End Of Life Blues For India’s VC Pioneers

When we looked at the state of exits for venture capital funds in India last week, several fund managers — former and active — texted me about how many of these funds on the exit path are acting out of desperation. To add context, my sources pointed to SEBI’s changes released in April around the one-year extension for funds to begin their liquidation process.

The extension itself is not a new development, as funds have typically received a 1+1 year extension for some time now. However, SEBI also changed its rules related to liquidation in April this year after several limited partners approached the regulator about funds delaying fund closures beyond these extensions.

Before we get to these rules, it’s important to understand that all AIF schemes in India or venture capital funds in common parlance have a fixed tenure. This depends on the fund itself and what kind of exit horizon it has set for its limited partners i.e. the investors that infuse the capital which is eventually invested in startups.

Some LPs want to invest in short horizon funds that commit to returning the capital and a profit in five to six years, but on average AIF schemes have a tenure of seven years. Over and above this, there is an extension from SEBI to close the fund. So a fund or AIF scheme that was announced in 2015 is more or less nearing its expiration in 2024 and 2025.

In recent times, SEBI has stepped up its scrutiny of AIFs that are seeking to extend tenures, because in many cases these funds were simply buying time and did not have a plan to liquidate their funds. Given the explosion of startups in the years following 2015, we can surmise that plenty of AIFs are currently either in their liquidation period or have already exhausted the extension from SEBI.

Many of these funds are some of the oldest in the country and were set up between 2015 and 2017, at a time when startups were just emerging as an asset class. This vintage of AIFs has seen plenty of upheaval too with the global economic slowdown in 2018 as well as the pandemic in 2020 and 2021. But through these cycles, the likes of Orios VP, IndiaQuotient, Kalaari Capital, Chiratae (formerly IDG), Blume and other VCs have closed funds and returned capital to investors.

These and other noted VCs from the Indian ecosystem will be close to their fund expiry dates in 2025 and 2026 as well. And as such SEBI’s rules for liquidation are most applicable for these funds, as well as their LPs and portfolio companies.

Why AIF Liquidation Rules Matter

In this context, the liquidation period refers to the one-year period following the completion of an AIF’s tenure, during which the fund manager has to liquidate all the fund’s unliquidated assets and distribute the proceeds to limited partners.

This is followed by a dissolution period and this can be opted by funds to deal with unliquidated investments, as long as there is LP consent.

This is undoubtedly one of the most challenging positions for a VC fund, where it has to look for buyers for assets that may not be all that attractive for the market even at a discount.

In the past, SEBI had allowed funds the flexibility to roll over unliquidated assets to a new scheme or fund, but this was not a route that limited partners were happy about. LPs would not only have to bear the risk of the asset remaining unattractive even under a separate AIF scheme, but also would have to bear tax expenses out-of-pocket with no other recourse under tax and foreign exchange laws. This option has been rescinded because of the tax implications for LPs and the fact that AIFs can exploit this loophole to keep limited partners on the hook for their returns.

The other option, i.e. pro-rata distribution of the asset to limited partners, was also a no-go as this would put private companies in a tricky position regulation wise.

Pro-rata distribution also known as in-kind distribution means LPs will get equivalent securities to avoid capital gains tax on liquidated holdings. LPs will have access to all information on the available bids prior to choosing between an in-kind distribution or a dissolution period, during which the assets will be opened for bids to the open market.

As per the Companies Act, 2013, a private unlisted company cannot have more than 200 shareholders and the number of LPs in any fund can go as high as 150. If each fund allocated shares from unliquidated assets to individual LPs, then the company would have to convert into a public limited company, which is simply not possible for most of the startups.

Given these challenges, SEBI brought in the new rules earlier this year, which give AIFs some leeway and flexibility in terms of closing their funds and giving returns to LPs.

Is SEBI Simplifying Fund Liquidation?

As we were told by a number of fund managers, closing a fund at one time was a major headache, but the new rules do make it simpler for VCs to manage this process if not get the best outcomes.

Under this, AIFs can avail a dissolution period with the consent of 75% of its LPs by the value of their investment in the scheme being liquidated. Such consent has to be sought only during the AIF’s liquidation period and cannot be secured ahead of time.

This consent procedure mandates that AIF managers obtain bids, on a consolidated basis for all unliquidated assets of the AIF, from the market and offer proportionate exits to investors who do not wish to continue under the dissolution period.

If an AIF manager is unable to obtain bids from the market but has obtained the 75% consent of its LPs, then the dissolution period can still go ahead. But as a penalty, such fund managers are required to report their performance to benchmarking agencies, with unliquidated assets to be reported at a value equivalent to INR 1, regardless of finally realised value.

This move by itself does not devalue the asset but is seen as a benchmarking exercise that can be used to certify and rate fund managers in the future. This is a crucial exercise to be seen along with the NISM certification requirement, which we wrote about last month.

With these two barometers — the certification to operate a fund and the benchmarking to map its performance — SEBI is making it extremely clear that it will not accept fly-by-night AIF operations or funds that are falling foul of their responsibility in terms of due diligence and portfolio governance. That’s been one of the key concerns raised by limited partners in the past two years.

Besides clarifying some of the rules pertaining to liquidation and dissolution of funds, SEBI has sought information reporting from AIFs that want to avail of the year-long extension to initiate liquidation.

