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Private equity’s 'cut, copy and paste theory' and its ramification on impact investing

Author: Arvind Agarwal, Founder & CEO - C4D Partners

Publication: CNBC TV18

The mid-20th century saw the formation, development and eventual burgeoning of modern-day private equity.

The mid-20th century saw the formation, development and eventual burgeoning of modern-day private equity. Although having originated in the US, this phenomenon has struck a chord globally as investors across the world have been able to build successful investment opportunities using this tool. Over the years, private equity has emerged as a critical asset class for both investors as well as for the economy as it paves way to growth and development.

The origin of the private equity’s "cut, copy, and paste theory”

Since its conception, although the basic norms of private equity have been institutionalized, the industry has witnessed several significant changes, which largely have been towards the improvement of the industry.

What is pertinent to note here is that these alterations that helped the sector evolve were bespoke to meet the local needs of developed countries (such as the US and Europe) keeping in mind the maturity of their public markets. However, with the private equity gaining popularity and sensing the scope of expansion, fund managers were quick enough to set-up shops in other countries (specially developing countries) where opportunities remained untapped.

In these countries, fund managers adopted a cookie cutter approach towards fund structuring and developing the regulatory framework – an approach that may have suited a more evolved public market. The primary aim for investors here was to make the process easier for fund managers to operate private equity funds in their respective countries.

It is this cookie cutter approach that gave way to the “Cut, Copy, and Paste Theory”.

Private Equity in India

In India, private equity gained popularity and momentum after the economic reforms in 1991. Back then, with the sector still in its infancy and coupled with faulty fund structuring, the sector was unable to thrive, thus resulting in the industry’s prospects remaining largely untapped.

However, to cash-in the opportunity present, Indian fund managers had begun replicating fund structures that prevailed in the US or the other European countries despite their public market still being quite immature.

The biggest mistake probably was to stick to the 10+2 fund life structure. A 10+2 fund life structure is when a fund manager needs to invest all the funds, exit the investments, book profits and eventually wind down the fund – all in a span of 10 years, which, at the most, is extendable by two additional years.

Most of the fund managers struggled to wind down their fund within the span of 10+2 years. This is because the time needed to do investments and exit from the investments in India required more time compared to the other developed markets.

As a result, most Indian private equity fund managers started making Private Investments in Public Enterprise (“PIPE”) deals to ensure exits within the fund life as it is always easier to exit from publicly listed companies.

The inclination towards PIPE deals resulted in a significant focus on public equities. The financial crisis of 1999-2000 and 2007-08 led to significant increase in stressed assets in the private equity portfolios. The steep slant in PIPE deals led to the stepping in of Limited Partners (LPs) to put a cap on PIPE deals. This, then compelled investors to shift focus due to limitations in the structure of the funds. Soon the gears were switched towards technology-led companies.

Perhaps, back then it would have been more prudent to revise the fund structure. Instead, investors adopted the easier and the quicker way out. Investors, presently focus on investments in tech focused companies (or financial institutions) as it is easier (or perceived) to exit such deals within the 10+2 fund life structure.

This strategy continues to prevail presently not only in India but also in the Middle East and other Southeast Asian Countries. For these markets, it was critical that the fund-structuring was innovative and tailored to meet the local needs.

Unfortunately, the lack of a customized approach adversely impacted the industry in these markets. As a result, Asian private equity never took off the way one had anticipated it to and the impact on local economies from private equity as an asset class was significantly muted.

Impact Investing in India and understanding the legal structures

India has seen the development and operating of structured impact funds only in the past 10 or 15 years. Although the structuring for impact funds should be drastically different from PE funds, unfortunately, impact fund managers have applied the same “Cut, Copy, and Paste” theory.

Before understanding why impact investing requires a different approach and the deployment challenges of the “Cut, Copy, and Paste”, let’s first understand what are the legal structures available for the fund managers in India.

As per the Securities & Exchange Board of India (“SEBI”), an Alternative Investment Fund (“AIF”) can be registered under three categories:

1. Category III – For Hedge Funds

2. Category II – For Private Equity Funds

3. Category I – For Start-ups and Early-Stage Ventures

a. Venture Capital Fund (“VCF”) – For Venture Funds

b. Social Venture Funds (“SVF”) – For Impact Funds

Impact investing challenges in India

To begin with, in this article, we will focus on category I AIF to understand the key challenges.

