Startups and risk capital

I admit that I've been pleasantly surprised by the positive momentum change in private capital flows into India. The decoupling from China has been an unexpected development. But it also is perhaps a tipping point effect with the maturity of India's startup scene. Even if these are all mostly entrepreneurs copying tried and tested ideas from developed markets, the size of the Indian market (even if much smaller than expected) is large enough to absorb large volumes of capital to support local champions, especially since most of these are services.  

For a capital starved economy, this spurt of foreign risk capital is a much welcome trend. First, for the last few years, there has been a consistent upward trend of private equity investments which now dominate the total foreign direct investment in India. In the last two years, there has been a surge in foreign venture capital in Indian start-ups, a trend accelerated by the developments in China. Now recently, mature Indian start-ups have started the to go public with their IPOs, a trend which looks likely to gain momentum in the months ahead. While these are all largely foreign capital, the wealth generated by successful Indian founders may be amplifying the start-up boom. Consider each of these. 

I have written here about the growing dominance of private equity in India's FDI composition and here and here about the IPO boom. The current year looks likely to set a record on capital raising through IPOs,

India Inc has raised over Rs 42,000 crore though 28 IPOs in seven months till date... this could easily cross Rs 1 lakh crore by December should the secondary market maintain its tempo. Besides companies in traditional businesses, the bumper listing of Zomato is set to trigger a host of IPOs from other new-age companies including Paytm, PhonePe, MobiKwik, Grofers, PolicyBazaar, Flipkart Internet, Delhivery among others that have shown their intention to list this year... Data compiled by Prime Database shows that 34 more companies have already filed offer documents with Sebi, and are estimated to raise over Rs 71,000 crore through IPOs. Further, 54 companies have announced their intention to tap the primary market this year, and just 21 of them are estimated to raise over Rs 70,000 crore.

And this,

In calendar 2021, 58 companies have already filed draft red herring prospectus (DRHPs), which exceeds the combined tally of initial public offers (IPOs) in calendar 2019 and 2020. The number of IPOs can easily exceed 100 in 2021 if this trend lasts.

See also this and this on the IPO boom. 

Akash Prakash writes about the flood of foreign venture capital into startups in India, 

In the first six months of calendar 2021, $10 billion was raised by start-ups and private companies in India. In July, another $10 billion was raised, led by the mammoth $3.6 billion by Flipkart, the single largest fundraise by a private company in India. Contrast this with a total of less than $10 billion raised in all of 2020. At this rate, in 2021, we may see almost $40 billion being pumped into the Indian private company universe by global capital. This trend is further reinforced as even the unicorn IPOs are raising mostly fresh capital (not just secondary sale)... For perspective, $40 billion is Rs 3 trillion, almost 2 per cent of GDP, that is being effectively pumped into our economy by foreign funds.

However, a majority of these capital raising are intended to provide an exit to existing PE/VC investors instead of growth capital for companies,

Investors and promoters raised around 62.5% or ₹17,140 crore through offer-for-sale (OFS) out of the total money raised through IPOs, according to data from primary market tracker Prime Database. The remaining ₹10,278 crore, or 37.5%, went towards fresh capital raising by companies. The dominant contribution of secondary share sales in the overall fundraising in the first six months of 2021 is a continuation of a trend seen in the past few years, with PE or VC funds, which have invested large sums of capital in Indian companies in the past decade, increasingly using the primary market route to exit their mature investments... It was the same story in the past two years. In 2019 and 2018, too, the proportion of OFS in the total IPO fundraising was 73.8% and 72.5%, respectively. 

Malini Goyal in Livemint on the recycling of risk capital by the successful startup firms, especially the unicorns,

According to a data analysis by Zinnov, Indian unicorns have invested in 90 plus startups in more than 110 deals over the last decade. 19 of the 50 unicorns in India have made at least one investment in an Indian startup. A majority of the investments have been made by Zerodha, Paytm and Zomato, which account for more than half of all equity investments by active unicorns. Interestingly, despite the pandemic, the investment pace of these unicorns has remained consistent. This year has already seen 14 investments in the first half from the likes of Zerodha.

