The Indian government is actively working on a framework designed to minimize risks associated with startup investments for local pension funds and insurance companies. This initiative aims to boost domestic capital invested in the Indian startup ecosystem, a significant driver of job creation and economic growth.
Motivations Behind the Framework
Several factors are propelling the government’s efforts to create this framework. One key reason is to increase the participation of domestic capital in funding Indian startups. Currently, Indian pension funds and insurance companies are restricted from directly investing in startups. However, they can allocate 3-5% of their investable surplus towards alternative investment funds (AIFs) or fund-of-funds that focus on supporting domestic startups.
The introduction of a risk mitigation framework could pave the way for relaxed regulations, potentially increasing the investment limit and permitting direct investments by these institutions. This holds significant weight considering they managed nearly Rs 100 lakh crore of public funds by the end of the 2023 fiscal year. Such an increase in domestic capital injection would be particularly welcome given the recent slowdown in new startup funding.
The Department of Financial Services Taking the Lead
The Department of Financial Services under the Ministry of Finance is spearheading the development of this risk framework to facilitate direct investments in local startups by pension funds and insurance companies.
Balancing Risk and Return
Acknowledging the inherent risks involved in startup investments, government officials recognize that complete risk elimination is not possible. Even established public markets carry inherent risks. However, the proposed framework aims to establish a mechanism that minimizes risk to the greatest extent possible. This would empower regulators to implement amendments that allow for higher investment limits from these institutions.
A significant concern lies in the high failure rate of startups, with statistics suggesting that eight out of ten fail. The government understands the need for a safety net to safeguard public money invested in such a potentially risky asset class.
Collaboration Between Government and Industry Bodies
The Ministry of Finance has actively participated in discussions with the Indian Venture and Alternate Capital Association (IVCA) regarding the issue of increasing domestic capital within the Indian startup landscape. Additionally, the National Startup Advisory Council, formed under the Ministry of Commerce, has also addressed this topic.
Statistics on Domestic Capital Participation
Industry sources reveal that only 15% of the capital invested in Indian startups comes from domestic sources. While this number has grown over time, overall investment in the Indian technology ecosystem has witnessed a significant decline in recent years.
Educating Investors: A Crucial Step
A venture capitalist involved in these discussions with the government highlighted the importance of educating fund managers at insurance companies and pension funds. Workshops have been organized to equip them with the knowledge and understanding of various startup investment mechanisms.
Redefining “Startup”
The proposed framework is expected to address the definition of a startup. This includes exploring the possibility of expanding the scope beyond the current parameters set by the Department for Promotion of Industry and Internal Trade (DPIIT).
Challenges Faced by Domestic Institutions
Siddarth Pai, founding partner at 3one4 Capital, sheds light on the challenges faced by domestic financial institutions. He highlights that global financial institutions are able to take on various risks, such as currency fluctuations and credit risks, to invest in Indian startups. However, Indian counterparts are restricted by regulations.
For example, insurance companies typically face limitations on investments in loss-making assets. Additionally, fair value norms for unlisted securities are based on book value. This translates to a significant portion of the investment potentially being underwater from the very beginning, impacting profits. These factors pose hurdles for domestic institutions considering startup investments.
Pai emphasizes the need for amendments to regulations and guidelines governing the pension and insurance sectors. This would enable them to participate more actively. He suggests providing them with specialized information on a regular basis and establishing specific reporting requirements for startups.
Stricter Reporting and Transparency
One of the government officials involved in the framework’s development mentioned that the framework could encompass stricter reporting norms. These norms would apply in scenarios where government pension funds or public/private insurers decide to invest directly in startups.
The successful implementation of this framework has the potential to significantly alter the landscape of startup funding in India. By mitigating risks and fostering greater participation from domestic capital sources, the government aims to create a more robust and sustainable ecosystem for Indian startups.
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