Lok Capital’s active portfolio management approach

About Lok Advisory

Lok Capital defines itself as a hands-on financial investor with social performance goals and standards based in India.

Most organisations hold more than one investment engagement and invest in multiple organisations. Portfolio management entails developing a diversified investment strategy with various investment vehicles with an aim to achieve the overall social and/or financial mission of the social investor.

Some considerations for funders are: what kind of organisations are added to the portfolio (pre-engagement), how to evaluate each organisations’ contribution (impact assessment), how social and potentially business outcomes of the supported organisations can be maximised (capacity building), and finally how they can exit organisational engagement at the end of the engagement period. Through these practices this area is linked to pre-engagement processes, informed by impact assessment and plays into multi-sector collaboration.

In this case, we aim to outline how Lok Capital is setting its portfolio management strategy and managing the portfolio based on this strategy.

Organisational Outline

Launched in 2002, the Lok initiative encompasses two establishments, Lok Foundation and Lok Capital.[1] Lok Foundation is a not-for-profit set-up that supports and nurtures advocacy and debates on issues pertaining to social and political inclusion in India through research and targeted grants. Lok Capital is a venture capital firm dedicated to making long-term equity investments in enterprises serving the Bottom of the Pyramid.[2] Through its affiliate, Lok Advisory Services, Lok Foundation also provides advice and services, including asset management services to Lok Capital.[3]

Lok’s Impact Thesis

Lok Capital’s goal is to promote inclusive growth by supporting the development of social enterprises that are commercially viable and can deliver basic services and livelihood solutions to low income households and underserved segments in a scalable and responsive manner. Low income and underserved segments of the population are defined by applying a combination of criteria such as “levels of income, value of assets owned, quality of life, access to basic needs including water, sanitation, power, and exclusion from vital services such as health and education”.[4] Their investment philosophy is rooted in partnering with entrepreneurs and companies across a wide range of backgrounds that have proven execution ability, innovative ideas for serving the low income segment and a strong desire to effect social change.[5]

Lok’s Portfolio

Lok Capital makes its investments through two funds, Lok Capital I and II. Lok Capital I was launched in 2006 with USD 22 million in investments from Accion, The Commonwealth Development Corporation (CDC), Développement international Desjardins, Netherlands Development Finance Company (also known by its Dutch acronym FMO), International Finance Corporation (IFC), Kreditanstalt für Wiederaufbau (KfW) and responsAbility Social Investments. The fund’s investments generally range from USD 500,000 to USD 3 million in size. Lok Capital II was closed in 2012 with USD 65 million. Its investors included previous Lok investors, IFC, CDC, KfW, FMO and responsAbility along with new investors, namely Proparco and ASN Novib.[6]

Lok aimed to close the first round of fund-raising for its USD 80 million third fund by January 2016. In this round, it hopes to raise USD 40-45 million and eyes 10-15 per cent from local limited partners compared with nil in its past two funds.[7]

Lessons in diversification

Lok Capital I, the first fund, was set up with the objective of catalysing the delivery of financial services to the underserved low-income households in India through equity investments in Micro-Finance Institutions (MFI) in India and provision of technical assistance and operational support to the MFI partners. A diversified portfolio was built across regions as well as urban and rural areas. The fund made nine investments, of which eight investments were in microfinance institutions and one in a rural Business Process Outsourcing (BPO) entity.[8]

lokcapital-microfinance-investment

In 2010, the Andhra Pradesh microfinance crisis happened and brought Lok Capital I’s concentration risk to the forefront. As Lok’s investment philosophy was about improving basic services and livelihood solutions to low income households, they had previously discussed health care in its mandate as a diversification strategy even before the crisis hit.[9] Though financial inclusion is a critical requirement of the Bottom of the Pyramid (BOP) segment, ensuring access to other essential services such as healthcare, education and livelihoods is equally important to achieve holistic development. Additionally, from a risk mitigation perspective, new sectors were identified, and a part of this learning is evident in the construction of Lok Capital I’s portfolio – in addition to microfinance companies, Lok Capital I also invested in Rural Shores, a rural BPO set up to provide livelihood opportunities to the rural youth.[10]

