating with domestic firms was concerned. A venture capitalist reacted by saying I don t need to look at a domestic for networking, they are no different from me Foreign partners have access to people in the US, which I would typically not have

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Also the need to syndicate with a foreign player to boost the entrepreneurs business and a need to access foreign markets were high.

7.3 Non-lead membership

The research conducted by Lockett & Wright (1999), on the UK market reveals that firms choose to syndicate investments in a non-lead role in those areas in which they already have exposure like industry sector, investment stage or geographical area, against the popular belief that firms tend to syndicate in order to gain exposure and information in which they do not have experience.

7.3.1 Finance Based Motive

Like in the case of syndicating deals, the reasons to join a syndicate were also finance driven. The investment time horizon and financial terms of the deal were of particular importance to investees.

7.3.2 Resource Based Motive

As established by Gupta & Sapienza (1992) young venture capital firms are seeking to build on technical and managerial know how and syndicating in the non-lead role with reputed firms with help in overcoming this drawback. The need to join a syndicate to leverage on the lead partners reputation was important for smaller or younger venture capital funds, while larger venture capital funds, with established track records, did not find it too significant in syndicating into a deal.

7.3.3 Deal Based Motive

Deal reciprocation was considered important by most venture capitalists as a reason to participate in a syndicate in a non-lead role. As one venture capitalists put it, Reciprocal deals, definitely, its a symbiotic relationship

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A mutual relationship of syndicate partners is based on trust and of each partner contributing deals leading to well functioning syndicate. Manigart et al (2002 b) in their analysis of syndication practices in Continental Europe have found similar patterns of non-lead syndication.

7.3.4 Local & Foreign Firms

Local firms wanting to syndicate with foreign firms in a non-lead role, found along with time scale and financial terms of the deal, the need to have access to additional rounds of financing as important motivators to syndicate. This is because the fund sizes of foreign firms are larger than most domestic firms.

Although some firms insisted they would invest with foreign firms only if in a compelling situation, the need to access resources they lacked was a motivator. In converse to Lockett & Wright (1999) findings in the UK industry the need to syndicate with foreign firms, were for reasons of gaining experience in areas in which firms lacked knowledge and information, while with domestic firms, the need was in line with UK findings of syndicating in areas where the firm already had substantial experience in industry, geography or stage. This significant difference can be attributed to the similarity in domestic firms resources. While the geographical area is similar, majority of domestic firms are concentrated in the lower investment sizes and focussed on the IT sector. And, at the same time, foreign firms are concentrated in the later stage of investment and allow for domestic firms to gain access to external markets. Foreign firms have sector focus and technical expertise

7.4 Partner Selection Criteria

7.4.1 Syndicating Out

Lead investors in general pay more attention to the investment style adopted, positive past interactions and reputation and trust of firms in selecting a syndicate partner.

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Trust seems to be pivotal in selecting a partner for syndication. It is the most important factor in firms selecting both domestic and foreign firms. A venture capitalist stressed the point by saying: There is no point in going along with a person I don t really trust or with whom I don t have a working relationship To be comfortable as partners, we should know them and also it should meet our strategic objective

In addition to the trust and reputation of the syndicate partners firms lay emphasis on the investment style, which enable them to meet their strategic objective. Investment style in relation to exit intention and re-financing are considered to be more important than legal documentation. Similarity in time horizon of investment is stressed upon, as no partner would like to be stranded midway in the investment, and at the same time firms look at the second round of financing as an opportunity to be bought out by the other/larger partner. In the second round of financing, probably he can buy me out, that is an exit option for me

However, expertise in legal documentation is not considered of much relevance as it could be met through other sources.

As lead investors would not want to tarnish their own reputation, they gave weightage to reputation for selecting good investment opportunities as an important criterion for selecting non-lead partners. In the process, they also give legitimacy to the non-lead (Manigart et al, 2002b). Reciprocation of past deal flow is recognised to be important in partner selection, while the expectation of reciprocation of future deal flow is not as important. This would tie into there existing sufficient deals at present in India.

The importance of a membership of a venture capital association does have its stand-alone benefits; but it does not add weightage in a firm being selected over another. Overall the findings are similar to those found by Lockett & Wright (1999).

