Venture Capital:

Possibilities at the Bottom of the Pyramid

by

Sunita Shreeradha Mohanty

A thesis submitted in fulfillment of the requirements of the Senior Seminar, April 27, 2006.

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© 2006 by Sunita Shreeradha Mohanty

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Acknowledgements

I can say, without a doubt, that none of the contents in the pages to follow would have

been possible without the guidance and friendship of many individuals. I do not think I can

properly express my thanks in a few simple words of gratitude, because I know that this effort is

a product of all the support I have been so lucky to receive.

First of all, I would like to thank my mentors for their sincere interest and encouragement

throughout this paper-writing process: Prof. George Siedel for devoting your time to helping the

Senior Seminar students accomplish what we thought was not possible, Prof. Judith Calhoun for

helping me develop skill in the highly confusing world of academic research, and Prof. David

Brophy for encouraging me to tackle a mountain of an issue.

To my friends and family, I want to say I am only motivated to reach for the stars

because of you. Thanks to: my friends for being there when I’m in need of a distraction; Marisa

for your incredible editorial skills; Nina for being my life companion in just about everything;

Eric for your amazing ability to be a source of positivity, motivation, and encouragement; and

my wonderful family for their endless love and understanding.

Additionally, I am lucky to have many resources at my fingertips through the Ross

School of Business. I would like to thank Michael Herbst for his excitement and interest in this

subject, as well as Prof. Ted London for pointing me in the direction of valuable resources.

Lastly, to my fellow seminar classmates, I would like to say I am thoroughly impressed

with the talent and amazing ability that everyone has shared through the seminar. I hope that all

of us are able to pursue the interests we are passionate about, and are able to encourage and

motivate others to action.

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Abstract

The purpose of this paper is to develop possible best practices for developmental venture capital in India and China, under the premise that investing in sustainable development will be in the best interests of both the community (by alleviating poverty) and venture capital (VC) firms (by creating new highly profitable markets).

The first section of this paper provides a brief overview of private equity/venture capital (PE/VC) investment by examining the structure and investment strategy of firms in developed PE/VC markets. Key factors that successful VC requires and simultaneously helps contribute to include promoting a culture of entrepreneurship, increasing transparent government policy, encouraging the formation of functional markets, and drawing more capital from willing investors.

The second section of the paper examines the current trends of private equity and venture capital markets in India and China, illustrating the lack of venture capital funding despite promising market conditions. To explain the lack of performance in Indian and Chinese markets, differences that arise in the entire venture investing cycle between developing and developed venture capital markets are discussed. These differences include increased difficulty in structuring VC firms, finding capital, conducting due diligence, structuring and monitoring investment, and exiting. Difficulties in the VC investment process in India and China are possibly explained by the inability of firms to correctly adapt to environmental conditions of these markets.

The third section of the paper discusses approaches to dealing with the key environmental aspect of the markets in India and China: poverty. Many theorists suggest the need for private sector initiatives that promote development of small and medium sized enterprises and increased entrepreneurship to alleviate poverty. Community development venture capital incorporates these development initiatives into the VC investment process. The paper will examine how VC firms can effectively combine social and financial goals by integrating strategies highlighted by Prahalad’s Bottom of the Pyramid business model, focused on serving the poor and underprivileged.

The fourth section examines how to evaluate the impact of VCs in India and China. VC firms must augment traditional performance metrics to incorporate a double bottom line approach that assesses performance based on both financial returns and social impact.

The last section of the paper presents case studies of several innovative venture funds currently operating in India and China that incorporate financial and social goals. Discussion of these funds will conclude by presenting possible best practices for venture capital firms participating in these economies.

CONTENTS Introduction 1 Venture Capital (VC) and Private Equity (PE) 2 Structure of VC Firms 3 Structure of Investment 4 Prerequisites and Effects of Successful VC 5 China and India: Current Trends of VC/PE 9 Comparison of Macro-Economic Trends 10 VC/PE Market in Asia 10 VC/PE Market in China 11 VC/PE Market in India 13 Differences in VC/PE Cycle in India/China vs Western Markets 14 Overcoming the Pyramid of Poverty in India and China 23 Sustainable Development for Alleviation 24 Private Sector as Key Player 25 Importance of Small and Medium Enterprises 25 Community Development Venture Capital (CDVC) 27 Target Market: Bottom of the Pyramid (BOP) 29 BOP Business Model 32 Evaluating the Impact of VC in Developing Markets 35 Best Practices of Current Innovative Funds 37 Microfinance Fund: responsAbility 37 Nonprofit Philanthropic Fund: Acumen Fund 40 Social Venture Fund: CARE Enterprise Partners 44 Emerging Markets Private Equity Investment: Actis 48 Analysis of Best Practices 51 Conclusion: Approaching New Frontiers in PE/VC 55 Appendix 57 Bibliography 62

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Introduction

At first glance, the streets of New Delhi, capital of India, seem to be filled with

destitution, poverty and sadness. Typical views include rail-thin boys no more than 15 years old

pulling rickshaws three times their size, families of five maintaining a balancing act on one

motor-scooter for transportation, and plastic tarps covering a small village of huts a few feet

from the roadside. The view is filled with bustling life, as one would expect of a country with a

population of 1.08 billion. In actuality, the typical views themselves signal all sorts of economic

activity and commerce. With the second glance, it is easy to explain why India and developing

countries hold strong potential to be the next economic giants of the world. With some additional

investment in equipment and perhaps some advice on operations management, the 15-year-old

could be operating a profitable network of rickshaws servicing the greater Delhi area. The key to

creating economic success stories in these markets lies in the possibility of involving the massive

populations by developing innovative approaches to include even the poorest of people.

On the other side of the wealth spectrum, an increasing number of private-sector firms

are realizing the potential profitability of emerging markets. Private equity activity, specifically,

is increasing throughout the developing world, as investors are finding better opportunities

relative to the saturated market of developed economies. Hailed as the “New Kings of

Capitalism,” private equity firms are perceived as contributors of “smart money,” able to add the

most economic value to growing companies throughout the investment lifecycle (Samdani 1).

The pool of private equity investment has ballooned over the past decade, growing from less than

$10 billion in 1991 to over $180 billion in 2000 (Reyes Private Equity Overview and Update

2002 in Kaplan and Schoar 2). Private equity funds, specifically venture capital funds, are the

cheapest source of financing in uncertain business environments, given their ability to lower

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informational asymmetries and uncertainty between private firms and the market (Ljungquist and

Richardson). Many even credit venture capital firms with sparking the growth of major

industries, such as telecommunications and biotechnology. Strong potential exists for venture

capital firms to assist in the private sector development of emerging markets such as India and

China.

The purpose of this paper is to develop possible best practices for developmental venture

capital in India and China, under the premise that investing in sustainable development will be in

the best interests of both the community (by alleviating poverty) and VC firms (by creating new

highly profitable markets).

The first section of this paper will provide a brief overview of venture capital investment

and highlight factors that lead to successful venture capital performance. The next section will

discuss the current trends of private equity and venture capital markets in India and China,

illustrating the lack of venture capital funding despite promising market conditions. To explain

the lack of performance in Indian and Chinese markets, the paper will look at differences that

arise in the entire venture investing cycle between developing and developed venture capital

markets. The next section of the paper will examine the Bottom of the Pyramid business model,

highlighting a necessary shift in operational strategy that venture capitalists need to adopt when

working with India and China. The final section will examine several innovative venture funds

currently operating in India and China that incorporate financial and social goals, in order to

present possible best practices for venture capital firms participating in these economies.

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Venture Capital (VC) and Private Equity (PE)

Private equity refers to a broad range of investments in unlisted companies (Da Rin,

Nicodano, Sembenelli 2), and includes but is not limited to leveraged buyouts1, venture capital,

growth capital, angel investing2, and mezzanine capital3. As a group of investments, private

equity is divided into two main segments: venture capital (investment in entrepreneurial

companies in developmental stages) and non-venture private equity (management buy-outs,

turnaround, and restructuring of established companies) (Da Rin, Nicodano and Sembenelli 2).

Exhibit 1 illustrates the different stages of development during the life of a company, and the

associated financing structures for those stages. Most commonly, private equity firms will focus

on one or the other because of fundamental differences in operational strategy: venture capitalist

interest lies in building companies, while non-venture private equity firms are interested in

financial returns from proven business models (McKnight and Parker 6). In regards to private

equity in developing economies, venture capital firms are most relevant to discussion because of

the highly-risky, highly-entrepreneurial markets of these countries.

Structure of VC Firms

Venture capital (VC), a major subset of private equity, is especially important in driving

economic growth through its focused investing in early stage firms. Entrepreneurs hold the key

to business development by recognizing innovative opportunities and having the necessary

motivation to start businesses. Venture capitalists provide entrepreneurs with the financial ability

1 A leveraged buyout of a firm involves a purchase transaction where the price is largely financed through debt (Leach and Melicher 492). 2 Angel investing is obtained from wealthy individuals who are willing to invest in early stage ventures due to the “excitement of launching a business and a share in any financial rewards” (Leach and Melicher 604). 3 Mezzanine financing is used to fund plant expansion, marketing expenditures, working capital or improvements. It involves debt financing attached to warrants, which are convertible options to equity stakes in the company (Leach and Melicher 24).

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to “turn ideas into companies, which employ staff and generate economic value” (McKnight and

Parker 5).

VC firms in Western economies are structured as limited partnerships that serve as an

intermediary to channel capital from wealthy investors towards firms struggling with cash needs.

This type of firm invests using equity stakes to finance “high-risk, potentially high-reward”

private startup companies that are unlikely to receive loan financing (Gompers and Lerner 284).

Third-party investors are silent limited partners (LPs) in VC firms, including wealthy

individuals, pension funds, foundations, endowments, and other institutional sources. The

general partners (GPs), known as venture capitalists, are usually former professionals with

industry experience. The general partners receive an annual management fee of about 2% of the

fund’s committed capital, and typically 20% of carried interest. Funds generally operate for a

fixed life of seven to ten years, in order to cut exposure to risks of any individual investment

(Dossani and Kenney 229).

Structure of Investment

Venture capital firms usually undertake high-risk investments in early stage firms that

demonstrate large potential for above average returns. The recently started firms are expected to

provide VCs with a financial return on investment of ten times or more in less than five years

(Dossani and Kenney 229). Due to the high-risk nature of investment, VC firms will mitigate

risk by investing in several firms and expect anywhere from 20%-90% of their investments to

fail entirely. The possible upside in returns on successful investments more than compensates for

the portfolio firms that do not perform well (Leach and Melicher 22), with returns of 300% to

1000% possible.

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VC firms usually invest using preferred stock or convertible debt (which can become

equity) combined with common equity. Using large equity stakes in the investment as well as

seats on its board of directors, VC firms are able to actively help and intervene in the growth of

the company. Through recruiting key personnel, providing strategic advice, and introducing

possible contacts for customers, strategic partners, and financiers (Dossani and Kenney 230), VC

firms provide their portfolio companies with resources that would they would otherwise not have

access to. This aspect of VC sets it apart from any other means of funding, as VC provides more

economic value than just money. VC firms ideally exit investments through either an initial

public offering (IPO) of the portfolio company or a strategic sale to another company (Dossani

and Kenney 229).

Prerequisites and Effects of Successful VC

Given high rates of failure in investment, VC firms must carefully evaluate the business

environment they will potentially operate in to best position themselves for success. As

demonstrated in the US and several other countries, successful VC has influenced small business

development and has sparked the growth of entire industries, such as telecommunications.

Additionally, successful VC creates a cyclical growth pattern of policy implementation and

reform that helps to establish a more favorable VC environment (Da Rin, Nicodano, and

Sembenelli 1). Growth of the VC industry encourages improvement in its environment by

helping to incorporate the very factors that make VC successful. These key factors that

successful VC firms require and simultaneously contribute to include: culture of

entrepreneurship, transparent government policy, functional markets, and willing investors.

