Seriously clueless

India, private equity and more ...

Sunday, October 30, 2005


As reinforced by the recent Knowledge@Wharton article on Warburg Pincus, most private equity investors in India have focused on later-stage investments in mature industries. Over 80% of the $3-odd billion invested in India over the last 3 years are in late-stage companies. 90% of investments have been in fairly mature industries, such as construction, financial services, hotels, manufacturing, pharma, healthcare, IT/BPO and energy.

At first glance, this seems quite simple and low-risk. We know there is strong demand. The products and services are standard. There is no technology risk or long product development cycle. All that is needed is for the company to execute to plan. That’s where is gets complicated. Execution isn’t as simple as it looks on paper (or powerpoint). In fact, the only thing that differentiates between companies in India is strong execution.

Let’s take the Bharti example. At the time Warburg invested, Bharti was one of a dozen emerging telcos, that each had a circle or two. Without the benefit of hindsight, all these companies looked more or less alike. All of them had access to the same network equipment, billing software, vendors, consultants, you-name-it. They all hired from the same pool of ex-FMCG managers to handle sales, distribution and marketing. While not all of them raised $ 600 million, access to capital wasn’t an issue either as everyone was affiliated to one business group or another. Today, Bharti’s a clear market leader, while several of the others don’t even exist anymore. Bharti has done the same things all telcos did – roll-out network, get the best price/service from vendors, market services, take care of bad debts, handle customer complaints etc. Only, they’ve done each of these just a little bit better and more consistently. It’s been plain, old-fashioned execution and managerial ability. The same story repeats itself as you look at companies such as HDFC Bank, Infosys or Bharat Forge.

As an investor in India, the single most important parameter to assess is the company’s execution ability. This ties in directly to the emphasis on later stage investments, as the only way to ascertain this is to actually see it in action. The main question is how long must one wait to figure out if this is a company that can execute its way to becoming a market leader?

To answer this question, let me take a specific sector – retail – as an illustration. I break up any retailer’s evolution into two phases – a trial & error phase, followed by an expansion phase. The first phase is where one figures out the right business model specific to the Indian context. This is an iterative process that can take several years. FoodWorld was the first organized retailer in India, starting in my hometown – Madras. They toiled many years with the supermarket format, before finally figuring out that this format doesn’t work and have now shifted focus to a big-box hypermarket format. The coffee chain Barista has gone through three owners and as many CEOs, in trying to figure out its positioning and pricing. Many others are grappling with choices to be made on store formats, size, own-vs-franchise etc. Once the right model is established, it’s a question of scaling up by rolling out a proven model across cities, regions and more stores. The most optimal approach is to stay small and preferably stick to one city/region in the first phase. This limits the amount of capital being expended on the ‘error’ part of trial & error. Besides getting the model right, this phase also demonstrates the ability of the core team to pull this off.

For an investor, the best risk-reward is to invest after the first phase, in a proven business model and team that can then expand significantly with access to capital. In predominantly execution-driven businesses (as opposed to those based on IP or innovation), I’d rather not invest early. This execution thing is way harder than it looks!

Here’s some food for thought. Warburg made about 6 times their investment in Bharti over approximately six years. If you or I had bought Bharti stock in 2002, we’d have made over 10 times our money in 3 years. Better late than early?

Saturday, October 22, 2005

Meet yet another Flocker

If all Bangalorians are like Honey, I pity Americans about to graduate college. They're up against a hungry, polite, Excel-proficient Indian army. Put it this way: Honey ends her emails with "Right time for right action, starts now!" Your average American assistant believes the "right time for right action" starts after a Starbucks venti latte and a discussion of last night's Amazing Race 8. - Esquire Magazine: My Outsourced Life

My first post from Flock. It been all of two hours, and Flock rocks already!

I visited a BPO set-up in Hyderabad earlier this week, and it felt scarily close to what AJ Jacobs writes in My Outsourced Life. I too met with a set of hungry, polite, computer-savvy and extremely competent people who had honed mundane tech-support activities into a fine art. Including an in-house software tool that allows clients to monitor any of their agents' calls real-time over the internet and tag live feedback to the call-transcript. This feedback is in-turn used in training and performance improvement. At one level I felt sorry for agents who had to live with every minute of their work being monitored by big-brother. That apart, I left feeling that the world would never be the same again, after the take-over by these hordes of young, motivated, tech-enabled agents striving to achieve customer service nirvana.