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7.4.2 Syndicating In

As non-lead members rely on the lead members to monitor the investee ex-post investment decision, it is expected that the accurate provision of information for the monitoring of investments be of particular importance in joining of a non-lead member into a syndicate. But contra-intuitively this is not the case. Here again reputation of the lead and the past positive interactions are the characteristics of the lead that influence non-lead firms to join a syndicate. Larger venture capital firms also emphasis on the need for investment style in relations to exit and refinancing as characteristics that they would like to find in syndicate leads.

In becoming a part of a syndicate, the lead member being foreign or Indian did not have any particular relevance.

7.5 Role of Lead and Non-lead in Monitoring of Investees

The syndicate lead being foreign or Indian did not have any influence on the roles of lead and non-lead members in monitoring of the investees.

The role of the lead was considered more hands on than the non-lead by investors of both early and late stages. While syndicate leads were given memberships on the board, non-lead members were only sometimes represented. We usually demand a position on the board even if we are non-lead said one venture capitalist.

The lead syndicate had a higher degree of contact with the investee on a day-to-day basis. Inspite of having only cursory contact, non-lead venture capitalist believed that all major decision had to be vetted and approved by all syndicate members. Non-leads had access to accounting information as they conducted independent audits.

The monitoring of investees has influenced future decisions while syndicating. A bad experience by a large venture capitalist in a non-lead role has resorted to them wanting to invest only in lead role and only if they have conducted the primary due diligence. While on the other hand, other non-lead investors are comfortable in leads taking an active role in
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monitoring as it is only on a deal to deal basis and relationship is based on trust. These findings are in line with those of Wright and Lockett (2003) where the lead investor had equal access to information on both accounting and managerial decisions. Also, leads took a more active role in monitoring of investees, while non-lead members did not have representation on the board.

7.6 Conclusion

An analysis of the syndication practices in India reveals that the current economic condition and internationalisation play a vital role.

A major distinguishing factor between a developed economy and an emerging market economy on syndication practices, which can be made, is the importance of deal flow as a motivator. Opportunities for investment are influence by economic cycles. UK data show that syndication levels increased with the onset of recession (Lockett & Wright, 1999). Deal flow is crucial in competitive environment as good deals are hard to come by. In the Indian context, as the environment is not yet highly competitive and given the high level of economic activity, there are sufficient deals. Therefore, the need to syndicate for the purpose of deal flow is not as important as it is in the developed countries.

Furthermore, there is difference from earlier findings when the domestic firms are analysed as a subgroup of specialists and generalists. While specialist / early stage want to syndicate to encash on resources like managerial talent, generalists / late stage firms also want to syndicate on the basis of resources like technical know how. The late stage/ generalist funds according to Jungwirth and Moog (2004), show that firms want to syndicate for increasing deal flow, which is not so in the Indian context.

There is no literature on the syndication practices between foreign and local firms in emerging markets. However, in the case of alliances between foreign firms and local firms in emerging markets the foreign partner is expected to contribute with finance and technological resources while a domestic partner contributes to the alliance with local knowledge and networking (De Mattos et al, 2002). Although, this reflects a pattern in alliances of firms the same pattern is seen in the Indian venture capital industry. Domestic firms find the motives to syndicate with foreign firms for financial and resource based reasons. But, while syndicating with domestic
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firms the reasons are predominantly to disperse risk, as the resources that a local firm would bring, like networking and geographical knowledge would be a duplication of their current resources.

Internationalisation acts as a conduit for transfer of skill sets, it also is a window for domestic firms to access foreign markets. Given, the high concentration of IT and ITES industry in India, with an export market aboard, the need to enter foreign markets to enhance value for the entrepreneur is key. A Venture capitalist accentuated the point by saying He [foreign company] will help the company scale up fast, if he has a sizable export market, the foreign partner will add more value than me alone

The findings of the non-lead participation in a syndicate are also different from those of developed market. Non-lead syndicate members in the UK (Lockett & Wright, 1999) tend to syndicate in such a role for the most part when they have expertise in a particular geography, sector or stage rather than the lack of it. While the sub- group of foreign and domestic firms exist in the Indian scenario, the results are also different. The non-lead choose to syndicate with foreign partners with an intention of gaining exposure to resources as well as their having of resource. Conversely, to join an Indian syndicate in a non-lead role domestic partners choose to do so, as there already had expertise in specific areas.

There were similarities in the motives for syndication between developed and emerging markets. Local companies stressed on the importance of reputation and credibility in the case of partner selection and there was no relevant difference in the choice between a foreign or domestic partner. Monitoring of investees in a lead role by either a foreign or domestic firm again did not bring out any difference.

