Does Venture debt make sense for banks?

Updated: April 3, 2018 11:55:35 AM

Last September, the Reserve Bank of India provided a much-needed clarity on the ability of banks to take part in venture funding. RBI gave a go-ahead for banks to invest up to 10 percent of the paid-up or unit capital in Category-I or Category-II Alternative Investment Funds.

Does Venture debt make sense for banks?

Sudip Bandyopadhyay

The Indian startup juggernaut is breaching new milestones every day. From raising eye-popping rounds to consolidation to attracting top CXO level talent, the startups have proved their worth on every count. Around 900 startups raised close to $14 billion last year. E-commerce giant Flipkart has raised close to $6.1 billion over the years in funding. Recently, read-to-cook food maker Fingerlix raised $1.3 million.

Clearly, the startup ecosystem lacks neither entrepreneurs nor investors ready to pump funds into new and innovative ideas. While new ideas are pouring in, the sector itself is over ten years old. Which leaves us with the question, when will banks join the party?

Bankers too have been silently watching the revolution and are exploring ways to hop on to the startups’ bus. Last September, the Reserve Bank of India provided a much-needed clarity on the ability of banks to take part in venture funding. RBI gave a go-ahead for banks to invest up to 10 percent of the paid-up or unit capital in Category-I or Category-II Alternative Investment Funds. Private equity and venture debt fund falls under the Category II, as specified by the Central Bank. This is proving to be a booster shot for bankers keen on backing startups.

Currently, two Indian banks have joined forces with venture investors and backed their Venture Debt Fund. Alteria Capital partnered with IndusInd Bank and Ratnakar Bank partnered with Trifecta Capital for similar funds. It is important to note that mid-sized banks and large banks are most excited to partner venture debt funds.

Why does VDF make sense?

Does it make sense for banks to launch venture debt funds? Currently, bank lending can be categorized in two major areas – retail and corporate. Today, banks are burdened with NPAs sitting on their books and generally muted economy, thereby left with tepid growth.

While industries and other sectors too are playing the wait-and-watch game, startups are not flinching before investing money into new ventures. Venture capital funds and Angel investors have returns that are significant, in very short periods of time. It is low hanging fruit for banks with attractive returns in the horizon.

Bank can earn good interest by investing in Venture debt funds that lend to startups. Project finance and providing lines of credit for working capital to large companies provides lower rates of return than funding a company, which is charting a high growth path.

Corporate loans vs VDFs

VDF interest rate is much higher than traditional lending, and brings an opportunity for banks to earn high yields. These funds are also flexible as VDF pays banks interest rates on quarterly basis, from the debt fund. These funds also have provisions to acquire in the borrowing startup Company, equity warrants along with debt, which have the potential to generate significant returns if a venture turns successful. More so, since a VDF handles all the operational efforts of investments, these returns can come with lesser efforts. Currently, such fast-growing innovators cannot borrow directly from banks due to traditional collateral-based loan rule.

A large number of startups are on path to become SMEs or MSMEs or even listed entities in the future. Early relationship with startups can help establish a lasting source of income. When a bank invests in VDF, the bank may retain multiple rights as to where a VDF will lend, which may also include offering: banking facilities to the startup exclusively. Subsequently, banks can benefit through CASA and transactions fees apart from the VDF investments.

How do VDFs work?

Venture Debt Funds lend money to startups in a structured manner. A lot of startups fail when they face delays in payments and end up exhausting all their cash. Being cash positive is their biggest financial challenge and VDFs infuse structure cash flow into such startups and protect them against failure. When startups know that there is a steady flow of cash from VDFs, there are fewer chances of failure.

Challenges for banks

Though VDFs sound very lucrative, like attractive investments but they come with their own limitations. Banks are still guided by traditional principles, which make it tough for them to absorb new or unheard-of category of investments in funds lending to startup sector where success rate is doubtful. Banks are too regulated, making it painful for them to streamline their processes, especially their risk mechanisms, which are tailor-made for corporates and not startups.

(By Sudip Bandyopadhyay, Managing Partner at Unicorn India Ventures)

Views in this column are author’s own, and do not necessarily reflect the opinion of www.financialexpress.com

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