Future of Venture Capital Firms in Pakistan

Pakistan is a country with immense strategic importance. It is at the cross roads between Eastern and Western Asia. Pakistani market is easily accessible with three major international airports and thirty-eight domestic airports. It is accessible via fifty international airlines. It has a rapidly expanding transportation and communications infrastructure. Pakistan’s environment is very attractive for foreign investors. It is quickly becoming the destination of choice for a huge number of international investors.

Venture Capital has grown drastically during the 1990s and from then onwards the performance of firms has improved in terms of survival rates, innovation and growth. Venture capital firms have been growing in Pakistan for the past few years. Investors running these venture capital firms include both domestic and international players. It is however at the emerging stage in Pakistan at the moment. Being successful in a venture needs strong experiential base, vision and urge to achieve something and a realistic business plan.

Venture Capital is an illiquid investment made in high potential and high risk business opportunities. These investments are typically minority equity interests in young, innovative, rapidly growing companies. They just have a potential to become large companies. Financial institutions and lenders are reluctant to invest in such companies because they are not credit-worthy and that is why they do not meet the eligibility criteria for traditional bank financing. These firms lack the resources required for success, therefore, they call upon the expertise and capital of the venture capital firms.

RESEARCH OBJECTIVE

The objective of this research paper is to identify whether there is potential in the Pakistan Venture Capital firms in the future or not. Our research question is:

“What is the future of Venture Capital Firms in Pakistan?”

LITERATURE REVIEW

According to SECP, a Venture Capital is, “a company which is engaged in financing any venture project, through equity or other instruments whether convertible into equity or not and provides managerial or technical expertise to venture projects, or acts as a management company for management of venture capital fund”.

Venture capital (VC) market is mature in developed countries like United States, United Kingdom, etc. This concept is also becoming popular in emerging economies like India, China, Malaysia and Pakistan.

According to Maria Trombly, in her article “China’s Venture Capital Market Springs Up”, the potential of Venture capital firms in China is expected to grow dramatically in future. The reasons behind this probable growth are flourishing Chinese economy and relaxed government regulations. Although China has an emerging economy but there are some risks associated with venture capital firms. Firstly, there is lack of management talent in China. Secondly, government owned banks offer cheap loans to Chinese competitors. This encourages Chinese firms to take financial funds from government rather than venture capitalist firms.

In order to compensate these problems government of China has announced to give bonus tax deduction of 70% to those venture capitalist firms that provide equity to high-tech companies. In development of venture capital in China government has played vital role.

In India, venture capital has flourished through three different phases, says B Bowonder and Sunil Mani in their research paper “Venture Capital and Innovation: The Indian Experience”. In the first phase, Indian financial strategists focused on simply making the masses aware of the concept of venture capital. World Bank provided massive support to the Indians in terms of funding and planning. In the second phase, they formulated different strategies in order to implement the concept of venture capital. The main strategy was to design such guidelines that make it easier for private firms to enter the VC market. The third phase was to expand the market from investing locally to attracting external investors in the industry.

Aydogan, in his research “Individual Social Capital and Access to Venture Capital: Case of Indian IT Regions”, found that entrepreneurship and innovation is not just about investments, it also involves having a blend of human capital, education, skills and having the traits of a proactive, risk taking individual. No doubt, an entrepreneur is a very innovative person but, he cannot be a researcher, financer, producer, accountant and lawyer of a newly developed firm all at the same time. Therefore, it is always beneficial for an entrepreneur to consult the expertise of a venture capitalist.