Lok Capital I has made seven exits, returning 100 per cent on the fund’s invested capital and generating an average return of three times in cash across these exits. This means a net internal rate of return of 15-20 per cent. The exit from RuralShores, Lok’s first exit from a non-MFI investment, returned six times the initial investment.[11]

Built on the lessons from the first fund, Lok Capital II, the second fund, was set up with the objective of backing entrepreneurs delivering essential services in the Financial Inclusion (FI) and broader inclusion sectors (employability solutions, healthcare, and education) with a strong socially driven approach[12]. Rather than becoming a sector-agnostic impact fund, Lok II has moved beyond the traditional Joint Liability Group (JLG)[13] driven loans to diversifying across various FI verticals such as Micro to Small and Medium-sized enterprise (MSME) finance, housing finance and vehicle loans. As of March 2015, traditional microfinance portfolio contributed 61 per cent of the portfolios of the partner companies, with the rest being made of the other categories.[14]

In terms of the sector strategy of the fund, Lok II has been actively tracking and investing across the healthcare and education sectors in high quality early-stage ventures. Lok II has made fourteen investments so far, of which at least five have been made in early-stage ventures with high potential for impact across sectors. Much of its USD 65 million Lok Fund II is well diversified and invested in sectors such as healthcare, agriculture, education and micro-housing finance.

lokcapital-chart

A third fund in its wings

Lok Capital III. In 2015, new issuance of bank licenses and the growth of the Fintech space led to a changing landscape in micro finance. As the impact sector in India developed, commercial interest grew, leading to the adoption of a new investment strategy.[15] According to Vishal Mehta, co-founder and partner of Lok Capital, the third fund would give a major thrust to small and medium enterprises, small finance banks, agriculture, health and others. Mehta said Lok Capital could not raise money from local LPs for the past two funds as investors did not understand the concept of impact investments in India. “Our successful exits have not only boosted the confidence of LPs (mainly government institutions, International Finance Corporation and others) from outside India, but have also increased domestic LPs’ interest.”[16] In addition to investors from the first two funds, a number of other potential LPs had been approached, including pension and insurance funds.[17]

On 16 June 2016, Lok announced the first close of Lok Fund III at USD 40.5 million.[18] This first close had investors CDC Group Plc, Dutch development bank FMO and French investor Proparco SA. TIAA Global Asset Management has come on board as a new investor. The third fund will also shift from early-stage investing to growth-stage investing (Series B and C stages).

A Balancing Act between Social and Financial Returns

Given Lok’s strategy to achieve both social and financial returns for each of their investments, decisions about straddling both occur at three times:

(1) Before the fund is launched and during the fundraising
(2) At the time of capital raise prior to Lok’s investments and at the time of Lok’s exit; and
(3) As part of the ongoing operational and strategic engagement with the portfolio companies.[19]

During the fundraising process the fund strategy is defined together with interested LPs. The Lok Advisory Services (LAS) team spearheads the fundraising process by identifying socially aligned investors, and approaching these LPs with their proposed investment strategy and impact thesis. After rounds of extensive discussions and incorporating feedback provided by the LPs, a fund strategy and investment thesis is formed and jointly agreed between the LPs and the Lok Group. The mandate for the fund is established and clearly aligned and defined on what the Lok Group can invest in, such that LP approval is not necessary. Lok started this process of looking for suitable investors late 2014 and the whole fund raising process from initial pitch to fund closure took between 12 to 18 months.

For the second point of time, when there is a capital raise subsequent to Lok’s investment in a company, there is a call to be taken on the kind of investor that should be brought in as the new shareholder. “There are situations where from an immediate valuation stand-point, certain investors would value our company higher and thereby creating a better mark-up for Lok. However, the impact alignment of such an investor can be a possible issue that needs to be taken into account. In Lok’s experience this misalignment would typically manifest in differences in growth strategy and/or lack of regulatory/political understanding of the sectors”, according to Rajat Bansal.[20] A case in point is the last round of capital raise at Ujjivan Financial Services, in which Lok is an investor from both its funds; Lok I and Lok II. As the capital requirements of the company were large (the round size was USD 96 million split evenly across primary and secondary funding), it necessitated reaching out to larger and more commercial Private Equity funds. Most of these funds are focused on financial returns only and would look at impact as an additional benefit and/or cost of doing business. Lok played a key role in balancing the need for large capital as well as maintaining a good balance of impact oriented shareholders in the company. Post completion of the round, CDC is the second largest shareholder in the company and, along with Lok and other impact investors, ensures that the impact focus of Ujjivan is not lost even though there are a number of non-impact focused shareholders in the company. For Lok, both social and financial returns are integral in making investment decisions.

