Alternative Investment (Specialized Investment Fund): Good for a Country like Nepal To Maintain Stable Growth

To transform sustainable growth and create jobs, private sectors such as PE/VC firms may play a crucial role in leading to prosperity. Nepal, for instance, targets an ambitious growth rate of 8%, which would require a great effort effort in a country like Nepal. For Nepal to achieve a higher level of economic growth rate, it needs to promote development-oriented policies that support productive activities, facilitate job creation, and innovation, as well as formalization and growth of entrepreneurship is essential. Lately, private equity/venture capital is viewed as a sector that can accelerate growth. This new blend of alternative investment class firms typically invests in and/or finance companies, whether start-up or existing, not listed on a public exchange. Besides providing capital to businesses, specialized investment funds (PE/VC) also assist in business strategy and scaling up the company. Hence, Nepal can explore alternative investment class to drive economic growth, sustainably, and ease pressures for job creation.

Every country has policies to encourage entrepreneurs to start businesses by creating favorable conditions. In this regard, Nepal implemented extensive reforms during the early 1990s to facilitate its integration into the global market. The main goal of these reforms was to accelerate economic growth & improve overall well-being. ADB says Nepal's average economic growth rate over the past three years has been 4%, which is lower than expected. As a result of various problems, Nepal has not been able to accelerate its economic growth rate in the last three decades. One such issue could be limited access to finance and/or availability of capital. On the other hand, Nepal's financial intermediaries have grown rapidly during the same time period. However, a significant segment of the economy remains excluded from mainstream financial services due to low financial proficiency.

In Nepal, where a sound & developed financial market is still growing, raising capital can be done through the money market or the capital market. Money markets are markets for obtaining bank credit available to a business or individual from BFIs in the form of loans. In the same way, 18% of the total population has access to banking credit, and the rest of the population has access to capital either through the capital market (issuance of shares, debentures) or through informal sector lending, which includes cooperatives and personal loans. In this regard, raising capital for a small business or start-up involves sacrificing the higher cost of capital absorption. Likewise, BFIs generally lend their portfolios to established firms that are already operating and earning profits. It is also imperative to understand how the banking sector operates with a minimal risk appetite. This is one of the major bottlenecks. Their primary focus is easy lending, including margin loans and the real estate sector. In addition, accessing collateralized loans is also a major constraint for SMEs and/or start-ups to finance a project. Above all, in the past five years, Nepal's economy has been slow largely due to exogenous factors such as covid-19, high credit growth (18% annually), followed by tight monetary policy, weak aggregate demand, slow capital expenditure, and crisis of loanable funds causing interest rates to go high. In addition, the ongoing Russia & Ukrainian war has caused persistent headwinds in global business, such as global inflation and a rise in the price of oil. Similarly, businesses generally look for financial institutions to meet their financial obligations. BFI's floating interest rate, however, hinders its growth. If this condition persists, small & medium-sized businesses (SMEs) and new businesses would be under pressure to obtain debt or a loan. For small and medium-sized enterprises (SMEs) and new businesses, debt/or loans would be a problem. Thus, despite limited access to finance, SMEs have played a significant role in the Nepal economy.

Likewise, the Nepalese economy aims to reach $80 billion from $40 billion within a decade. To achieve this far-fetched goal, Nepal must encourage and exhibit more investment classes, such as PEVC hedge funds (i.e., hedging for stable foreign exchange current in terms of US dollar repatriation) of investment.

This write-up outlines where specialized investment (PE/VC or hedge fund) may play a major role in filling the funding gap between entrepreneurs & alternative investment firms. As an alternative investment class, PE funds generally invest in companies, whether startups or established companies, not listed on public exchanges (such as NEPSE). However, they have the potential to grow if additional funds are injected into the company. Furthermore, PE/VCs generally create value/growth in selected companies by injecting funds and planning an exit plan through public issuances or finding other firms. In Nepal's PEVC sector, fundraising could be the biggest challenge, especially being dominated by traditional asset classes (Land, FD, & stock market) competing with prejudiced investment mindsets. On top of that, most PEVCs are novice players who have limited experience in a typical PEVC cycle, an inefficient capital market, including fundraising, deal-making, talent acquisition & nurturing young start-ups.

Figure1: The relationship between PE Investors & Venture -Backed Company operate.

