What's evolving PE and VC landscape in India?

The year 2014, in many ways, turned out to be an inflection point for the two Indian asset classes - private equity (PE) and venture capital (VC). While PE saw investments surge to $12.4 billion, an all-time high since 2008, VC too took a gigantic leap with investments nearly doubling to $2.1 billion. Thanks to the booming tech ecosystem witnessing an unprecedented e-commerce growth along with change in investor sentiments due to a pro-business government acquiring the centre stage. The outlook for 2015 and onwards seems even more promising with its fair share of trials.

Private Equity

In last few years, PE funds haven’t shown much optimism towards India growth story, courtesy major challenges like the lack of clarity and uncertainty around various regulations and taxation policies, policy paralysis, poor corporate governance and hard-to-find exits. These were cited as main reasons restricting PE investors to invest and do business in India as per Bain & Company PE Investor Confidence Survey 2014.

(image) “Last year, there was some despair primarily because exits were not happening, the currency depreciation was scaring investors in terms of exits and also the tax issues. Despite that last year has been an interesting year as PE segment saw increase both in terms of volumes and values from the preceding year. But significant component of the investment activity was restricted to around three sectors like e-commerce, financial services and IT. There weren’t too many large deals, there were only about 18-20 deals which were about more than $100 million,” says Sanjeev Krishan, Leader, PE and Transaction Services, PwC India.

Changes in Fund formation

Foreign limited partners (LPs) have largely been the source of capital required (almost 80 per cent) for private funds in India. However in the last few years, domestic LPs have also started investing in PE funds, sourcing capital from Indian banks. This has led to a hybrid form of fund formation in India.

(image) “Till recently, most capital into VC funds flowed almost entirely from overseas LPs. Today, there has been a spurt in both the number and quantum of contributions from domestic LPs. Recently, Orios, an early stage investor saw its contributions coming entirely from Indian investors. We increasingly see a hybrid structure becoming more popular wherein the proportion of overseas LPs will continue to be high, but will be balanced by increasing appetite from domestic angel investors, family offices and financial institutions,” says Sanjay Nath, Co-founder and MD, Blume Ventures. However, the entire fund raising process, which takes 12-18 months, has become quite strenuous and more engaging. More importantly, it has got new changes.

“Among various new dimensions, effective portfolio management is a new aspect that finds mention in the fund documentation. A decade ago, LPs wouldn’t be that interested in the intensity and style that a general partner (GP) would adopt to engage with an investee company. It was completely a GP discretion to adopt an appropriate rules of engagement to manage an investee company. Contrary to the earlier approach, LPs now prefer to have an oversight on the quality of portfolio engagement, level of good governance, adoption of best practices, such as anti-corruption policies, and avoidance of conflicts to name a few,” says PM Devaiah, Partner and General Counsel, Everstone Capital Advisors.

Another change being seen is the increased empowerment of company’s supervisory board to take high-level decisions. Investments are usually done by investment committees set up by GPs where supervisory board doesn’t interfere in their day-to-day management.

“Today, it is not uncommon to see deviations from contracted fund terms being reserved for a supervisory board’s consultative decision making. The approach to commercial dispute resolution at investee company level is another area of concern for both LPs and GPs due to frequent instances of investee companies’ and it promoters seeking to wrongly knock the doors of criminal courts in matters that fall within the sphere of civil jurisdiction to exert pressure on the investors,” says Devaiah.

Overlapping Support

PE funds increasingly try and spend time with promoters of investee companies to make sure they are aligned with the common goal. However, often their efforts to add value in everything that promoters do hamper the business growth.

“We have a mix of companies, there are some on which we have control and run by us, and there are some in which we have just one per cent stake. It is a simple rule – if you realise the other person knows more than you on a particular subject, then you must shut-up. If we try to add value in everything that a promoter does, then it will make his/her life a nuisance,” says Rahul Bhasin, Managing Partner, Baring Private Equity.

There is some sort of operational assistance investors can provide, but they must know when to back off as they are not the ones running the business. “You must sort that out with the promoter which is crucial from exit perspective as you need the management and the promoter to be aligned with you. If the promoter does not align with you, there will be no exit,” says Ashley Menezes, MD, ChrysCapital.

Pockets of Opportunities

In India, many capital-intensive sectors like manufacturing, industrial and infrastructure have not seen good growth for the past several years. Hence entrepreneurs’ aspirations in these sectors to get more capital were fairly neutral. However the demand for capital by these sectors will return back as the investment sentiments continue to turnaround this year.

Alternatively, sectors like e-commerce will be a big opportunity for investors but consumer businesses will continue to attract major capital. Hence, PE investments henceforth can be more rounded.

(image) “Consumer businesses will continue to attract investment because businesses that target the growing disposable income of a consumer have a long runway for growth. The opportunity continues to be broad-based. Sectors such as Internet and e-commerce, also continue to be exciting,” says Niten Malhan, Vice Chairman, The Indian Private Equity & Venture Capital Association (IVCA) and Co-head and MD, Warburg Pincus India Pvt Ltd.

However, the stake of PE investors in most of the investee companies will continue to be of minority, “India will continue to remain a minority-growth market because Indian entrepreneurs have the tendency to own a large portion of their business and that is not going to change,” says Menezes.

