Accept Market Risk, Manage Operating Risk

In a previous post, we suggested that to grow financially sustainable enterprises (social or otherwise) it’s important to build off of the demand for “choice”—not just the “needs”—of an underserved community. This was the basis on which Song Investment Advisors was founded in 2008; it aimed to provide growth capital to small and medium-sized enterprises (SMEs) in India to improve the quality of life of “aspiring” household incomes less than INR 10,000 per month (about $6 to $13 per day). When Vishal (co-author of this series) led Song, he theorized that as incomes grew for these Indian consumers, demand for basic services would increase dramatically—sometimes so fast that building capacity to meet this demand could be the central challenge faced by the pioneering organizations Song sought to invest in.

One of Song’s early investments was in healthcare, as India lags behind world averages in doctors, nurses, and beds. Over the past ten years, big investors broke into the multi-service tertiary care market by targeting big cities and their rapidly expanding populations of affluent patients; these projects needed substantial private capital to succeed. At the village and district level, however, business remained largely status quo; latent demand was present, but for-profit enterprises had not solved the value equation. Song was already familiar with the success of Aravind Eye and Vasan in the south, but northern India seemed underrepresented.

Enter Eye Q, a small eye-care hospital chain. The management team—Rajat Goel, an IIM trained MBA with industry experience from Bausch and Lomb, and Dr. Ajay Sharma, a leading ophthalmologist—had built four eye-care hospitals on greenfield locations in Haryana and Uttrakhand. Goel shared similar concerns about the unmet needs of the under-represented market. In fact, he was already seeing a significant number of patients within the target income market, performing basic eye-care checkups, screenings, and cataract surgeries. The problem was that the company needed cash to grow. Goel had taken on an additional investor who wasn’t willing to stay for the long haul, adding fundraising pressure to a management team that was already stretched thin.

Song was interested, but only if the time and costs of building new centers was less than the first four that Eye Q built. Vishal later recalled, “You could see the market potential and dedication, but what was needed was a less risky growth plan with streamlined processes and resources align to it.” Long before making any investment, Vishal and Eye Q’s management team discussed ways to reach the market faster, how to professionalize day-to-day operations, and the importance of avoiding informal and poorly documented contracts. (This last point can be very complicated in India, especially for early stage companies; the team worked to quantify what Eye Q owed to outside investors, and to construct an exit strategy for the outsiders, generate new growth capital from Song, and create a simpler, more transparent capital structure.) All of this took 12 months to complete, and Song became a significant minority investor.

In the process, Song learned that buying control was not a critical success factor— these businesses operate largely on a “relationship” basis. Vishal notes, “Everything in India is a relationship—customers, suppliers, and partners.” In addition to business and industry diligence, “It is critical to spend the time upfront to determine the motivation and trustworthiness of management partners.” That is, do partners share the same goals for business growth in the target market?

By 2011, Eye Q had 14 hospitals and a plan for rapid growth, and with Song’s assistance, the company established a working capital line—a commercial lender collateralized by assets under a single set of bank documents. Based on the success of the revised business plan and increased financial transparency, two additional investor groups—both very well respected in India—signed on to fund growth. While Song’s ownership was diluted on a value-per-share basis, the new investors purchased shares at a handsome premium over Song’s initial investment price.

Today, Eye Q has the potential to reach more than 500,000 people with incomes below INR 10,000 a month by 2014-2015—all by focusing on prerequisites to scaling any business enterprise: revenue generation, sustainable cash flows, and financial transparency.

The most important message of Eye Q’s story is for investors to deliberately assess the risks associated with making an investment. Song was prepared to start out and remain a minority investor—control was far less important to success than trust in the relationship. It also took on the troublesome job of providing an exit for a previous investor. Only then could the new partners embark on a strategy for growth. Song realized it could be the catalyst to reducing Eye Q’s operating risk by bringing a professional approach to financial sustainability. Song recognized that the problem wasn’t demand but effective supply. Song also recruited additional capital to the enterprise, largely by proving the business model and thus reducing the risk profile for new investors.

This type of risk reduction can make the field of impact investing much more manageable for investors who want to put money to work but who are discouraged by calls to reduce return expectations as a price of entry. There are too many good investment opportunities for active fund managers who can bring strong operating backgrounds to growing markets for basic needs.

Read more stories by Vishal Vasishth & Bo Hopkins.