Some of the reasons that local firms found as a deterrent to syndicate with foreign partners was their having rupee denominated funds and the existence of centralise control in decision making for foreign funds. As a venture capitalist said Their approval and consent tends to be centralized abroad and take too much time in decision making, that we think is a drawback

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Currently syndication in India is still in a nascent stage. But as the industry develops and the competitive environment intensifies, there is bound to be an increase in co-invested deals.

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CHAPTER 8 CONCLUSION

The study has been directed towards the investigation of the growth and development of the venture capital industry in India and is the culmination of extensive field and desk-based research. It provides useful insights into the recent trends in the industry as well as syndication practices in an emerging market scenario.

The main finding of the study are summarized as follows: Section 8.1 recapitulates the development of the Indian venture capital industry, highlighting the current scenario, while section 8.2 summarizes the comparative analysis of the development of the venture capital industry in India and CEE countries. Section 8.4 provides a synopsis of the syndication trends in India and the final section, 8.5 addresses the implication of this study followed by a concluding note.

8.1 Development in the Indian VC Industry The embracing of liberalization resulted in a monumental shift in India s economy. The hubbub of economic activity fuelled by regulatory changes has helped the venture capital industry in India grow and flourish.

The industry began with governmental impetus in the late 1980s and since has seen the entry of foreign and other private players. Since liberalization in the early 1990s, policy makers have constantly had their finger on the pulse of the industry. They have brought about changes to allow for greater entry of funds. Entrepreneurial investments in Information Technology industry provided the initial source of deal flow. Since then India has seen a growth in other industry like Retail, Banking and Financial Services and Infrastructure. There has been growing attention in the late stage deals including listed equity. Internationalisation has influenced the behaviour of venture capital firms (Wright et al, 2002a).

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8.2 Comparative Analysis between India and CEE markets

The economic and political backgrounds influenced the initial landscape of the industry. The supply of opportunities predominantly coming from the privatisation of deals in CEE, and in the Indian sub-continent economic activity attracted investments into early stage ventures due to the existence of an entrepreneurial culture. The general economic environment has been responsible for putting both regions under the radar of the Foreign Institutional Investors. Strong FDI inflows have helped in supplying the crucial capital required for growing and expanding companies.

The proximity to the western, more developed countries and the European Union (EU) membership has allowed the CEE countries to fine-tune their legal, tax and market oriented policies and regulation towards those of other EU members. Opening of borders for the free flow of labour and capital has enabled world-class companies to set up shop. Foreign firms in legal and accounting services have supported creation of deals in addition to training the workforce in western practices. The Indian government too has recognised the importance of a venture capital industry and have been undertaking continuous regulatory reforms. Though liberalisation of Indian policies heightened economic activity in the early years of 1990s, the relaxing of regulations towards foreign venture capital investment in 2000 was the turning point for its development. Having said that, there is still need for further regulation. The recent commitment of the Prime Minister to further loosen the exchange controls and make the Indian Rupee fully convertible is a major step towards meeting those requirements (EMPER, 2006). This is also a big leap from lowering bureaucratic controls.

The stock markets in both countries are well developed allowing for exits through flotation for companies. The level of exits via trade and secondary sales reflect strong liquidity conditions. The major structural changes are already in place in the CEE region. Now, with the EU membership, harmonizing of legal and marketing policies will further strengthen and shape the CEE industry.

The CEE is at a higher level of development than India. But, with the lowering of intrusive governmental control coupled with an explosive demand for growth capital the prospects of progress of the Indian venture capital industry is robust.

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8.3 Syndication

The syndication or co-investment of deals is still in its nascent stage in India. An analysis of the various motives inducing syndication behaviour reflects both similarities and difference with results from western countries. Internationalization and the economic conditions of India influence the motives to syndicate.

In line with studies conducted in developed countries the traditional finance based reason of diversification of risk, and size of deal in relation to average deal size is considered the most important reason to syndicate by all sub groups. The resource-based view when compared in the context of generalist and specialist funds, was important for the former for technical resources and significant to the later for managerial know how. The reason to syndicate on the bases of deal flow was not considered at par or more important than the resource base. Although the importance of deals is acknowledged, the economic conditions allow for sufficient deal flow, lowering its importance as a motivator to syndicate.

