With the increasingly confident opening up of the Indian economy, international investors are becoming more interested in considering India as an investment destination.

If one excludes foreign direct investment by the large international corporations, there are three broad types of foreign investment in companies started and run by others, viz.

(i) foreign institutional investors or FIIs, which normally invest in quoted equity through the stock market, though occasionally they may take an agreed stake in a company;

(ii) private equity -- these are large, unquoted, privately marshalled funds collected by fund managers from institutions, pension funds and wealthy individuals, and provide capital and normally seek representation on the board of the investee company so that they can keep a close watch on the workings of the company and occasionally offer advice;

(iii) venture capital funds, which are promoted by a management team that evaluates and invests, mostly in start-up companies where the risks are greater. There are also phenomena like the now ubiquitous hedge funds.

Money is flowing into India through all these avenues. The private equity that has come into India in the last 12 months (July 2006 to June 2007) alone is estimated at $7 billion -- which is much more than even FDI flows used to be until recently. FII investments have been even greater, and have kept the stock market buoyant. Ironically, the smallest of the three categories is venture capital funds -- which are what help and promote domestic entrepreneurship.

VCFs add value because the management in a VCF team will seek to play an active role in the management of the investee company and contribute its expertise to the promoters of the investee company.

Although the aim of the venture fund is to limit itself to a minority stake in the investee company, it is not unusual for the fund to end up having a majority stake because the promoter may not be able to bring in additional funds when the company needs more capital.

Venture capital funds usually have a life of seven to 10 years. In other words, investors in a VCF cannot expect to get their returns in a period shorter than this. This length of time is required because the investee companies have to go through the investment and growth phases before they can be sold or taken to the stock market.

The task and the aim of the management team in a VCF are to give to the investors an 'inflation proofed' return that is substantially higher than what they would have got by placing their money in less risky avenues.

The management team usually charges a fee of about 2-2.5 per cent of the total funds committed by investors. For example, a $50 million VCF will pay a management fee of $1.25 million per annum. In addition, the management team will be entitled to what in VCF parlance is called 'carry'.

This is usually 20 per cent of the gain registered by the fund, with gain defined as the net realisation of disinvestment of all their investments minus the actual investment. The net realisation is discounted for the inflation during the period between the date of actual contribution by the investors and the date of return received by them. To achieve such a gain is a challenging task for the managers of the fund. However, the reward for success is also substantial.

It is inevitable that a proportion of investee companies will fail. The risks of failure are greater than normal in a VCF as the entrepreneurs are not experienced and the technology may be unproven. Among other dangers is the integrity of the entrepreneur/promoter, who can conceal things from the managers of the VCF. The promoter could also underestimate the challenge of competition -- either already existing or potentially emerging.

Another common danger is that of being carried away by the current 'buzz' in the market, the internet boom being a good example. Then, due to over-enthusiasm, the entrepreneur may be tempted to go in for excessive borrowing in order to prevent any dilution of his shareholding. This can be a potential source of trouble as very often the expectations of sales and profitabilities may not be met, and the debt-servicing burden can prove fatal.

It is obvious from the above analysis that successful management of a VCF requires a combination of skills, consisting of the ability to judge the competence and the integrity of the investee company's promoters, contributing to the effective management of the enterprise by providing mature advice based on wider experience, and so on.

A VCF can choose to invest in a chosen area of business like information technology or consumer products, or it can invest in a range of activities and engage specialists or advisors, who then provide the necessary expertise. Most successful VCFs tend to limit themselves to a few chosen areas of expertise.

Another consideration in investment is geographical. As frequent interaction is required between the VCF management and the investee company, it is inevitable that investments are bunched around the location of the fund. In the US, the main focal points are Silicon Valley in California and Cambridge in Boston. These locations emerged because most of the early entrepreneurs were from Stanford University in Los Altos near Silicon Valley and MIT in Cambridge.

On a much smaller scale in India, the entrepreneurial clusters based on universities are in Bangalore/Chennai and to a limited extent in Delhi. But it can be expected that more such clusters will develop in Gujarat, Punjab, Pune and Kolkata as Indians are by nature serial entrepreneurs.

Venture capital funds are one of the most effective ways of bringing out and nurturing this innate ability of our people. However, there are very few rich individuals in India who can risk financing a VCF and most of our financial institutions are owned by the government and therefore not capable of the entrepreneurship that is required. But the attractions of India for a VCF are very significant, viz. (i) the high rate of growth in the economy, (ii) the availability of skilled managerial talent, (iii) the low cost of such manpower, and (iv) stability in the tax and economic regimes.

It must be hoped that VC managers from the US will discover these attributes and take a bigger call on India. The presence of several Indians in Silicon Valley is an enabling factor, but the bigger story that needs to be told is about the quality and range of entrepreneurial ability within the country.