Private Equity (PE) and Venture Capital (VC) represent dynamic segments of the investment landscape, providing crucial capital to businesses at various stages of growth. They typically invest in companies with high growth potential. The life of such a fund is typically 10-15 years and involves four key stages: fundraising, deal selection, value creation and deal exit & liquidation.

PE/VCs invest in portfolio companies through funds sourced from various investors, including banks and financial institutions (BFIs), insurance companies, social security funds and high-net-worth individuals (HNIs), among others. Two key parties contribute to PE/VC funds: General Partners (GPs) and Limited Partners (LPs). GPs are fund managers responsible for raising capital, selecting and managing portfolio companies, and making decisions regarding investments and exits. LPs, on the other hand, are the primary source of capital for the fund but have limited involvement in the fund's day-to-day operations.

The Specialized Investment Fund (SIF) Regulation of 2019, introduced by the Securities Board of Nepal (Sebon), provides the legal framework to govern PE/VC funds in Nepal. Before this, there were no specific regulations for these investment vehicles in the country. One of the requirements of the SIF regulations is that fund managers must invest at least 2% of the total fund size from their resources. This rule ensures that GPs have a financial stake in the fund, aligning their interests with those of the LPs. This provision also enhances the credibility and attractiveness of the PE/VC sector in Nepal.

Importance of LPs in PE/VC Landscape

The significance of LPs can be traced back to the French "commandite" system in the early 18th century where investors supplied funds with limited liability. This enabled investors to participate in profits without direct involvement in operations. This system laid the groundwork for modern PE/VC structures. Today, LPs are essential in the contemporary PE/VC landscape for several reasons some of which are listed below:

Funding Capacity: LPs provide essential capital that enables GPs to pursue investment opportunities. This financial support is crucial for executing investment strategies, whether it is funding innovative startups or acquiring and transforming established companies. Without capital from LPs, GPs would not have the resources to drive growth, implement strategic initiatives or meet the fund’s objectives.

Strategic Influence: LPs with substantial investments can shape the fund’s strategic direction by influencing key decisions. Additionally, LPs may secure board representation in portfolio companies which allows them to actively contribute to governance, monitor performance and ensure that strategic decisions reflect their interests and objectives.

Advisory Role: LPs participate in advisory committees and ensure that GPs manage investments responsibly, adhere to ethical standards and pursue strategies that maximise returns.

Building a Community: LPs are more than just passive investors; they actively contribute to shape the direction of PE/VC funds. Beyond providing capital, many bring industry expertise, valuable networks and a long-term focus on sustainable growth. This not only supports GPs in investing in startups, acquiring and improving established companies and implementing strategies that create lasting value but also helps build a strong community thereby enhancing the overall effectiveness of the PE/VC ecosystem.

The way LPs actively engage and influence strategies shows how diverse their roles are in the PE/VC world. This leads us to consider the various types of LPs and the unique opportunities they bring to the investment process. In the global PE/VC landscape, LPs such as Sovereign Wealth Funds, university endowments, HNIs, BFIs, funds of funds and family offices have become pivotal due to their longstanding role in providing capital.

Prospective LPs in Nepali PE/VC Ecosystem

Nepal’s evolving PE/VC landscape is attracting interest from various LPs, aligning with global investment trends while adhering to the country’s regulatory framework. The SIF Regulations has set a minimum investment threshold of Rs 5 million for all LPs. The prospective LPs eligible for investment in the Nepali PE/VC ecosystem are:

Banks and Financial Institutions (BFIs): BFIs can serve as prospective LPs for PE/VC firms as they have substantial capital reserves. This allows them to invest significant amounts of capital, which is necessary for PE/VC firms.

Through such investments, BFIs can also gain valuable insights into emerging industries which can align with their core business operations like lending and asset management. The long-term investment horizons of BFIs align well with those of PE/VC, and the returns can help them meet future long-term liabilities. BFIs can also diversify their investment portfolios which helps them hedge against the risks of market volatility.

The central bank’s Unified Directives, 2023, have made A, B, and C class BFIs, as well as infrastructure banks, more attractive as prospective LPs for PE/VC firms. Previously, investments in PE/VC had to be made from undistributed reserves which limited the ability of BFIs to invest without affecting distributable profits and Tier I capital. The new directives, however, allow these investments without deductions from core capital, freeing up more resources for banks to invest in PE/VC. This is highly favourable for PE/VC firms as it expands the pool of available capital, making it easier to raise funds. The exemption from blacklisting provisions for entities with over 50% foreign investment when investing in SMEs through PE/VC funds further incentivises participation from institutional investors.