As part of the ongoing operational and strategic engagement with the portfolio companies to achieve both social and financial returns, Lok’s team takes an active approach to helping its investees perform by mentoring and offering strategic advisory, organization building, operational effectiveness projects, and reporting and review.

For start-up/early-stage companies, a critical element is to align and work closely with the promoter. Lok provides assistance to the entrepreneur or management where there is mutual agreement on Lok’s ability to add value to the company.[21] Beyond these interactions, Lok’s capacity building fund is a separate pool of funds made available by one of the LPs, over and above the funds committed to Lok for investments. The capacity building fund is a grant that investees can apply for.[22]

The level and nature of Lok’s engagement with the portfolio company evolves over the lifecycle of an investment.[23] Lok’s approach is also specifically catered to the investee company, informed by an assessment during the pre-investment diagnosis and periodic reviews.[24] Lok interacts with investees on a regular basis depending on the engagement modes.

Lok sees these three points as critical elements for fostering alignment between stakeholders of the fund and for the growth of the company. Capacity Building will be outlined in more details in the next section.

Capital is not the only constraint: Creating value through Capacity Building

Lok Capital recognises the constraints in a rapidly changing business environment faced by early-stage businesses where budgets are tight and functional and strategic handholding might be required. Promoters, founder(s) of the investee company, who commit capital and hold the initial shareholding in the company, often need a sounding board while developing and implementing various strategies, and the need to deliver numbers while achieving the right social-commercial balance calls for constant debate and introspection. Managing and maintaining the scale is another challenge.

lok-capital-pm-process

Lok’s level of engagement with an investee company is very specific to that company, and is assessed during the pre-investment diagnosis and periodic reviews.

Depending on the size of investment, historical relationship and engagement with the company, they are classified in terms of low, medium and high priority. For high priority cases, e.g. fast growing companies with new products/services expanding into new geographies, this would involve a high level of both financial support and operational advisory including site visits and monthly catch-up calls on performance.[25] Appendix B has more examples.

lok-capital-pm-process-2

Beyond the classifications, Lok engages and capacity builds it investees in three ways.  Usually Lok has a board seat in almost all their investee companies and has created a robust advisory pool to guide investee companies at a board level. The advisory pool comprises of domain and function experts.[26]

In conjunction with Lok Foundation, Lok Group also runs a fellowship program that places talented young professionals with its investee companies in 12-18 month roles as consultants, analysts, researchers and advisors. They are engaged across a wide range of functions at the portfolio companies such as business strategy development, analysis of growth alternatives, and marketing and brand development.[27]

Finally, the capacity building fund and technical assistance pool are resources Lok’s investee companies can tap into. Where needed, costs are sometimes split equally between Lok and the investee.[28]

A few critical areas of engagement would be in finance, products/services, organization development, business growth and business cycle mid-life crisis. For example, in the area of business growth, an investee might be over aggressive in launching a new product or a service. Lok thus adds value through risk management combined with scientific assessment and market knowledge, and introducing inorganic options through networks.[29] For more examples, Appendix A is attached for reference.

Two case studies of Lok’s capacity-building approach

Case Studies – Organization Design Assessment at a Financial Services Investee

Lok’s portfolio team works closely to mentor the promoter and identify bottlenecks for future growth, developing an action plan for bridging organizational gaps. While this investee was well run at the upper end, there were problems with the operating core such as an unstable field structure. To this end, Lok recruited senior management resources including CXOs at the organization, built the entire marketing team, and sought the advice of part-time industry experts. Two of Lok’s senior internal resources even took up positions as COOs of MFIs subsequent to their stints with Lok.[30]