Take Zerodha’s Rainmatter funds for instance. Last year, it set up a dedicated team to focus on fintech startups. The Bengaluru-based fund functions more like an incubator that provides well-equipped workspaces and a funding of $100,000 to $1 million to innovative startups in the space of capital markets... Besides, being part of the Zerodha stable also helps these startups forge new connections in the industry and get relevant advice and mentorship to grow their product... Zerodha has invested in a range of startups including Streak (an end-to-end platform that creates, back-tests and deploys algos without coding), GoldenPi (India’s first online marketplace for fixed income instruments like bonds and debentures), Digio (bringing paperless documentation to business and consumers), Finception (aims to simplify all things finance for millennials from financial news to financial planning), Smallcase (a thematic investment platform that helps investors build a diversified low-cost portfolio) and Tradelab (builds cutting edge technology for capital market businesses). Through its fund, Zerodha’s attempt is to tap into adjacencies and focus on nurturing a vibrant ecosystem in the capital market with it at the centre.

Lenskart’s $20 million Vision Fund plans to invest up to $2 million each in startups that are synergistic to the eyewear, eye-care and omni-channel retail sectors. With 5,000 people, 750 plus stores and a daily processing rate of 20,000 for eyewear products, “startups that engage with us will have the potential to leverage all of this," says Lenskart co-founder Peyush Bansal... In 2019, Paytm had set aside ₹500 crore to invest in early-stage startups for the purpose. While each deal varies in its construct depending on the entrepreneur’s comfort, typically, Paytm prefers to take large strategic stakes (of 50% or above) and lets these startups leverage its platform to reach customers... Dream Sports has invested in FanCode, a sports content and commerce platform. This aligns well with the parent’s ambitions to become a one-stop solution for sports... Though no longer a startup and part of retail giant Walmart, Flipkart too has set up a $100 million fund called Flipkart Ventures. Over the last decade, the home-grown e-tailer has taken minority stakes in over 12 startups, including Blackbuck, Ninjacart and Shadowfax... The fund, managed by a dedicated team of experienced investment professionals, will do early-stage investments with a cheque size of $1-3 million for the first round which can go up to $5 million.

The attractions for unicorns and other successful startups to recycle capital,

Catching them young and investing in startups at an early stage through funds offers these unicorns a good entry point. Of course, the valuations are much lower. However, it helps them enter the fray from a position of strength. With a large user base and a deeper understanding of the digital landscape, the unicorns can spot emerging trends far ahead of others. Their young discerning founders think about risks very differently than the large traditional corporates whose risk appetite is constrained. Also, culturally unicorns can relate to these startups and their entrepreneurial energy a lot better.

The dynamism of the startup market as reflected in the soaring valuations, rising numbers of unicorns, flood of foreign capital, and surge in IPOs has also started to attract Indian domestic investors.

Domestic investors, including family offices and high net-worth individuals (HNIs), are pouring money into pre-initial public offering (IPO) funds to get early access to India’s major tech companies, which are getting ready to hit the stock markets... These include Edelweiss Wealth Management’s Crossover Opportunities Fund, which has raised ₹1,500 crore so far and plans to take the corpus of this fund to as much as ₹7,500 crore in the next 12-18 months. Trifecta Capital has raised ₹1,000 crore for its late stage and pre-IPO venture capital fund, while Kotak Investment Advisors has raised ₹1,386 crore and IIFL Wealth is raising up to ₹2,000 crore for its pre-IPO fund that will focus on tech companies... “Of the billions that are invested in India by private equity and venture capital firms, not even 10% is domestic capital. Most of our new-age technology companies are majority foreign owned with very little Indian capital. Why shouldn’t Indian investors have access to these companies? There is a strong demand and hence these pre-IPO funds are doing well with HNIs and family offices," said Anshu Kapoor, president and head, investment management, Edelweiss Wealth.

