But consider how this scenario plays out in India. Let’s take Kalaari’s last fund of approximately $300 million for instance. An annual fee of 2% means that the firm gets nearly $6 million (Rs 37.5 crores) every year as management fees. That is a big chunk of change for a company operating in India, especially so when the team has only 3 GPs and around 10 supporting staff.
This “management fee bloat” problem is compounded by the fact that firms like Kalaari don’t operate just one fund. They have multiple funds active at any point in time with a total corpus exceeding $500 million in most cases. This means that the total management fee across all the funds that each of these VCs runs can easily top $10 million per year.
What is the hurdle rate?
Now consider the 20% carry. For a $300 million fund with a hurdle rate of 8%, the fund has to return $600 million to the LPs before it makes its own first dollar of profit. Given that the firm is likely to own around 15% of a portfolio company at the time of a successful exit, for the carry to merely match the $60 million or so management fee, the total exit value has to be well over $4 billion.
A large guaranteed management fee that a GP can get in the present against an uncertain carry that she may or may not get in the future.
Say hello to Mr. Moral Hazard.
A large management fee creates an “asymmetry penalty” where the VC makes out well, irrespective of whether the fund itself provides a profit or a loss to LPs. Interests are no longer aligned and generate further perverse incentives—most notably the urge to raise further follow-up funds, each bigger than the previous one.
Which brings us to the next structural problem in Indian VC firms.
If you have the right pedigree, it is easy enough for a new VC to raise her first fund. Sell the “India potential” story and chances are that there will be at least a few LPs who will be willing to bet on you.
But for the second fund onwards, you can’t flog potential. You need to demonstrate performance. Along two dimensions. First, in picking the right companies to back. Second and more important, by demonstrating gains in the value of your investments in these companies.
How do you demonstrate such gains?
In the old world, you would have to actually shepherd your portfolio company towards an exit event—either an IPO or an acquisition. But in the new world, it is much easier to show this. Ensure that your portfolio firm has raised a follow-on round at a nice valuation multiple to the previous round and you have “paper gains” to show your mettle.
In the old world, the way to raise a follow-on round was to demonstrate some significant improvement in a core business metric—revenue or profit. But in the new world, all you need to do is convince a large hedge-fund investor or Chinese behemoth to invest in you.
Tiger Global first triggered the trend of putting in large gobs of money into Indian startups like Flipkart and Ola at significantly higher valuations than their previous rounds, merely on the perceived potential of these startups.
This meant that pretty much every Indian investor who had portfolio companies that Tiger picked, could demonstrate huge markups in the value of their holdings. All these firms leveraged this “performance” to raise follow-up funds. Admittedly, Tiger has exited India now but its place has been taken by other sugar daddies like SoftBank and Tencent.
So why is this a bad thing?
Permit me to count the ways.