As shown in the chart, investors get shares of the company's equity in return for cash inflows. It collects the funds through the issuance of equity on the private market. It does not pay interest to the PEI for the funds collected. The professional investor will create profit only through capital gain, i.e., exiting from investment by selling shares to someone else on the market. Likewise, the Securities Exchange Board of Nepal (SEBON) has endorsed the regulatory framework for specialized investment funds (SIF Act 2075). With the endorsement of this act, till the middle of 2023, 12 to 15 PE firms have received licenses, and few have funding approval from the authorities. PE firms can also contribute significantly to the capital market. This includes young start-ups or potential business firms that may easily get capital from these firms.

PEVC is an emerging concept in Nepal, which is known in the West. According to the American Investment Council, 85% of private equity investments are in small businesses. This provides them with capital in exchange for shares and proper advisory guidance when growing and expanding the business. Private equity firms create two-thirds of job creation and contribute almost 44% of the United States' gross domestic product (GDP). Likewise, India's economy has been growing significantly since 2000 A.D. At present time India is considered on the global frontier and is one of the fastest-growing countries with an annual growth rate of around 6.5% (as per world economic firm) in the last decade. Further, it aims to reach an economy of US$5Trillion within a short period of time from its current real GDP value of US$3Trillion.

In recent years, there has been a surge of start-up businesses in India due to a vibrant start-up culture. India is home to the 3rd largest start-up ecosystem in the world, expected to witness a consistent annual growth of 12% to 15% as per the PE market in India blog research report. A booming start-up industry has led to the creation of dozens of unicorn companies valued at over $1 billion. According to the PwC report, deal activity in India during the first half of 2021 amounted to US$ 40.7 billion across 710 deals, including both private equity (PE) and strategic acquisitions. In 2022, PEVC investment surpassed US$60 billion for the third consecutive year, according to a report published by Bain & Company “India Private Equity Report 2023”, with more than 2,000 deals. The strong deal flow from the previous year is expected to continue. As per the 2020 report, the India food-tech industry was expected to grow to $5 billion by 2023. PE/VC firms invest in major food-tech players such as Zomato, Swiggy, Uber Eats, etc.

According to the chart above, private equity and venture capital closed over $1000 billion in 2021. All this chart has combined to incentive general limited partners (GP) to specialize & look for niche investment opportunities to generate value & drive return. Hence, the chart reveals alternative investment classes have been growing & recognized as the driver of sustainable value add to the economy.

At the end

The private sector can play a major role in economic growth. It is the government's responsibility to provide a friendly business environment by fixing the necessary investment-related bottlenecks to create an environment that promotes real economic growth and job creation in the country.

A few years ago, PE/VC funds were in their infancy, with only a few funds, such as a business oxygen fund and a Kriti venture fund. These funds follow the concept of limited partner & general partner while bringing in investments & managing the funds. After the SIF 2075 Act, PE/VC is slowly gaining market recognition. Already 12 to 15 PE funds have got a license, approved the funds, and started deals. They also prioritize financing sectors such as renewable energy, healthcare, IT, e-commerce, education, financial services, agriculture, and many more.  A popular food delivery company founded in 2010, Foodmandu has partnered with over 500 restaurants. It has raised investment from Nepal-based PE firms such as Dolma Impact Fund, Team Venture, Avasar Equity & True North Associates. Similarly, another startup company, Sastodeal, has raised billions from Dolma Impact Fund. In recent years, local PE firms have steadily increased their investment size to facilitate business expansion, empowerment, and the development of cutting-edge innovations in products and services. PE/VC also plays a major role in shaping enterprises holistically. As of FY 2021/22, there were 7,459 registered SMEs in Nepal, with a total capital of NPR 3.96 billion. These SMEs contributed 22% to the national economy by creating more than 1.7 million jobs. Hence, that’s a 3.02% increase in registered shares compared to FY 2020/21.

Therefore, the major takeaway points

• Achieving an annual 8% growth rate would not be an arduous process in a country with a 30 million population.
• It’s all about our mindset, and how we want our economy to flourish in the coming days. What is our potential? What problems do we need to fix to attract foreign firms & foreign capital to invest in Nepal?
• In the current scenario, alternative investment classes (PEVC, & Hedge) can play a major role in filling the investment gap. Thus, more reforms from the government should be implemented to create an encouraging & friendly business environment for both the private sector and investors. This will contribute to sustainable synergies growth along with investment return.

Finally, PEVC funding will be a win-win situation along with the goal of encouraging access to finance for SMEs & start-ups.

Contributed by Deepak Luitel

Luitel is an MBA (Finance) graduate and has completed the CFA level (I) program. Currently, he is an adjunct faculty of the Shree College of Management.