Syndication motives cannot be viewed in a vacuum.

Characteristics of firms play an

important role in the decision to syndicate. In the Indian context, the existence of foreign players, divides the population of venture capital firms into domestic and foreign. Internationalisation of the industry is considered crucial for the development of the venture capital industry (Wright et al, 2005). It is influencing the syndication behaviour of Indian firms.

India being a hub of IT and ITES ventures with export markets abroad, domestic firms find the need to syndicate with foreign firms in order to gain access to export markets and networks in developed countries. Therefore making the finance and resource based motives equally important. Unlike non-lead firms in the UK, (Lockett & Wright, 2002b); domestic firms choose to join a syndicate as a non-lead influenced by lack of resources. But, syndicating with other local firms is influenced by the having of specialised skills in areas of stage, sector and regional expertise. The partner selection and monitoring of investees in a lead role is not influence by the foreign and domestic sub group.

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8.4 Implication

This research has implications for venture capitalist, entrepreneurs and policy makers. . The study has special significance for policy makers. The benefits of a venture capital industry are multi-fold and have direct consequence on the macro economic condition of the country. Given the implication of venture capital on the economy, policy makers need to provide for an infrastructure and regulatory climate conductive for the entry of venture capital funds.

Though India has been undertaking reforms, further changes concerning infrastructure are required. Regulatory reforms like full convertibility of rupee and the relaxing of the ceiling on mutual funds investment of 5% into venture capital funds, will allow for a larger inflow of funds into the sector. Increasing university and industry collaboration and will enhance the entrepreneurial climate in India. A Limited Partnership (LP) structure for firms need if adopted will provide transparency in tax and investor protection of limited liability (Planning Commission, 2006). Finally, the CEE region has benefited extensively with the active participation of private equity firms in privatisation. Hence, India too along with hastening the process of divestment should encourage participation from private equity firms in the process.

Venture capital firms have been concentrating on the late stage investments due to drying of early stage ventures post the IT bubble bust and also as newer firms are entering the country, they find it more feasible to invest in late stage investments as they are less risky (Alyward, 1998). This has lead to the early stage ventures being ignored; hence the suggestion to venture capitalists is to also explore options in the early stage ventures.

The study helps venture capitalists in understanding the various benefits to syndication. For venture capitalists entering the country the level at which they adapt to local conditions is key (Wright et al, 2002). As partner selection is dependent on trust and relationship building (Lockett & Wright, 1999) the centralised decision making of foreign firms may create ex-post decision-making agency problems.

The implication of the study has a bearing on entrepreneurs too. A better understanding of syndication behaviour would allow entrepreneurs to meet their strategic goal by leveraging on
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the various resources that the individual venture capitalists bring to a syndicate. These resources can be in providing expert management advice, access to foreign markets and networks and also to a firm s expertise in exit routes.

8.5 Conclusion

The study is an attempt to bring out factors that are instrumental in the growth and development of a Venture Capital industry, with special focus on India. Sufficient literature present in the development of venture capital industry has allowed for a comparative study between the CEE region and India. Keeping in mind the current trends of internationalisation and transition, an insight into syndication behaviour of firms within India is also presented. This study is significant, as no prior research has been conducted in the motives for syndication in the Indian sub-continent. India s venture capital industry is still at a nascent stage of development. While further regulatory changes are required, research on practices and behaviour with in the industry is pivotal for the growth and enhancement of the industry.

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APPENDIX I LIST OF PARTICPANT VENTURE CAPITAL FIRMS

IL & FS-Mumbai ilabs Venture Capital Fund- Hyderabad & Chennai India Value Fund- Mumbai Infinity Ventures-Mumbai Jumpstart Up Fund Advisors Ltd-Bangalore KITVEN-Bangalore Punjab Infotech Venture Fund-Jaipur Rajasthan Venture Capital Fund-Chandigarh SICOM Capital Management Ltd-Pune SIDBI Ventures-Regional Office-Bangalore UTI Ventures-Bangalore

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APPENDIX II LISTS OF TOP INVESTMENST ACROSS ALL STAGES IN INDIA-2005