The VC industry is focused on the funding of new small businesses and is therefore

dependent on entrepreneurial talent to develop innovative ventures. A successful VC

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environment can only exist when there is “a constant flow of opportunities that have great upside

potential” (Dossani and Kenney 230). In an atmosphere where pioneering research is supported

and entrepreneurs are encouraged to be innovative and push the limits of imagination, new

business ventures give rise to entire industries. These fledgling industries, such as the Internet

dot-coms, present VC firms with a wide variety of possibilities.

VC investing also encourages and increases sophisticated entrepreneurship that can spark

innovative technologies and developments (Dossani and Kenney 230). Funding from VC creates

positive reinforcement for entrepreneurial activity by developing a competitive market for

entrepreneurial ideas. Also, the existence of venture investing changes the environment it

operates in by reinforcing structural components of the legal and financial world that are VC-

friendly (Kenney 5). The existence of VC activity also helps to address small businesses’ gaps in

capital and knowledge, allowing entrepreneurs to pursue opportunities otherwise not possible. As

entrepreneurs are rewarded for their efforts through partnering with VC firms, a culture can

develop that promotes innovation and creativity, allowing entrepreneurship to thrive (Dossani

and Kenney 230).

To encourage a business-friendly environment, government policy should be developed

in an efficient manner that protects the interests of contractually-involved parties. VC

investments are usually much higher risk in comparison to most other investments and therefore

require fair, transparent, and stable government policy that allows use of risk-taking capital for

private gain (Low and Tierney). Literature suggests that the success of the VC industry is built

on having equity-based financial institutions or common-law legal regimes (Black and Gibson

1998 ctd. in Kenney 3) With better government policy, both the cost of investing and the amount

of information asymmetry are reduced, thereby encouraging more business activity and

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investment (Lerner and Pacanins 3). Such government policy includes transparency in terms of

accounting policy, intellectual property protection, and efficient tax structures. Industries

targeted by most VC firms are those where small businesses have high growth potential, most

commonly seen with telecommunications, technology and healthcare. In most of these types of

industries, intellectual property (IP) protection is essential to success of the venture’s business

model. For example, one popular venture capital investment opportunity is an innovative

pharmaceutical firm such as AVEO Pharmaceuticals (focusing on the development of cancer

treatments), whose profitability is based on securing drug patent rights. IP protection laws play a

large role in determining whether VC firms will enter a marketplace and expose their capital to

higher levels of risk (McKnight and Parker 4).

At the same time, the existence of VC encourages policy reform to promote overall

economic growth. In many countries with thriving VC industries, such as Israel and the U.S., the

government has enacted regulations that help small businesses through contract enforcement, IP

protection, and accounting standards. The presence of VC firms in these markets has encouraged

this regulatory reform and therefore has helped to stabilize the entire private sector.

Moreover, because the structure of successful VC also involves the need for liquidation

of investments through exit opportunities, VC activity encourages strong and proficient markets.

VC exits typically occur through an initial public offering (IPO sale of stock) or a strategic sale

(where the venture is merged with an existing firm) (McKnight 6). Jeng and Wells (ctd in.

Dossani and Kenney 229) found that the single strongest driver of venture capital investing is the

number of IPOs occurring in the market, signaling successful investments. Efficiently structured

markets, such as the NYSE and NASDAQ, allow for better information flow and more

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successful stock transactions. Using efficient markets, VC investments are able to find higher

returns for their investors, encouraging overall industry growth.

VC activity also encourages development of the necessary infrastructure for functional

markets by building information networks between local entrepreneurs and national/international

level businesses. This infrastructure allows entrepreneurs access to global markets and resources

that they would not have access to without the intervention of VC (Low and Tierney). The

creation of an efficient infrastructure provides a sustainable framework for future market

development. Through the information networks provided by VC, entrepreneurs are able to

access higher levels of expertise as well as build supplier and customer relationships otherwise

not achievable. Additionally, VC encourages the formation of new industries arising from the

characteristic innovative technology of its investments (Christensen, Craig, and Hart 1). VC’s

ability to produce sustainable economic growth through establishing necessary infrastructure is

unparalleled by any other form of investment.

The investment ability of any firm relies on its access to capital. VC firms rely on third-

party investors to provide capital for any potential investment. These firms require investor

confidence in order to raise funds necessary to operate. When operating in overly risky markets

and industries, VC firms have a more difficult time raising funds from investors (Da Rin,

Nicodano and Sembenelli 17). Alternatively, when there is more capital than can be allotted to

attractive investments, VC firms face “money-chasing deals” due to the effect of capital

overhang causing unjustifiable increases in deal valuation (Gompers and Lerner 321). In any

case, VC firms must be backed by sufficient capital in order to carry on investment activity.

When VC has helped to establish functional markets, investors are more willing to put

capital into entrepreneurial ventures as a result of increased availability of information and less

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perceived risk. Investors can take comfort in the direct involvement of VCs in overseeing the

investment process while being more informed of risks and rewards for their capital’s use

(Samdani).

China and India: Current Trends of VC/PE

East Asia is undoubtedly on the verge of becoming one of the most important economic

regions in the world, as demonstrated by the recent fanfare for the region at the 2006 World

Economic Forum in Davos. Venture capitalists have taken notice of the possible opportunities in

Asia, particularly India and China. Ray Lane, a partner in the top VC firm Kleiner Perkins

Caufield & Byers discussed the potential for successful VC (“Next Silicon Valley will be in

India or China, says top VC” 1): “The next Silicon Valley is likely to come from India or China

rather than from Boston or North Carolina.” The potential of these countries can be attributed to

the startling GDP growth rates of both, as they are the two fastest maturing countries in the world

(China with growth of 9.1% and India with growth of 7.1%) (Asia-Pacific M&A Bulletin 8).

Many of the emerging businesses in these countries resemble the high-risk/high-reward business

model traditionally sought after by venture capitalists. Many Indian companies exhibit

astonishing growth similar to VC-targeted industries, with yearly gains of 15-25% (Zakaria 19).

Policymakers, firms and entrepreneurs of India and China have used Silicon Valley as a pattern

to create a successful VC industry by focusing on high technology industries and startup

companies (Kenney 9). Despite the numerous growth prospects, VC returns in China and India

have proven to be much more uncertain than the established industries of the US and Europe.

This lack of performance in such promising markets leads one to speculate as to why firms are

not able to realize the full potential of these markets.

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Examining the actual performance of private equity and venture capital markets in Asia

highlights the emergence of a strong venture capital presence in the region. Cambridge

Associates Emerging Markets (EM) VC & PE Index (EMPEA 1) illustrates the increasing

competitiveness in performance between emerging market funds and US/European funds. For

the year ended March 31, 2005, the EM VC&PE Index indicated an 18% 1-year return on 169

emerging market funds. Though this is a lower return than the US PE index (returning 23.5%)

and the W. European PE index (returning 31.2%), the 2004 performance of emerging markets

represents a significant increase from 2003 returns of -9.3% (EMPEA 1).

Comparison of Macro-Economic Trends

The strength demonstrated in terms of several macro-economic indicators provides a

solid background for the growth story of India and China. In comparison to the US, both India

and China present much higher levels of economic growth attainable through a much larger

population, as illustrated in the table below.

ECONOMIC INDICATORS

China India U.S.

Population 1.3 billion 1.1 billion 295 million Consumer Price (% Change YOY)

1.9% 4.1% 3.2%

Industrial Production (% Change YOY)

27.7% 8.2% 3.2%

Real GDP Growth (% Change YOY)

9.2% 7.1% 3.5%

(“India”; “China”; “United States”) VC/PE Market in Asia

Overall, VC/PE markets in Asia exhibited strong performance in the past year, with

record levels of funds raised and invested, more prevalent growth/expansion investment, and

healthy IPO markets. In 2005, funds raised in the Asian private equity market totaled over $17.6

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billion from 82 funds (a substantial increase over $6.5 billion raised in 2004). This represents the

highest known amount raised in the Asian market. Several funds valued at over $500 million

were established during 2005, illustrating that markets of several countries are reaching further

stages of maturity (APER 2005 Year-End Review).

Investment levels also soared, with over $15.2 billion invested in 2005 (a 29% increase

compared to $11.8 billion in 2004). Although the number of deals (271) remained at a relatively

stable level, the average deal size grew 31% from 2004 figures to $63 million. Buyout

transactions represented less than 50% of all transactions for the first time in the market, with an

increasing presence of growth/expansion investments. The industrial sector drew the most

investment, with over $5.3 billion total (APER 2005 Year-End Review).

Overall, 188 exits occurred in 2005, a 25% increase compared to 150 exits in 2004.

Investors were returned $19.8 billion on these exits, representing a return of 235% on initial

invested capital of $5.9 billion. IPOs represented 50.5% of total exits, illustrating healthy

markets in Asia (APER 2005 Year-End Review).

VC/PE in China

In 2004, China was ranked as the 3rd largest VC market in Asia (behind Japan and

Taiwan). Recent performance in the Chinese VC market is characterized by increased amounts

of investment overall, less investment in early stage firms, and declining performance of

domestic funds. The VC industry in China saw total investment of $1.27 billion in 253

companies for 2004, representing an enormous increase in activity from $418 million in 226

companies in 2002. Similar to the Asian market, the amount of invested capital grew

significantly in 2004 (an average deal size of $5 million compared to $1.8 million in 2002) but

the total number of deals remained relatively stable. IPO and M&A exits returned $802 million

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on venture-backed investments in 2004, with 21 venture-backed IPOs raising a total of $4.3

billion in 2004. The 2004 IPO activity from China represented a significant portion of total

global activity, illustrating the strong potential for VC success in China (Global Private Equity

36).

Investment in 2004 was focused less on early stage investment, with 34.4% on expansion

stage deals and 24.2% in mature stage deals. This signifies that funds are looking for quicker

returns on their capital, though several funds interviewed signaled a need for early stage VC

investment. However, examining first quarter results of 2005, the venture capital industry in

China did not demonstrate increased performance. Total funding for VC dropped to $165 million

for this quarter, which was a decline of 24% from the first quarter of 2004 (Global Private Equity

36).

Comparison of foreign and domestic VC involvement in China illustrates declining

performance for domestic funds. From information on 187 funds that disclose operational data

(out of 300 active funds), 130 are domestically-run firms, 40 are foreign firms, and 17 are joint

Chinese-foreign ventures. In the first quarter of 2005, foreign VC funds represent 63% of deals

and 80% of the total invested capital. Current market conditions show a large decline in domestic

activity, compared to 2001 where domestic VC comprised 50% of total activity. A direct cause

of the decreased domestic VC performance is a regulatory structure in China that restricts capital

formation and effective capital structure (Global Private Equity 38). Domestic VCs are not able

to grow to the same size as foreign VCs, which are on average seven times larger than of local

funds and average $200 million per fund. The Chinese government is expected to ease some of

the regulations that present difficulties to the formation and listing of companies (Global Private

Equity 38).

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VC/PE in India

As the fourth largest economy in Asia, India recently demonstrated strong performance in

terms of its VC/PE industry characterized by increased overall levels of investment. Though

there was less investment in early stage companies, there is a promising future for VC due to

encouraging government regulatory reforms. India represented the largest market for funds

raised in Asia in 2005, attracting a total of $2.3 billion in new capital (APER 2005 Year-End

Review). In 2004, investment of $1.1 billion in 66 companies represented a 100% increase on

the $507 million invested in 2003. Investment was mainly focused on private equity, with

expansion, later stage and private investment in public entities (PIPE) deals representing 72% of

total deal flow and 87% of total value in the market. Startup and early stage venture capital

accounted for 28% of deals and only 12% of total value. Investment was heavily concentrated in

business processing operations (BPO), though these deals represent a declining share over last

year’s BPO deal flow. Industries that saw an increased share of activity include heavy

industrials, pharmaceuticals, and healthcare (TSJ Media ctd. in Global Private Equity 47).