Another instance is the Uttarakhand operation of the financial services portfolio company, IFMR Rural Channels and Services. Uttarakhand is a hilly state in the northern part of India where due to poorer infrastructure and low population density, logistics prove to be a challenge for any brick and mortar business. IFMR had started a regional Strategic Business Unit (SBU) in Uttarakhand since the requirement for inclusive financial services in the state was high (one of the most unbanked areas in India), however the SBU has been making losses since its founding in 2009. Shutting down the operations of this SBU and focusing on more profitable regions was probably the simplest option. After multiple rounds of deliberations with the company and the board, it was decided to undertake an assessment of the changes required to be made to turn around this operation. Lok took the lead in this and undertook a detailed study of the factors affecting the performance of the SBU and made recommendations to the board to improve the situation. A majority of these have been implemented and the SBU is projected to make an operational profit this fiscal year.[31]

Case Study – Vistaar Attrition Control

Vistaar was facing high attrition at its branches. The problem was spread across all zones, leading to a performance slowdown, pressure on recruitment and training and delaying growth plans. Lok’s team made extensive field visits to understand reasons for attrition on the ground. From the analysis, they developed more employee centric communication, non-monetary incentives and reward mechanisms, such as the gradual scale-up of targets for new Customer Relationship Officers in performance measurement. As a result of their recommendations, attrition was reduced by over 30 per cent and Vistaar is now in a high growth phase.[32]

Impact Assessment and Mission-Aligned Exits

Lok assesses impact based on the investees’ operational performance as a lever for social impact. As business and operations expand and become successful, so does social impact, directly impacting financial performance. For more information, please see the Lok case study on impact assessment at https://avpn.asia/2015/11/16/impact-assessment-lok-capital/.

Lok spends a lot of time getting aligned with the owner or founder from both a business and a social perspective when making an investment. As a part of the alignment process, Lok discusses practical exit scenarios in a five to seven year timeframe. Exit scenarios may include going public, buying back by the company if it generates enough profitability and probable income, or a secondary sale of our stakes to another fund. Ensuring that the company’s social values are preserved is crucial, and Lok’s practical learnings thus far are:

  1. keep the social aspect of the business fully integrated with the operations of the business;
  2. carefully choose co-investors and future investors so that the business expectations of shareholders stay focused; and
  3. build the right management team at the companies so that the culture is set before the shareholder base becomes broad.

Lok has found that when communicating business principles and objectives clearly, most investors will realise that if the social mission is compromised, the business will also be negatively affected.[33]

For well performing investments, Lok stays invested for as long as practically possible. The life of the fund forms the key decision criteria for exit in such cases. For financial services businesses, exit decisions can be kept dynamic given there are multiple fund raises post Lok’s investment where they can exit. However for non-FI investments, planning an exit well in advance and in line with a fundraise is important, as that is not undertaken very frequently. Other considerations that may lead to Lok exiting may be the profile of new investors coming in, and a change in company’s strategic direction. For example, Ujjivan raised a large round of capital end of 2014, but rather than judging on pure play valuation, where it might be higher, a reasonable but socially aligned mission was taken into higher consideration.[34] Overall, it has been reported that “Lok Capital has completely exited companies in which it invested from its first fund of USD 22 million; it has also existed from five of the 16 companies in which it invested from its second fund of USD 62 million.”[35]

In Summary

Lok’s track record of success can be attributed to their capitalization of learnings into the evolving construction of their portfolios, and in their ability to be a value-add investor at the business operations level while diversifying risks in a controlled manner. At the core are fund management and portfolio management skills, including (1) risk management and diversification of Lok’s portfolio, (2) supporting portfolio companies in achieving their social and financial mission through capacity building, and (3) raising funds from the right kind of impact-aligned investors and managing toward exits while balancing both social and financial returns.