World Bank gave the ranking of 178 countries in a report issued in 2008 to see the ease of doing business in each of the country. It was identified that China came on the 83rd position whereas India was ranked at the 120th position. It was surprising to see Pakistan’s position to be on the rank 76. This indicates that it is far easier to do business and to make investments in Pakistan rather than going to other emerging economies such as India and China. With a rapidly growing population of 160 million people, the real GDP of Pakistan has constantly been growing at the rate of over 7% since the last four years and this year, in 2008, it is expected to reach 7.2%. Therefore, Pakistan’s market has immense potential to grow at a much faster rate with the help of venture capital funds. (Pakistan Economy Remains Resilient Amid Crisis)

An article published in “The News” also supports the report of the World Bank by saying that Pakistan has the larger percentage of Internet penetration, i.e. 7.5%, whereas in India this percentage is only 4.5%. With an investment of over USD $500 million currently invested in Pakistan in the broadband and WiMAX infrastructure, the Internet penetration is expected to increase to 16% over the span of next three years.

According to an article published in the Dawn newspaper written by Salman Siddiqui, venture capital funds and private equity funds are considered to be one and the same thing in Pakistan. These two are considered to be from one asset class. Over the last ten years, a trend has been noticed that VC/PE funds are increasingly being invested in the emerging markets such as china, India, Korea and Brazil. Pakistan was considered to be late in implementing the concept of venture capital funds, but, Securities and Exchange Commission of Pakistan (SECP) has been on the fore front in order to develop this sector. According to the center for international private enterprise (CIPE), SECP has developed draft regulations for the venture capital firms.

Currently in Pakistan there are six venture capital firms operating. These include Punjab Venture Capital Limited (PVCL), Pakistan Venture Capital Fund Limited (PVCL), TMT-PKIC incubation fund ventures limited, TRG, e-Planet and Draper Fisher Jurvetson (DFJ). There are more VC firms that are under the process of starting operations regularly. All venture capital firms need to register under the regulations of SECP.

From studying the literature relevant to venture capital funds, we have identified that there are certain gaps that need to be addressed. The economy of Pakistan is constantly growing and there is alot of potential in this country. We are already ahead of India and China in terms of Internet penetration and easy access to business opportunities. In this research paper, we have pointed out the reasons due to which venture capital funds have not been fully implemented in Pakistan. We have also given our analysis of the future prospects for venture capital firms in Pakistan.

LIMITATIONS OF THE RESEARCH

This research paper has the following limitations:

• This research paper is totally based on the secondary data. We have not conducted any primary research.

• We have taken only two countries for the purpose of comparison with Pakistan. Since Pakistan is an emerging economy, we have compared it with these two countries because they have recently been successful in this area.

TYPES OF VENTURE CAPITAL FIRMS

There are three types of Venture Capital Firms. These are briefly discussed below :

Captive Venture Capital Firms

These are specialist venture capital firms that are subsidiaries of a larger financial institution. They receive their capital from the parent firms. These subsidiaries are set-up to provide a portion of their own funds into venture capital or risky enterprises. The investment packages often include a higher debt element and a greater emphasis on income producing instruments than is the case with funds from non-banking venture capital groupings.

Independent Venture Capital Firms

These firms raise their capital for investment either from private investors or from financial institutions like pension and insurance companies, academic institutions and government agencies. A common feature of independent firms is that no one investor or shareholder has a dominant position in the firm’s ownership.

These independent firms are mainly equity-oriented. This kind of venture capital firms prevail in Pakistan.

Semi-Captive Venture Firms

In this kind of venture capital firm, subsidiary of a bank or other investment management group has established its own in-house fund and at some stage invites a number of investors to join the fund (Lorenz, 1989). This type of venture capital firm often starts as a captive firm and then raises money from sources other than the parent company.

VENTURE CAPITAL FIRMS IN PAKISTAN

1. EPLANET VENTURES

Eplanet ventures make private equity investments on a global basis in order to provide superior returns to its investors. It invests in companies where innovation’ application in technology and business models have the potential to create high growth, category-dominant companies. This company has a fully integrated network of companies that operate globally in countries such as Beijing, Shanghai, Singapore, Bangalore, New Delhi, London, Silicon Valley, Hong Kong, Seoul and now in Tokyo. Their philosophy of entrepreneurial investing is that they not only provide financial support but also offer much more than just money. The venture capitalist for a start-up firm becomes the company’s financial strategist, headhunter, investment banker, etc.