VC in India is expected to demonstrate an increase in activity in the near future due to

industry growth and decreased regulatory environment (including an increased flexibility in

capital convertibility, i.e., transferring funds into and out of India). The Indian IT services

industry is expected to grow at 22% per year, the fastest growth rate out of all Asian countries.

Growth in IT-related fields is closely tied with a strong environment for VC, as VC funding is

well suited for the IT business model. Additionally, growth in the VC industry is expected

following several reforms encouraging foreign direct investment, which specifically lower

regulations required for VC activity and investment in the telecommunication industry (TSJ

Media ctd. in Global Private Equity 49).

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Differences in VC/PE Cycle in India and China vs. Western Markets

Though an attempt has been made to develop the next Silicon Valley in India or China,

VC firms have not seen the overall expected performance and level of return in their

investments. Many firms entering the region expect to import the same operational model that

achieved high returns in the US/European markets. However, research indicates that when

investing in India and China, firms encounter a variety of differences in the entire VC investing

cycle that suggest a more customized approach is necessary for investing in these countries

(Lerner and Pacanins 2). More sensitive approaches, required to handle the fundamental

differences, are emerging at every stage of the process, including investment motivation,

structure of fund, method of fundraising, process of deal sourcing, structure of deal, management

of investment, and exit.

Investment Motivation

Research indicates that VC firms, traditionally thriving in established markets such as the

US and Europe, are increasingly globalizing their investment strategy for a number of reasons.

Lerner and Pacanins (2-3) suggest that firms are increasingly attracted to investing in China,

India, and other developing nations due to the economic progress realized through economic

reforms and the adoption of capitalism. Many developing nations are supporting more business-

friendly environments through encouragement of equity investing, tax reform, lowered

restriction on foreign investment, and improvement of disclosure standards. Additionally,

advancement in technology allows VC firms to achieve higher levels of monitoring investment

and lower transportation costs than previously seen in these economies (Lerner and Pacanins 3).

The decreasing attractiveness of markets in developed nations, such as the US, is also

driving VC firms to globalize. The market for private equity in the US grew from $4B in 1980 to

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over $125B in 1995, growing at a rate not sustainable for much longer into the future. The

current market for private equity investment operates at an imbalance, with greater amounts of

capital than of attractive investment opportunities available (Lerner and Pacanins 3). The

resulting environment is highly competitive for VC firms in established markets, where deals are

unjustifiably overvalued due to excess supply of capital (Gompers and Lerner 2). Kenney notes

that VCs are increasingly globalizing due to the additional investment opportunities available

abroad (6). By investing in developing economies, firms are open to a wider variety of

investment opportunities. Firms are also able to achieve economies of scope and diversification

through investing in developing economy firms.

Structure of Fund

Due to regulatory differences, typical fund structures in India and China vary from the

traditional VC LP formation. In China, until 1992, most private equity was only able to function

as a highly regulated China Direct Investment Fund (known as a CDIF). Under this structure, the

fund could only invest as a minority investor, could not play a role in management, and could not

place more than 20% of total funds in one investment (Bruton and Ahlstrom 236). In many Asian

countries, the limited partner structure is not permitted, causing most domestic VCs to operate as

corporations. The corporate structure limits many key flexibilities VC firms typically use, such

as the ability to ensure that a fund will dissolve at the end of a stated period. By preventing the

limited life of a fund, GPs may draw out the life of a fund, which prevents the LPs’ ability to

force liquidation and have initial funds returned (Lerner and Pacanins). Ernst and Young’s

Venture Capital Report summarizes other common forms of structures found for foreign funds in

China:

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• Formal Alliances or Joint Funds: Relation between foreign funds and China-based funds

based on joint investments in deals and mutual deal sourcing, for example, China-based

Accel and International Data Group Ventures (IDG) forming IDG-Accel China Growth

Fund.

• Joint Cooperation: Joint investment with foreign and local funds without a formal

alliance, such as Venrock Associates and Granite Global Ventures.

• Affiliate Funds: Domestically-established deal sourcing arm of foreign fund (commonly

U.S.-based) in China, such as Sequoia Capital’s China Fund.

• Branch Office in China: Increasingly popular model for foreign funds with branch office

in charge of deal sourcing and business development for portfolio companies, used by

Doll Capital Management.

• Frequent Flyer: Foreign fund with operation in China without a local office in the

country, for example, ComVentures. (Global Private Equity 43).

Domestic funds in India are more likely to be structured like the traditional LP, as the

regulatory environment has become more VC-friendly. Foreign investors, however, more

commonly use a US-based model with a domestic branch office, which allows for easier access

to more liquid US capital markets for easier exit options. The US-incorporated company will

handle sales, marketing and product development, while a subsidiary in India will handle

oversight specific operational details (Global Private Equity 53).

Method of Fundraising

Capital sources for VC firms operating in India and China are similar to those in the US

and developed economies, consisting of pension funds, corporations, insurance companies and

high net worth individuals. Additional parties targeted to assist with developmental goals are also

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involved in funding VC in these countries. Such parties include foreign aid organizations, quasi-

government corporations, and multilateral financial institutions (such as the World Bank’s

International Finance Corporation). Though these additional sources present a steady stream of

capital, funding from these organizations can complicate VC investment given that many

government-related funds are accompanied by excessive constraints on investment (Lerner and

Pacanins 5-6). In some cases, such government-related funds impose reporting requirements that

prevent the institutional investor from keeping details of VC investments confidential,

weakening VC firms’ competitive abilities. Several sources indicate a lack of initial funding in

early stage risk capital (called “bootstrap financing”) from angel investors for startup firms in

India, creating difficulties in establishing firms sizeable enough for VC investment (TSJ Media

ctd. in Global Private Equity: Venture Capital Insights Report 2004-2005 53).

Process of Deal Sourcing

Major differences exist between the process of sourcing deals in developed and

developing VC industries. Industry focus for investments is somewhat similar, with most VC

firms targeting high tech-related companies (Global Private Equity 42). Other PE deals are

focused on privatizations and corporate restructurings, similar to established PE markets. China

and India also feature deals that are unique to developing markets, such as strategic alliances

(where major corporations use PE firms to fill lack of knowledge in operating in foreign market)

and infrastructure funds (focused specifically on investing in building bridges, roads, etc.)

(Lerner and Pacanins 6). VC in India operates on a slightly different industry dynamic, due to the

strong performance of the services firms (related to India’s strength in BPO services). Services-

related firms do not promote the usual VC model, which is driven by value held in protecting

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intellectual property (such as specific technologies) and capitalizing on the related proprietary

knowledge (Global Private Equity 52).

The actual screening process of potential investments also requires a uniquely-tailored

approach for the funds operating in India and China. In a study of VC firms in China, Bruton and

Ahlstrom (245) found that conducting due diligence on potential deals required much more effort

on part of the VC firm operating in China compared to firms operating in developed markets.

Firms found more success with screening of deals when located close to the potential ventures,

which resulted in using more of a regional focus rather than industry orientation for initial

screening. Close physical presence to portfolio firms is important in both India and China, due to

the fact that many business transactions have strong roots in personal relationships. VC firms

therefore must work to build strong local connections with influential officials, social groups and

businesses in order to gain trust to successfully manage investments (Lerner and Pacinins 7,

Bruton and Ahlstrom 234).

Additional difficulties in sourcing deals come from China and India’s lack of regulatory

environment and from weak corporate governance. In the West, VC firms are able to use

company financial statements to asses the level of risk of a firm. China and India lack uniform

accounting policies as strong as the US’s highly-structured Generally Accepted Accounting

Principals (GAAP), therefore firms are not able to rely mostly on financials in risk assessment

(Bruton and Ahlstrom 245). VC firms operating in China report that due diligence of potential

investments requires up to 6 months more effort compared to investments in the West due to

extensive background checking and less efficient legal systems (Bruton and Ahlstrom 246).

Furthermore, several firms that are currently operating in both India and China have cited

difficulties in managing their investments due to the region’s lack of necessary training.

19

Specifically, India and China both lack the experienced management personnel required to direct

high stakes ventures (Kenney 10; Actis). The paucity of experienced professionals could be due

to a variety of factors: the educational system’s inability to promote managerial science, low

literacy rates throughout the region, and fewer opportunities for management positions given the

population size. Additionally, there is an immense lack of research funding for creating products

that would attract VC-friendly business models (Kenney 10). In vibrant VC markets such as the

US, research funding allows entrepreneurs to develop the high-tech and innovative products that

may result in high return businesses. Overall, India, China, and VC firms collectively need to

focus additional effort on harvesting talent to support a VC industry.

Structure of Deal

Traditional VC firms assume a majority stake in their portfolio firms to most effectively

drive the change necessary for successful performance, often stifling the entrepreneur’s say in

company matters. In Asian cultures, entrepreneurs are much more reluctant to give away large

portions of equity in their firms, which they see as an expression of themselves and their family

(Kenney 10). As a result, VC firms in Asian cultures must create a trusted and close personal

relationship between themselves and the entrepreneur. Several firms cite success through

maintaining minority stakes in firms, but maintaining close relationships with management

(Actis 4).

In terms of specific deal structure, India and China PE is characterized by financing

mostly through common stock. Preferred equity and debt instruments are most commonly used

in Western PE markets, which allow firms to stage investment, gain more control over the

portfolio firm, and provide incentives for management performance. In Asia, some markets do

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not allow for different classes of stock, which create difficulties in structuring VC deals that

mitigate the risk of startup firms (Lerner and Pacanins 8-9).

The usual minimum investment size for VC firms is $10 million; however, this size

represents an additional challenge when considering VC undertakings in China and India. For

most large foreign funds, making an investment of less than $10 million does not make sense due

to the lack of returns for the amount of effort used in the investment process. Many startup firms

in India and China, however, are not able to absorb large sums of financing because lack of the

proper infrastructure to allocate funds (Global Private Equity 47) and therefore fall below the

radar of VC funding.

Management of Investment

The cultural differences in attitudes of Western and Asian entrepreneurs lead to important

operational differences in VC portfolio management. Again, firms in China reported physical

location close to portfolio firms is of utmost importance in monitoring investment due to a higher

amount of information asymmetry between the entrepreneur and investor (Bruton and Ahlstrom

245). Additionally, fostering a close relationship with the portfolio firm can lead to increased

levels of trust between the two parties, especially due to the increased difficulty in establishing

an “insider relationship” with most portfolio firms (Bruton and Ahlstrom 244). Entrepreneurs in

India and China are much more reluctant to give up control of their firms (Global Private Equity

23, 45) allowing for less value-added and strategy-directing activity on part of the VC firm

(Bruton and Ahlstrom 245). Instead, many VC firms have found much of their input in

improving operations is related to building business fundamentals (such as accounting and

operations) (Bruton and Ahlstrom 244), which many entrepreneurs in India and China lack.

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Difficulties in handling the regulatory environment have also led to the failure of VC

firms in India and China. Over-regulation, lack of corporate governance legislation and

transparency all result in a high level of costly risk management required to operate business

(Actis; Kenney 20). A World Bank Case Study of India cites a problem in Indian businesses

specifically due to the fact that markets are “stifled by a web of government controls and

regulations,” causing poor infrastructure and low public investment to further growth (ctd. in

McKnight and Parker 7). Recent liberalization of international investments in India and China

show policy initiatives that address these regulatory issues. In collaboration with governmental

and regulatory agencies, VC firms can help to establish practices that will create a more efficient

business environment.