Insurance Companies: Similar to BFIs, life insurance, non-life insurance, and reinsurance companies manage substantial capital generated as premiums collected from policyholders. They are required to reinvest these premiums to cover future claims and operational expenses. PE/VC funds offer insurance companies an alternative investment avenue, allowing them to diversify their portfolios beyond traditional assets like stocks and bonds. The Nepal Insurance Authority (NIA) recently broadened the investment scope for insurance companies but also included specific restrictions to ensure prudent investment practices. Under the updated directives, insurance companies are permitted to invest up to 15% of their insurance funds, an increase from the previous 5%. Within this, they can allocate up to 1.5% of their total investments to PE/VC funds licensed by the Sebon. However, no more than 1% of the total 1.5% allocation can be invested in any single fund. This means that while insurance companies are permitted to invest 1.5% of their total investments in PE/VC funds, only 1% of that 1.5% can be invested in a single PE/VC fund. Additionally, prior approval from the NIA is required if investments are to be made outside the prescribed areas or exceed the specified limits.

Welfare Funds: A welfare fund refers to a pool of money aggregated by an employer or organisation to support various social welfare activities. These funds are typically financed through contributions from employers, employees and other sources. With large capital at their disposal, welfare funds can be prospective LPs for PE/VC funds. For example, the Nepal Army Welfare Fund holds a significant amount of capital primarily deposited in various bank accounts with nominal interest rates. Investing in PE/VCs could provide the welfare fund with greater returns and diversification. However, the Army Act, 2006, imposes a legal restriction that bars them from investing in business enterprises, including PE/VC funds. This legal constraint prevents the Nepal Army from taking advantage of the potential benefits associated with PE/VC investments.

Pension Funds:

a. Employee Provident Fund (EPF): EPF is a crucial retirement benefits scheme established in 1962 under the Karmachari Sanchaya Kosh Act to serve salaried employees by collecting their savings and providing them with retirement benefits. As a potential LP in a PE/VC firm, EPF can offer significant financial capital, sourced from employee and employer contributions.

b. Citizen Investment Trust (CIT): CIT Nepal is a key player in mobilising savings from Nepali citizens and investing them in various sectors to generate returns. As a potential LP in PE/VC firms, CIT can provide significant long-term capital from its pension funds and savings plans. Similarly, CIT’s governance, backed by its establishment under the Citizen Investment Trust Act 1990, ensures that its investments are both financially sound and supportive of Nepal’s broader economic development goals, positioning it as a trusted partner for PE/VC firms.

c. Social Security Fund (SSF): The SSF established under the Social Security Act, 2018, is a key social protection program funded by mandatory contributions from employers (20%) and employees (11%). As a prospective LP in a PE/VC firm, the SSF can offer substantial long-term capital that aligns with the growth-oriented strategies typical of PE/VC investments. Investing in PE/VC allows the SSF to potentially achieve higher returns, enhancing its ability to provide comprehensive social security benefits.

Foreign Individual and Institutional Corporate Investors: Foreign individual and institutional investors are key prospective LPs for PE/VC firms, providing substantial capital, global reach and long-term investment horizons. These investors often seek diversification beyond their home markets, looking for investment opportunities in emerging markets and technologies. So, they are valuable prospective LPs for Nepali PE/VC funds.

However, the provision of proportional repatriation under FITTA can pose challenges for foreign investors, as they can only repatriate amounts in proportion to their investments. This restriction can limit their willingness to invest in Nepal, as they cannot fully repatriate their investments and profits back to their home country.

Development Finance Institutions (DFIs): DFIs are specialised financial institutions established by governments to provide risk capital for development projects. These institutions often accept higher risks than commercial investors. Their participation not only enhances a fund’s credibility, meeting key development and sustainability standards, but also attracts further investments. DFIs have been the largest contributors to investment funds in Nepal, investing around $105.56 million between 2013 and 2023. Firms like Business Oxygen and Dolma Impact Fund have benefited significantly from their investments. DFIs are particularly important for Nepal due to their ability to provide not only substantial financial resources but also technical expertise and a focus on development impact. DFIs, however, have not yet invested in licensed SIF funds. While the SIF Regulations include bilateral and multilateral corporate investors as eligible LPs, they do not explicitly mention DFIs, creating uncertainty about their role. The regulations should include them as eligible investors to encourage greater participation.