Tuesday, October 18, 2005

Valuation - Neither here nor there

In my first year at IIT Madras, I learnt the difference between accuracy and precision. Accuracy is how close a measured/estimated value is to the true or actual value (assuming that one exists). Precision reflects the repeatability or consistency of measured values across different experimental set-ups and observers. Nowadays, I am reminded of these whenever I get into discussion (debate, really) on valuation.

In early-stage investing, valuation is simpler. There is no question of being either accurate or precise, since valuation has little to do with the company’s worth at that point of time. Valuation is a derived number from how much capital the company needs and the % of the company the VCs would like to own given the high-risk nature of the investment. Except for a vague sense that the market being addressed is adequately large, there is no pretense of knowing future revenues or profitability. Almost all early stage investments are through preferred instruments that are more like a loan with an option than straight equity and traditional valuation techniques are irrelevant. Brad Feld and Fred Wilson’s posts on this topic are quite insightful.

At the other extreme, valuation of large publicly-listed companies is simple too! Not so much in an absolute sense, but relative to smaller, less-predictable companies. Besides the traded stock price, these companies have dozens of equity analysts figuring out what the stock is worth and which way it will move. The true value of these stocks is as much a function of supply-demand and investor preferences, as they are of cash flows and discount rates. So, accuracy is questionable, but the level of precision is far higher. Analyst estimates and the actual stock price typically fall within a reasonable band. Most prospective investors are price-takers and the only decision to be made is whether to buy or avoid (alternately, sell or hold).

It is hardest to agree on a valuation in those companies that are somewhere between the above two extremes. In India, most investment opportunities that we see are in companies that are somewhere between $5 million and $100-odd million in size. These are often privately-held and almost always project rapid growth (that’s why they need the funds in the first place). The valuation dance gets messy, as these are neither here nor there. Given the small size and relatively early stage in their lifecycle, their future performance is subject to a high level of variability. At the same time, they are not starting from zero, and offer some basis (or at least, pretense) to link valuation to past or future financials.

I believe that the agreed valuation has little to do with the projected financials. It is a lot more about the softer factors – supply-demand for deals, relationships, competitive dynamics, bull or bear nature of the investing environment. The actual projections and valuation techniques tend to be more distracting than helpful. Traditional approaches that are used in valuing larger companies are mostly irrelevant:

  • Forward P/E: This is the most popular metric, and people spend days arguing over what the multiple should be. My view is – forget the multiple, even the next 12 months’ earnings are debatable in such companies. Typically, the company expects to double earnings and the investor thinks the company will be lucky to grow at 50%. If you get past this, then try agreeing on a roughly comparable listed company. Most benchmarks are from companies that are a lot larger and less risky, and tend to vary widely even within a sector.
  • Discounted cash flow: Expectations on projected growth rates and profitability vary so widely for this method is the least useful. Between a company growing at 30% (investor’s view) and 50% (company’s view), the DCF outcome varies by a factor of two.
  • Other comparable deals: Baidu’s valuation is nice, but pegging off this to value an Indian internet company is a big stretch. M&A valuations are even more amusing – “Did you know that Cisco bought TinyCo for $ _ million”! Sure, but strategic buyers have an entirely different rationale for investing in start-ups.

The above techniques and numbers are ok for the both sides to separately figure out what they are willing to pay/accept. Arguing over input-metrics - growth rates, profitability, multiples – is futile. Simply ‘agree to disagree’ and move onto price. If the gap is over 30%, shake hands and get on with your lives (by the way, walking away can call any bluffs that were there in the first place). If the gap is under 30%, keep going. Time and sheer attrition will narrow the gap! Or, someone else will offer a higher price and its back to ‘take it or leave it’.

My philosophy in such discussions is simple. As an investor, I am entering a 5-year partnership with a great team going after a large market. Both sides are seriously clueless on where the company will be after 5 years. It is more important for all parties to feel positive and motivated about getting into this partnership than it is for any one party to get the best bargain. Obviously, both sides are unlikely to be wildly happy at the end of the valuation discussion. The ideal outcome is one where both sides come away thinking “I’d have been really pleased if the price was 10% lower/higher, but I am ok with this deal. More importantly, I liked the way these guys handled this.”

Monday, October 17, 2005

Something's got to give

I am at the departure lounge of Mumbai’s domestic airport, as yet another flight is delayed for over an hour. I get the feeling that both frequency and magnitude of airline delays have increased in the last few months. The slew of budget airlines have done a great job of pushing fares down and opening up more flight options. However, our airport infrastructure is not keeping up with the increased load. Even as the Indian private sector keeps chugging along, public infrastructure is just not keeping up. New flights are being added, but runways are not. New plants are being built, but there isn’t enough power to run them. World class software companies in Bangalore face the world’s worst traffic jams. The difference in quality and service between privately owned and publicly owned companies is stark. Telecom is a good example. I am posting this using my Tata Indicom data card that gives me very reliable wireless internet access from anywhere in India. The MTNL broadband connection that I applied for 2 months back is yet to arrive. In fact, I have no idea of its status. And this is in an industry where the incumbent PSUs are no longer monopolies. Our culture of subsidizing a few million employees at the expense of a billion consumers cannot continue. As we strive to reach 8% GDP growth, something’s got to give.

