VCs welcome move to let private funds invest up to 5 pc in AIFs that back startups, small businesses

Venture capital (VC) funds that invest in small businesses and startups have welcomed the government’s move to let private retirement funds invest up to five percent of their investible surplus in alternative investment funds (AIF).

In a notification, the department of economic affairs (DEA) under the finance ministry said non-government provident funds (PF), superannuation funds, and gratuity funds can now invest in units issued by select Category I and Category II AIFs regulated by the Securities and Exchange Board of India. These AIFs must support infrastructure entities, small and medium enterprises (SME), and VCs including social VCs.

The government’s decision means startups and SMEs can now unlock retirement savings and raise a large sum for themselves if these guidelines are adopted by the Employees’ Provident Fund Organisation (EPFO). 

“This will bring larger pools of domestic money for companies in their early and growth stages,” said Padmaja Ruparel, Co-founder of Indian Angel Network(IAN) and Founding Partner at IAN Fund. “By investing even a small amount in high-risk, but experienced and well-versed fund managers will enable these pension funds to earn good returns.” 

Ankur Mittal, Co-founder of Inflection Point Ventures, said the move indicates a growing recognition of angel investing as a viable asset class. “This step will encourage even more investors to look at angel/startups investments.” 

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The five percent cap will likely facilitate the flow of money that will eventually be invested in startups propelling their growth further, said Anil Joshi, Managing Partner at Unicorn India Ventures. “Although it will take time for pension funds to allocate the money to AIFs, it is certainly a positive step for the whole ecosystem.”

In other guidelines, the DEA said funds can invest only in those AIFs with a corpus equal to or more than Rs 100 crore and exposure to a single AIF should not exceed 10 percent of the AIF size. The 10 percent limit will not apply to government-sponsored AIFs.

For a Category II AIF, at least 51 percent of its funds should be invested in either infrastructure, SME, VC, or social welfare entities, said the notification. Funds have to ensure the investments are not made directly or indirectly in securities of companies or funds incorporated/operated outside India.

According to Anup Jain, Managing Partner at Orios Venture Partners, as interest rates are at their lowest in a decade, it would be tough not just for private pension funds, but also for the government’s EPFO to deliver high single-digit returns without giving a portion of the pool into AIFs that help deliver 20-25 percent internal rate of return (a method to calculate an investment’s rate of return).

“So far, we have only seen foreign pension funds investing capital into the startup ecosystem through AIFs or direct investments,” he said. 

With India becoming a hub of unicorn startups, the government’s decision is likely to improve fund flow to the startup ecosystem, as domestic private pension funds can now invest in AIFs, in addition to foreign pension funds that are already allowed to do so.  

“This is an important step of the government towards validation of the private equity and venture capital product as a viable asset class,” said Gautam Patel, Founder and Managing Partner at Z3 Ventures. “The onus is now on us as asset managers to ensure we keep up to the investment requirement of managing ‘protection capital’. This includes ensuring steady and consistent returns by generating timely and rewarding exits to these investors.” 

Nimesh Kampani, President of LetsVenturePlus, made a similar point. “PF managers will have to ensure that proper processes are put in place to ensure that contributions made to PF funds are utilised and employed judiciously with minimal element of risk for stakeholders,” he said.