Exit Options

As described in the earlier section on common VC structure, IPO exits are the most

common route to achieving returns on investment in developed VC industries. In India and

China, achieving expected returns through IPO is a less likely reality. Though markets in both

countries are evolving to be more efficient, as demonstrated by the level of IPO activity in 2004

and 2005, listing small companies on national exchanges is a difficult task. In China, selection

for listing on national exchanges (Hong Kong Stock Exchange, or Shanghai and Shenzhen Stock

Exchange) is a state decision. The Chinese government currently approaches the evaluation for

public listing with the attitude that VC-backed firms do not need the additional capital that a

stock offering provides due to the strong resources provided by the VC funding (Bruton and

Ahlstrom 239). One possible initiative to promote VC activity in both India and China is to

develop a small-capitalization market like NASDAQ in these countries (Global Private Equity

43). Already, China’s Shanghai and Shenzhen Exchanges have announced plans for a NASDAQ-

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type market, and Hong Kong Exchange has created the Growth Enterprise market (Bruton and

Ahlstrom 252). With the development of markets targeted towards smaller firms, VC

investments are poised to achieve more successful returns through IPO.

Due to the current lack of small IPO-friendly markets, VC firms in India and China find a

higher probability of exit through strategic sale or through selling back of stock to the portfolio

company (Bruton and Ahlstrom 252; Lerner and Pacanins 9-10). The sale of companies to

strategic investors does not provide for same returns expected in an IPO due to the purchaser’s

power in pricing at a lower premium (Bruton and Ahlstrom 252; Lerner and Pacanins 9-10).

Other possible exit routes that have achieved more success for VC-backed firms include listing

shares in a more profitable foreign market’s exchange or pursuing an acquisition by a strategic

buyer in a developed economy (Lerner and Pacanins 10).

Analysis of the current state of venture capital investing in India and China highlights

many difficulties that arise when trying to apply the Western VC business model to create a

successful investing industry in these countries. Those difficulties illustrate several key

misunderstandings that prevent successful investment in India and China. Most VC firms that

have entered the China/India market have not been able to properly overcome the cultural

differences, the lack of necessary training, and the difficult regulatory environment in order to

achieve the desired level of return on their investment. Firms must adapt the traditional operation

model in order to address the key differences between developed and developing markets

discussed in the VC investing processes to rectify the lack of successful performance. In

adopting an approach tailored to the Asian culture and environment, VC firms can potentially

realize greater success in the region. These current misunderstandings stem from the VC

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industry’s inability to address a fundamental aspect of the environment in both India and China:

poverty.

Overcoming the Pyramid of Poverty in India and China

Poverty is undoubtedly one of the most disastrous conditions plaguing the world today. A

majority of society’s problems can claim poverty as their root cause, including but not limited to

AIDS and other infectious diseases, terrorism, environmental damage, illiteracy, malnutrition,

human rights abuses, human trafficking, narcotics trafficking, illegal immigration, ideological

intolerance, tyranny, genocide, and debt slavery (Magleby 6). In recent years, organizations such

as the United Nations, World Bank, and the World Economic Forum have all recognized poverty

as a global issue to be addressed with utmost importance and urgency.

Wide-spread poverty is entrenched in society by the pyramidal distribution of wealth and

capacity to generate income most commonly found in developing countries. The top of the

pyramid comprises of a small number of individuals with numerous opportunities for generating

wealth. At the bottom of the pyramid (BOP), more than 4 billion people live on less than $2 per

day, with purchasing power of less than $2000 per year (Prahalad 4). This population represents

a staggering 65% of the world’s total size. This pyramidal distribution of income has stifled the

economic potential of the 4 billion people at the BOP, who have previously not been offered

opportunities to participate in the formal economy as consumers or producers (Prahalad 7).

Attempts to find a solution to poverty have been long been a hot topic of discussion.

Charitable donations from non-government organizations (NGOs), countries, and individuals are

traditionally thought of as the most helpful approach. However, these methods of addressing

poverty have not been effective, as there are still 4 billion people at the BOP (Prahalad 4).

Solutions to poverty thus far have not created a long-term resolution, as charity runs out and

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development has not been encouraged. Many current approaches to this global issue emphasize

the importance of sustainable development as the most effective principle to aid in promoting

human development and fighting poverty.

Sustainable Development for Alleviation

Sustainable development is based on the premise that “interests of future generations

should receive the same kind of attention that those in the present generation get.” (Anand and

Sen 1). Many forms of aid to impoverished countries today represent only temporary aid, as they

do not consider how to promote and maintain the positive benefits they achieve over a long

period of time (such as donating in emergency situations such as a tsunami to preserve life, but

not investing in infrastructure to prevent such a situation in the future). To eradicate poverty,

Magleby summarizes six metrics, which when increased, signal the sustainable effectiveness of

any anti-poverty actions: freedom, transparency, human development, equality, ecological

sustainability, and enterprise sustainability (13). Enterprise sustainability has recently drawn

more attention as an important metric, pulling in more private sector involvement to fight

poverty.

Poverty interventions can be characterized on a scale of long-term economic

development effectiveness (as determined by Stephen W. Gibson and Jason Fairbourne ctd. in

Magelby 19): disaster aid (least long term effect), poverty relief, excursions, microcredit,

microfinance, microenterprise, and lastly microfranchising (greatest long term effect). As is

evident from the preceding list, the most effective long-term economic solutions involve private

sector businesses pursuing a “triple bottom line of profitability, environmental stewardship, and

social responsibility.” (Magelby 20) The new breed of solutions to poverty focus on sustainable

development initiatives stemming from efforts of private sector businesses, which are able most

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effectively able to address Magleby’s six metrics of anti-poverty actions (referenced in the above

paragraph).

Private Sector as Key Player

The increased role of the private sector in development initiatives is rooted in healthy

competition encouraged by for-profit ventures. Business competition encourages innovation,

creating more efficient processes and other positive externalities for the markets in which they

operate, as described by the World Bank:

Private firms are at the heart of the development process. Driven by the quest for profits, firms of all types – from farmers and microentrepreneurs to local manufacturing companies and multinational enterprises – invest in new ideas and new facilities that strengthen the foundation of economic growth and prosperity. They provide more than 90% of jobs – creating opportunities for people to apply their talents and improve their situations. They provide the goods and services needed to sustain life and improve living standards. They are also the main source of tax revenues, contributing to public funding for health, education and other services. Firms are thus central actors in the quest for growth and poverty reduction. (World Bank’s 2005 World Development Report ctd. in Doing Business in 2006 3).

Market-based solutions to development promote competition and spur innovation,

providing incentives for sustained development that are not found through most other forms of

aid. At the same time, private businesses will also benefit from developmental initiatives that

address unmet needs in impoverished areas. The low-income market represents tremendous

opportunity for business growth, as many other mature parts of the market become saturated and

are highly competitive.

Importance of Small and Medium Enterprises

Many organizations suggest that the key to growing the economies of developing countries

lies within the scope of small- and medium-sized enterprises (SMEs), which are usually more

prevalent in areas of lower income. SMEs are a diverse group covering a “range of sophistication

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and skill, and operate in very different markets and social environments” (Hallberg 2). Examples

of SMEs include village handicraft makers, restaurants, and internet startup firms. Small

enterprises employ anywhere from 5-50 people, where medium enterprises employ about 100-

250. SMEs usually “operate in the formal sector of the economy, employ wage-earning workers,

participate in organized markets, and have strong potential to grow and become competitive in

domestic and international markets” (Hallberg 2).

SME development has numerous benefits that aid economic growth within developing

countries. Economic theory suggests that SMEs support job creation, as many SMEs tend to be

in more labor-intensive industries than larger firms (Hallberg 3). These firms are also credited by

some with having the ability to more equitably distribute income, due to the fact that workers

employed by such firms are usually from lower levels of wealth (Hallberg 3). Also, SMEs can be

a strong source of innovation in the economy because they consist of emerging businesses with

innovative technologies that compete with established firms (Making Markets Work for the Poor

7). SMEs promote market creation, as smaller-scale businesses depend on each other to develop

productive networks and supply chains to deliver their products (Making Markets Work for the

Poor 9). However, all of these benefits are debated by scholars who believe the biggest benefit of

promoting SME development in developing countries arises simply because “they are there” and

account for a large share of the market serving lower levels of wealth (Hallberg 6).

Regardless of the debated benefits, entrepreneurship is the driving factor behind most SME

development, and is thus the most important societal characteristic to encourage. SME

development promotes entrepreneurial ideas that allow individuals to create employment

opportunities for those around them. Christensen, Craig and Hart (1) support entrepreneurial

development through their theory of “disruptive technologies,” which are innovations that

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“create major new growth in industries they penetrate by allowing less-skilled and less-affluent

people to do things previously done only by expensive specialists in centralized inconvenient

locations.” Through encouraging entrepreneurial efforts, VC funding drives the innovation

needed for disruptive technology development, and thus helps to spur economic growth.

International Finance Corporation (IFC)’s pillars-of-enterprise model provides a

framework for analyzing successful factors that encourage entrepreneurial venture creation.

Under this model, there are three categories of business needs: access to capital, business

development services, and an enabling environment (IFC in Making Markets Work For the Poor

9). Most developing nations face conditions that make entrepreneurial ventures difficult

undertakings and inhibit one or more of the IFC’s pillars, creating many challenges for the

success of a VC industry. Private sector development in these countries is challenged due to the

following factors: an inhibiting regulatory environment, a lack of access to credit, and negative

market conditions (Making Markets Work For the Poor 9). In order to successfully operate in

developing countries and to address these three key challenges, innovative business models must

be able to promote sustainable development and overcome the national economic problems

caused by poverty.

Community Development Venture Capital (CDVC)

CDVC is a fast growing practice in development finance that is based on the abilities of

venture capital to “create jobs wealth, and entrepreneurial capacity to benefit low-income people

and distressed communities” (Tesdell 24). Venture capital is particularly well-suited to handle

financing for development, especially in low income areas where seed capital required to start

new companies is not readily available (Tesdell 24). Micro-credit banks are not able to offer the

long-term debt and equity financing most SMEs need to expand BOP-viable businesses. On the

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other hand, large regulated institutions do not usually undertake the high risk associated with

loans to such businesses. Socially-motivated investment is able to best fill the gap between more

traditional development financing (such as grants and charity) and private-sector investment

driven solely by pursuit of profits (Making Markets Work for the Poor 2)

This type of VC operates on the premise of traditional VC investment in high-risk, high

growth enterprises, but includes the dimension of investing to pursue a “double-bottom line” of

financial and social returns (Making Markets Work for the Poor 2; Tesdell 24). CDVC focuses

mostly on companies whose growth would benefit social development, such as those that target

the needs of minorities and women, or those that are environmentally focused (Tesdell 24).

Benefits of socially responsible VC are numerous for both communities and investors.

In terms of community impact, VC has a unique ability to add value to the business

environment of low-income areas. Many CDVC firms provide the valuable entrepreneurial and

managerial assistance that most businesses in developing areas may lack. Specific value-added

activities of VC firms for community development include acting as an intermediary between

workforce development programs and portfolio companies to facilitate employment. Another

highly-valuable contribution of VC firms is the ability to coach portfolio firms in taking

advantage of government tax incentives for locating in low-income areas (Tesdell 25). By

creating a competitive business environment focused on pursuit of profits, VC firms investing in

developing areas are able to help reduce market inefficiencies and encourage a more business-

friendly environment (Making Markets Work for the Poor 9). Most importantly, VC firms are

able to achieve a “ripple effect” through development of their portfolio companies in low income

areas. These portfolio companies not only provide for job creation, but also provide health

benefits and pension plans for employees and their families (AVCA 5).