These positive developments provide an unexpected boost for the Indian economy. Akash Prakash makes an important point,

The reality is that all this money is being raised by the start-up/private ecosystem to spend. Money raised will be spent or burnt, such is the nature and the stage of life cycle of most of these companies. The money will be spent to hire people, build infrastructure, strengthen the core tech, accelerate demand and build the brand. None of these companies will just sit on the money raised. Mind you, this money is entirely equity, most of these unicorns do not raise debt... This may be the stimulus that the government was unable to provide due to a lack of resources. The stimulus will come from foreign funds, not the central government. Frankly, how does it matter where the money comes from as long as it is spent in our economy and is not debt?

Clearly foreign investors are becoming confident about India's economic prospects. I am inclined to believe that this flood of venture capital is more the "large market effect" at work, a driver of growth which China benefited enormously in its early stage where foreign investment played an important role.  With China becoming increasingly out of bound, foreign investors perceive the fear of missing out on the large Indian market. 

But, as Prakash cautions, it's important for India to keep doing the right things (or not take wrong steps) to keep the momentum going,

First of all, the proposed pricing and valuation of some of the new issuances in this space seem quite rich. It is inevitable that a few issues will fail and investors, including retail, will lose money. It is critical for our regulatory authorities to hold their nerve at this point. Just because some issues may fail, we cannot shut the door to IPOs by the start-up ecosystem or raise significant hurdles to listing. Any change in regulatory stance will only make monetisation more difficult or push eligible companies to list overseas, neither of which helps our markets or the economy. We must also be careful to guard against the perception of a lack of a level playing field. Many global investors are continually worried that domestic lobbies can make the operating and regulatory environment difficult for foreign funded companies. Hopefully, there will be no discriminatory treatment of such companies. If investors feel the odds are stacked against them, they will not commit money. This perception must be nipped in the bud.

Then there is the critical role of what's happening in the US. This comment, made in the context of frothy valuations in the market for Active Pharmaceutical Ingredients (APIs) applies just as much elsewhere in the startup sector, 

“To say that valuations are frothy is an understatement," said Vishal Nevatia, managing partner at True North, a home-grown PE fund. “The key call that people need to take is how long will the liquidity that has been pumped in by the US Federal Reserve and other central banks continue. If inflation in the US picks up and interest rates increase, then there will be a huge question mark on valuations. That is a very difficult call because nobody knows what will happen. We are in uncharted territory," Nevatia said. “This kind of stimulus, both fiscal and monetary, has never been seen before."

As I blogged earlier here, the challenge for India is to manage the continuation of the existing hype around startups. 

There is the window for both attracting new risk capital and for recycling existing venture capital towards other newer enterprises. While countless retail investors are likely to eventually lose their shirts at such inflated entries, it's also likely to create a generation of wealthy local investors with both the capital volumes and the appetite to assume risks. Equally important, it has the potential to change the investor culture in India and thereby expand both the envelope and, equally importantly, the share of risk capital (among all financing savings) available in the country. This is one of the most important requirements for the sustainability of high national economic growth rates. However, this requires the party to go on for some more time. And that critically depends on what the US Fed does with its monetary policy actions. Indian startups should egg the Fed to keep the monetary gravy train going on. This, and not any real innovation in their activities, may well be the real creative destruction from the startup bubble.

It still remains to be seen how long the momentum can sustain, especially given the frothing secondary markets (globally too) and the questionable profitability of many of the startups. It also remains to be seen whether such foreign capital can be a significant substitute for the deficiency of domestic risk capital. Or whether the startup boom can significantly expand the envelope of domestic risk capital. But while it's on, this remains a very important and rare bright spot in the Indian economic horizon.