Wednesday, October 12, 2005


Today was a delightfully lazy day. The usual – late start, cricket on TV (Laxman is God), leisurely newspaper read, blogging, afternoon nap, lots of coffee, good book (called Against The Gods, on the history of risk). In short, it felt like any other weekend, until I remembered that it was a holiday due to Dusshera. That got me thinking.

Around how different festivals feel now, compared to when I was growing up. At home in Madras, festival days certainly felt different from regular weekend days. Navratri meant golu (an arrangement of colorful dolls, kept for 9 days), sundal to eat and visits to friends & family. Deepavali meant early morning oil-baths, crackers and new clothes. Don’t forget the new Rajinikant movie release (though, I personally fell in the Kamalhaasan camp). We also had a fair share of rituals and prayers. While I’ve never been very religious, I quite like the symbolism in most of these. They made me feel connected to friends, family, culture, tradition, history, religion, mythology and most importantly, the broader society around me. The spring harvest is certainly worth celebrating in what is still a very agrarian economy. Similarly, the triumph of good over evil, the love of a wife-for-husband or sister-for-brother, return of triumphant kings after adventure, birth, a new year dawning and the like are good reasons to get together and celebrate.

Like several others, my wife and I live in a different city than the ones we grew up in and are physically separated from immediate family. We lead busy, yet fulfilling, professional lives. We are both quite irreligious. While we observe Mumbai celebrating many festivities, we don’t follow any rituals or pujas at home. These are personal choices that we’ve made, are comfortable with and unlikely to change.

However, I do miss the feeling of connectedness that comes from being a part of these celebrations. Even if I am not a believer myself!

Investing in India (2 of 3) - Labor arbitrage+

Every rupee invested in Bharat Forge 3 years back would be worth over Rs. 12 today. Infosys’ profits have grown on average at 67% annually since 1999. A single investment in Spectramind returned ChrysCapital’s entire first fund. These and other impressive factoids stem from one underlying concept – labor arbitrage. The logic for this opportunity is simple – 40% of the world’s working age population is in India and China. And for most of the workforce, salaries are as low as 10-15% of those in US, Western Europe and Japan. And how large is this opportunity, to relocate jobs to these countries? Just look at the P&L of any company, for labor cost that is embedded into COGS, sales/marketing, G&A, R&D and overheads. It doesn’t end there. There is labor cost in their service providers’ billings – utility companies, telcos, banks, insurers employ large numbers of people to service their customers. Then, go one level deeper into each company’s salaries and see how their employees spend their money – retail, consumer goods, healthcare, hotels, airlines all have their own labor cost. As long as cost savings more than cover increased physical and virtual coordination costs, several labor-intensive activities (except a few high-touch and critical ones) can be performed remotely from low-cost countries such as India and China. And to restate the obvious, coordination costs have dropped dramatically over the last decade, allowing a thousand call centers to bloom!

Personally, this opportunity is the most boring and the most significant among the three that I mentioned. Boring, since these are simply existing products/services being delivered from a new location. Significant, since this can comfortably scale into the 100s of billions of $ over the next decade. India’s FY05 exports of IT, BPO, textiles, auto components and pharmaceuticals add up to $12.2 billion, $ 5.1 billion, $ 14 billion, $ 1.2 billion and $ 3 billion respectively. At a 30% growth rate, this would reach $100 billion in 4 years! For that much money, I can put up with some boring stuff! (FYI, China’s exports are 6x that of India).

All this is nice, but where do I invest? Let me start with manufacturing, for a change. Auto components offers great potential, since the opportunity is led as much by high-skill engineering as by low cost shop-floor labor. Industry cost pressures are immense, as reflected in this morning’s headlines on GM, Delphi and Dana. I’ve personally spoken to purchasing managers at global auto OEMs who have a target to move 30% of their components to low-cost countries (the math works out to $250 billion). With a premium on quality/precision, timely delivery directly to the production line and turning around new designs quickly, this plays to India’s advantages. The key is to look for companies that have strong in-house skills in product design, tool/die design, indigenization of capital equipment (this can reduce capital cost by as much as 5-10x) and a focus on high-precision components. Earlier this year, we invested in Rico Auto, for precisely these reasons. With industry exports at $1.2 billion, there is a lot of headroom left to grow.