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Socially responsible VC also holds benefits for the investor. Garnering a lower expected

return, CDVC allows investors to make a more effective contribution to poverty than those

achieved by simply granting funds. Instead, by encouraging accountability of investment through

returns, this type of investment uses capital more efficiently by reinvesting and recycling the

initial invested capital (Making Markets Work for the Poor 9). CDVC also addresses growing

concerns in investor behavior. Investors are increasingly looking for ways to diversify their risk,

to encourage sustainable development, and to capitalize on new niche markets. Investment in

most developing areas is less correlated with traditional market returns, as there are more

opportunities for niche market growth in these areas (Making Markets Work for the Poor 9).

Target Market: Bottom of the Pyramid (BOP)

BOP development theories, such as those of Prahalad and Hart, suggest multinational

corporations and other private sector investors can further their bottom line while helping to

eradicate poverty by focusing on serving consumers at the BOP. Such theorists predict that in the

near future, the most successful businesses will be those that incorporate a dual bottom line of

profits and societal benefit into their core practices. VCs are most uniquely positioned to succeed

under these circumstances, as they are best equipped to help start firms in high-risk business

environments including the BOP. In order to profitably operate at the BOP, businesses must

challenge traditional views by adopting two key understandings: that developing countries hold

great amounts of internally-trapped capital and that the BOP population will make a highly

profitable consumer group.

Traditional tactics such as foreign aid and charity have based their efforts on the

assumption that poor countries are poor because they lack resources. By comparison, foreign aid

represents only a fraction of the potential for capital that is trapped within most developing

30

countries (Prahalad 79). This insight was first discovered by economist Hernando DeSoto, who

noted that the poorest populations collectively own about $9 trillion in unregistered assets due to

inefficient local policies blocking property rights (Prahalad 80). Due to the lack of land rights,

entrepreneurs are not able to use houses as collateral as they do in developed economies to obtain

loans. In most developing countries, local commerce is conducted in the informal sector (or

blackmarkets) because of the lack of enforceable contract law (Magelby 8-9).

The sheer difficulty of doing business in most developing markets creates a self-

enforcing cycle that discourages market growth. For example, opening a new business takes an

average of 198 days in Laos, costs an average of $61,000 in minimum capital in Syria (51 times

annual average income), and requires payment of 164% of a company’s gross profits in business

taxes in Sierra Leone (Doing Business in 2006 1). As a result of the immensely challenging

conditions, many firms operating in such environments are not able to attract or retain capital and

are thus unable to grow (Making Markets Work for the Poor 2). Potential for business

sustainability is realizable; developing economies can mobilize the capital found within their

own countries and can help the private sector exponentially increase profits while reducing

poverty. For VC, understanding the potential of trapped capital within the BOP suggests the

ability to harvest high value businesses in this market with the proper expertise.

Another key understanding VC firms must adopt to do business in developing countries

is a view of the BOP as a highly profitable consumer group. The sheer volume of this segment of

the population (over 4 billion people) suggests enormous potential profits if the BOP is provided

the opportunity to consume. Currently, most businesses do not offer accessible products to this

market. Most products are targeted towards higher income individuals who have necessary

technologies such as washing machines, or are able to buy a large amount of product at one time.

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Though the BOP consumer cannot afford the same type of lifestyle, Prahalad discusses

characteristics of the BOP consumer that suggest the possibility of creating a highly attractive

mass market for businesses (13-17).

The BOP population demonstrates similar consumer characteristics to the usually

targeted wealthy markets. For example, BOP consumers are brand-conscious and value-

conscious, which implies that appealing to customers based on one of these aspects will help

build a loyal, repeat customer base (Prahalad 13). Furthermore, BOP consumers readily accept

advanced technology, adapting to products and innovations (such as cell phones) at much faster

rates than previously seen in the US (Prahalad 15). The rapid adaptation rate is also due to the

fact that the BOP population is highly networked through computer and cellular phone access.

Additionally, a key to serving this part of the market involves creating the capacity to consume

within this population by offering innovative products that fit needs specific to the BOP segment

(Prahalad 16-17). These consumer characteristics suggest the possibility that firms traditionally

supported by VC, such as telecommunications and biotechnology, would find a highly viable

market if the firms were to adequately address the needs at the BOP.

In focusing on the BOP market, businesses will see the most success when “creating

opportunities for the poor by offering choices and encouraging self-esteem” (Prahalad 5).

Building a sense of dignity and worth in poor individuals positively encourages this population

to take part in formal segments of the economy. Prahalad suggests developing BOP-targeted

business models that focus on product characteristics traditionally withheld from this population:

affordability, access, and availability (18). If firms are able to create products appealing to the

BOP consumer and their needs, this population could serve as a new highly profitable market for

high risk/high reward businesses.

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BOP Business Model

New operational constraints are posed in developing economies that make it difficult to

respond to the needs of the overall population. In response to these operational constraints, VC

firms must accordingly adjust the traditional business model that has achieved success in

America and other developed nations. Both the VC operational strategy and the portfolio firm

operational strategy must evolve to incorporate BOP-friendly best practices. Overall, BOP

markets require “entrepreneurship on a massive scale” (Prahalad 2), due to the fact that BOP

entrepreneurs already have the best understanding of what needs are to be met for their own poor

population. Three key strategies that must be addressed for companies to succeed are: high

volume/low margin production, attention to quality of service for clients, and intensive risk

management.

High volume/low margin production

To achieve profitability in the BOP market, small micro-entrepreneurs must be able to

create a business model that is scalable to the entire population of 4 billion impoverished

individuals, as low margins realized in this market must be balanced by high volume of sales.

The BOP consumer has a lower disposable income than the wealthy consumer but will typically

pay similar price points. The difference in the two consumer’s behavior is that the BOP

consumer buys more on a needs basis than a want basis. Thus, Prahalad cites several key

business practices companies must keep in mind to be successful when approaching a BOP

initiative: focus on small unit packages, low margin per unit, high volume production, and high

return on capital employed (24-46). This production strategy should be encouraged in the

portfolio companies in which VC firms invest.

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VC firms should also accordingly alter their operational strategy to offer a high volume,

low margin service. The adaptation of VC services in developing/BOP economies is similar to

the principal of microfinance and micro-credit banking, where small informal loans are issued to

individuals at a rate of interest that covers the cost of operations (Silverman D1). Most BOP

businesses, even when highly scalable, do not require and cannot handle the same amount of

investment as traditionally-targeted VC portfolio firms. As a result, VC investors should consider

investing smaller amounts of capital that will potentially realize higher returns than those

traditionally sought. With this strategy, firms will also be able to handle a larger number of

portfolio companies.

Attention to quality of service for clients

Responding to the needs of the BOP consumer, as mentioned earlier, will best position

firms to succeed in this market. London and Hart found that firms cannot simply rely on the

transfer of knowledge and resources developed in top of the pyramid markets when operating at

the BOP (9-11). Firms accustomed to operating in developed economies must adjust their

practices to address and understand the local environment and local consumer. Firms should

focus on fostering capability in “social embeddedness,” which London and Hart describe as “the

ability to create competitive advantage based on a deep understanding and integration with the

local environment” (15). To develop social embeddedness, successful BOP market entrants

should focus on “collaborating with non-traditional partners” (such as local and non-profit

organizations), “co-inventing custom solutions” (to address specific needs of BOP consumers),

and “building local capacity” (such as offering training programs and developing infrastructure)

(London and Hart 12-15). Prahalad notes several steps that firms can take to tailor their services

and products: innovate using hybrid solutions (such as single serve laundry detergent packets

34

tailored for low-income purchase), create solutions that are transportable across multiple cultures

and countries, understand the appropriate functionality for BOP needs, and educate customers on

product usage (24-46). Attempting to understand and serve the needs of BOP consumers will be

the most important strategy for firms in this market, as it creates “the capacity to consume”

(Prahalad 16) and builds purchasing power in this market segment.

Again, VC firms must incorporate this strategy into both their own operations and their

portfolio companies. In terms of VC investing, firms must consider working more closely with

local entrepreneurs, especially given the importance of fostering close relationships in doing

business in developing countries. Chambers (ctd. in London and Hart 3) found that one key to

success in these markets is the ability to understand and respond to the existing social

infrastructure. VC firms should work to build trust with entrepreneurs through illustrating their

deep understanding of local customs, most effectively done through establishing local offices in

the BOP markets in which they operate. Microlending institutions have achieved high repayment

rates through a similar tactic, and many theorists credit the proximity of these institutions to their

success (responsAbility Global Microfinance Fund). Additionally, VC firms should work with

non-profit organizations and universities to encourage the development of entrepreneurial

networks and innovative research.

Intensive risk management

Given the extremely high risk environment presented by the instability of most BOP

markets, successful business operations in these markets must take precautionary measures to

ensure proper risk management. The lack of transparency and certainty in day-to-day business

operations requires the challenging task of close coordination with the local regulatory agencies

to develop more appropriate business standards. As mentioned earlier, successful performance in

35

BOP markets is furthered by building community relations through a local office (Bruton 241-

246). This will also allow for VC firms to lower informational risks by providing the ability to

closely monitor their portfolio investments and will encourage the development of a close

trusting relationship between VC firms and entrepreneurs (Bruton 246; Wright et al. 19).

Through utilizing a BOP-oriented business model in India and China VC markets, firms

will better be able to address challenges presented in these countries. The three key aspects of the

business model discussed in this paper represent the most relevant BOP strategies for VC firms.

Additionally, changes to the VC business model must incorporate sustainability objectives. The

best way to ensure that sustainability is maintained as a priority is to incorporate a system of

measurement of the societal impact of VC investment.

Evaluating the Impact of VC in Developing Markets

As venture capitalists create new business strategies for operating in India and China,

they should also augment the metrics used to measure performance outcomes. Any investment

approach in both countries requires a long-term approach in understanding that increased social

impact now will lead to increased financial returns in upcoming years. Assessing fund

performance must incorporate the “double bottom line” not only of financial returns but also of

social impact. Financial returns are necessary to drive competitive performance that will lead to

increased efficiency while also attracting a growing pool of investors, who are looking for

additional investment opportunities. Measurement of social returns is required to encourage

sustainable development in the economies in which the VC firms operate. Firms will be able to

realize more profits as more sophisticated market structures are developed through efficient

investing, consequently increasing both social and financial returns.

36

Methods used to assess financial returns and performance for funds in India and China

are virtually the same as for firms operating in the West. The internal rate of return method (IRR)

is the most common form of reporting financial returns of funds. IRR is calculated as the annual

percentage return that annual revenues produce on the total costs of investment (Clark et al. 38).

For most established VC markets, the expected IRR is around 30%. Funds in developing

economies should expect lower returns (around 8-15%) given the unsophisticated markets in

these countries. These lower financial returns, however, are compensated for in terms of

increased social returns.

Social returns should be measured and tracked as part of fund performance; however,

firms face a large problem in avoiding subjective standards when coming up with an appropriate

method of measurement of social returns. Social returns can be defined as any increase in factors

that lead to sustainable income generation. Magleby’s six metrics of effective anti-poverty

actions (13) can be used to gauge progress of the development in terms of increased freedom,

transparency, human development, equality, ecological sustainability, and enterprise

sustainability, as discussed earlier. A systematic system to monetize the value of these metrics

would provide the most effective way to measure social returns. Returns should be evaluated by

the impact of the VC investment, defined as the outcome reached through investment minus the

outcome that would have resulted without the investment (Clark et al. 7). Exhibit 2 summarizes

nine different methods of evaluating social returns in terms of the effectiveness of each method

in addressing assessment of process, impact, and monetization of effects as described by Clark et

al. Many current methods of evaluating social returns are based on measuring the number of jobs

created by the investment and the potential effect of employment generation on the community,

for example: increases in health benefits coverage, income, and education (Clark et al. 18-34).

37

Another possible method of monetizing social effects is to incorporate real options analysis

(which warrants much further explanation than possible through this paper). Funds that develop

and employ comprehensive performance measures that incorporate both social and financial

returns will carry a distinct advantage in maintaining profitable operations in India and China.

