Startups Moving To Alternative Source Of Capital – Venture Debt

Nishchal Joshipura who heads the Private Equity and M&A practice at an India-centric global law firm, Nishith Desai Associates elaborates and highlights the key areas of concern and possible forces to direct the startup ecosystem towards large-scale capital creation and economic success  

To unlock India’s potential which lies in the startup ecosystem, systems and regulations are required to revisit the procedures and laws. The VC and PE segment highly laments that the critical directives shall be simplified and actionable.  

1. It appears funds largely emanate or are parked with family offices or PEs in India. Do you see this situation change as India matures as a startup/ entrepreneurial market? 

Family and friends, angel investors, family offices and VCs will continue to remain prominent sources of funding for early stage startups due to their easy accessibility to Founders. 

Since the last couple of years, startups have been moving to an alternative source of capital – venture debt. Since markets worldwide are facing a liquidity crunch, debt financing has become crucial to meet working capital requirements and capex expenditure. Notably, the ‘India Venture Debt Report 2022’ reports that startup funding through venture debt has nearly doubled in the past year. 

As per Invest India, as on 29 June 2022, India is home to 103 unicorns with a total valuation of $335.80 billion. Given the promising Indian growth story and the pace at which India is adding unicorns every year, there will be a quantum jump in investment by VCs and venture debt funds over the next few years. 

2. Government has established a model, Fund of Funds (FOF), which has enhanced the domestic capital pool. How does this help the ecosystem in the long-term? 

Historically, the foreign capital invested in the Indian portfolio companies has been atleast 3-4 times compared to the domestic capital. It signifies the heavy dependence of the Indian PE/VC industry on foreign capital for growth of Indian businesses. There is a pressing need to reduce dependence on foreign capital by encouraging new sources of domestic capital to invest in Indian portfolio companies. In this respect, the FOF is a laudable initiative that will enable other domestic funds in India to deploy capital for building Indian businesses, and such capital deployed by the domestic funds can be leveraged for raising additional funds from other sources such as banks and NBFCs. 

3. The year gone by saw many profitable exits. Will this continue and how do you see exit strategies change in the year ahead? 

After a long dry spell, the acquisition of Flipkart by Walmart was the biggest PE exit from India, which instilled the confidence of the Indian and foreign PE/VC players in India as an attractive investment destination. Ever since, there have been an increased number of big-ticket PE exits from India. In the year 2021, India saw the highest number of IPOs (65) of Indian portfolio companies on the main market and approximately 60 IPOs on the SME exchange. While the IPOs have tapered off in 2022 on account of global developments, India will continue to see robust exits through secondary sale and trade sale going forward. 

4. The government and other governing bodies such as IVCA have been deeply involved in streamlining the segment. What is your take on the work done so far and your advice on what more can be done? 

Since its formation, the IVCA has been very active in representing the Indian PE/VC industry and has been instrumental in liaising with government agencies for ironing out creases and for streamlining the segment. In fact, multiple legal and tax changes have been introduced by the government due to the IVCA’s timely intervention. 

The next big initiatives that the government can take vis-à-vis the PE/VC industry are: 

1. Spot the potential domestic pool of capital: The government needs to allow provident funds and insurance companies to deploy more capital from their mammoth balance sheets for the growth of Indian businesses. Internationally, the largest sources of capital for local businesses have been pension funds, sovereign wealth funds, and insurance companies.  

2. Ease of Deal Making: Like the ‘Ease of Doing Business’ initiative, to shorten the timelines for deal making, the government should introduce ‘Ease of Deal Making’ as the next initiative. As part of this initiative, the government should focus on removal of obstacles such as extensive compliance requirements and lengthy waiting process for obtaining regulatory approvals. In this respect, the time has come for significant regulators such as RBI, SEBI, CCI and IRDAI to re-examine the entire approval process that will ensure the consummation of deals in the shortest possible time. 

3. Tax parity between foreign and domestic investors: Currently, long-term capital gains (LTCG) earned by foreign investors from sale of shares in Indian private companies are taxed at approximately 10 per cent, while domestic investors are taxed at approximately 20 per cent. Measures must be taken to bring parity so that the domestic investors have a level-playing field vis-à-vis their foreign counterparts. 

4. Tax certainty to foreign and domestic PE/VC investors: In the past few years, the Indian tax department has issued a number of tax notices questioning the treaty benefits and imposing GST on carried interest income. This has resulted in a lot of ambiguity and uncertainty amongst the domestic and foreign PE/VC players. For issues such as these, it is absolutely important that the tax laws in India are made crystal clear for no ambiguity. 

5. India being strong in international investments and available foreign capital, what are the challenges that Indian VCs face? 

For Indian fund managers, the biggest challenge is availability of large pools of domestic capital. On account of this, unlike their foreign counterparts, Indian fund managers have been unable to acquire large businesses on their own. Indian fund managers have to pay almost twice as much capital gains tax on exits for domestic capital raised by them as compared to foreign capital. Additionally, given that the Indian Rupee is not fully convertible on capital account, Indian fund managers also have limited flexibility to invest abroad in lucrative global businesses which their foreign counterparts have been able to benefit from.