After working with large global organisations for more than two decades each, Rahul Khanna and Nilesh Kothari started brainstorming for Trifecta Capital, a venture debt fund, in March last year. Since then, Trifecta is in the process of raising Rs 500 crore to lend to start-ups who are in need of short-term capital. In a conversation with Business Today's Manu Kaushik, Kothari and Khanna explain the potential of venture debt market in India, and their future plans. Edited excerpts:
BT- What are the opportunities in the venture debt space?
Rahul Khanna: The old economy is creaking along. Manufacturing, industrials and infrastructure are stuck. On the other hand, new economy sector such as consumer, technology, healthcare are pushing forward and creating jobs and brands.
The consumer spending is moving to these areas. So, at least for us, as we have gone out speaking to prospective investors to invest in our fund, they have been quite enthused by this side of the economy. We have said all along that we would like to be the preferred provider of alternative financing to the new economy.
The venture debt is a relatively mature asset class in the western countries. It typically comes to life 10-15 years after venture capital market matures. In India, venture capital is a 10-15 year phenomena.
Nilesh Kothari: The US has been a lot more innovative in terms of new financial instruments. Venture debt started in US more than 20 years; in Europe, about 15 years ago. It's now emerging as an asset class in Asia. As the venture capital ecosystem develops in different markets, venture debt follows with a 10-15 years lag.
BT- What are the benefits of venture debt?
Khanna: In most cases, venture debt is provided to companies that have already raised venture capital. In the past, the company [promoter] would have to dilute [stake] to raise capital. Venture debt helps the entrepreneur protect some ownership.
Many start-ups, as they grow, need capital financing and have short-term mismatches in cash flows. Rather than using equity to finance that, the right thing to do is to use debt to finance it. In the Indian context, banks and NBFCs don't have the expertise to understand these kinds of businesses. They have a hard time understanding how to lend to this business.
They [start-ups] are funded by venture capital, started by first-generation entrepreneurs, and generally belong to asset-light industries (with no plant or machinery). Some of them have built great brands, are growing rapidly, and, therefore, are burning cash. We step into these companies along with venture debt and solve the problem of access to debt for these kinds of businesses.
BT- How do you plan to make money?
Khanna: As an equity investor, I expect to make a return of 30-plus per cent. The IRR (internal rate of return) for the equity investor is 30 per cent every year on an average. In the case of lending, I don't expect to make 30 per cent IRR. So, the cost of debt is significantly lower than the cost of equity.
The entrepreneur has to find the lowest cost of capital because at the end of the day, equity is valuable.
Till a few years ago, the only way to provide loans in this fashion was to set up an NBFC. Three years ago, SEBI laid down alternative investment fund guidelines. We are the country's first SEBI-registered category-II AIF. We can provide debt by using financial instruments, typically debentures. If you are borrowing money from us, we will effectively subscribe to debentures that you will issue to us. This would be senior secured debentures. Secured against whatever collateral is available to us in the form of brand, IP or receivables. By design, it tends to be amortising which means that in a short-term (about 2-3 years); I will be paid back both principal and interest.
Kothari: The fund is structured in a way where operational expenses and management fees are at a minimum. We guide our investors to a high-teen return.
Khanna: To be able to attract capital, the expectation is that we should deliver high-teens. Anything over 15 is high-teen.
BT- What will be your investment philosophy?
Khanna: Venture debt is usually provided after a company has raised an institutional round - series A, B or C. Our bias is to back leading VCs in the country who have some track record, where they are making a significant commitment in the range of $3-5 million. Our debt is typically 20 per cent of the most recent round of equity funding. So, if someone has raised $5 million, we will provide $1 million in debt.
Kothari: Our debt is priced between 15-17 per cent. We will not lend at moneylenders kind of rates. We [will] lend at rates which we believe is comfortable for the investee companies to service. On top of that, we also like to take an equity kicker in these companies. We take a small equity position in these companies which helps us increase our overall returns. That equity kicker will be in the form of cashless warrants or partly-paid shares. These warrants will convert into equity shares at our option at a future point in time but they are priced today.
Khanna: It would be 10 per cent of our debenture amount. It would be separate from debt. Our target rate of return is 20-plus per cent. We cannot achieve that with just debentures. To structure our returns, without burdening the company, we have this combination of coupon and equity kicker.
Our pipeline [of investee start-ups] is interesting. It's a combination of companies in healthcare services, consumer and technology. These companies are doing Rs 10 crore to Rs 500 crore turnover. These are well-known businesses. Our bias is to focus on sectors where we think equity is appropriately priced. Today, in the e-commerce sector, valuations are stretched. As we come in, there is a bearing on our return profile as well.
We have a pipeline of 30 companies. Many of these have been introduced to us by the VC community; others are direct approaches from the entrepreneurs. Every other day, we get a call from venture capital fund asking us to look at companies where they have just invested or planning to invest.
Kothari: We will be investing in about 10-15 companies a year. We will invest only in companies which we believe will be fit candidate for venture debt.
BT- Why did you choose venture debt and not venture capital?
Khanna: There's enough supply of equity capital. Debt financing is completely missing in these companies. As an entrepreneur, when we look to build new business, we can either go to red ocean or find a blue ocean.
We have not invested as yet. We have been raising capital right now. Our fund target is Rs 500 crore. We have already announced our anchor investor - RBL Bank. They have committed Rs 50 crore to the fund. We are on track for the first close -- with about 50 per cent of fund [size] - and will start deploying the fund next quarter.
We will keep the fund open until we get to our fund target of Rs 500 crore which we hope we will reach that target by year end.
Kothari: We have been in the venture capital ecosystem for many years. We have been investing, we have done start-ups, we understand what makes these companies successful, and we understand the difficulties they face. We believe the venture capital ecosystem in India has now come to a stage of maturing.
We believe that over the next 7-10 years, Trifecta Capital would be managing $1 billion across different products. We may not be doing venture capital but we will do everything else these companies need to grow.