Best Practices of Current Innovative Funds

Following the trend of increased social awareness in the private sector, numerous VC

firms are emerging with funds using pioneering approaches to handle the challenging social

environments in India and China. These funds represent the next generation in VC, integrating

pursuit of financial and social returns into innovative business models. Through examining

several funds based on operational strategy and performance, this paper aims to highlight

strengths and weaknesses of each model in order to direct the development of successful future

funds in India and China.

Microfinance Fund: responsAbility

responsAbility Global Microfinance Fund is an innovative fund seeking dual

returns through moderate financial gains and social benefits. Started in November 2003,

the Fund's main investment focus is microfinance; but also has a limited amount of investments

in SMEs and trade finance businesses for small producers in developing countries

(responsAbility Global Microfinance Fund). Operating as an open-ended investment fund for

private investors, the Fund has $42.99M of assets under management at the end of 2005, an

increase from $22.70M at mid-2005. A total of $41.85M is allocated to a total of 77 active

microfinance investments (compared to $21.99M in 59 investments at mid-2005), with a

projected $30.00M of new funds allocated to microfinance investments. Since inception, the

fund has realized a 4.23% net asset value increase. The Fund currently has microfinance

38

institution (MFI) investments in 36 developing countries worldwide (Exhibit 3 illustrates the

specific regional breakdown), but reports that future investments will specifically emphasize the

Asian and African regions (Microfinance- The MIX Market).

The Fund is advised by responsAbility Social Investment Services AG (responsAbility –

Social Investment Services), a private sector initiative with partners that represent the main

segments of the Swiss financial market: Credit Suisse, Raiffeisenbanken, Baumann & Cie

Banquiers, Alternative Bank ABS, and the Andromeda Fund (a social venture capital fund)

(responsAbility Global Microfinance Fund). With Credit Suisse’s involvement in this initiative,

responsAbility illustrates a possible structure for larger banks to emulate when entering emerging

markets, using partnerships with firms that have more specific expertise in this investing. As an

advisor to the Fund, responsAbility is the contact point for obtaining access to microfinancing

institutions. It conducts the necessary preliminary assessments that provide information on which

it bases its credit decisions, serving as a reliable quality control mechanism to ensure the loaned

money is also well invested (responsAbility Global Microfinance Fund). In order to diversify the

Fund’s holdings, investments are in two categories: direct investment in MFIs in developing

countries or indirect investment through other institutions which themselves invest in MFIs

(responsAbility Global Microfinance Fund).

Due diligence for screening of investments is usually carried out by sub-advisors, and

occasionally through responsAbility. Potential investments are evaluated on the basis of strategy,

management, financial performance and social performance. Qualification criteria for

investments include a minimal track record and viable business case based on the following

characteristics (Microfinance- The MIX Market): professional management and establishment,

39

promising young MFIs with strong business potential that pass due diligence or, to a limited

extent, investment in fair trade producers, traders, and SMEs.

Fixed income is the Fund’s major asset class, mostly short- to medium-term debt

securities with fixed or variable repayments of principal and interest. The portfolio consists of

direct loans and indirect lending through partners and mandates or through specialized

investment instruments. All loans are ultimately used to refinance MFI credit portfolios. The

Fund may also have a very limited exposure in equity investments in MFIs (responsAbility

Global Microfinance Fund), as illustrated in Exhibit 3.

In order to address the diverse environments of the microfinance industry, responsAbility

employs the “Best Partner” concept as a key operating strategy. Through involving organizations

that are local leaders in their respective fields in the investment process, the Fund is able to

achieve “a local presence, specific expert knowledge, and many year’s experience”

(responsAbility – Social Investment Services). Through this initiative, responsAbility aims

to recognize and understand local needs and to best impact the allocation of investments for both

social and financial gains.

responsAbility measures successful financial performance based on the aim of achieving

growth in value and returns in excess of the US dollar money market. Additionally, the Fund

gauges returns on the basis of social performance through measurement of various local social

effects. A yearly report is prepared that analyzes social indicators of successful performance

observed at individual, local community, and regional levels. These indicators measure the

impact of microfinance in terms of advancement of the banking industry, financial empowerment

of individuals, and creation of jobs (responsAbility Global Microfinance Fund). Several

examples of indicators include: structured descriptions of MFI clients and their economic

40

activity, number of branches or credit officers operating in rural/urban locations, number of

active borrowers/outstanding loans, and percentage share of women, as part of total clients.

Investors targeted by the Fund include private and institutional clients with medium to

long-term horizons who are seeking both financial returns and social benefits through their

investment (responsAbility Global Microfinance Fund). Many current investors in the fund

are seeking social impact through their contributions, specifically through supporting

“enterprising individuals who are forced to work under extremely difficult circumstances and

who are seeking very small sums to expand their business activities” (responsAbility – Social

Investment Services). Investment in the Fund also offers the attractive benefit of portfolio-

diversification. MFIs and their customers fulfill basic needs that are largely independent from

macroeconomic cycles. Additionally, investments in microfinance exhibit low correlation with

other investment categories or asset classes (responsAbility Global Microfinance Fund).

Several additionally noted funds specializing in microfinance investing are listed in Exhibit 3.

Nonprofit Philanthropic Fund: Acumen Fund

The Acumen Fund was founded in 2001 to link high net worth individuals with

innovative experts on global issues. In response to charity’s lack of effectiveness in addressing

poverty, the Fund was started to develop a means to fill the financing gap for smaller,

financially-sustainable ventures in developing countries. The Fund was established with seed

money from the Rockefeller and Cisco Foundations and several Silicon Valley investors

(Zaidman 3). The Fund had raised $22 million from over 100 individuals, corporations, and

foundations by December of 2004 (Zaidman 3). Using both measurements of social and financial

returns, the Fund operates as a non-profit venture fund. The fund’s mission is to “use

entrepreneurial approaches to address poverty through identifying, supporting and scaling

41

sustainable enterprises to deliver critical goods to target two-thirds of the world’s population

who live on less that $4 a day” (Acumen Fund).

As a non-profit organization, the Acumen fund invests charitable donations in both non-

profit and for-profit organizations that focus mostly in South Asia and East Africa. Donors to the

Fund, referred to as “partners”, play the role of silent investor LPs in the investing process but do

not receive returns on their investment. Partners donate anywhere from $1 to $1 million (referred

to as the Leadership Circle partners) (Acumen Fund).

The Fund is divided into three sector investment portfolios; a portfolio manager with

extensive experience and technical knowledge in his or her particular market directs each

portfolio. The portfolio manager is responsible for selecting the investment opportunities and for

transferring knowledge to individual portfolio firms from networks of entrepreneurs, funding

institutions, philanthropists, and corporations. Portfolio managers are also supported by advisory

panels consisting of field experts. Additional support to local entrepreneurs is provided by the

on-the-ground American Fellows Program, which matches volunteer expertise with the specific

support needs of individual ventures (Zaidman 4).

Acumen’s main regions of focus are South Asia and East Africa, “where a $2-$3 per day

income meant increased economic stability” (Zaidman 2). In these regions, investments belong

to one of three sector portfolios: health technology, housing/financing, water innovations.

Potential investments (listed in Exhibit 4) are assessed in terms of fit with the specific strategy of

each portfolio:

• Health Technology: Assessed on ability to leverage technology to improve access to

quality healthcare through “reducing cost of treatments, new pricing models, novel

delivery systems, and public health communications technology” (Zaidman 5)

42

• Housing/Finance: Assessed on ability to prevent “social exclusion and economic

inequality through enterprises that expand economic opportunity” (Zaidman 5) as

well as increase access to technology, capital and markets

• Water Innovations: Assessed on ability to “improve access to clean water and water

management tools” (Zaidman 5)

Like many social investors, Acumen’s efforts are based on belief in the power of the

capital markets to create opportunities for the poor. The Fund functions as a model for

innovation, hoping to help spur larger flows of private capital to enterprises that serve the poor.

Acumen places importance on creating a viable model for venture investing in developing

countries by focusing only on a few investments to which significant resources and capital are

committed (Acumen Fund).

Through its involvement with high-profile partners, such as the Gates Millenium

Foundation, Acumen utilizes extensive networks of entrepreneurs, philanthropists, experts, and

corporations to channel necessary knowledge into its investments (Acumen Fund). Acumen’s

highly-localized operations allow the Fund to closely monitor and provide the necessary help to

foster business development. The focus on building a large network of resources has benefited

Acumen in being able to provide assistance to entrepreneurs with four fundamental concepts of

business development:

• Design: Focus on innovations that are “inexpensive, useful, and elegant while integrating

an understanding of poor as consumers.”

• Marketing: “Create demand through creativity and understanding individuals in the

marketplace.”

• Pricing: Find optimal pricing that poor can afford while sustaining enterprise.

43

• Distribution: Overcome infrastructure inadequacies by creating “distribution networks

that are inexpensive, flexible, and scalable.” (Acumen Fund).

As a non-profit organization, Acumen focuses on achieving both social and financial

returns. Targeted investors, however, do not receive any financial return on their philanthropic

capital. The Fund is unable to compensate such investors for the additional risk caused by the

creation of innovative services and products for low-income individuals in emerging economies.

To compensate for the lack of financial returns, Acumen informs investors about the impact of

investment compared with alternative uses for philanthropy (Zaidman 3).

Acumen is highly focused on performance metrics as a core part of operations. Monthly

reporting on investments allows the firm to measure portfolio performance along four criteria:

financial sustainability, social impact, scale, and cost effectiveness. In examining social impact

and scale, Acumen focuses on evaluating the investment’s output (count of goods/services

delivered on superior scale and cost), impact (measurable improvement in quality of life), and

systems change (transformation in marketplace for critical goods and services) (Acumen Fund).

The Fund also maintains a “scorecard” analysis for each investment to evaluate performance

along the four criteria mentioned as portfolio performance measures. Through the use of

scorecards, Acumen emphasizes the concurrent pursuit of both financial and specific social goals

for each investment (Acumen Fund; Clark et al. 28). Investors can clearly see the benefits of

donation thus far in the Fund’s life through measurement of investment impact:

Since making our first investment three years ago, more than 500,000 people have been protected from malaria, 12,000 women have received micro-finance loans, 5,000 farmers have increased their income by purchasing drip irrigation systems, and 11,000 families have bought life-saving de-fluoridation water filters (Acumen Fund).

44

Social Venture Fund: CARE Enterprise Partners

CARE Enterprise Partners (CEP) is at the forefront of innovative social venture capital,

aiming to draw larger private investors into the arena. CEP is an extension of CARECanada, a

non-profit organization focusing efforts on the developing world. The investment approach of

CEP is based on the premise of creating wealth to bridge the gap in the “missing middle,” or the

space between formal and informal economies in these countries. Business models targeted by

CEP generate both economic and social value in BOP markets that are usually disregarded by

traditional investments because of their small size (CARE Enterprise Partners). The organization

is based on the following goals: to implement a comprehensive approach to providing technical

help and capital deployment for use by entrepreneurs serving the poor, to demonstrate viability

of investing in SMEs in the developing world, and to pilot a Canadian fund as a model for filling

the “missing middle” (Making Markets Work for the Poor 19).

CEP’s funding consists of $10 million Canadian from CIDA-related (Canadian

International Development Agency) funds and $5 million Canadian from private investors.