2. PUNJAB VENTURE CAPITAL LIMITED (PVCL)

Punjab Venture Capital Limited (PVCL) is an asset management company. It controls the overall management of Venture Capital Fund, which is the Punjab Infotech Venture Fund (PIVF). It has the necessary authority to consider and evaluate a given proposal to decide if the firm should invest in it or not.

3. PAKISTAN VENTURE CAPITAL FUND LIMITED (PVCL)

Pakistan Venture Capital Fund Limited (PVCL) is a venture capital fund owned 25% by Asian Development Bank (ADB) and 30% owned by Dawood Leasing Company Limited. This company has recently decided to move away from this business of providing venture capital. It is facing a lot of problems in its portfolio and problems have increased due to the loan recovery system of Pakistan. It intends to change its focus towards fund management and will seize to exist as a venture capital company.

4. TMT VENTURES
TMT ventures operate under the TMT-PKIC Fund. It has assets worth PKR 200 million under management. AKD Securities, Pakistan Kuwait Investment Company, Habib Bank Limited, National Investment Trust and SME Bank Limited are five of the leading financial institutions that invest in TMT Ventures. Up till now, TMT Ventures has invested in seven start-ups. Out of these, five are in the technology domain and two are in the media businesses.
5. DRAPER FISHER JURVETSON

Draper Fisher Jurvetson is one of the finest venture capital firms. It has a global presence with offices in over 33 cities around the world. It has capital commitments of over $5.5 billion. Its mission is to identify, serve and provide capital to extraordinary and innovative entrepreneurs anywhere who carry a mission to change the world. Since the past twenty years, DFJ has been providing capital to over three hundred companies from various sectors. These include industry giants such as Hotmail, Baidu, Skype, United Online, Overture, Athena Health, EnerNOC, Interwoven, Four Eleven, Parametric and Digidesign.

6. TRG

The Resource Group (TRG) is the world’s leading ‘acquire and migrate’ call center business. It serves over 1000 corporate customers including several fortune 100 companies all over the world. It is the venture of the famed IT entrepreneur Zia Chishti. It made Pakistan noticeable all over the world.

REGULATION OF THE BUSINESS OF VENTURE CAPITAL COMPANIES

In order to operate in Pakistan, venture capital firms need to register with the Securities and Exchange Commission of Pakistan (SECP). SECP allows Venture Capital companies to take an equity stake of upto 70% of an investee firm’s capital. Earlier they were not allowed to invest more than 30%. Following are some of the rules and regulations regarding the venture capital firms that they need to fulfill before operations .

Eligibility conditions for grant of license to a venture capital company

In order to get a license for opening a venture capital company, a firm needs to fulfill the following conditions of SECP:

(1) A venture capital company shall not be granted license unless it fulfills the following conditions, namely:

a) It is incorporated as a public limited company under the Companies Ordinance, 1984 (XLVII of 1984);

b) It is not engaged in any business other than that of investment in venture projects;

c) It has a minimum paid-up share capital of five million rupees subscribed by the promoters and by others through private placement;

d) It has certified that the chief executive of the venture capital company does not hold such office in any competing business;

Explanation: The phrase “competing business” shall have the same meaning as defined in section 203 of the Companies Ordinance, 1984 (XLVII of 1984).

e) It has certified that not more than twenty-five per cent of its directors are from the same family, including spouse, dependent lineal ascendants and descendants and dependent brothers and sisters ; and

f) It has appointed as its chief accounting officer a person who a chartered accountant or cost and management accountant or a person is having Master's Degree in Commerce or Business Administration from a university recognized by the Universities Grants Commission with at least five years experience in finance and accounting.

