Early-stage investors setting up buildup funds to stay invested in key startups

Investors look to stay invested and earn big from potential winners in their portfolio.

NEW DELHI / BENGALURU: A number of leading early-stage investment firms are now setting up opportunity or buildout funds to continue to back top startups in their portfolios as they look to stay invested and earn bigger returns from these potential winners.

Blume Ventures, 3one4Capital, and DSG Consumer Partners, which typically invest $1-3 million from their main early-stage investment vehicles, and count Unacademy, DarwinBox, and Oyo, respectively, in their portfolios, have all set up opportunity funds which have the ability to cut larger cheques in companies that are highly valued, and are seen as breakouts in their respective segments.

This comes even as blue-chip Silicon Valley-based funds such as Sequoia Capital, Accel Partners and Lightspeed Ventures are raising a larger corpus to double down on their biggest bets in India. These funds also have global pool of capital to dip into for late stage rounds. Others like Alpha Wave Incubation fund, anchored by Abu Dhabi’s ADQ, have kept the option of independently leading growth-stage rounds in companies from parent fund ADQ, sources say.

With so many funds vying for mid and later stage companies, smaller-sized venture capitalists are trying hard to keep their ownership intact as much as possible, industry insiders said.

Staying invested
Blume Ventures made its eighth consecutive follow-on investment in Unacademy’s $150 million funding round, which was led by Japanese investor SoftBank, valuing the Bengaluru-based ed-tech company at $1.45 billion.

“It feels like short-changing yourself and the founder if we can't show support and hold ownership in your strongest companies,” said Karthik Reddy, managing partner at Blume Ventures. “Once we sensed that we are on the verge of 10-12 breakouts from Funds I and II in early 2018, we built a shorter life, opportunity fund. We do not do any deals with an opportunity fund that aren't our own investments from seed and pre-A stage,” he told ET.

Blume has now invested in Unacademy from seed to series F, Reddy said. Last week Unacademy became the first startup in its portfolio to cross a $1-billion valuation mark.

Blume had raised a $41-million opportunity fund in February, just a week after announcing the final close of its third fund at $102 million.

Pranav Pai, founding partner of 3one4 Capital, said raising opportunity or buildout funds is both a cyclical and an acyclical strategy, pointing at legendary stock picker Warren Buffett as an example.

“Buffett, for example, had a special situation strategy in 2008; he said no to Lehman Brothers and a bunch of others, but he bought a bunch of Goldman Sachs and JP Morgan (stock),” Pai said. “This strategy can operate across equity and debt. The cyclical way of thinking helps to plan for the downside of the cycle.”

The Bengaluru-headquartered investor, which made final close of its latest fund Continuum-I at Rs 400 crore in December, looks to pick select bets from its 50-odd portfolio of companies to participate in their growth-stage rounds, primarily Series B onwards, investing $3-5 million each.

Partners’ backing
“When we spoke to our investors and presented the idea to them, they said if we were starting an opportunity fund, they would like a piece of it,” Pai told ET. “That’s why we launched it and closed it so quickly. The idea had reached a point where investors wanted access to these models. Instead of picking companies directly, they can make one allocation to 3one4 Capital and we will manage the portfolio construction.”

Venture funds such as Blume Ventures and DSG Consumer Partners said their opportunities fund will only back companies in their portfolio, while3one4 Capital has no such restrictions.

“In our structure, we are not limited to our own portfolio,” Pai said. “But we have to make an equally strong case. We haven’t done that yet, since we already have a good selection internally.”

Deepak Shahdadpuri, managing director of DSG Consumer Partners, however, said, “Our opportunity fund is not for looking at everything in the market. We only consider at deals in our portfolio, select companies, which are growing at a certain pace.”

DSG, one of the earliest backers of SoftBank-backed hospitality chain Oyo Hotels and Rooms, made the first close of its second buildout fund at $35 million in August last year.

It remains a point of contention whether having an opportunity fund helps early-stage investors to win more deals. But maintaining ownership in early winners is a trend even the broader smaller fund ecosystem looks for.

For instance, Fireside Ventures, which has not separately raised an opportunity fund, has found ways to keep its ownership.

“Based on our experience with Fund 1, we realised that new-age millennial brands are scaling faster than before...and therefore we needed to get minimum ownership in the companies in the first round itself,” said Kanwaljit Singh, founder of Fireside Ventures.

Mama Earth, boAt, Yogabars and Kapiva are some of the startups where the fund increased its ownership in subsequent rounds but could have done more, he told ET. Fireside doubled its corpus from $50 million in the first fund to $100 million in the second fund.

Helps dealmaking

Early-stage funds may have an advantage in striking competitive deals in later rounds due to their reputation and familiarity after backing a venture in usually pre-revenue stage when its business success is uncertain.

Shahdadpuri of DSG said, “I would like to believe that DSG has built a track record and reputation where the right founders want to work with us. Having that reputation I believe is relevant if you’re trying to get into highly-competitive deals.”

He said, “I don’t think having a follow-on fund makes that much of a difference."

Blume’s Reddy said the internal rate of returns, or IRR, between an early-stage fund manager’s core fund and that of its opportunity fund differ. “The IRR clock starts sooner in an opportunity fund since all the capital gets deployed in 18-24 months and life is 5-6 years as opposed to a core fund where it gets deployed over 4-5 years and life is 10-12 years,” he said.

Pai of 3one4 said an opportunity fund is technically a mid-stage entry vehicle. “By that time, a lot of the risks that an early-stage firm had to face have been managed, therefore, a buyer is much more informed,” he said. “A mid-stage fund will not have to deal with so many of those risks. Therefore, the IRR expectations are more moderate. Also, the companies are filtered before they come to this stage. So the mid-stage fund has a natural filter to rely on, and therefore, it can focus its corpus on companies that have a higher probability of being absolute winners... The risk-adjusted return expectations are managed this way to design these strategies.”