Operating as a non-profit, CEP reinvests any returns back into the fund. To promote competitive

returns, however, CEP is organized as a for-profit venture fund with the following staff:

• Investment committee: Prominent Canadian professionals who function to add expertise

and management oversight

• Fund manager: Senior leader of daily operations who has background in developing

finance

• Market analyst: Catalyst in identifying investment opportunities through examining

markets/target industries

45

• Business development services expert: Provider of technical assistance through

supervising projects directly and overseeing local staff/consultants

• Local managers: Domestic experts in national market or subsector

• Field consultant: Analyst focused on thorough understanding of local market, may also

conduct technical-training sessions (Making Markets Work for the Poor 52-53)

CARE Enterprise Partners operates with a specific BOP initiative at its core. CEP targets

innovative enterprises that help micro-entrepreneurs at the BOP to connect with larger firms and

clients in the formal economy. Investments in 10-15 new/young enterprises are in the form of

seed capital of $25,000-$300,000 per investment (CARE Enterprise Partners). A list of portfolio

investments is located in Exhibit 5.

CEP investments are chosen based on several criteria in the following two categories:

“capacity to generate social value for poor communities and demonstrated plan for commercial

viability” (Making Markets Work for the Poor 44). Enterprises that qualify for funding must

illustrate service to the poor through either: at least 51% ownership by poor, employment of poor

as at least 50% workforce, provision of goods/services that have significant benefit to poor, or

status as recipient of CARE assistance not yet ready for market self-sufficiency. CEP targets

investments in sectors that promote sustainable development in the BOP such as health,

environment, water/sanitation, agriculture, food security, manufacturing/textiles, and

microfinance. In order to avoid conflicts of interest in promoting sustainable development, CEP

disqualifies any potential investment in firearms or tobacco. In evaluating potential investments,

CEP conducts a thorough analysis weighing the following metrics of an enterprise and its related

market: political stability, business environment, strength of opportunity, feasibility of pro-poor

46

enterprise solution, presence of willing partners, market distortions, existing investments,

environment, and gender (Making Markets Work for the Poor 46-47).

Funding for investments is tailored to specifically meet the needs of each individual

enterprise. When appropriate, CEP will issue short-term loans at low/no interest rate, patient

capital loans, medium to longer term debt, or equity stakes. All debt financing is made in local

funds and if possible issued with local partner institutions in order to lower management costs, as

well as reduce overall portfolio risk (Making Markets Work for the Poor 47).

Overall, CEP focuses on a bottom-up, demand-driven approach to alleviating poverty and

aiding development. By fostering capital accumulation among the poor through encouraging pro-

poor enterprise growth, CEP works to educate and empower the BOP market. Investments are

concentrated on demand-driven enterprises that fit a specific need for the poor, as CEP feels this

approach is better targeted, more efficient, and more effective in providing assistance. The most

unique aspect of CEP’s investment strategy is focusing on investments in “gateway agencies”

(enterprises that bridge the formal economy of the established private sector with the informal

economy of microentrepreneurs and consumers) in order to accomplish the following:

“aggregate production/buying power of poor, facilitate business linkages between formal and

informal economies, and generate positive social impact for poor through increased income and

growth opportunities” (CARE Enterprise Partners).

CEP’s investment strategy is modeled after traditional venture capital in terms of

diversification, but aims to promote sustainable growth and confidence amongst its investments.

In regards to diversification, CEP reduces its overall portfolio risk by maintaining geographic

diversification (no more than 40% of pool in one country), industry diversification (no more than

50% in any one subsector), and stage diversification (no more than 60% to incubate pro-poor

47

enterprises). To promote sustainable growth and confidence in entrepreneurs CEP avoids holding

a majority equity stake in any investment so as to not dictate overall strategy. By not holding

majority stakes in risky investments, CEP is also able to achieve a higher likelihood of successful

exit. Exit strategies for investments also focus on maintaining autonomy of the entrepreneur.

Equity swaps and stock buybacks are preferred methods of exit and are more feasible strategies

than public offerings given the smaller size of the enterprises (Making Markets Work for the

Poor 42-52).

To address the lack of necessary business acumen in most BOP entrepreneurs, CEP

emphasizes the importance of providing business development services throughout the

investment process. CEP partners with CARE Enterprise Assistance, another arm of

CARECanada, to provide tailored help with increasing market access, input supply, technology

and product development, training/technical assistance, and infrastructure development. Through

CARE Enterprise Assistance, smaller ventures also have access to otherwise unavailable

resources, such as a larger customer base and a wider variety of supplier options (CARE

Enterprise Partners).

CEP currently focuses on measurement of dual returns using financial performance and

social outcomes. As a non-profit, CEP considers successful investments to be those returning

initial funds for reinvestment, and not necessarily realizing above market returns. As

communicated by the organization’s developmentally-oriented goals, social improvements are

thought of as a better indicator of successful investment (Making Markets Work for the Poor 44-

46). CEP measures indicators that establish a ground for sustainable development, such as

number of jobs created and maintained rise in income, improvement in health conditions, rise in

education attendance, and increased food security (CARE Enterprise Partners).

48

Emerging Markets Private Equity Fund: Actis

With over 57 years of experience, Actis is a leading private equity fund manager

specializing in emerging markets. The firm was established in 2004 following a self-funded

management buyout from CDC Capital Partners (formerly Commonwealth Development

Corporation, a UK governmental organization for private sector investment in developing

countries). Actis is a for-profit firm that operates on two basic goals established by CDC: “To

invest in emerging market private equity to reduce poverty and to mobilize 3rd party capital to

further the effort” (Hardymon and Leamon 2). The firm operates under the motto of harnessing

“the positive power of capital” (Actis). As of June 2004, Actis was operating with 27 partners

and over 90 professionals located across 16 offices in Asia, Africa and Latin America.

The firm currently manages $3.0 billion of funds. Current funds include the following:

India Fund II ($325M), South Asia Fund II ($150M), China Fund II ($225M), Canada

Investment Fund for Africa ($162M), Africa Fund II ($310M), Malaysia Fund LP ($60M), and

Africa Empowerment Fund ($50M). The regional focus of funds and assets is illustrated in

Exhibit 6. Additionally, the Actis Umbrella Fund ($100M) is a uniquely diversified fund that

offers combined exposure to multiple emerging markets (Actis). The firm has seen myriad

successful investments in the recent past, including its investment in Chinese dairy producer

Mengniu, which yielded a 211% IRR at its IPO (Actis 10). Information on Actis funds in China

show remarkable performance prospects. With $286 million of funds under management, Actis

realized a gross portfolio return of 59% IRR and total portfolio return of IRR 28% (Actis 3).

The buyout of Actis in 2004 was in response to the UK government’s decision to create

an entity that is able to efficiently mobilize private capital and public funds. In splitting from

CDC, Actis acts as a general partner, with CDC as the limited partner. Actis maintains the duties

49

of raising money from third parties, and creating funds to meet the organization’s development

goals, as well as overseeing the entire investment cycle. CDC, as an LP, can invest in any

operations (not solely Actis) that achieve the original development goals set forth by the UK

government. This arrangement provides an incentive for Actis to maintain a variety of acceptable

funds (Hardymon and Leamon 8-9). Maintaining numerous funds of different investment focus

allows the firm to pursue both developmental and financial goals. Funds are focused on different

regions and have differing hurdle rates for internal returns according to the risk and growth

prospects of each region. By creating a variety of funds, Actis is able to effectively target

different investor objectives (Hardymon and Leamon 11).

Actis investments are screened for fit with the developmental goals established by the

UK government to “invest in emerging market private equity to reduce poverty” (Actis). The

firm focuses most investments on the emerging markets of Africa, China, Malaysia and South

Asia. Investments span numerous divisions, with emphasis on the energy sector as illustrated in

Exhibit 6. Actis primarily invests in energy through the use of Globeleq, an emerging markets

power operating company (Actis). Other types of investments that Actis focuses on in emerging

markets (especially China) include: domestic companies with global potential, domestic

companies serving local markets, and overseas companies transplanting operations to emerging

markets (Actis 8).

To ensure a positive social impact through its involvement, Actis assesses all potential

investments in terms of financial viability as well as on contributions to business integrity, social

improvement, environmental maintenance, and involvement in health and safety. If undertaking

a potential investment that is lacking in any of these areas, Actis helps the portfolio company in

50

developing an action plan to address the shortfalls. Actis will assist the company in providing the

appropriate management and monitoring to ensure achievement of these goals (Actis).

Actis focuses on later stage equity and mezzanine financing in amounts from $5 million

to $100 million. The most common methods of financing the firm uses are: expansion capital,

management buyouts, privatization, mezzanine finance (for infrastructure projects), and energy

financing (Actis).

Due to CDC’s long-standing history in emerging markets, Actis has the advantage of

large established networks and experience in its primary markets. Actis’s key strategies in

driving successful investment are: maintaining a clear geographic focus, on-the-ground

involvement with portfolio companies, and preserving large international networks of contacts

and expertise. As previously mentioned, Actis maintains several targeted geographic funds that

allow investors to focus on particular investment motivations related to development of the

different regions (Hardymon and Leamon 10). Actis maintains a long-term and hands-on

investing approach through working locally with the investment as needed, which encourages

sustainable success. Through Actis’s extensive network of contacts across its operations in

several emerging markets, the firm is able to provide portfolio companies with “support with

license bids and operational issues, identify new investment and expansion opportunities,

potential employees, local partners, and potential new suppliers, some of which were other Actis

investee companies” (Actis).

Actis evaluates the social impact of its investments in terms of fulfillment of the

principles relating to business integrity, social improvement, environmental maintenance, and

involvement in health and safety (Actis). Financial returns measured by IRR are the most

commonly used measure metric of investment success (Actis 3). Currently, given the

51

developmental stage of private equity in emerging markets, Actis targets “multiple agenda

investors who have broader agendas such as strategic or public policy interest” (Hardymon and

Leamon 11). However, the long-term target investor would have a purely financial interest in

order to most efficiently drive returns and build funds (Hardymon and Leamon 11). Similar

emerging markets private equity investors are listed in Exhibit 6.

Analysis of Best Practices

The purpose of this paper is to summarize possible best practices for development VC in

India and China, under the premise that investing in sustainable development will be in the best

interests of both the community (by alleviating poverty) and VC firms (by creating new highly

profitable markets). The previous four cases represent some of the most current innovative

approaches to pursuing VC in the Indian and Chinese economies. Due to the lack of reporting

information on these firms, analysis of these cases will not be based on success in terms of

measured financial or social returns. Instead, this paper will examine best practices that address

concurrent pursuit of profits and development in India and China. The following section will

discuss these best practices in terms of how the funds incorporate the strategic factors discussed

in previous sections that both encourage VC investment and support success in BOP markets.

Fundraising

Currently, VC funds operating in India and China with developmental focus receive

funding from various government and philanthropic organizations. As Lerner and Pacanins (4)

discuss, this type of funding does not encourage the most competitive allocation of investment

due to restrictions in fund use. For this reason, for-profit VC funds, such as responsAbility and

Actis, that provide competitive returns for their investors, are driven to constantly achieve better

52

performance. By providing returns in India and China, similar VC funds offer an advantage for

investors over philanthropic funds, thereby drawing more capital to these VC markets.

Investment Focus

This paper’s findings indicate that sustainable development in India and China is possible

by bridging the formal and informal sectors of the economy. All four of the funds incorporate

developmental goals that address this need. The most innovative models in bridging the gap

incorporate an intermediary party to help extend the reach of each fund’s financing to the poorest

populations. These models demonstrate adoption of the BOP operational strategy of providing

lower margin/higher volume investments through the use of a middle party. responsAbility’s

microfinance focus is a highly effective model to channel seed capital towards micro-

entrepreneurs and SMEs . This model, using financial intermediaries, allows funds to lower their

investment risk by involving MFIs that absorb the highest amount of risk while allowing the

MFIs to develop the necessary expertise to serve entrepreneurs. CARE Enterprise Partners’ focus

on “gateway agencies” also provides an interesting model for investment by focusing on service

intermediaries that can encourage micro-entrepreneurship. This model may be more costly, as it

requires more attention and expertise on part of the VC firm in order to understand the necessary

operations management gateway agencies need to establish.