(2) The sponsors, directors, chief executive and chairman of the Board of Directors, fulfill the following conditions, namely: -

a) They have not been associated with any illegal banking business, deposit taking or financial dealings;

b) They and companies in which they are directors or hold ten percent or more beneficial interest, have no over-due loans or installments, outstanding towards banks or other financial institutions or defaulted in the payment of taxes;

c) They have never been convicted of fraud or breach of trust or economic offense or of an offense involving moral turpitude or removed from service for misconduct;

d) They have neither been adjudged as insolvent or compounded with their creditors;

e) The promoters and directors of such company are, in the opinion of the Commission, persons of means and integrity and have special knowledge of matters which the company may have to deal with as a venture capital company; and

f) The proposed chief executive and at least one of the proposed sponsor directors have senior management level experience in industrial enterprises or the financial sector for at least five years.

Terms and conditions of operation

Unless granted a general or specific waiver by the Commission, a venture capital company shall:

a) Not expose more than forty per cent of its equity to any single group of companies;

Explanation: For the purposes of this rule group of companies shall mean companies controlled by the members of one family including spouse, dependent lineal ascendants and descendants and dependent brothers and sisters.

b) Disclose in its accounts all investments in companies and group of companies exceeding ten per cent of paid up capital of venture capital company;

c) Ensure that the maximum exposure of the venture capital company to its directors, affiliated companies and companies in which any of the directors and their family members including spouse, dependent lineal ascendants and descendants and dependent brothers and sisters hold controlling interest shall not exceed ten per cent of the overall portfolio of venture capital; and

d) Not accept any investment from any investor, which is less than one million rupees.

Private placement

In addition to its paid-up capital, a venture capital company may receive monies for investment in venture projects through private placement of such securities as may be notified by the Commission from time to time.

Placement memorandum

A venture capital company shall, before soliciting placement of its securities, file with the Commission a placement memorandum which shall inter alia give details of the terms subject to which monies are proposed to be raised from such placements.
TAX STATUS FOR VENTURE CAPITAL INVESTMENTS

Under clause 101 of part 1 of second schedule of Income Tax Ordinance, 2001 the profits and gains derived by a venture capital company and the venture capital fund registered under the Venture Capital Companies and Fund Management Rules are exempt from income tax upto 30th June 2014.

CALCULATION OF VENTURE CAPITAL RETURNS

In order to calculate the investment performance of venture capital there are two complementary measures. One is the Internal Rate of Return (IRR) and the second is the Multiples of Invested Capital (Realization Ratio). Both these approaches take into account cash inflows from the investors and cash outflows to the investors after the payment of fees and performance profits, known to be “Carried Interest”, to the management company.

The IRR approach also takes into account the time value of money and considers the time value of money and assumes periodic reinvestment of earnings calculated over the investment period. Both these methods have their limitations and are best viewed when compared with each other. However, generally IRR is considered the more popular approach. The ability to keep the money invested over a significant period of time for a taxable investor is preferable. It builds values equivalent to multiples of the original investment. It is preferable to a series of short-term investments that produce comparable composite IRRs. Due to this, the Realization Ratio is a worthwhile measure.

















WAYS IN WHICH FIRMS RECEIVE VENTURE CAPITAL

Firms receive venture capital in two ways. Investors, such as individuals and corporations can directly supply venture capital. The other way is that it can be supplied indirectly from specialized venture capital funds. These specialized venture capital funds play the role of intermediaries between investors and portfolio firms. Investors in this case may include individuals, corporations, pension funds, banks and insurance companies. The process is shown below.






















Figure 1: Ways in which firms receive venture capital

DISCUSSION

After studying the relevant literature, we have identified the following gaps:

• As seen in the case of China, when venture capitalists invest in a particular venture, they immediately start expecting a better performance and accountability from the ventures in which they have invested. Venture capitalists are very prudent people due to the fact that internationally many companies are not capable of paying back the initial amount that they borrowed. This is also the case in Pakistan. There is a high risk of default due to which venture capitalists are reluctant to invest in new ventures. Investors usually want quick returns which is usually not possible in venture capital investments. This makes the investors very impatient.