Pharmaceutical exports, that leverage process chemistry skills, also offer similar scope. However, I do find a few concern areas here. To start with, product costs are a very small part of the final sale price, with R&D and sales/marketing being far larger cost heads. There are also regulatory risks in patent challenges that are very hard to assess. Unlike relatively stable car (and component) prices, drug prices tend to crash once they go off-patent, potentially squeezing margins more than anticipated. To address and/or bypass these risks, companies are evolving new business models around contract research, contract manufacturing and clinical trials. While I remain bullish on the sector, picking specific companies to invest in requires a thorough understanding of each of these risks, in the context of the company’s focus area and business model. I’ll be honest in admitting that I am not a pharma expert, and actively invite comments on this topic.

Textiles are India’s largest export category, in revenue terms. However, the China-factor looms largest here, especially in products with lower levels of value-add. I find the argument that ‘retailers will buy from India, to hedge their China concentration risk’ hard to accept as a sustainable demand driver. I would rather invest in companies that can sustain their market and profitability in their own right, through making finished garments that meet global design and quality levels, at a competitive price. Companies like Gokaldas and Zodiac are succeeding in doing this, and I see more of these emerging.

Now, services. I’ll pass on IT Services in this piece, since this is too well understood for me to say anything interesting. Further, most players are generating so much cash, that they don’t really need growth capital from external investors like us.

The 1st wave of BPO companies were funded in 1999-2000. I compare these to the first 15 overs of a one-day cricket match, played on the sub-continent. You’re in early. Huge opportunity (hardly any fielders outside the circle, docile wicket). The strategy is to get going quickly and make the most of it. Who cares about sound technique. Someone else can consolidate the innings later! My test for separating these first-15-overs deals from later ones is very simple – do a ctrl-F for words such as ‘profit’ or ‘margins’ in any press release on both the entry and exit. If you get zero results, there you go. These are top-line and potential driven, similar to internet deals in the days gone by. An astute reader would figure out that Skype falls into this category!

BPO today is more of a test match. Minor details such as cost and profitability matter. Consolidation and big-getting-bigger are imminent. While I wish I were investing 5 years ago, I have to live with what I have now. The basic horizontal services – data entry, customer service, transaction processing – are well covered by the incumbents. There is a second wave of more focused, niche BPO services companies that are emerging. I find the KPO phrase quite contrived (When was the last time you used the phrase ‘knowledge process’ in everyday conversation, with a straight face? If you did, my condolences!). Like web 2.0, it is a good catch-phrase that may yield higher valuations from the unsuspecting. The main challenges facing these niche-BPO companies are scalability, a much harder selling process and people-retention. Niches are called that for a good reason. Several such areas are amenable to companies reaching $10+ million revenue, but not a lot more. Further, individual contracts tend to be both project-like (as opposed to ongoing processes) and small (I’ve heard of 1 FTE contracts), in areas such as analytics and research. Such services are more core to what the client does, making it a hard-sell. Internal teams at the client themselves are fragmented and de-centralized (retailers and consumer goods companies have research/analytics people embedded into each business division/department, making outsourcing even harder). By definition, such BPO companies employ people with higher skills and commensurate aspirations. Such people are harder to retain. A good financial analyst would rather work in a client-facing role with an investment bank, than in a back-office, vendor set-up.

If you are running a niche BPO company, and have figured these out, what are you waiting for – give me a call!

Sunday, October 09, 2005

Whats wrong with this picture?

Every newspaper, magazine and TV channel covers the Indian consumer boom with monotonous regularity. I am numb from hearing terms such as 300-million-middle-class, rising aspirations, credit-culture etc. One of my pet peeves is that most of these articles (and the data they quote therein) are poorly researched, inconsistent or plain wrong. What worries me further is a culture where we as readers/viewers neither notice nor question these mistakes. I would like to use a recent example to highlight the fact that we are relatively loose with data and assertions. My objective is to get each of you to ask “Hey, does this make sense?” the next time you see any data being thrown across by so-called experts and then come to an independent, fact-based and rational view-point. Take a good look at the chart that I have attached. This is from a recent research report on the Indian consumer, published by the equity research division of a decent investment bank. Further, the chart quotes its source as market research done by another well-known consultancy. Given this pedigree, one would assume that they have their facts right. I did so too, and my first reaction was that the Indian consumer spend on lifestyle categories was a significant 30% (add up books&music, entertainment, movies, eating out and vacation). Just as I was thinking that I needed to apologize for being wrong in my more pessimistic post on the same topic, I noticed that this picture didn’t really add up. Take a second look. What do you think? Here’s what I thought:

  • These categories cannot possibly add up to 100% - what about health, education, rent (or EMI on home loan), power/fuel, transportation, communication??? I didn’t know these were free!
  • Some glaring inconsistencies, both within the report and with respect to market data
    • A 10% eating-out expense is great news for restaurants. Then I wonder why the report goes on to size the restaurant market at Rs. 11,500 crore vs Rs. 17,600 crore for branded apparel (after all, this says that entire clothing spend is only 7% of the basket). Don’t even mention the fact that branded apparel in India accounts for under a third of the total apparel market.
    • The chart claims that people spend more money on books & music than on durables. A quick google search on “India music industry size” throws up an estimate of Rs. 450 crore. I don’t have an estimate on books, but expect it to be in the same order of magnitude. TVs alone sell over Rs. 13,000 crore a year.
I know I’ve quoted all-India market sizes, while the chart refers to urban spend (wonder if you noticed!). However, my comparisons are like-to-like, and shows that some of these inconsistencies are glaring and off by an order of magnitude. I encourage you to spot other mistakes in this data (e.g. savings look kinda low, wonder how large the Indian movie industry is). Note that I’ve taken an example from a detailed (the entire report is over 180 pages) report, published by a good quality firm, targeted at discerning investors. This problem is a lot worse in newspaper and TV sound-bites. All I can say is, Reader Beware.

Wednesday, October 05, 2005

Investing in India (3 of 3) - Holy Grail

Based on the feedback I received, I decided to switch the order of the remaining 2 posts of this trilogy. Let me talk about the more interesting area first - Indian IP-led companies. The Holy Grail for any VC is what Christian Mayaud calls a MOTU investment. A recent MOTU example is Bessemer’s investment in Skype that returned well over 100x returns in 2 years, when Ebay acquired Skype. Such dramatic value creation in a relatively short time-span can only occur through technology that is both truly innovative and incredibly simple to use, thereby fueling widespread adoption. Can the next generation of such companies originate in India? Or will we continue only in the (Revenue = # of employees * utilization * billing rate) set of industries? There’s always the chance that we see a blazing genius from IIT Madras (ha, ha – slipped that one in) come up with a revolutionary technology that will change the world (hopefully for the better). Serendipity apart, what we need is a thriving Silicon-valley-type ecosystem that systematically allows new technologies to emerge, develop and get commercialized. Dozens of books have been written on the Valley and what makes it tick, by people far wiser than me. Let me stick to what I’ve seen in India that makes me confident about our ability to create successful, innovative companies in the long term. I’ve spent a lot of time in Bangalore over the last year. Based on what I’ve seen, I am convinced that is a question of when-rather-than-if before we see home-grown innovative product companies that could dominate their respective markets. Here is a set of anecdotal, yet indicative, evidence to support my confidence:

  • World-class product design now done in India: I met one of the smartest guys from my undergrad class, with a PhD to boot, who has moved back with Intel from Santa Clara to Bangalore. His work in Bangalore is as cutting-edge as in the valley. Google’s Bangalore center is considered a ‘peer’ of their Mountain View center, and their Bangalore employees have the option to move to the valley whenever they choose, as the people & work in both places are comparable. Similar examples abound from Microsoft, Oracle, TI, Cadence and many others.
  • Emerging pool of people with start-up experience: A start-up environment is unique and requires people with passion, drive, flexibility, risk-appetite and comfort with ambiguity. Thanks to hundreds of India development centers of US start-ups (including some of Bessemer’s), several high-quality product design teams with such experience have emerged, would form the core of a new set of such start-ups.
  • Academia has come a long way: Groups such as IITM’s TeNet and IIT Mumbai’s KRISIT have facilitated greater interaction with industry both among students and faculty, and incubated several start-ups. While these are not yet where a Stanford-Silicon Valley interaction would be, what’s been done is commendable. I’ve personally met several students who’ve passed on more lucrative opportunities to follow their passion in a campus start-up. Two of my IIT classmates, who became top-tier researchers in analog design (they did their PhD with Yannis Tsividis of Columbia, a God in the field – rumor has it that Tsividis considered these 2 to be his best students ever!) have now returned as faculty at IIT Madras. Their skills and research are as good as it gets, with spillover effects on the students and industry they interact with. Academia is critical, both as a supply of talent and as an incubator for innovative research ideas.
  • Awareness of and efforts to plug gaps in the ecosystem: It is well known that seed-funding, incubation and mentorship are still lacking in the system. Dr Sridhar Mitta (e4e, India Semiconductor Association) shared with us some of his efforts to create incubators in Bangalore, in conjunction with TiE. The ISA forum itself acts as a great networking and mentoring opportunity. I know of at least one early-stage-tech-focused fund being raised, with an India focus.
  • VC time & money: Building a successful company from scratch is as much about investing time as it is about investing money. Given the response at last month’s Silicon Valley Bank VC conference where over 30 US, UK, Asian and Israeli VCs participated, there is plenty of money and interest. The time angle is about having people on the ground in India, who can work closely with the company. Bessemer made a conscious choice, for both Dinesh Vaswani and myself to be based full-time in India, so that we work with our Indian companies just the way we do with our US companies. There is increasing realization that companies cannot be built from 12,000 miles away and several other VCs have recruited people to be based in India.
Naturally, none of this is going to happen overnight. However, most of the ingredients are either in place already or moving in the right direction. This effect is strengthened by longer-term trends - India/China graduate more engineers than the US, more new hiring is done in India/China that in US for companies such as Intel and TI. There are a few factors around our education system not fostering real-world thinking and broader social acceptance of off-beaten-track career paths that I worry about, but do not have definitive views on. I am also concerned about the domestic market for these high-technology products being relatively small (except possibly wireless) and therefore not having adequate market knowledge/networks in our teams. These can be partly offset by returning Indians with such experience or hiring local sales teams in the target markets, but still remain a challenge. The main question, in my mind, is “how long will it take”? I have started seeing interesting start-ups in areas such as telecom equipment, enterprise software, mobile application software and chip design. I expect these to grow, both in quantity and quality, for the reasons outlined above. When do I see critical mass –2 years, give or take! What do you think?

Monday, October 03, 2005

Investing in India (1 of 3) - Domestic market

Over the last many months, planeloads of VCs have visited India, looking to understand what this India-thing is all about and (hopefully) invest in exciting Indian companies. Between CIOs looking to get code written in India, CFOs wanting to get invoices processed in India and VCs trying deploy capital into India, our 5-star hotels are both full and bloody expensive (Rs. 12,000/night in Bangalore – no complementary breakfast)! India is definitely a great place to be right now, with every company in the world looking at Indians either as consumers or employees. However, there are some home-truths about India that potential investors (and pretty much anyone else looking at the India opportunity) should be aware of. These are especially relevant when one looks at ‘Investing in India for India’ – where domestic demand is the main driver. These commonsensical fundas don’t make the macro-opportunity any less attractive, but may just help in figuring which kinds of business models are best suited to the Indian market.

Having grown up in middle-class Madras, I used to think that I understand how the average Indian consumer behaves. A recent review of some statistics proved me wrong. Based on proxy indicators – my parents had a (company-provided) car, 2-bedroom flat, colour TV and fridge since the early 80s - I now realize that we actually fell in the top 1% of Indian households (it certainly didn’t feel that way back then). Thanks to inheriting some of my parents’ intelligence and their wise pressure to make me study hard, I am now even less representative of the average Indian. Several products and services that I’d be willing to pay for are limited to a niche segment of the Indian populace. Quite often, this personal bias subconsciously permeates my (and others’) investment decisions as well, leading to companies and business models that simply cannot scale in India.

I define scale as building billion-$ companies tapping Indian domestic demand. I am sure there are niche opportunities that will profitably reach 10s of million dollars. But, don’t we all want to find the next google (or at least, the next Bharti)! If this is your goal, ALWAYS remember that if you are fortunate enough to be reading business plans, you are most certainly not the representative Indian middle-class (leave alone poor) customer.

So, the 2 obvious home-truths are:

1. Despite the new daily-high that Sensex reached this morning, we are still quite poor

The average Indian earns $2/day (at today’s prices) and spends over 80% of his/her income on necessities such as food, rent & utilities, transport, communication and clothing. The balance is predominantly used for the more longer-term necessities – health, children’s education. The oft-quoted and poorly-understood 300-million strong middle class is somewhat better off, but still has a similar share of wallet. They earn more, but live in proportionately better houses and eat more nutritious food (still, well below western living standards). Even the 300-million number is misleading (will cover this in a later post). Even my eternally optimistic McKinsey colleagues (led by good friend VT Bharadwaj) put this number at under 200 million (see “Winning the Indian Consumer” in the recent McKinsey Quarterly).