Investment Structure

In the investment process, it is also important to develop a VC structure that is best suited

to the additional risks found in the Indian and Chinese markets, as supported by the BOP-focused

strategy of maintaining intensive risk management. CARE Enterprise Partner’s approach to

reducing investment risk presents a feasible solution by partnering with a local bank in providing

financing to risky investments. Use of local partners provides VC firms with a more informed,

53

insider view of the markets in which they are investing. Actis’ strategy of providing funding

through multiple regionally-focused funds allows the firms to further diversify their overall

portfolio, thereby mitigating some additional risk found in these markets. Additionally, all funds

reported successful reduction of risk through issuing smaller investments or fewer majority

equity positions.

Screening and Monitoring of Investment

The necessity for VC firms in India and China to maintain a close physical presence to

their portfolio companies is discussed earlier in the paper. Establishing local offices in these

markets also addresses the BOP strategic initiative of intensive risk management. All funds

discussed utilize some sort of local division of operations and recognize the importance of

understanding the culture in which they operate (achieving social embeddedness). Ranging from

responsAbility Microfinance Fund's close partnership with “best partners” in the local market to

Acumen’s directly established local market investment teams, the funds recognize the

importance of developing local access channels to better screen and monitor investments.

The firms have also developed various methods of providing quality service for their

portfolio companies, illustrating another group of best practices for BOP operations. Although

most VC funds focus on harvesting workforce talent, three of these funds report specific business

development services that provide fundamental business skills needed. CARE Enterprise

Partners and Acumen both leverage their network of associated organizations to provide

fundamental entrepreneurial skills and support. VC firms in India and China should recognize

the importance of creating networks that develop managerial talent through connections with

firms in other nations, educational institutions, and entrepreneurial associations.

Performance Measures

54

Measurement of performance in VC encourages funds to improve on their investments, in

turn driving growth of the industry. Performance in India and China should be considered using

both financial and social returns, as discussed previously, to develop a competitive environment

capable of both high financial gains and sustainable development. All four of the funds discussed

gauge the social impact of their investment through some measure of development such as job

creation. Acumen has a highly-developed scorecard method for evaluation of the effect on the

surrounding community. Both responsAbility and CARE Enterprise Partners use similar

methods, examining the effect of investment on specific indicators of community development.

Actis incorporates a broader approach in evaluation, looking at a full spectrum of social effects

similar to most corporate social responsibility initiatives. To best communicate the improvement

in sustainable development, firms must implement an indicator of social returns similar to

financial IRR in terms of simplicity for comparison and measurement.

55

Conclusion: Approaching New Frontiers in PE/VC

Private equity activity is increasing throughout the developing world as investors are

finding better opportunities relative to the saturated market of developed economies. However,

the expected stellar performance of economic superstars India and China has not yet occurred.

Instability and uncertainty have thus far impeded successful VC investment in India and China.

The unfamiliar environment of these countries, dominated by poverty, necessitates the ability for

firms to correctly adapt to the local condition of these markets.

The four case studies provided in this paper serve to highlight possible best practices VC

firms can incorporate into their Indian and Chinese funds. In terms of capital sources, VC

investment is best deployed through for-profit ventures using traditional investors to encourage

strong returns and efficiency in operations. Investment focus should incorporate the BOP

business strategy of providing low margin/high volume service through microfinance or gateway

enterprise investing. Investment structure must be augmented to address the BOP business

model’s need for intensive risk management to encourage successful performance. Screening and

monitoring of investment also requires firms to develop the capability of social embeddedness in

order to best serve the local market and most effectively manage risky investment. Lastly,

performance measures must incorporate the view of success through both financial and social

returns, in order to promote sustainable development as a key to maintaining and increasing

profitable operations.

The funds presented in this discussion represent only a small fraction of the innovation

currently occurring in the field of VC. They represent a new wave in community development

that holds great potential for solving fundamental problems involving poverty and mortality in

the most destitute areas of the world. Approaching these new frontiers of social development,

56

one can only feel excited about the prospects ahead and encouraged by the possibilities that are

within reach.

57

Appendix

Exhibit 1: Lifecycle of a Growing Business

0

R&D-None-

1

Start-upUp to $2.0

2

Early Growth$2 -10

3Accelerating

Growth$10-15

4Sustaining

Growth$25-40

5

Maturity$40 and up

Phase:

Activity Stage:Revenues in Millions

$500,000-1,000,0001-5

$500,000-2,500,0001-3

$2 million - 6 million2-3

$6 million - 15 million3-4

$15 million - 30 million2-5

$30 million +-

I Company Characteristics;CapitalizationLength of Phase (years)

Professional Managers;Complex Organization

Multi-layered ComplexManagement Organization

Founder or ProfessionalFormal Organization

2-3$100,000 (private)

1-3$750,000 (private)

2-3$1,500,000 (private)

1$7,500,000 (public or

senior privateplacement)

1-2$15,000,000 (insuranceCo. and other long-term

capital)

Ongoing(various)

Founder & AssociatesVery loose organization

FounderNo Organization

Founder or ProfessionalManager: Emerging

Organization

Management andOrganization

“Equity” FinancingNumber of investorsAverage Size(Nature)

II Principal Financing SourcesPrivate

Personal InvestmentIndividual InvestmentInvestment Firms (VC’s)Commercial Bank-PersonalCommercial Bank-Corp.Insurance Companies

Public Financing

Source: (Brophy 7)

Exhibit 2: Summary of Social Impact Assessment

Source: (Clark et al. 11)

58

Exhibit 3: responsAbility Microfinance Fund

Regional Investment Focus 03/31/05

E. Europe and Central Asia

39%

Latin America41%

E. Asia and Pacific

9%

Africa11%

Middle East and N. Africa

0%

Regional Investment Focus 12/31/05

E. Europe and Central

Asia47%

Latin America

42%

E. Asia and Pacific

1%

Africa9%

Middle East and N. Africa

1%

Source: (Microfinance- The MIX Market) Source: (Microfinance- The MIX Market)

Composition of Asset Class 2005

0%

25%

50%

75%

100%

Q105 Q205 Q305 Q405

% o

f inv

estm

ent

Loans and Debt Securities Equity

Source: (Microfinance- The MIX Market) Similar Microfinance Funds: INVESTMENT MINIMUM COMMENT

Calvert Foundation Community Investment Notes www.calvertfoundation.org

$1,000 Investors can earmark the notes to be invested in microfinance initiatives. Notes can earn up to 3%, depending on the note term.

Oikocredit USA Global Community Note www.oikocredit.org

$1,000 The capital raised from the notes is used to help finance various microlenders. Investors can choose returns of up to 2%.

MicroVest I Fund www.microvestfund.com

$100,000. Only available to accredited investors.

Fund makes both debt and equity investments in microlenders. Equity partners can expect to earn 7% to 9% annualized returns, while debt investors might earn 4.5% to 6%.

Accion Investments www.accion.org

$250,000. Only available to accredited investors.

Makes equity investments in microlenders and expects to generate about 8% to 10% annual returns.

Grameen Foundation USA Growth Guarantees www.gfusa.org

$1 million minimum letter of credit.

Guarantors do not contribute any money or get an upfront charitable deduction. Instead, they provide letters of credit which help guarantee loans by the lenders in developing countries.

Source: (Silverman D1)

59

Exhibit 4: Acumen Fund

List of Portfolio Investments: Portfolio Investment Name Location Description

HEALTH Project Impact India Affordable hearing aids Immunosensors Nicaragua Low-cost disease diagnostic platform SatelLife Africa Handheld PDAs for rural healthcare Aravind Eye

Hospital India Telemedicine for eyecare

A to Z Textile Mills East Africa Long-lasting anti-malaria bednets SHEF Kenya Micro-franchise drug distribution Voxiva Peru, India Remote healthcare communications BroadReach South Africa Efficient healthcare distribution HOUSING Saiban Pakistan Housing for low-income urban squatters Sekem Egypt Organic farming supply network

Kashf Pakistan Microlending for women Care with Love Egypt Healthcare training and employment Nadim Pakistan Training and employment for low-income artisans WATER IDE India India Affordable drip irrigation Heritage Livelihood

Services Provider India Improves water supply for slum dwellers

WaterHealth International

India Safe drinking water for the poor

Mytry De-Flouridation Filter Technologies

India Fluoride removal water filter

Source: (Acumen Fund) Exhibit 5: CARE Enterprise Partners List of Portfolio Companies:

Investment Name Location Description VegCARE Limited Kenya Links smallholder farmers to high-value export markets Streetwires South Africa Creates and markets contemporary African wire and bead

craft art Gone Rural Swaziland Creates and markets high quality grass-plaited homeware

products Livestock Marketing Enterprise Kenya Links farmers with resources to sell cattle Agricultural Marketing Initiative (AMI)

Uganda Loans and provides service to farmers at every stage of crop cycle

Village WEB/Bata Bangladesh Sources shoes from large producer and utilizes village distributors to reach rural market

Promexport Honduras Links Honduran coffee farmers to Quebec’s largest coffee retailer

Source: (Care Enterprise Partners)

60

Exhibit 6: Actis Fund Regional Focus of Funds and Assets Investment Sector Breakdown

Source: (Actis) Source: (Actis) Selected List of Portfolio Companies:

Investment Name Location Sector Alumnus Software South Asia IT & software Banco Solidario Latin America Financial services Celtel International Africa Telecommunications China National Offshore Oil Company Asia Pacific Minerals, oil & gas China Wolfberry Asia Pacific Food and drink CICO Technologies South Asia Chemical manufacturing Daksh South Asia IT & software Engro Chemicals South Asia Chemical manufacturing Flamingo Africa Agribusiness

Glenmark Pharmaceuticals South Asia Healthcare and pharmaceuticals

Globeleq Energy Grameenphone South Asia Telecommunications Housing Development Finance Corporation South Asia Financial services Jyothy Laboratories South Asia FMCG Mengniu Dairy Asia Pacific FMCG Nitrex Chemicals South Asia Chemical manufacturing Orascom Telecom Algeria Africa Telecommunications Powercom Asia Pacific Telecommunications Punjab Tractors South Asia Manufacturing Sify South Asia IT & software South Asia Gateway Terminals Asia Pacific Transport & logistics Tavant Technologies South Asia IT & software UTI Bank South Asia Financial services Source: (Actis)

61

Similar Emerging Market Private Equity Investors: AIF Capital Jahangir Siddiqui GroupAIG Capital Partners, Inc. Lincoln GroupAlfa Capital Partners Lombard InvestmentsAlothon Group Luxembourg Government Asian Development Bank Madagascar Development PartnersAureos Advisers Limited Median Fund Avenue Capital Group Mekong Capital, LtdBaring Private Equity Asia Limited Milbridge Capital Management BPE Investimentos Opus Electra and Partners Brait South Africa Limited Oxford Bioscience PartnersCapital International Poteza PartnersCaribbean Basin Investors Limited Rio Bravo Investments LimitedCDC Group plc Romanian-American Enterprise FundChrysCapital Scimitar Global VenturesCiticorp Venture Capital International SigmaBleyzerClearwater Capital Partners LLC Siguler Guff & Company LLCDebevoise & Plimpton Small Enterprise Assistance FundsEthos Private Equity Ltd SVG Advisers LimitedEuropean Investment Bank The Carlyle GroupEuroventures Ukraine Fund The Rohatyn Group Evolvence Capital Thousand Hills Venture FundExport Development Canada TMG Capital Partners Ltd FIR CAPITAL Partners Ltda. Trivella Investimentos FMO- Netherlands Development Company Tuninvest Finance Group Global Environment Fund Walden International Global Horizon Fund Warburg Pincus International LLCGP Investimentos Western NIS Enterprise Fund GVFL Limited Westmount Pacific LLC Zephyr Management, LP

Source: (EMPEA)

62

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