• It has also been seen that initially in China, venture capitalists were reluctant to invest in private innovative business ideas. But gradually, foreign investors started investing in high tech innovative business and although the risk was high their returns were also excellent. However, in Pakistan people are still hesitant and risk averse. They do not want to invest in businesses where the return is not confirmed. This is due to the high volatility in the Pakistani market.

• The government of China has supported the venture capital firms by offering them tax rebates and bonus tax exemptions for investing particularly in high tech industries. Due to this their economy has also benefited. In Pakistan, no such policy has been seen that encourages the operation of venture capital firms in high-risk businesses.

• In India, it has been analyzed that they developed by focusing their foreign investments on Research and Development activities. Due to this, their investments were authentic and fruitful. In Pakistan, however, the people are more eager to jump towards opportunities instead of properly conducting a research on a large scale to see if the venture will be feasible in the long run or not.

• Venture Capital Firms in India have been developed by passing through a three-stage process. In this, the first stage was to educate masses just about the concept of Venture Capital firms. In Pakistan, majority of the people are not even aware about the concept of Venture Capital. Most of the people do not know that if they have innovative ideas they can consult these firms in order to get assistance.

• It has also been noticed that the Indian venture capitalists have been very focused in their guidelines for investing in new ventures. These guidelines have been formulated in India with the harmonization of the World Bank. They have targeted particular industries where they should invest. These include primarily private industrial firms. They have a target portfolio return of at least 20% annually. Whereas, in Pakistan no particular targets have been established. Even if there are certain targets they are not duly followed.

• In India and China, the main focus of investment is on Technology industry. In Pakistan there is a lot of potential in the High-tech IT industries. But, banks and other financial institutions are reluctant to invest in these firms because banks hesitate in funding companies without tangible collateral. Because it cannot be sold off in case of default. Therefore there is a huge need of VC firms in the IT industry.

• In almost all of the developed economies and most of the developing economies, there is a set criterion for providing loans, checking the credibility of a business and recovering the loans. We have seen that although SECP has developed several rules and guidelines for the people who want to set up a venture capital firm, but these firms have not devised a mechanism that checks the credibility of the business demanding funds. Due to this, the default rate is very high in Pakistan.

These are the gaps that need to be addressed by the Government of Pakistan and financial institutions in order to improve the mechanism of Venture Capital Firms in Pakistan.





























FUTURE OF VENTURE CAPITAL FIRMS IN PAKISTAN

Pakistan is a very suitable country for investments. It has abundant resources but needs the right capital and human resource investments. It offers competitive advantages over other investment destinations. These include high quality software development, swift and convenient establishment of businesses, lower cost basis and a good Telecommunications and IT Infrastructure. The graph shown below shows the World Bank ranking of Pakistan overall in South Asia. This graph clearly shows the position of Pakistan currently and its potential for tomorrow.



Graph 1: Pakistan ranks second overall in South Asia

The future of venture capital firms that invest in IT industries is very bright because the government of Pakistan offers several incentives to these investors. Major incentives to the investors in the IT industry include the following :

• Tax holidays for fifteen years and 100% foreign equity ownership.

• Provision of Information Technology parks with low rent, fiber optic connectivity, libraries and conference rooms.

• Providing funds to software companies in order to get ISO-9000 certification and CMM/CMMI rating.

• 100% repatriation of profits allowed to IT companies.

• Seven years tax holidays for venture capital funds that invest in this sector.

• Minimum rate of 30% depreciation on computer equipment.

• The State Bank of Pakistan (SBP) has allowed the opening Internet Merchant Accounts by banks.

• Availability of Internet connectivity in more than 1862 cities/towns across Pakistan.

• Reduction of the cost of 2Mbps connection to US $1000 per month.

Due to these incentives, a large number of foreign IT companies have chosen Pakistan for their IT operations. We can see from the above stated graph and the government support to the IT industry that there is a lot of potential and chances of growth of venture capital firms in Pakistan.

