GalaTime: Risk mitigation for investors in MSMEs

galatime.com - Kaushik Gala

Note: The views & opinions expressed in these essays are strictly my own, and not those of any entity I may be associated with as an employee, consultant, promoter, investor, etc.

Risk mitigation for investors in MSMEs

(Last revised 16-Mar-2010, Send comments to galatime@gmail.com)

Given the numerous issues w.r.t. risk funding of MSMEs, people across the world have come up with innovative solutions. Many of them are driven by non-profits / not-for-profits such as Jacqueline Novogratz's Acumen Fund. There are many ideas we can borrow while considering risk capital for (innovative, high-growth) MSMEs in India. Here are a few.

Investment business model

There has been ample research on the negative effects of management fees on investment returns. Obviously, this is true for mutual funds, hedge funds, VCs as well as private equity firms. A 2-and-20 model automatically raises the bar on expected IRR from each investment in the portfolio. A low-cost model to venture funding lowers the IRR needed from each investment, thus lowering the risk that needs to be taken by the investment manager.

A recent example is Right Side Capital, which is a US VC firm. But this low-cost approach is especially relevant for emerging / developing countries; an example is Equity for Africa (EFA). Here is what they have to say:

"Transaction costs are reduced by sourcing local, reliable staff, and using a few skilled people to design, develop and oversee the process at charity salaries rather than MBA salaries. No frills: no business class flights, no US$ 10,000 memberships of development networks, no international networking conferences, no Western-style hotels."

Investment focus

This is not new in the sense that VCs tend to stick to domains where they have an 'edge'. But it is interesting how angels/VCs differ in how they define their focus areas.

For example:

Acumen has aligned its investment portfolios along global issues: Health, Water, Energy, Housing, Agriculture
EFA focuses on investments in the $2K-$75K range, Y-Combinator puts in $20K for 2-10%, etc.
Ron Conway & Mike Maples are angel investors, but Ron has invested $50-$100K per deal across 500+ tech startups, while Maples focuses on 'capital efficient' startups and will invest even $500K.
Andreessen Horowitz invests in Internet/IT startups based in Silicon Valley, prefers technical founders as CEOs and is keen to understand/define the products built by its investees.

There are many ways to slice the pie, but the lesson is to focus on strengths that lead to a better risk-reward ratio.

Controlling fraud

Investing risk capital into MSMEs, especially in developing countries, must address the prevalence of fraud. While evaluation and due diligence prior to investment can help filter out most cases, it is important to design the investment such that it deters fraudulent behavior.

For example:

Provide capital directly to investees' suppliers, landlords, employees, creditors, service providers, etc.
Require MSMEs to get rated annually - via agencies such as SMERA, CRISIL, ICRA; note that the government subsidizes some of the rating fees via the Ministry of MSME.
Incorporate investment terms that create personal liabilities in case of fraud.
Deploy capital in installments tied to milestones, thus buying time to learn more about the investee.
Use board observers to keep an eye on company operations and strategy.
Focus by geography/industry sector, where reputation risk is high for the investee.
Use company ownership structure, entrepreneur personality/background, age of venture, etc. as leading indicators of performance

What is most important is that these do not drive away the genuinely good MSMEs (aka adverse selection).

Simplification, standardization

Seed-stage investors in the US - for example: Y Combinator - are leading this shift towards simpler investment process, standardized term sheets, transparent agreements, etc. There are now in fact four excellent sources of publicly available documents for seed-stage investments:

Legal costs become much lesser with such easy access to high-quality resources, combined with standard investment terms. While some terms need to be modified to comply with Indian law, this is much easier than finding rare (expensive!) CAs/lawyers in India who understand (ad)venture capital.

Technology

While most Indian MSMEs may not be tech-savvy, an MSME-oriented venture fund can certainly use technology wisely throughout the investment process. For example, Angelsoft provides "simple, powerful, deal-flow and portfolio management tools for accepting, tracking and collaborating on early-stage investments". I think there are even opportunities to use data-driven algorithms to sort out investment candidates, much like 'quant' investment strategies. This, of course, runs counter to the 'expert' method of VC investing.

Again, see how EFA uses technology to streamline risk funding for MSMEs:

"Well-designed software also improves efficiency, and appropriate SMS technology can enhance this further. It is important to emphasize that this is not a question of the more innovative the better: this is about consistent, single-minded delivery."

A combination of the above - plus a few inventive modifications - ought to result in a viable business model for risk funding of innovative, high-growth MSMEs in India.