2. The labour pool for simple jobs is practically infinite.

The same report estimates over 750 million Indians in the ‘struggling’ and ‘destitute’ segments. Any capital vs. labour allocation decision needs to be viewed in the context of this near-inexhaustible, available and willing workforce, which can perform low-to-moderate skill tasks. 600 million farm labourers each earn ~$1.5/day, that too only in the harvest season. Their actual (or impending) migration to cities keeps wage rates low and inelastic for all low-skill jobs.

The 1st point impacts what kinds of products/services can achieve both scale and profitability. The 2nd point impacts how one should go about delivering these. So, what does this mean for investors and entrepreneurs looking to build billion-$ businesses:

1. Stick to basic needs

It will take us a while to get to self-actualization needs. Health spas, blogging and other self-indulgent pastimes will remain pastimes, not businesses. Billion $ businesses are most likely in food, clothes, basic infrastructure (roads, houses, health, education), communication, transport, household goods.

2. Think utility, not fun

Middle-class Indian households are used to an all-encompassing entertainment budget of $1/month/head for unlimited cricket, news, songs and movies. And this even includes the EMI on the TV (in addition to the cable bill and a newspaper subscription). No one is in a hurry to pay $5 a pop for a mobile phone game.

3. Price rules – but think VFM, affordability, TCO

Necessity makes us smart consumers. I worry whenever entrepreneurs talk of convenience and choice, without mentioning price. Classic example – Indians buy 2 million cellphones a month, compared to under 100,000 PCs (only consumer sales). Why? Greater value-for-money (most small businessmen actually make up for its cost through higher revenues). Low entry cost ($10-20 to go mobile). No other costs that add to TCO (PC ownership cost equation gets messed up by expensive home internet costs).

4. Unorganized sector is here to stay

With plentiful & cheap labor, there will always be an unorganized sector that is extremely efficient. Factory-processed foods will compete against local kitchen-help. The latter can typically deliver better taste, freshness and convenience, at a lower cost (remember, no overhead, no taxes). So, its going to be far harder to create the next General Mills or Campbell Soup in India. Similarly, kirana shops will stay long after FDI in retail is opened up.

5. Think hard before substituting capital for labor

Western capital-intensive models are often uncompetitive. Both at home (vacuum cleaners never took off, since maids are inexpensive) and in companies (high-volume flour mills still cannot match local ‘chakki-atta’ costs, in the $15 billion wheat-flour market)

Investing in India

Almost all investment opportunities in India fall into one of 3 not-so-MECE (mutually exclusive, collectively exhaustive) categories:

  1. Domestic – tapping Indian consumer and enterprise demand (e.g. retail, construction & real estate, financial services, hotels)
  2. Export of existing goods/services – shift production/delivery of existing goods and services from high cost countries to India (e.g. IT, BPO, pharma generics, auto components, textiles)
  3. Export of innovative goods/services – creation of new IP (e.g. software products, pharma NCEs, semiconductor products)

Naturally, the 1st and 2nd categories have achieved more scale and prominence so far. The main distinction of (3) over (2) lies in creation of products (one-to-many sale), higher R&D costs, long gestation period before revenues, patent-filing, royalty revenues from the same etc. While a few companies have adopted this route, few companies have scaled up in innovative areas. I-flex was probably the largest company in this segment, before being bought out by Oracle.

In theory, the same goods and services that are exported can also be sold in the domestic market. In areas such as auto components and pharmaceuticals, domestic market revenues are comparable to export revenues. However, in most of these areas, the export opportunity is likely to be substantially larger than the domestic market opportunity. Also, the product range and pricing are also substantially different for the export market. We are therefore better off treating (1) and (2) as two separate categories.

More on each of these areas in later posts …

Sunday, October 02, 2005

Straddling two worlds

US-India. Silicon Valley-Bangalore. New economy-old economy. Cutting-edge technology-basic necessities. High-speed internet-cheap mobile phones. Self actualization-food&shelter. Nariman Point-Dharavi. Dream-reality. Future-present.

My work and life straddle two worlds. I work for a US VC called Bessemer Venture Partners, looking to invest in India (along with my colleagues – Dinesh Vaswani and Rob Chandra). On one side, I see the latest technologies, web 2.0, new media, billion-$ exits, people who have made millions of dollars from stock, options or carry. On the other hand, I live and work in a $500 annual-per-capita-income country, trying to identify the most interesting and lucrative investment opportunities for Bessemer. I’ve seen equally-deserving business plans of both analog chip-design and road construction companies. I use the latest video-conferencing over IP technology to join our weekly conference calls, and commute by Mumbai’s suburban trains for under $8/month. I’ve studied and worked in both US and India. I’ve been inside both semiconductor fabs and steel mills. You get the idea. One of these worlds reflects the reality of where we are today. The other offers promise – jobs, money, technology, markets.