Appendices

Appendix A


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Appendix B

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[1] See also AVPN case on Lok’s Impact Assessment available at http://avpn.asia/2015/11/16/impact-assessment-ia-loks-customized-approach-using-external-parties-and-internal-observations/

[2] Lok Capital Website, http://lokcapital.com accessed on 10 Oct 2016

[3] Lok Capital Website, http://lok-foundation.org/aboutus.html accessed on 10 Oct 2016

[4] Lok Capital Website, http://lokcapital.com/about-lok-capital/philosophy/ accessed on 10 Oct 2016

[5] Lok Capital Website, http://lokcapital.com/about-lok-capital/investment-approach/ accessed on 10 Oct 2016

[6] Lok Capital LLC. Accessed online on 11 Jan 2016 and 10 Oct 2016 at http://www.microcapital.org/microfinanceuniverse/tiki-index.php?page=Lok+Capital+LLC

[7] Lok Capital eyes 15% from local LPs for its third fund. 10 Dec 2015. Accessed online on 11 Jan 2016 and 10 Oct 2016 at http://www.business-standard.com/article/companies/lok-capital-eyes-15-from-local-lps-for-its-third-fund-115121000017_1.html

[8] Lok Capital Impact Report 2014-2015: Lok Capital Fund Impact, pp.8.

[9] Phone call with Rajat Bansal, Associate Lok Capital, on 07 Jan, 2016.

[10] Phone call with Rajat Bansal, Associate Lok Capital, on 07 Jan, 2016.

[11] Lok Capital eyes 15% from local LPs for its third fund. 10 Dec 2015. Accessed online on 11 Jan 2016 and 10 Oct 2016 at http://www.business-standard.com/article/companies/lok-capital-eyes-15-from-local-lps-for-its-third-fund-115121000017_1.html

[12] Lok Capital Impact Report 2014-2015: Lok Capital Fund Impact, pp.14.

[13] See for example a comparison between self-help and joint liability groups (JLGs) for microfinance: http://www.academia.edu/5344123/The_Best_Model_for_Micro-lending_Self_Help_Group_or_Joint_Liability_Group

[14] Lok Capital Impact Report 2014-2015: Lok Capital Fund Impact, pp.16.

[15]Phone call with Rajat Bansal, Associate Lok Capital, on 07 Jan, 2016.

[16] Lok Capital eyes 15% from local LPs for its third fund. 10 Dec 2015. Accessed online on 11 Jan 2016 and 10 Oct 2016 at http://www.business-standard.com/article/companies/lok-capital-eyes-15-from-local-lps-for-its-third-fund-115121000017_1.html

[17] Phone call with Rajat Bansal, Associate Lok Capital, on 07 Jan, 2016.

[18] LiveMint, 16 June 2016, available at http://www.livemint.com/Companies/Esv6kLRPtWzmz0fBC2lQXO/Lok-Capital-announces-first-close-of-third-fund-at-405-mil.html, accessed online on 10 Oct 2016

[19] Internal document provided by Rajat Bansal, Associate Lok Capital

[20] Phone call with Rajat Bansal, Associate Lok Capital, on 07 Jan, 2016.

[21] Lok Capital Portfolio Management Process, PPT March 2015, pp. 8.

[22] Phone call with Rajat Bansal, Associate Lok Capital, on 07 Jan, 2016.

[23] Lok Capital Portfolio Management Process, PPT March 2015, pp. 6.

[24] Lok Capital Portfolio Management Process, PPT March 2015, pp. 7.

[25] Phone call with Rajat Bansal, Associate Lok Capital, on 07 Jan 2016.

[26] Lok Capital Portfolio Management Process, PPT March 2015, pp. 7.

[27] Lok Capital Portfolio Management Process, PPT March 2015, pp. 15.

[28] Phone call with Rajat Bansal, Associate Lok Capital, on 07 Jan, 2016.

[29] Lok Capital Portfolio Management Process, PPT March 2015, pp. 8.

[30] Lok Capital Portfolio Management Process, PPT March 2015, pp. 13.

[31] Internal document provided by Rajat Bansal, Associate Lok Capital

[32] Lok Capital Portfolio Management Process, PPT March 2015, pp. 27.

[33] GIIN Investor Spotlight: Lok Capital. 29 Aug 2012. Accessed online on 12 Jan 2016 and on 10 Oct 2016 at https://thegiin.org/knowledge/spotlight/investor-spotlight-lok-capital

[34] Phone call with Rajat Bansal, Associate Lok Capital, on 07 Jan, 2016.

[35] LiveMint, 16 June 2016, available at http://www.livemint.com/Companies/Esv6kLRPtWzmz0fBC2lQXO/Lok-Capital-announces-first-close-of-third-fund-at-405-mil.html, accessed online on 10 Oct 2016
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