Source: Venture Intelligence India- Round Up- Annual 2005
Sl No. Company

Name

Investors
GW Capital (about $30 million), ChrysCapital (about $ 30million) and CVC International (about $26.3 million) Warburg Pincus Warburg Pincus IDFC, HDFC, IL&FS, Leela Fashions Infinity Capital Temasek General Atlantic Partners CIFC, New Vernon Bharat ChrysCapital General Atlantic Partners Morgan Stanley, New Vernon, Bessemer Venture Partners ChrysCapital ICICI Ventures ChrysCapital IFC CVC International, IIML CVC International IFC CLSA Private Equity Newbridge Capital Merlion India Fund, IIML Amaranth Advisors IDFC Private Equity Actis Warburg Pincus Temasek Actis Actis Farallon Capital Greater Pacific Capital Actis IDFC Technology Crossover Ventures IFC IIML WestBridge NEA Bessemer Ventures, New Vernon

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40

Centurion Bank of Punjab Vaibhav Gems Sintex Industries Leela Hotels Sify Welspun India NDTV Balrampur Chini Mills Balakrishna Industries Jubilant Organosys Rico Auto Industries Shriram Group Viceroy Hotels Simplex Concrete Piles Apollo Hospitals Enterprise JBF Industries Spentex Industries Dabur Pharma Apar Industries Shriram Holdings (Madras) ABG Shipyard Indiabulls Finance Gujarat Pipavav Port AVTEC (Hindustan Motors) Max Healthcare Institute Medreich Sandhar Locking Devices Blue Bird Indiabulls Credit Services Edelweiss Capital TEMA India Chalet Hotels EXLService Holdings International Auto Gokuldas Images Dr. Lal PathLabs Sasken Communication Technologies Sarovar Hotels & Resorts

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43 44 45 46 47 48 50 51 52 53 54

Thomas Cook India Sify Ace Refractories Ranbaxy Fine Chemicals VA Tech WABAG India Nimbus Communications Perlecan Pharma Malladi Drugs and Pharmaceuticals Karvy Stock Broking Persistent Systems

Dubai Investment Group Infinity Capital ICICI Ventures ICICI Ventures ICICI Ventures 3i ICICI Ventures, CVC International ICICI Ventures, IIML, Sander Morris Harris Group Pacific Century Group Norwest Ventures, Gabriel Ventures WestBridge ($8 million), Sequoia Capital ($3.25 million), Cisco ($2.25 million) IIML, Others Kotak Private Equity Merrill Lynch, Citigroup Global Markets, India Capital Fund, India Institutional Fund IFC Motorola Ventures Temasek, JP Morgan New Vernon Softbank Asia Infrastructure Fund Baring Private Equity HSBC Private Equity GEM India Advisors NewMedia Spark GEM India Advisors SIDBI VC SIDBI VC WestBridge JAFCO Asia, New Path Ventures, CMEA Ventures, NEA, Intel Capital TD Capital Ventures (lead), Mitsui & Company Venture Partners, Entrepia Ventures, Venrock Associates, Sofinnova Ventures, JumpStartUp New Enterprise Associates, BlueRun Ventures, New Path Ventures Trident Capital, Siemens Venture Capital, Walden International, Blueprint Ventures, Granite Ventures Sierra Ventures (lead), WestBridge GVFL

55 56 57

Bharti Telesoft Manipal AcuNova Paramount Airways

58 59 60 61 62 65 66 67 68 69 70 71 72 73 76

Northgate Technologies Ramky Group July Systems Apollo Health Street Jagran TV Makemytrip.com Maples ESM Technologies MeritTrac Services Samant Soma Wines IMISoft Trak Services Carz-on-rent Bravo Healthcare Nazara Technologies Telsima

77 78

HelloSoft Nevis Networks

79 80 81

AirTight Networks Astra Business Services ConvergeLabs

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APPENDIX III
Figure 1: Graph showing venture capital in developing countries by financing stage (1995) (Alyward, 1998, pp. 8)

Figure 2: Graph Showing Indian Venture Capital Investment Trend

1,400 1,200 1,160 937 774 500 250 20 96 80 97 98 99 '00 '01 '02 '03 '04 590 900

USD (Millions)

1,000 800 600 400 200 0

Years Source: IVCA/AVCJ

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Figure 3: Table showing Evolution of Private Equity Finance in India

As cited in Planning Commission (2006)

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Figure 4: Chart showing PE investment by Stages-2005

Source: Venture Intelligence India- Round Up- Annual 2005

Figure 5: Chart showing PE investment by Industry-2005

Source: Venture Intelligence India- Round Up- Annual 2005

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