Is private investing just a fair weather game?

• The global scenario is changing yet again. India is a liquidity driven market. Why and how things are changing in PE/VC investing and what can it translate into?
• Originally published on November 30, 2016

Global overhang

1. Consumption hasn’t taken off in real terms: Despite the Central Banks throwing billions in form of quantitative easing to save colossal collapse of respective economies, much needs to be done to fix the systemic issues which caused the financial meltdown of 2008 and can likely cause many more with impunity. The only thing that these monetary measures have failed to achieve, which perhaps should have been their primary target, is creating real demand, giving the end consumer more power to buy or power to buy more.
2. Economists are falling over their feet to be the first one to predict accurately the timing and scale of an impending financial crisis, which they feel will be far more complex than that of 2008 both in terms of geopolitical reach and complexity, involving slowdown in some parts and a complete meltdown in others including Americas, Eurozone, Russia, China, Oil, commodities.
3. Risk averse sentiments are beginning to take over. Strengthening of US Dollar across a wide spectrum can be a signal. This can feed a dollar flight specially from emerging markets. If and when the dollar flight happens, the liquidity fed small cap stock of global markets i.e. the emerging markets will be hit. Liquidity will dry up fast, excess of which has taken the valuations to unsustainable levels already, and result in currency devaluations. This will be red flag for many PE/VC firms investing in emerging markets as this makes their exits unattractive. And unless a market gives regular and robust exits, PE/VC firms find it difficult to support it.

Challenging fund raising environment

1. Allocation to risk capital is reducing. Risk averseness means lower allocation to risk assets. In fact it means unwinding of bets in risk assets, whether listed or unlisted.
2. Allocation to alternate assets is shrinking. Alternate assets are considered one of the riskier asset classes. A direct casualty of risk averseness is reduction and in some cases cancellation of allocations to alternate assets.
3. Within the alternate assets basket the PE and VC allocation shrinks faster as they carry high risk and are illiquid, a combination which becomes a deterrent.
4. Within this the emerging market, considered the riskiest, allocation drops even more given relatively less penetration of private capital and local risks like weaker currency, fewer exits.

The cumulative effect of this scuffling is visible in failure of many existing GPs to raise their 2nd or 3rd India Funds and almost drying up of commitments to 1st time GPs. Those few who have been able to raise successive funds include non-commercial (read not so commercial) GPs and those who missed being hit, by a whisker.

PE/VC terms getting challenged

1. LPs are renegotiating terms, 2:20 model and blind pool commitments, hitherto considered sacrosanct, are being questioned with an ever increasing regularity.
2. LPs are now demanding say in deciding GP expenses, including payroll to make sure that Carry becomes the sole alignment tool between the GPs and LPs. This is going to affect the type of talent the GPs will be able to attract and set in realignment within the industry. It will become difficult for GPs to retain investment professionals who want immediate gratification and have lesser belief in carry.

India PE/VC market remains a tough with high valuations and low exits

Then there are a few issues specific to Indian GPs, including:

1. Limited return of capital, with limited or no upside and in many cases with significant write down including inter alia due to INR devaluation by more than 50% over last 5 years or so.
2. Indian market gets crowded and expensive in its early stages itself, making it difficult for the PE/VC funds to enter at sensible multiples.
3. Many Indian GPs have failed to keep their flock together, including due to succession issues, rift between top executives and an aspiration to set up own shop. This has seen some of the best talents leaving the GPs early.
4. A related issue is that many GPs have teams that are not necessarily seasoned enough and are attracted to a GP more due to the glamour attached to the PE/VC firms rather than a true alignment with the GP and to build a carrier in private investing.
5. This affects the ability of the GPs to effectively deploy money. As is evident, quite a few GPs, who were able to raise big money in hay days, chased flavor of the season rather than business models which were sustainable and which could attain scale whilst remaining profitable. In many cases they were competing to support ventures whose only claim to fame was the dollars they raised. The moment the taps went dry, such businesses wound up/merged.
6. India is neither China nor US, and therefore, most of the business models which were copy paste from these markets, did not replicate success.
7. Not China — India, being a democracy, is more open, is freer and far more complex and diverse. Its infrastructural and more importantly implementation challenges are no less complex either.
8. Not US — Physical Infrastructure in India is far weaker/ non-existent but at places gets compensated by easy availability of cheap labour — so for example home delivery from a grocery store has always existed unlike in US. Further the size and non-uniform population and income dynamics are a big challenge.
9. Private businesses, no matter how large, typically are not investing in developing the infrastructure. The reliance is still on government. For example only a small proportion of PIN Codes are being served by the largest of digital/logistics businesses. Investment by private telecom, banking, education, health, aviation players in developing a deeper reach is limited to doing the minimum needed to meet the regulator guidelines if any.
10. Though debatable, but new business models that have developed are at times too asset light and too undifferentiated to withstand competition/ rough weather. If fixed cost component is too low, the entry barrier goes away. In traditional business models, once a business has recovered its fixed costs, it can look to sustain through a trough by just seeking to recover its marginal costs. However, in asset light businesses the marginal cost itself is quite high and it becomes difficult to sustain it without either cash from investor or business cash flow, both of which are hard to come in an adverse market.

PE/VC investments in India are getting harder to manage

1. Capital is drying up fast due to GPs being able to raise much lesser money for India. Even where capital pools are available, GPs are finding it harder to deploy due to limited choices of sustainable, scalable models or models customised for India or stellar founding teams.
2. Immediate fallout is on valuations, which are getting reset. This becomes more complex in situations where the venture is raising second or subsequent rounds as their existing investors will be forced to mark the valuations to the revised market. In a challenging market and at a time when GPs are trying to raise money for their subsequent Funds, these write downs are not easy to digest/explain.
3. Founders who run businesses with holes in the bottom line, big or small, have a hard choice (or no choice?) i.e. whether to protect last round valuation or accept a dilutive/ super-dilutive new round or shut shop/merge.
4. Consolidation is the latest trend in the market, but the question remains will merging two weak players produce a single strong player. Maybe the combined business can survive for some more time but for how long. Jury is still out on this.
5. Board room battles are becoming increasingly common. Acrimony between existing investors and Founders is on rise. Investors were being heard till they were putting in money. The moment the money tap goes dry, blame game starts. On one hand, Investors say their money has been burnt without tangible value creation and that Founders have failed to perform to the promised business plan while continuing to draw fat salaries. Founders, on the other hand, say that Investors were riding a high horse, they just wanted expanding top lines and increasing valuations and always assured that there is sufficient capital to burn and that the Investors have suddenly pulled the plug leaving them with poor cap tables and nowhere to go.

Way forward: get real, get saner

Founders will need to increasingly focus on the reason for their businesses to exist or the problem they are solving. They need to be more aware that Investor’s money is not going to remain forever. They need to think about break even points earlier in their journey so that they need cash to grow and not to survive.

The PE/VC cycles take time to turn. They are affected by a host of issues and hence resolve only over a period. Its more likely that the GPs which have a track record of returning the money back and holding their flock together, will be favoured. Also, niche stories backed by seasoned professionals will be heard with greater interest. Multistage, sector specific GPs, with ears and eyes closer to ground are likely to get better traction due to their ability to pick deals early and enter cheaper. Even Founders are likely to get more comfort raising initial rounds from such Investors as they provide them visibility for the next 2 or 3 rounds.

India is seeing a far deeper breadth of Founders. A lot of experienced, middle aged, well earning operating experts are giving up jobs and becoming entrepreneurs, in addition to the ever increasing fresh out of the college, very young and energetic professionals. The start-up ecosystem is developing and getting support from UHNIs, who are either high earning professionals or Founders who made their money in their existing/previous ventures. This provides VCs a lot of choices in terms of business models and the breadth and depth of managerial talent, both of which are essential ingredients for building capacity for the Indian market to absorb risk capital.

The expectation is that the current churn in the market will throw up a sustainable PE/VC market in India, where the consumer needs get served, businesses models are profitable and scalable and investors get to make returns on their money.