Catalysing Venture Capital Funding

The importance of venture capital (VC) for business growth is critical, as the VC funding is available to nascent companies with little financial wherewithal and no track record but strong products or services and innovative business models.

Such funding helps these early-stage companies to grow beyond a certain level and also bring in innovation into the overall business landscape. VC funding is generally funneled into these companies after the seed capital infusion and is critical for them, as they often find it hard to get funding from other commercial sources.

The absence of any ‘angel investor’ networks also prevents these early stage companies to look elsewhere for capital. VC funds provide these companies the much-needed capital to take off the ground and these companies in turn generate employment, contribute to economic growth and more importantly help diversify the economic base. In a country like ours, venture capital can play a vital role in spurring new business activity and job creation.

Venture capital industry has had little success here so far, with only a handful of companies providing VC funding. The World Bank has ranked Pakistan 61 in the world in terms of venture capital availability, as opposed to Indonesia, Malaysia and India at 18th, 19th and 20th positions respectively. In recent years, one or two international VC companies have also looked at Pakistani market but so far have had little outstanding portfolio. Abraaj Capital’s investment in KESC may be only one of the exceptions, which despite being a private equity deal was not a typical VC transaction.

Some of the international development agencies have also endeavoured to provide VC funding in Pakistan in collaboration with the private sector partners but these joint initiatives have also not been very successful. The situation has failed to improve despite the availability of a decent regulatory regime in the shape of initially the Non-Banking Finance Companies Rules of 2003 and more recently the Private Equity and Venture Capital Fund Regulations of 2008.

The key hurdles in VC growth do not lie in the form of a restraining regulatory regime. Instead there are scores of other issues, which prevent the VC companies to flourish, especially including a limited pipeline of potential deals and dearth of exit opportunities.

Most of the VC companies, invest in selected sectors in deals ranging within a certain transaction size. According to the US National Venture Capital Association, the average deal size in 2009 was close to $8 million. In Pakistan, not only these deals are rare to find, the average deal size is typically small. Furthermore the absence of a commercial complaint redressal system and poor contract enforcement discourage these companies in picking up a stake in local businesses. The local businessmen also have limited appetite for entrepreneurial ventures and control issues typically prevail in family owned businesses.

While implementing a better contract enforcement regime and providing alternate commercial dispute resolution may address the problem from the state’s perspective, changing the business attitude and breeding an entrepreneurial culture may be a slower process requiring initiation of change from multiple levels, including universities, etc. Another critical issue hampering VC growth is the lack of appropriate exit opportunities. VC companies’ investment horizon is rarely more than 5-7 years, after which they exit the market, making profits on their high-risk investments. Such exits mostly come through IPOs of the target companies or in some cases through strategic sales, etc. These exit opportunities are difficult to materialise due to limited public interest in IPOs and new stock offerings. The bourses are marred with speculative investments and investors are quite apprehensive in putting their money into new enterprises.

Day traders having short investment horizons, dominate most of the investment activity. This lack of interest in capital markets by general investors hints towards weak capital markets which must be strengthened, not only to support the VC investment but also to help grow the new companies from VC-funding stage to maturity and growth. The capital market reforms however, must be carried out with a strong political commitment along with developing institutional capacity for adequate surveillance.

While multiple efforts are required at various levels for promotion of venture capital, the state should take the driving seat, through adequate policy reforms, direct investment into targeted venture capital funds and availability of potential deals through divestment in state-owned enterprises.

In recent years, countries like China, Malaysia and India have adopted similar courses with successful results. The state initially should assume the role of catalysing a collaborative initiative for this purpose, involving various stakeholders, such as investors, academia and international donors to work towards breeding an entrepreneurial culture.

Pakistan remains a difficult destination for venture capital industry, especially for the international VC Funds considering the worsening law and order situation and the recessionary economic trends. However, timely interventions by the government and other stakeholders can definitely set the stage for venture capital growth.

This article was originally published in the Daily Dawn.