Which way is the exit?

Hardly a day passes without a venture getting funded. In 2015, start-up investment deals happened at the rate of one every eight hours on average, according to data from Grant Thornton that show $16 billion was invested in 1,049 deals. Lots of money are going into the system for sure, but what about exit for investors?

Venture capitalists and market observers worry that exits have been slow, which is beginning to affect new investments. Even among the companies that exited, data from the India Venture Capital and Private Equity Report 2015 show that returns have been lacklustre.

Return percentage, based on when investment was made, is on a downtrend since 2001 and sectors such as manufacturing have given poor returns, with a median return of 4 per cent between 2002 and 2015. BFSI, which accounts for a fifth of exits by value in the last decade, had the second worst return rate, of 12 per cent.

Data from Venture Intelligence on exits in specific sectors show that key sectors such as manufacturing, which accounted for over 10 per cent of exits by value in the last 10 years, slowed in 2015. Deal value slipped 28 per cent y-o-y in 2015, compared with the average growth rate of 10 per cent in the last decade. There were 229 exits in 2015, with manufacturing and BFSI topping the list with 34 exits each.

One reason for the poor exit performance is lack of market depth. Private equity markets in India have not evolved as in developed countries, says Venky Natarajan, Managing Partner, Lok Capital. “There are no secondary-only funds that buy out primary investors in India,” he says. Investors typically want to invest growth capital to scale up operations, rather than use the money to provide exit to early investors.

Also, primary-market exits through IPOs have been poor. Even companies with good growth record are not ready to undergo public scrutiny and some may not stack up on governance, says Natarajan.

Nor is the listing process easy even for those companies that are willing and able.

“For most start-ups in India, it is extremely cumbersome to list on the main bourse in India,” says Vineet Shingal, Associate Partner, Khaitan and Co. He notes that issues range from regulatory eligibility conditions such as profitability track record and getting the desired valuations, as Indian investors are not seasoned to invest in tech companies.

Sectoral differences There are also sector-specific issues that impact exits. For example, sectors such as BFSI see multiple funding rounds as their capital needs are higher. In these cases, early investors have a better chance of getting an exit. Also, traditional sectors have long gestation periods. “Scale must be built by working with customers offline and this takes time,” says Radha Kizhanattam of Unitus Seed Fund. Acquisition is a common way for companies to exit in most sectors, especially in the IT and internet space. Corporates often choose to acquire a start-up rather than buy a product or service from them, as it cuts costs and improves bottom line, says Sanjay Khan Nagra, Senior Associate, Khaitan and Co. Some high profile acquisitions include Snapdeal-FreeCharge, Facebook-Little Eye Labs, and Twitter-ZipDial.

But typically, strategic investors may not give high valuations as they may only be interested in specific verticals. Acqui-hiring — acquiring not for the business but for the employee talent — is another trend that is picking up, notes Kizhanattam.

Valuation concerns There is also the elephant in the room — valuation concerns. Often, investors can get an exit if they are willing to take a lower valuation. But, if investors got in at high valuation multiples and expect similar or better multiples, they may be stuck.

Funds however seem to take a pragmatic stance, working with a time-bound exit plan and accept valuation haircuts if needed. Lok Capital, which invested in 25 companies in the last 10 years, had 13 exits (partial or full). Of these, two were not profitable.

But, even if funds accept exiting at lower valuation, founders may not be keen to take the offer.

More pain?

While there is pain currently, there have been some bright spots too. The internet sector, for example, has seen large number of exits rewarding investors, albeit lingering concerns over lack of profits. Also, late-stage investors such as PE funds have averaged returns of 6 per cent (2002 to 2015).

So what’s ahead? M&A consolidation is likely to increase in markets such as e-commerce that are oversaturated and stronger start-ups may fold in a weaker competitor, says Peesh Chopra, Managing Partner, Peesh Venture Capital. Natarajan of Lok Capital points out that due to variability in currency-exchange rate, returns for investors have been depressed in dollar terms.

Many sectors may see a slow-down in growth rates, as market matures. So, exits and returns may not improve in a hurry.

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