For more good than bad, both worlds are irrevocably intertwined. And not just in my life. Technology advances have enabled prosperous, high-wage economies to build/buy code, medicines, auto parts, chemicals, customer service and operations support from poorer, low-wage economies. Seamless capital flows fund those Indian companies that deliver these products/services and in-turn boost the purchasing power of their direct and indirect employees. This in-turn drives consumer demand, enhances quality-of-life and stimulates a new set of companies/products/services to cater to this demand. These effects are accelerated by global media exposure, favorable demographics, changing aspirations & mindsets, supportive government policy and cheap financing. As a result, we see tremendous change and growth all around us, right from the way we shop to what kinds of jobs are available for the next generation.

India is at the confluence of these worlds and is hence (at least, for me) the most exciting place to be in. While there is rapid change all around us, no one fully understands its pace, direction and implications. I see both the opportunity to help create the next generation of successful Indian businesses, and the intellectual challenge of figuring out where and how.

This challenge is significant and cannot be understated. Here are some real questions that get thrown up, as we go after this opportunity:

  • Is PC/internet penetration about to take off the way mobile phones have?
  • Once 300 million Indians have cell phones, what else (other than communication) will they use it for?
  • There have been half-a-dozen occasions over the last 20 years when the mood in India was similarly optimistic. How is this time different?
  • How much risk do poor infrastructure and coalition politics pose to growth?
  • So many techies, but so few technology innovations! Will we remain a technology-services country or will products finally reach scale? When will Bangalore become Silicon Valley?
  • Is the Indian consumer getting any less price-sensitive? Will low-cost, low-price be the only strategy that will scale in India?
  • How large is this middle-class really? Is it really 300 million? How to segment it further?
  • Is India 5 years behind China? Should I simply look at what’s taking off in China today and bet on similar things in India?

I don’t know the answers to any of these questions. I wish I did. The most important step is to know that these challenges exist and acknowledge that there are no easy or readymade answers. This knowledge (or, awareness of ignorance really) should allow each investment and business decision to be viewed specific to the Indian context. More often than not, Indian businesses will look substantially different from their counterparts in the US or China. I intend to talk about some of these challenges and questions in future posts. I will not have answers then either, but hope to trigger interesting discussions.

Let me end with one of these questions we faced at Bessemer. As we entered India, over the last 12 months, we had to figure out our own India strategy. The easy answer would have been to continue doing what we do in the US – invest in early-stage, IP-led, technology companies. As we spent time on the ground, we realized that the ecosystem for such companies – seed funding, mentors, a thriving domestic tech market, critical mass of people with product-lifecycle experience – doesn’t yet exist. At the same time, domestic demand growth is fueling several successful companies in a range of non-tech sectors. These aren’t necessarily IP-led companies, but are certainly built on strong execution and process capabilities.

Our approach – a broader investment focus in India. We are looking at both venture capital and growth capital opportunities. While we remain committed to help create and be a part of the high-tech ecosystem in India, we are also actively looking at later stage, sector-agnostic investment opportunities. The only constant is our basic philosophy of backing strong entrepreneurs addressing large markets. We believe that this broader investment focus best reflects the reality of where India is today.

Naturally, our unique structure (we have only one Limited Partner, who had been with us since 1911) gave us the flexibility to make this decision!

Why blog?

Honestly, I don’t know. Maybe, it’s the cheap thrill of becoming the first Indian venture capitalist blogger (if there are others before me, I apologize). The hope that there are a few souls who might actually care to read what I write. The thrill of exploring first-hand what this web 2.0 thing is all about. The challenge of coming up with thoughts that are insightful, or at the least interesting. The opportunity to reach out, professionally and personally, through a new medium. All of the above, I guess.

Since May this year, I have become an avid reader of several blogs, including those of my colleagues David Cowan and Jeremy Levine. A few have been extremely useful, as I entered the world of Venture Capital and Private Equity (notably, Brad Feld’s blog). Many have made fascinating reading. Without exception, all have told me something new and exposed me to ideas I’d have never got by limiting myself to professionally-generated content.

Most importantly, I am a strong believer in personal freedom – so long as we don’t harm or inconvenience others, we should be free to think, say and do as we please. Blogging resonates with that belief. I am happy to join this world of free expression and exchange of thoughts.

Lastly, why the title – Seriously clueless? Before you (or more likely, I) take myself too seriously, its good to remind ourselves that there’s an infinite amount of stuff that we don’t have a clue about. While its my best intention to back-up my posts (and investments) with knowledge, the truth is – sometimes I don’t have a clue and at other times, I think I do!