Fetish For Funds, Destructive Babus and Three Inviolable Commandments

The Modi government has a fetish for funds - not for raising, but creating them. The latest one being talked about is a Venture Capital Fund (VCF) dedicated for defence industries, its corpus arising from the offset obligations of foreign arms' suppliers. The proposal is quite ingenious, and rather simple: every vendor who sells armaments to India has to compulsorily invest 30 percent of the contract value in domestic industries – so if Bofors or Agusta Westland sell Rs 10,000 crore worth of guns or choppers to India, they have to commit to invest Rs 3,000 crore in domestic industries. That's called an offset obligation. But foreign firms find it difficult to source enough credible investment opportunities – frankly, many of them find this obligation to be a pain in the neck.

So if they are given an opportunity to simply put their money in a fund which would then have the headache of sourcing downstream proposals, they should be happy about it, a sort of good riddance. Since India is a such a humongous buyer of foreign arsenal, the government estimates that Rs 30,000 crore could flow into VCFs over the next 5 years, even if only 25 percent of the total offset obligation is infused.

Of course, I am assuming that the government will not create a complex web of conditions here (what am I smoking!?). I am assuming there would be a rational lock-in period of, say, ten years, and the projects would be vetted by globally renowned private equity players like The Carlyle Group, KKR, Temasek and others. But am I asking for too much? Would the government adopt such an intuitive and practical model? Or would it come in with a heavy, micro managing hand? Would it insist that the VCFs invest only in projects that are short-listed by the Ministry of Defense? That are in joint ventures with state owned companies? That are in “hi tech” operations (however fuzzily that is defined, by a bunch of Raisina Hill bureaucrats whose face-off with hi tech is confined to using WhatsApp for setting up golf groups) with at least “50 percent of technology to be transferred to the state corporation along with the creation of at least 100 jobs per crore rupees of capital deployed”? I can go on and on about the inane travesty of government guidelines, but I reckon you get the drift.

Never put it past our babus to come up with a good idea, but disfigure it violently in the fine print with ridiculous, asphyxiating conditions, simply killing the original one.

The Startup India Example

Am I being utterly unkind to the Majesty of The Government of The Republic of India? Is it not all about the ease of doing business, about starting up India? Aaah, Start Up India! Now this is an evocative example to dig into. It's a show piece project, rocket propelled by the indefatigable Prime Minister himself. It's supposed to kick start an entrepreneurial upsurge, converting sundry Jhumritalias scattered all over Mother India into mini Silicon Valleys. It gives a generous income tax holiday to start ups which are “hi tech & innovative”. But wait, there's a catch. Who gets to decide whether you are “hi tech & innovative” or not? Why of course a “committee of government secretaries”, to whom you shall pitch your idea, quite similar to the pitch any sweating start up has to make to a welter of angel investors before it can hope to raise its first dollar. Unfortunately, while the angels are driven by the ruthless efficiency of free markets – so your idea shall pass muster only if it is genuinely hi tech or innovative – the pitch to the committee of secretaries is tethered to that obnoxious killer of human enterprise called “government discretion”. And that's not where it ends. There is another income tax holiday, this time for the investors in these “state selected” start ups. Their profits at exit shall be tax free, provided these are re-invested in government mandated funds. Yes, you heard it right. A plan to ignite an entrepreneurial revolution will be throttled by the government's clumsy, heavy, discretionary hand at every point, converting North Block into a parody of Shark Tank Billionaires, as babus decide who & what is hi tech & innovative, who should get tax holidays, and where you should invest to become eligible for those tax goodies. Unbelievable! This happens only in India…

Okay, enough of the lampooning. The truth is that genuine entrepreneurship can never be mandated by a government decree. It has to be left to the ruthless, take-no-prisoners' efficiency of competitive markets. Only the best should, and shall, survive. Only the survivors deserve risk capital.

Others must die, destroying their failed ventures, wiping out their investors' wrongly called capital – and if they are people of substance, they shall pick themselves up from the rubble, and build and invest again, perhaps to succeed, perhaps to fail yet again, and to pick themselves up one more time for a third throw of the gauntlet. That's how entrepreneurs are born, through several Schumpeterian rounds of “creative destruction”. But never, ever, never by a committee of government secretaries!

State Selection = Death Knell for Funds

So now we have to solve a dilemma for Prime Minister Modi. This fetish for creating Funds – whether for defense industries, or starting up India, or refinancing micro businesses (MUDRA: Micro Units Development and Refinance Agency), or harnessing sovereign capital for big infrastructure projects (NIIF: National Investment and Infrastructure Fund) – is an excellent one. But its death knell is the process of state selection, mandated by civil servants deeply suspicious of market forces, who honestly believe, with devastatingly dangerous sincerity, that they can pick the winners and losers. Let me end here with equally devastating, but effective, simplicity.

Here are Three Inviolable Commandments:

One, the government should not even think of selecting or making choices.

Two, it should make all its investments via a “capital protected” financial instrument, so that public money is not risked in venture capital activities; the instrument could be a coupon carrying Equity Recourse Note or Optionally Convertible Venture Debt with superior liquidation rights. Simply put, the government's investment should be secured at a market rate of return, with a marginal equity kicker tied to the success of the underlying project.

Three, the government should not assess individual projects. Instead, it should allow open bidding (as it does for Foreign Portfolio Investors' debt quotas) by qualified private equity players for co-investments; this is critical, because the government should only put public money in projects where the lead investor has also got a bigger skin in the game, that is, it's got much more to lose if things go wrong. The eligibility criteria should be such that only the best domestic and global venture capitalists are allowed to competitively bid for these funds.

With these Three Inviolable Commandments in play, the government can sleep easy, and yet remain excited that its Fetish For Funds is creating real value for India. Unfortunately, North Block's mandarins may never allow these rules to prevail. They are just too simple, and too effective, for their liking.

(Raghav Bahl is the co-founder and chairman of Quintillion Media, including BloombergQuint. He is the author of two books, viz ‘Superpower?: The Amazing Race Between China's Hare and India's Tortoise', and ‘Super Economies: America, India, China & The Future Of The World'.)