Although VCFs and SVFs stem from the same AIF category, the main difference between VCF and SVF is that:

1. If one is registered under SVF, they can accept grants and give grants; and

2. A fund registered under SVF is required to mention in their Private Placement Memorandum (“PPM") that they will target muted returns.

What is surprising is that an SVF does not enjoy any benefit as compared to a venture capital fund when registering with the SEBI or with respect to taxes.

In fact, it is these two distinctions itself that work against a social venture fund. These two factors are critical because, a fund should not be responsible to accept grants or give grants. The not-for-profit sector is already doing a commendable job with respect to giving or accepting grants. Additionally, the moment a social venture fund mentions that their fund will target muted returns, fund raising can be challenging as it gives the impression that it will be treated as free money.

As a result of the above challenges, being registered as a VCF than a SVF is easier and hence most impact funds in India are registered under VCF instead of SVF.

One can’t fault the impact fund managers for not registering under the SVF category as there is no upside but only downside. So here, investors are left with much prodding on two huge challenges:

1. If almost everyone is registered under VCF, then what are the factors that can help distinguish an impact investor from a venture capital investor?

2. To standardize the procedure and bring in uniformity, should SVFs register themselves as VCFs, copy the same structure as a VCF/Private Equity Fund, and start operating similarly?

The need for an innovative approach towards impact investing

Assessing these challenges and bringing a strong distinction is quite essential for the impact sector.

Today, while VCFs may not need innovative fund structuring, a fresh perspective is certainly required for an impact fund. This is because, impact investing is always touted as “patient capital,” and given how social enterprises operate (or should operate), a 10+2 fund life structure may not work. Unless once again, the focus for the sector is doing just technology-driven deals.

The other challenges with impact funds are also based on:

1. The manager performance bonus (carried interest) – An impact fund manager is only incentivized for the financial returns they generate, irrespective of the social return on the investment. This is because the incentive structure for private equity fund managers is the same as a social venture fund. So, for every dollar of return generated, the fund manager gets 20 percent of that profit regardless of the social impact that the fund has managed to create.

2. GP (General Partner) commitments: A huge challenge for many fund managers is to contribute 1 percent of the fund size, irrespective of being an impact fund manager or a venture capitalist. This is done so that the GPs share the risk of non-performance (financial performance) which in turn incentivizes the fund manager aim for a higher commercial return. There are no incentives for impact achievement.

3. The hurdle rate (minimum threshold returns): An impact fund manager is expected to make similar minimum returns to earn any incentives when compared to a venture capital/private equity fund. The hurdle is always measured in terms of financial success only and unfortunately very rarely on the social impact generated.

The need for innovative structuring of impact funds

These factors above, give way to two critical questions that should to be addressed:

1. If the need of a social enterprise is not different from an enterprise that needs the backing of a traditional venture capital fund, then why to have two categories of investors in the first place?

2. If the need is different, how can two funds registered under the same category, following the same strategy, same structure, same incentives, cater to the different needs?

To address these two questions, perhaps we can start by first understanding i) who can be categorized as (legally) impact investors in India? and ii) who can be categorized as (legally) social entrepreneurs in India?

I do believe that once both the questions are answered, collective brainstorming has the potential to fix the problems to a large extent. Apart from finding answers, clarifying the grey areas, we will also have to work towards understanding what is a right structure for an impact fund and how should the managers be incentivized differently when compared to a VC or a PE fund if the objective is different.

A renewed approach towards developing innovative structured impact funds, can greatly incentivize fund managers to balance financial returns as well as social impact. The innovation here would lie in aligning the objectives of the LPs and GPs, addressing the challenges related to the hurdle rate, managing GP commitments and building an impact driven fund life structure.

To give a small example of how such a small change can work wonders, let us consider the following. If a fund manager has a mandate to invest a certain portion (say 50 percent) of the fund in women focused SMEs, then can we perhaps look at fixing the carried interest percent that is proportional to funds invested in women SMEs? In my opinion, this one change has the potential to not only incentivize fund managers to ensure women SMEs are adequately funded but also eliminate personal biases out of the equation.

To conclude, all the challenges discussed above can be solved, if there is an intent. The present need of the hour is for all stakeholders - LPs, GPs and the industry bodies representing impact investing to change and think beyond the “Cut, Copy, and Paste Theory”.

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