Too early to write-off the Indian start-up story

The mood in the start-up space has changed from cocky confidence to palpable nervousness. There are increasing reports of fund crunch, employees being retrenched by droves, unviable verticals being shut down, reduction in customer acquisition spends and a general shift towards lower cash burn.

However, the writing has been on the wall for some time now, with the value and number of deals declining sharply since the last quarter of 2021. But this had been brushed aside as a temporary blip with companies optimistic that the funding environment will improve soon.

The cat was set among the pigeons by Masayoshi Son, CEO of SoftBank Group, when he made a candid confession at the company’s earnings call for the March quarter that the company was going to hunker down to a ‘defence position’ — monetising current investments and becoming extremely careful with fresh investments. These musings were prompted by a humunguous $26.2 billion loss posted by its Vision fund through investments in high-growth tech companies.

Distress in the portfolios of global PE/VC investors is leading to lower investments and higher scrutiny of start-ups. So, is the party in start-up ecosystem over? While there is no doubt that Indian as well as global start-ups are entering a difficult period where funds will be scarcer compared with the last two years, it may not be right to assume that this will end the investment boom in start-ups.

Private equity and venture capital funds will continue to find lucrative investment opportunity among Indian start-ups going ahead. But Indian entrepreneurs need to do some course correction to retain credibility.

What went wrong?

There had been frenetic activity in PE and VC investments into India. Surfeit of global liquidity due to central bank stimuli made it easy for these funds to raise money, some of which found its way to high growth regions such as India. Both deal value at $77 billion and number of deals at 1,266 were the highest ever in 2021. As digital adoption increased during the pandemic in areas such as education, shopping, payments and within enterprises, tech companies catering to these needs saw a surge in PE/VC interest.

But the tide began reversing from November 2021, with number of deals as well as deal value declining from there (see graph). The US Federal Reserve and the Bank of England beginning the taper of liquidity infusion and prospects of higher interest rates made investors cautious. High inflation globally also played a part in restricting flows.

The first quarter of 2022 was difficult for all asset classes with the Omicron wave, Russia-Ukraine war, Chinese lockdown and high inflation causing steep decline in equity, cryptocurrency, SPACS, commodities and other assets. The Nasdaq composite which is a gauge of prices of tech stocks is down 29 per cent since the beginning of this calendar year. Bitcoin is down 38 per cent this year and equity markets have turned tepid. PE and VC funds have seen their profits whittle in this crash and some such as SoftBank’s Vision Fund and Tiger Global hedge fund have made big losses.

Funds with large exposure to China had already received a blow in 2021 due to the meltdown in edtech stocks on Shanghai and Shenzhen stock exchanges as the Chinese government cracked down on these stocks.

Given these difficult conditions, it is not surprising that global investors are taking a defensive position.

The Indian saga

Global PE and VC investors have not had it too easy in India too. While the booming stock market last year helped exits, the market conditions this year has turned quite challenging. Exits were at record levels with value of $11.9 billion in May 2021 and $7.4 billion in August 2021. But April 2022 witnessed exit worth just $1.2 billion.

The stock market performance of some of the start-ups that had garnered immense investor interest has been quite disappointing, roiling matters further. Zomato for instance, which had been oversubscribed 38 times with investors pouring in over ₹3 lakh crore into the issue, has witnessed stock price decline of 20 per cent from its IPO price. The financial performance of the company has also been dismal with losses of ₹360 crore in the March 2022 quarter.

Other start-ups which listed since last year such as One97 Communication, PB fintech and CarTrade Tech have also resulted in eroding investor wealth. While PE and VC investors may have made profits during the listing, other investors who subscribed to the offer would be feeling cheated, making future exits difficult.

All is not lost yet

Though the current outlook appears bleak for start-ups with investors tightening the purse-strings and looking closer at their operations and valuations, there are many reasons why the conditions could ease going forward.

One, a closer look at the data on PE/VC deals reveals that the value of deals in the first quarter of 2022 at $15.7 billion is much higher than the values in the first quarters of 2021, 2020 and 2019. Deal value as well as number of deals in April 2022 is slightly higher compared to the previous month. While the investments are down from the peak last year, it can not be called a total halt.

What is more heartening is that fund raising by India specific funds is continuing. According to EY-IVCA report, total of $1.5 billion was raised across 16 funds in April 2022 compared with $569 million raised by eight funds in April 2021. Elevation Capital raised its eighth India dedicated fund at $670 million, which is its largest ever corpus. Advent International recently announced that it will invest $5 billion in India and other Asian countries over the coming years.

With digital adoption the reining theme, investors can not afford to avoid India which is a large market. According to Inc42, number of internet subscribers has almost doubled from 446 million in 2017 to 834 million in September 2021. Internet penetration has increased to 61 per cent with 931 million smartphone users. Companies catering to this market have much better growth prospects and investors are aware of that fact.

But start-up promoters in India need to improve their act if they want to continue receiving private equity and venture capital funding. The competition is intense in the Indian start-up space and only the best will be able to survive and grow. Of the 40,000 active start-ups, only 4,700 or less than 10 per cent have received funds from PE and VC investors and just 17 of them have got listed till date.

But in a bid to attract funding, they should be careful not to resort to short-cuts such as inflating revenue or user base or making tall projections. Governance needs to improve in the companies and needless in-fighting among founders should be avoided. The focus should shift to product innovation rather than providing me-too products and services which have very low entry barriers.

The Centre can also increase the corpus set aside for funding start-ups in this period when global PE/VC investors are likely to reduce investments.

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