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India shifts gears to IT and outsourcing services

The Indian venture capital industry is a constantly evolving landscape as investment into the region shifts from sector to sector. The domestic technology market is currently enjoying enormous growth. David Leidl of the AVCJ discusses the trends of the current market and offers a word of caution to those investors who are contemplating jumping on the bandwagon.

From afar, India seems filled with Cinderella opportunities. The burgeoning software-services sector, business processing outsourcing (BPO), intellectual property or IP-based possibilities in IT software, wireless, semi-conductors; it's all there. Yet for the unwary VC in the wrong vehicle… that exotic golden coach could suddenly become a pumpkin, a commodity.

So, climb aboard but watch your step. That's the core advice of an expert panel at the 2002 AVF/USA conference held in California. Sumir Chadha, moderator and WestBridge Capital Partners senior managing director, posed the questions: What's the outlook for IT services? Is the game over for start-ups? What about the much-ballyhooed BPO space? What about the IP arena? The panel lobbed back their opinions.

So then, the bad and the good, the gourds and the gold. The removal of the licensing raj, the Securities & Exchange Board of India's relaxation of investment rules, the lure of the huge and largely untapped domestic market, the come-hither of nascent export markets have helped propel India into the top ranks of the Asian VC arena. In 2005, foreign investors' comfort level will further increase when the ‘patent-protection regime' takes hold and IP protection is given legal teeth.

Dramatic changes
‘From an investor's point of view, the environment has changed dramatically,' panel member Muneesh Chawla, managing director of IL&FS Investment Managers, assured the audience. American fund models are understood. A typical term sheet from Silicon Valley is ‘fairly well acceptable' to Indian entrepreneurs: ‘The regulations, the ability to bring capital in and out of the country, the respect for third-party capital in a business, the ability to enforce certain legal covenants. Today, it's a completely different mindset.'

The prime catalyst: India's global success in the IT and software services sector. Over the last decade, revenues in the software-services sector alone have grown from about $50m a year to $10bn. Last year the industry grew by 30 per cent and still has an average profit margin of 20 to 25 per cent - most impressive and what Chawla calls ‘a clear success story' especially as 70 per cent of revenues are derived from the US economy still struggling from its own downturn.

Emboldened by this tangible success, India looks outward. Then again, it has little choice. ‘Merging with the global economy is no longer considered an option,' says Chawla. ‘It's already there. Irrespective of which government or political ideology is in power, it's something that underlines everybody's political agenda.'

Country risks? India-Pakistan war, something that Warburg Pincus managing director Bowman Cutter dryly notes, ‘would knock the hell out of our portfolio.' But assuming the big ones stay put, Cutter is highly bullish on India. His reasons:

Trend lines
Trend I: the place is flying. In macro-economic terms, India has one of the top five fastest growing economies in the world. Chasing after it, Warburg Pincus has $800m (and counting) in 13 Indian companies with 50 per cent plus in four, the rest ‘quite purposely extremely diversified' among the rest. The emphasis is technology and telco balanced with prosaic - but high growth - ‘old economy' products and services such as mortgages and cement. Sure, they're not sexy but Bowman says they are transparent, predictable and in increasing demand.

Trend II: the ‘encouraging but nerve-wracking' progress of deregulation ‘in areas we care about' (ie investment, capital markets, telco) continues. Deregulation fosters new capital investment, generally improves the overall economic and social environment, encourages productivity and bolsters IP-based IT businesses.

Trend III: the rise of the Indian domestic technology market. It's a biggie. Economic liberalisation, the links to the overseas Indian community and India's tech-skills base have birthed an entrepreneurial focus on the domestic economy ‘very reminiscent' of the US in the 1980s and 1990s and thus ‘really ripe for development.' And then there's that management skill set. Says Cutter: ‘Without any question, across our entire portfolio, the best management teams that we have seen, and that includes the US, have been Indian management teams.'

Managers who know how to ‘leverage' their knowledge, adds Ash Lilani, senior VP Silicon Valley Bank.

Capital starved
But India is saddled with public service deficits, many inefficient public enterprises, immature capital markets and low levels of foreign direct investment (FDI). It also, says Cutter, is ‘effectively capital starved'… and thus aching for private equity. Enter the VCs. ‘Our field to play on has a much broader range than it does in any country we know of in the world.'