AIF managers need to submit details of the AIF, the unliquidated portfolio and its value, and pending investor complaints. Those AIFs entering into a dissolution period after the liquidation period are required to file an information memorandum with SEBI, accompanied by a due diligence certificate from a merchant banker.

Are VC Funds Relieved? 

SEBI’s requirements do increase the potential compliance burden for VC funds, but fund managers have welcomed these rules, especially given the reputational damage to some VCs in light of the value erosion in their portfolios.

However, in practice, most AIFs in India have not yet adopted the new regulations since they are so new, and as per experienced fund managers that we spoke to, there’s still a lot of uncertainty about how this might play out in the long run.

“Nobody knows whether the new regulations are better for funds because they are new to everyone. Even experienced fund managers don’t yet know whether the new regulations are better since the adoption is ongoing,” according to a veteran fund manager who has invested in startups through AIFs since 2013.

The fund manager quoted above closed their first fund in 2021-22 after availing the 1+1 year extension offered by SEBI. That particular fund delivered 5X-6X returns for LPs, an outcome that funds today might welcome with open arms.

On the flip side, some startup founders might find themselves at the wrong end of secondary deal structures as funds push to get bids for unliquidated assets.

As per one Bengaluru-based early stage and growth stage AIF founder, even in good times and at the peak of market liquidity during the pandemic, the discount for secondaries was 10% on average.

In the run-up to 2021, for instance, we saw several secondary deals led by PE funds as half a dozen startups lined up for IPOs, including the likes of Paytm and Zomato. It’s possible that many of these institutional funds were nearing end of life in 2021.

Plus, in July 2021, Tiger Global, Matrix Partners (now known as Z47) and others sold some of their stake in Ola Cabs parent ANI Technologies to Temasek and Warburg Pincus for $500 Mn. This is one of the biggest secondary deals in the Indian startup ecosystem, which also gave an exit to some investors who had backed startups acquired by Ola such as TaxiForSure.

For the above Ola example, Matrix launched its ‘Matrix Partners India II’ fund in 2011, and it invested in the likes of Ola and OfBusiness through this second fund. According to Pitchbook, the fund has been closed, and it was very likely up for liquidation by 2022. Besides Ola, Matrix saw a partial exit from OfBusiness via a secondary sale to Alpha Wave and Tiger Global in 2022.

Some of those secondaries in 2021 came at a discount even though the market had high liquidity, and now, with the future uncertain, those in the market for secondaries in 2024 enjoy the advantage of getting an even bigger discount. “In the VC world, this discount is called the liquidity discount. Even in good times when the market is pretty good, it is generally considered to be 10%. If the asset does not have super demand, the secondary buyer will always get a discount and this depends on the asset.”

Prominent examples of discounted secondaries in 2024 include the likes of SoftBank-backed Eruditus, Insight Partners-backed Postman, and SaaS startup MoEngage, among others. Bengaluru-based ecommerce unicorn Meesho is also reportedly in talks for a primary infusion and secondary deal at a discount of 20%.

But for every unicorn and scaled up startup, there are assets that have seen deep value erosion. Offloading these assets or finding bids for them in the open market might become a steep uphill battle for inexperienced fund managers and even some experienced ones.

Buyer’s Market For VC Assets AKA ‘Caveat Venditor’

Like 2021, and to some extent 2022, this is a great year for secondaries but largely for buyers. For VCs, there is a feeling of being resigned to heavy discounting.

“There is no doubt that this is a buyer’s market. Many VCs are desperate to exit their funds and show some positive track record in terms of LP returns. For many of the professional fund managers, this is a litmus test and therefore some of them might pressurise founders to execute deals quickly,” the VC firm founder quoted above added.

Fund managers are more than happy to enter secondaries as it creates a positive track record as far as their performance is concerned.

SEBI’s streamlined process penalises the AIF managers for failing to liquidate an AIF’s investments within its original or extended tenure, given the mandate on performance reporting. As a result, many fund managers are likely to be in the midst of discussions for secondary transactions and structures are being planned in light of some of these deals happening in IPO-bound companies.

On the founder side, there are concerns about increased due diligence burden as well as potential mismatch in terms of the expectations of the incoming investors and the business trajectory. But these points of friction are part of building a startup with VC money.

“Founders have to accept that if there was a time for primary rounds and capital infusion, it will be followed by a time for secondaries and exits. This is part and parcel of venture investing, and there is no doubt that some founders may feel shortchanged, but that’s the reality they have to accept,” said a third Bengaluru-based fund manager.

In fact, according to this individual, founders who pose hurdles to their shareholders in terms of secondaries are doing a disservice to the ecosystem and risk being blacklisted by VCs in the future. There’s undoubtedly bound to be some friction though.

Despite SEBI’s regulations and clarity on the liquidation path, there are practical challenges in going through this process. Plus, the introduction of performance reporting for AIF managers at the end of a fund’s lifecycle means for the first time many VCs and their track record will be out in the open.

VC industry insiders believe this had to happen because SEBI is looking at private market investments through the same lens as it does public markets. The regulator’s focus has clearly been on cleaning up the fluff from the frothy AIF market, but these regulations have second and third-order impacts.

Founders might soon find themselves with investors that don’t fit their vision, while funds might have to settle for discounts even for assets that might grow into their promise in the years to come. And for VC fund managers dealing with the liquidation process, it’s not just returns at stake but also reputation.