ALTHOUGH FINAL FIGURES ARE STILL BEING COLLATED, over $1.1 billion was invested in venture capital and private equity investments in India in 2002, essentially flat with 2001. This puts India in the top 3 destinations in Asia for this class of investment. By comparison, venture investment in the U.S. in 2002 declined by approximately 50% (to $21 billion) over 2001, which makes the situation in India look positively rosy.

As with most statistics, however, these figures do not tell the full story. The number of transactions was down by half, to approximately 50. Excluding 3 large transactions over $100 mill, the total invested amounted to approximately $600 million in 49 companies. Only 15 early stage investments (below $5 million) were made, totaling $34 million.

The Past
Most early venture investors in India have all but stopped investing in early stage companies, as the track record for profitable exits from young companies has been less than stellar. Where there have been exits, such as the successful IPO (market capitalization of $600 million as of early February 2003) of banking application software company i-Flex Solutions in mid-2002, they have occurred after a lengthy gestation period often exceeding 10 years (i-Flex started as a Citicorp subsidiary in the early 1990s). Correspondingly, where an exit took place in a reasonable timeframe, such as the ADR listing of web portal Rediff, the company’s share price slid rapidly within the 6-month lockup period leaving the venture investors holding an unprofitable investment.

The most common limiting factor has been the inability of young companies to scale. This in turn has been driven by the inability of the entrepreneur to scale, resistance to bring in new talent, the relative scarcity of professional managers willing to undertake the risk of a start-up, and lack of sales and marketing expertise. In addition, there is a scarcity of angel investors who can serve as mentors in the early stages of growth. By comparison, entrepreneurial centers such as Silicon Valley have built rich ecosystems of talented executives, service providers, angel investors and mentors and most importantly a culture of start-ups. The lack of a strong ecosystem for startups remains a significant impediment to early stage investments in India.

Funding Dynamics
Another reason investors are flocking to later stage investments is the increase in fund sizes over the past few years. At my firm Walden International, for example, we are currently investing out of a $750 million fund. It is not feasible to add meaningful value whilst sitting on dozens of boards, so from a practical perspective we concentrate on making fewer but larger size investments. The lower valuations of the past couple of years have only served to exacerbate this issue.

Exits – Pipe Dreams?
Historically, exits from venture-funded companies in India have been few and far between. However, the recent sale of the 2 ½ year-old call center company Spectramind to Wipro for $115 million in cash, which netted its early VC over 8x, has served to re-awaken trust that if a company executes well, financial returns will follow. Despite the recent announcement of a revenue miss, Spectramind ramped to $38 million in revenue in its 2nd full year of operation, a level that still eludes most of the software service companies that have been operating for far longer.

Opportunities...
Since the Indian market for technology and lifesciences remains small by global standards, building a sizeable business in these sectors inevitably means targeting the U.S. and western European markets. We have found that in these sectors, opportunities in India remain primarily services driven. Product or IP-centric deals are primarily sourced in Silicon Valley.

...in Products
India has achieved mainstream status for software and semiconductor engineering work. An increasing percentage of software and semiconductor start-ups in the U.S. have captive or outsourced development centers in India. For these companies, their Indian centers are critical to developing quality products cost-effectively. The use of India-based resources often enables faster time to market while reducing product development costs by as much as 50%, thereby serving as a key competitive advantage. However, the executive management teams and customers, and hence core nucleus, of these companies typically remain in the U.S., predominantly in Silicon Valley. The few product companies that have originated in India have found that to scale (see remarks above) the management teams need to move to the U.S. A case in point is Alopa Networks, whose founders and core engineering team came out of Wipro’s operations in Bangalore. While most of the company’s employees, including its core development engineers, are based in Bangalore, virtually all the company’s executives, investors and board members are based in the U.S.

...in Services
The good news is that the services sector has shown renewed momentum, driven by customer focus on driving down costs. This is not just in traditional areas such as software services but also in newly emerging areas such as call centers and Business Process Outsourcing (BPO).

The software services sector is going through a consolidation phase whereby the established leaders Infosys, Wipro and TCS are all gaining share, and are expected to be increasingly formidable challengers to the global consulting companies such as Accenture and EDS. Similarly, standardization and commoditization of software architectures is going to help Indian companies, as the mystique and knowledge associated with proprietary architectures and usually found only in the U.S. is going to be less important going forward.

While considering outsourcing call center and BPO activities to India, customers initially focus on cost reduction. However, they usually find that after an initial ramp period productivity exceeds that of their U.S. centers. This is because a call center operator in India is usually more highly educated than his or her counterpart in the U.S., views it as a career and hence applies more diligence to the task at hand, and job-hops less frequently. One large multinational, for example, found that India-based agents achieved 36% higher credit card collections (all of which flowed to the bottom line) after an initial period of a few months.

There were a number of call centers founded and funded 18-30 months ago, and the winners and losers from that wave are starting to become apparent. Opportunities to invest in call centers are primarily in expansion stage companies, many of which are currently at a $1 million monthly revenue run rate.

While call centers have been treated as synonymous with BPO, the reality is that they are quite different, with BPO requiring deep domain expertise. These companies will require significant amounts of capital to achieve critical mass. This is driven both by dynamics of the business as well as the need to show a healthy balance sheet so as to convince customers of the long-term viability of the business. We estimate that most BPO companies will require a minimum of $40-$50 million to scale.

...in Other Sectors
Another sector that has received a great deal of press recently is lifesciences. Here too, while a few companies are focused exclusively on drug discovery, most are focused on outsourced services such as clinical trials and HIPAA compliance, with a longer-term plan for IP-creation. There are also some companies focused on primary and secondary patient care facilities for the Indian market.

Besides technology and lifesciences, other areas of interest include entertainment and retailing. Both these sectors aim to capitalize on the size and the rising disposable income of the middle class in India. Bollywood’s increasing global popularity is also creating opportunities to transform a domestic cottage industry into a more organized one with global marketing and distribution expertise.

A Place to Invest?
As with the U.S., there is currently an overhang of excess private equity and venture capital available to invest in India. Unlike the U.S., however, which is still digesting a huge technology binge, the macroeconomic environment clearly plays to India’s strengths of cost reduction and efficiency improvements. While many bemoan the good old days of the late 1990’s, when software service companies recorded 80-100% revenue growth rates, the reality is that the current growth rates of 20-30% are far better than most companies, regardless of industry, in the U.S. While many VCs, especially those in Silicon Valley, have historically shied away from investing in services companies, believing them to be low-margin, low growth businesses, India-centric services companies are realizing 20-25% operating margins, comparable to those of Microsoft. The economics are compelling.

There is currently a debate whether the emerging areas of call centers and BPO will go the way of the software service industry, which has created several multi-billion dollar companies, or whether they will go the way of the medical transcription industry, which rapidly became commoditized. The answer to this will determine whether fortunes are made or lost, but that’s why its called risk capital.