Listed and Non-listed Investment Companies: Investment companies pool capital from investors to invest in a range of financial securities. They can serve as LPs in PE/VC funds, contributing capital while avoiding direct management. Listed investment companies bring credibility and large-scale funding due to their transparency and public capital access. In contrast, non-listed companies, backed by private investors or HNIs, offer greater flexibility and higher risk tolerance, making them valuable LPs for PE/VC funds.

High Net Worth Individuals (HNIs): HNIs, who typically possess substantial liquid assets, come from diverse backgrounds, including executives, entrepreneurs and investors. In recent years, they have increasingly become prominent investors in PE/VC firms due to their ability to commit significant capital and their growing interest in alternative investments. As traditional assets often offer lower returns, many HNIs have turned to PE/VC funds to diversify their portfolios and capitalise on high-growth opportunities. With a higher risk tolerance and a long-term investment outlook, HNIs are well-suited for the extended commitment periods of PE/VC investments. This trend has made them a crucial source of capital for the growth and innovation of PE/VC firms.

Non-Resident Nepalis (NRNs): NRNs are increasingly interested in diversifying their investment portfolios, with many drawn to the high-growth opportunities in both global and local markets. Emerging markets like Nepal hold particular appeal due to their financial potential and the emotional connection NRNs have with their homeland. For NRNs, investing in Nepal is often more than a financial decision—it is a way to contribute to the country's development and prosperity, strengthening ties with their roots and supporting communities where their families still live.

Although SIF Regulations have identified NRNs as eligible investors in PE/VC funds, they are treated as foreign investors under the law. This means they must gain prior approval from the Department of Industries (DOI) and may face challenges due to the tedious process of seeking various approvals from multiple regulatory bodies. Therefore, regulatory bodies should explore streamlined processes to facilitate NRN investment in PE/VC firms.

Advantages of Investing in PE/PC for LPs

Investing in alternative asset classes like PE/VC offers several compelling advantages for LPs. One of the primary benefits is the potential for greater returns compared to traditional market instruments. Although PE/VC investments carry higher risks, they often yield higher returns, with fund managers in Nepal targeting returns above 20%. Although Nepal's PE/VC ecosystem is still in its nascent stage with limited exits, the 2018 US Private Equity Index Report (Cambridge Associates) highlighted that over a 20-year period, PE funds achieved an average return of 11.88%, substantially surpassing the S&P 500, which had an average return of 6.48%. This shows that the returns of PE funds outpace the market over a longer period.

Similarly, as per SIF Regulations PE/VC funds are only subject to one year lock-in period post IPO while other companies are bound by the lock-in period of three years. This allows the PE/VC funds to realise their returns sooner than other corporate investors. Another key advantage is portfolio diversification, as PE/VC investments provide exposure to private, unlisted companies that traditional stock and bond markets often overlook. This diversification helps LPs broaden their investment portfolios and hedge against market volatility. In underdeveloped nations like Nepal, the capital markets often lack the diversity needed to give investors broad exposure to different sectors, as stock exchanges in these regions typically do not reflect the full spectrum of the economy. This is where PE/VC funds can play a crucial role by offering LPs access to a wider range of sectors and growth opportunities that are otherwise difficult to tap into through traditional markets.

Conclusion

PE/VC firms thrive on a strong partnership between GPs and LPs. While GPs use funds of LPs to drive innovation and growth, LPs rely on GPs' expertise to maximise returns. By fostering mutual trust and adapting to each other's needs, both GPs and LPs can achieve long-term success and impactful investments. The increasing number of Sebon-licensed SIFs entering the Nepali market presents a promising opportunity for LPs to enhance their investment strategies. With a broader range of options, LPs can better align their goals with the available opportunities, choosing funds that cater specifically to their risk tolerance and investment horizon. This allows LPs to focus more on long-term value creation and capitalising on the potential rewards of PE/VC investments.

This surge of SIFs also ignites healthy competition among fund managers, encouraging fund managers to improve their operational efficiency, transparency and investor-friendly practices. This competitive environment benefits LPs by offering funds with better performance metrics and robust risk management, ensuring their capital is invested wisely. This increased competitiveness encourages better investments and also ensures that the capital is channelled to those funds with efficient operations and growth potential.

(TEAM Ventures, is an industry-agnostic alternative investment firm with a diverse portfolio spanning the energy, technology, real estate, manufacturing, financial institutions, agri-infrastructure, and electric-vehicles sectors)

(The opinion article was originally publihsed in the October, 2024 issue of the New Business Age Magazine.)