RECOMMENDATIONS

Although the environment of Pakistan is very favorable for investors and venture capital firms, but still we need to discuss ways in which we can improve the working of the venture capital firms. The future of venture capital is very bright if some of the procedures are improved. We have given certain recommendations, which will be useful for the government and for the venture capital firms in Pakistan. These are:

• First of all, we need to see the venture capital structure and policies of operating of venture capital firms in other emerging economies that are successful. These include India, China, Thailand, Malaysia and Korea etc. These are also emerging economies like Pakistan but they have a higher growth in venture capital investments than in Pakistan. Therefore, we need to learn from their experiences and adapt to them accordingly.

• The loan recovery procedure of Pakistan needs to be improved. SECP has rules for VC firms to start operating but there are no rules that can help Venture Capital firms to judge whether the idea or firm in which they are about to invest is credible or not. There are no policies through which the risk of default is reduced. We also saw PVCL’s case that is willing to leave venture capital industry due to problems in loan recovery. This high volatility in Pakistani market is making investors reluctant to invest in new ventures. Therefore work needs to be done on the loan giving and recovering structure.

• Uptill now, there are more private Venture Capital firms in Pakistan like e-Planet and DFJ. The government can boost the venture capital industry by taking initiative itself also. If the government will open more venture capital firms then the foreign firms will also be attracted in this sector.

• In China, the government offers 70 percent bonus deduction to firms that invest in unlisted medium or small-scale industries. If a firm does not utilize this deduction in one year then it is carried forward to the next year. In Pakistan also, the government needs to offer such tax rebates, incentives and bonuses.

• Spreading of awareness about Venture Capital firms is very important for the development of these firms in Pakistan. Usually financial institutions are seen to be advertising about insurance policies, mutual funds, etc. Then why don’t we ever see advertising campaigns of venture capital firms? These firms also need to advertise on television and internet. Government also needs to take initiatives of conducting forums and discussion sessions of experts on this topic.

• We support the recommendation given by Arthur Bayhan in his paper “Venture Capital Action Agenda Situation Today and Opportunities for Tomorrow”, that the government needs to make the rules and regulations of Karachi Stock Exchange more flexible. A system similar to NASDAQ needs to be developed so that smaller firms and their eventual IPOs can easily be listed.

• Management skills can be further improved in Venture Capital Firms in Pakistan by collaborating efforts with foreign venture capital firms. This way we can learn different practices from other countries and improve our systems accordingly.

CONCLUSION

The venture capital system of Pakistan is still on the emerging stage. It is immature in terms of resources and stability. But after going through this research we have concluded that if Pakistan is able to fill these few gaps mentioned above then the answer to our research question is ‘yes, the future of venture capital firms in Pakistan is very bright’. Pakistan has immense capabilities to be a fruitful nation to invest in. If only the volatility of the market is minimized by taken certain measures then the venture capital industry will flourish. We hope that our research will be helpful for the venture capital firms in Pakistan, prospect investors in Pakistan’s venture capital firms and the Government of Pakistan.

About the Author

Sidra Zahid: MBA Finance Final Semester student Irum Ibrahim: MBA Finance Final Semester student Nazia Khan: MBA Finance Final Semester student

---

Comments

No comments posted.

Add Comment

You do not have permission to comment. If you log in, you may be able to comment.

latest articles from sidrazahid

Top ten popular articles about Venture Capital

1: The Eyes And Ears Of The U.S. Venture Capital Industry
2: The Fundamentals And Life Cycle Of Venture Capitalism
3: Getting Funds And More With Venture Capital Financing
4: Things Anyone Should Know About Venture Capital Investment
5: Venture Capital In Arkansas - What You Should Know
6: Startup Capital For A Business Venture In Arkansas
7: Seeking Credit For Your Venture Backed Business
8: An Investor Should Know How Venture Capitalism Works
9: How To Open A Business Using Venture Capital Funds
10: Fox Arkansas Looking For New Ventures
Venture Capital

Traslate your website with this tool