RECENT REPORT BY THE INDIAN VENTURE Capital Association (IVCA) found that India ranks third in Asia in venture capital activity. Over $1.1 billion was invested in venture capital and private equity investments in India in 2002, essentially flat with 2001. By comparison, venture investment in the U.S. in 2002 declined by approximately 50% (to $21 billion) over 2001. Yet, most VCs are unanimous in their opinion that there is too much capital in the country chasing too few companies.

Services companies have long been seen as bad investment vehicles. Most VCs in the U.S. shy away from investing in services companies since they do not fit the risk-return profile. It is this characteristic that has served to make U.S. the world’s most vibrant economy. However VCs in India contend that since the nature of the industry in India is different.

One such believer is Saurabh Srivastava, president of the Indian Venture Capitalists Association (IVCA)–an umbrella organization of India’s prominent venture funds. “There is no reason to shy away from the services sector in India because from past records, it is evident that the services model has worked for us,” he says. Srivastava contends that the services sector will continue to be successful in India even as companies in the U.S. discover more and more ways to cut costs by jettisoning work to India.

ICF Ventures’ managing director Vijay Angadi agrees. “India is one of the best places in the world for innovation. And companies here have perfected the services business model. It isn’t about cutting costs anymore. And this is where companies have shown their competence. And let’s face it, services is what we do best.” Angadi feels that while there will be successful product startups in India, services companies will still account for the majority.

Business Process Outsourcing is one such services industry that is seeing a lot of momentum. Says Ganapathy Subramaniam, managing director of Bangalore based Jumpstartup. “Nowadays people are thinking a lot more creatively. Wherever there are more than 200 people doing a similar job, people are looking to moving it to India. It could be in mortgage, receivables or even payroll. So obviously BPO is still a very exciting field and we have not reached anywhere close to a saturation point in this industry.”

Another interesting field is semiconductor design. With the success of semiconductor design startups like Ittiam, VCs are expecting more companies to follow their lead. Says Subramaniam, “We are seeing companies that want to be in high-end services with a combination of IP or a full chip on a particular application line on some of the new standards. This is an interesting field for Indian companies to be in.”

Most VCs credit the changing ecosystem for growth in VC activity. A number of multinationals (like Intel) are now doing end-to-end work in India, right from product design to testing, validation and in some cases even marketing, These companies are creating a lot of competencies in various new fields. Industry watchers feel these companies will add more and more people to the entrepreneurial ranks in India. “We are continually receiving business plans from people who have put in years in MNCs in India,” says Subramaniam.

Dinesh Vaswani, managing director, Walden Nikko puts his money on telecom. “The telecom sector is a burgeoning field in India. And unlike other sectors that depend on exports, there is a sizeable telecom market within the country itself. In a few years, the Indian telecom market will equal China as one of the biggest markets in the world.”

Other potential sectors are lifesciences (pharmaceuticals, biotechnology), retailing, media and entertainment. However, few VCs seem willing to take a risk on these ‘unknowns’. For example, a number of big name VCs siliconindia spoke to professed ignorance about the biotech sector. A few others, however, admitted that biotech was not a very attractive sector because of the long gestation periods involved.

In fact gestation periods are one of the biggest problems faced by Indian VCs. Indian markets are not seen as great places for an IPO. One of the most successful IPOs In recent times was i-Flex Solutions, which went public in mid 2002. Even then, the bosses at I-Flex took 10 years before they could be assured of a fair valuation (i-Flex started out as a Citicorp subsidiary).

Most VCs are unanimous in their opinion that India isn’t a very good market for a successful exit. Says Subramaniam, “We are not even assuming that an IPO for one of our portfolio companies will happen in India. There is just no visibility in the Indian market. Whatever exits happen are likely to be through strategic buys. But even that is a dicey proposition in India.”

The paucity of viable exit options has led many VCs to focus more on innovative funding strategies. One such is the cross border company.

Cross Border Investment
A host of India focused VCs are now investing a significant amount of their corpuses directly in the U.S. Generally, this is in what they call a ‘cross-border’ company, where the key executives sit in the U.S. while India hosts most of the operations.

This scenario has proved more acceptable than the traditional Indian companies for multiple reasons. First, being in the U.S. increases the opportunities for viable exits with high valuations. Secondly, from a company perspective, is the proximity to markets.

On both counts, being in the U.S. is the best alternative. Mountain View, California based Neoteris is one example. The company recently announced its acquisition by the Sunnyvale-based Netscreen Technologies for $265 million.

In most cases, the corpus would eventually be channeled into the Indian subsidiary, but the initial investment is invariably made in the U.S. parent company.

This scenario works well because the India-based VCs are best placed to provide value to the back-end operations, often in terms of support, and knowledge of the local HR scenario etc.

However, most VCs do agree that the near term future looks good, both for VCs looking for good deals as well as startups looking for capital.

With horizons shrinking, Indians are considering newer technologies and standards to play in. And VCs are ever more willing to fund good ideas, never mind the slowdown.