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How US interest rates affect Indian venture capital funding

Sumeet Swarup
28th Oct 2015
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Most venture capital and private equity firms that are investing in the Indian startup market are raising funds from US institutional investors – endowments, pension funds, insurance companies, corporations, banks, mutual funds etc. Together, these institutional investors hold trillions of dollars in investments, which they deploy in various financial instruments around the world. For example, in US and international equity markets, US and international bond markets, US and international government bonds, real estate, commodities, venture capital and private equity, derivatives and many more.

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Each institutional investor will have an annual target rate of return that it wants to achieve for its investors. For example, a public pension fund may target a three-to-four per cent annual return, an endowment might target five-to-eight per cent, whereas a hedge fund might target 15 to 20 per cent. Increased return will mean increased risk; hence a public pension fund will typically target a much lesser return rate than a privately-held hedge fund.

Let’s take the Harvard University endowment as an example, which has approximately USD 36 billion in management. Let’s say it targets six per cent annual return (in the last reported number it was achieving 5.8 per cent return). To target this return, let’s say it invests in the following manner - 40 per cent in US and international equity, 20 per cent in US and other government bonds, 10 per cent in corporate bonds, 10 per cent in real estate, 10 per cent in private equity, five per cent in cash and five per cent in other asset classes. The 10 per cent in private equity is further divided into five per cent in US private equity, and five per cent to international equity. This international five per cent is further divided amongst various attractive countries, and Indian private equity might land up getting 0.5 per cent to one per cent = USD 100 to USD 200 million. This is money that is invested into private companies and startups in India, through various venture capital firms. So if you look at the USD 10 billion that is getting invested in the Indian venture capital space in 2015, it’s a very small part (one per cent) of the USD one trillion that US institutional investors are investing across all asset classes.

What happens if the US raises interest rates by 0.25 per cent? That is quite significant for a Harvard endowment that is targeting six per cent return. So the endowment will quickly shift money to US bonds that are giving the higher interest rates. But, the more challenging question is where will Harvard pull the money from? It will most likely look at all its assets and their returns over the last few years, and take money out of the low performing assets. And if they decide that Indian private equity is not performing as well as other assets (in terms of risk and return), that’s when the money starts flying out of the Indian venture capital funds, and future commitment of funds becomes more difficult.

Two more important questions remain:

First, will the US Federal Reserve (the counterpart of India’s Reserve Bank of India) increase interest rates? Obviously I don’t know, and I doubt anyone else does. The next Federal Reserve meeting is in December, and many pundits are betting on an increase at that time. The last time the Fed raised interest rate was in June 2006. After the financial crisis of 2008, the Fed quickly brought the interest down to almost zero in December 2008, and it has kept it at that level ever since. The US economy has done well in the last few years: unemployment is low, which implies an upward pressure on wages, which means inflationary pressures are building, which points to higher Federal interest rates. But a strong dollar and falling oil prices are keeping consumer prices low in the US, hence a lack of inflation, which points to no change in interest rates. Low interest rates also help international economies with cheap US money, and the Federal Reserve Bank is in favour of that, so another argument against increasing interest rates.

Second, and more importantly: are US Institutional investors looking at Indian private equity as a low performing asset?

The last downturn in the Indian startup-funding environment was in 2012-13. The conditions remained steady in 2013-14, but really picked up after Modi came to power in May 2014 (remember Flipkart raised their USD one billion in July 2014), and funding conditions have remained very good ever since (USD 7.3 billion has been invested from January to September 2015). But the Modi euphoria has settled and investors will be looking at more data points like how many investors have got exits and actual returns in the last five years? How is the progress of Justdial and Infibeam in the markets? Will Modi be able to deliver in 2016? Does the Indian consumption story have depth or is it mainly driven by discounts?

We also must remember that the memory of the 2008 financial crisis is still fresh in the minds of US institutional investors, most of whom lost significant money during the collapse. So this time they are looking at their asset classes, and looking at not just the valuation numbers, but also metrics like risk profile, sector bubbles, paper money, lack of liquidity and lack of real returns.

Summary: While I’m very optimistic about the intellect, energy and creativity of the Indian entrepreneur these days, those qualities will need money to go to market. I wouldn’t be surprised if private equity investor expectations have started to cool a little, and investors have started to rethink their positions in India, or at least are waiting for more favourable data to come out of India before committing more money in future years. So my advice to the entrepreneur is this – if your idea is good, and you’re thinking of raising a Seed or Pre-Series A round (a relatively small amount), then you should be okay. But if you’re thinking of raising a Series A or B or C, you should not wait, and should at least start talking to people to get a sense of the market and whether your business is good enough to get funding irrespective of market conditions.

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory)

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