Agreed, says Lilani. The lack of domestic capital, coupled with ‘the turmoil in the market,' has pushed certain domestic Indian venture funds into ‘going upstream,' away from early-stage and seed investments and into safer, later-stage vehicles. Which means even less capital for the start-ups. As Lilani pointedly wonders: ‘Who is going to seed these companies? There are a few people doing it but there is not enough money to fund the number of ideas we believe exist in India.'

Which segues neatly into sleuthing down the winners and the importance of building cross-cultural networks, relationships and the ‘Indian connection' into each investment; be it managers, entrepreneurs, an India-origin VC co-partner or investor such as WestBridge. Local knowledge also comforts follow-on and ‘sandhill' investors who fret about strange landscapes.

Paresh Patel, managing director, Sparta Group, believes today's investors seek new lands. In the US, the venture market is in flux, consolidation is in the air, and the domestic venture funds and the peeved limited partners who want the returns, but do begrudge the fees assail general partners.

The great escape?
Over in India, where life is simpler, low pre-money valuations are the norm, the concept of a great exit is achievable. (Sure, few exits have been achieved to date but Chawla believes the returns are there.)

Although the panel agreed that many starry-eyed Indian companies are enamoured with US and European export markets and aren't paying enough attention to local needs, the American-style fixation on costly, complex technology that might, or might not fly, isn't rooted as deeply in India. Compared to typical R&D burn rates in Silicon Valley, India is dead cheap; mere fractions of the cost but with impressively high skill sets.

Vis-à-vis Europe and North America, wages in India are low, the work standards high. The human capital is smart, professional, English-speaking and has a deep pool of skilled ‘cross cultural' managers familiar with Western and domestic ways. It's also largely devoid of what Lilani calls ‘technical snobbery' found among high-end semiconductor engineers in the US: If it isn't cutting edge, it's boring. In India, Lilani says the attitude is pragmatically different: ‘They want to work and they want to be part of this technical revolution.'

A little goes a long way
Money goes a lot, lot farther in India. Here, a small VC fund stake buys a lot. The focus isn't on garnering management fees; the incentive is on building contenders. Although the panel agreed on most points, business process outsourcing was not one of them. Whereas Lilani points to India's highly educated English-speaking labour pool, the US's need for 24/7 coverage and ‘numerous, numerous opportunities' Cutter waves his finger in caution. Yes, BPO is bounding, estimated to grow from $500m today to $10bn over the next decade. Yes, the cost advantages are substantial, the margins (for now) high. But so is the peril. As in way too many players, low values to entry, low technology, thinning margins, very long selling cycles to the client and the risk it will become a low-margin commodity at day's end anyway.

Meanwhile, the huge Indian domestic market awaits. But don't get ahead of yourself. Prove success in the local waters, develop and sell, say, telecom equipment to Bharti Telecom or Reliance, and Patel says only then will you impress dubious US carriers. Tailor the innovations, score locally, and then sell globally.

The roadblocks?
The slew of low-margin IT-enabled concerns that might look great on the top-line but on the bottom line, watch out. Ditto for the swarm of ‘me too' service companies. Patel's advice: take advantage of ‘the amount of innovation you can create with a much smaller amount of money.' Fund companies that are practical, don't require costly marketing, have solutions tailored to specific needs and aren't overly complex. ‘In that paradigm, India makes a lot of sense.' But don't forget those nascent export markets either. Chawla's dream horse: a ‘hybrid' services/product company with a strong client base but which uses surplus cash to innovate new product models. Zero burn rate, little risk in running out of cash and yet it can chase risky - yet potentially very remunerative - new technologies. ‘If I was putting all my personal savings into a company, this is what I'd do.'

Copyright © 2002 AVCJ

David Leidl is a journalist with the AVCJ.

This article first appeared in the Asian Venture Capital Journal, July 2002.

The Asian Venture Capital Journal is the region's leading publication on private equity and venture capital. With readers worldwide, AVCJ provides monthly coverage of fund raising, investments, exits and the people behind them. For more information please visit www.asianfn.com

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