Exit Sentiments

While the volume of exits shrunk from 156 transactions in 2013 to around 100 in 2014, the deal size or value shot up from around $3.5 billion in 2013 to more than $5 billion in 2014. The key businesses that saw exits were IT & ITeS, real estate, automotive, pharma, retail and consumer and telecom. The preferred route to PE exit last year was through the public market or open market sales that stood at around $2.5 billion.

(image)

“Since the formation of new government, public market exits have quite increased. Last year, out of $3.7 billion of exits, nearly $2.9 were from listed companies. That is the sense of changed sentiments at least from listed companies’ perspective,” says Vikram Hosangady, Partner, KPMG.

As per the PwC’s survey of 40 PE houses, IPOs, secondary buyouts and getting a strategic investor will help them exit some of their existing investments. However, most of them feel timing to be very critical for an IPO exit.

Venture Capital

In 2014, VC investments worth $2.1 billion were made in 246 start-ups, mostly in technology domain. While the majority of the sum was attracted by e-commerce ventures like Flipkart, Snapdeal, Jabong, Zomato and Ola Cabs, investments in angel or seed stages by VCs too saw increased activity. Up from $69.14 million in 2013, $109.35 million were invested across 283 angel-or seed-stage deals in 2014.

(image) This, however, may lead to several angel or seed stage investors being edged out in dealmaking even as early stage or Series A crunch continues to haunt seed-funded start-ups looking to raise the follow on Series A funding.

The prime reason for this increased seed or angel funding has been VCs’ winner-takes-all strategy (to identify and back start-ups that have huge growth potential at a very early stage). Technology-focused venture fund IDG Ventures India did nearly a dozen such deals last year. Moreover, funds like Sequoia Capital, Matrix Partners, SAIF Partners, Accel Partners and Nexus Venture Partners have increased their spending focused on making early-stage deals.

Another reason for VCs zeroing in on seed investments is the competition coming from large PEs and hedge funds. These funds include Hong Kong-based Steadview Capital that invested in Ola Cabs, New York-based Falcon Edge Capital that put money in Housing.com etc. From hedge funds’ perspective, it makes sense investing in Indian e-commerce, which is maturing rapidly. Last year, around $525 million were invested by several hedge funds in about 18 deals, says research and analysis firm Venture Intelligence.

Amidst the high deal flow are the exits that investment managers would be focusing this year given the past year’s record. According to financial data platform VCCEdge, out of $6.5 billion secured by e-commerce and Internet businesses through 722 deals since 2011, just a handful of 49 exits worth $334 million have been made since then. In 2014, Sequoia Capital and Blume Ventures had maximum exits, with eight exits for each, followed by Accel Partners and IDG Ventures with four exits each.

Changing Times for VC

The VC industry have suddenly picked up steam in the last around 18 months with real acceleration coming only in the last six-eight months precisely. And within this time frame, the sector has seen couple of very significant changes. The first visible change, which we have seen, is the quantum of deal flow moving towards technology-enabled firms. The biggest reason for that has been the improved quality of teams than last two-three years.

(image) “The deal flow and team quality are the biggest positive change that we have seen over last 12-18 months. Apart from that mobile traction has positively surprised us. In the last six-12 months there is hardly any company where less than 25-30 per cent of its transactions are not happening on mobile. For e.g. Bookmyshow (online movie and event ticketing platform) where SAIF is an investor sees 55+ per cent of its transactions on mobile,” says Deepak Gaur, MD, SAIF Partners.

Moreover, the large amount of capital raised by very early stage start-ups has been seen as both good and bad. Around two-three years back, the normal growth path for a start-up used to be raising Rs 1-2 crore initially, spending that for next 12 months for a product market fit, expanding tech team and then looking for $1-3 million round. However that has shrunk quite a bit.

“It is bad because many times risk/reward ratio does not work out and good because if the product market fit is right and if start-up is on the right path, the ability for them to accelerate the growth increases and it is not constrained by capital,” adds Gaur.

Another area of change is the rise of angel investors in India. “Around 10 years back, VC activity started in India. There was a healthier amount of Series A and Series B activity too, but there was no angel capital and growth capital available. But in the last few years, we saw the rise of angel funds, and in the last 18 months, we also saw tremendous growth in the late stage VCs. So it is great to see maturing of different stages of financing,” says Rahul Khanna, Co-founder and Managing Partner, Trifecta Capital, claimed to be the first fund focusing on new asset class, venture debt in India.

(image)

Angel investments kicked off in India with the setting up of angel funds like Indian Angel Network, Mumbai Angels and Chennai Angels around 2006. However, major part of the fund raising process has been shifted online since last year with platforms like LetsVenture, ah! Ventures and TermSheet, facilitating online screening process for start-ups.

Also See: From Matchmaking to Dealmaking

Winner-Takes-All Market?

Raising late-stage investments, primarily involving Series B and C rounds, have been elusive for start-ups. The number of such deals actually narrows down for only few emerging category leaders. Start-ups, such as TaxiForSure, Power2SME, Zomato, Olacabs, ItzCash, FreeCharge and Delhivery, that had entered the growth phase were able to raise Series C round last year. This means capital has been raining only on leaders.

(image) “By 2011-12, around 55 companies raised Series A funding in e-commerce, out of which only 20 companies were able to raise Series B round. By now, only a dozen of them have got Series C funding. So it will be brutal for start-ups if they are not able to scale rapidly to attract capital. If they cannot be among top two or three companies, they won’t get capital,” says T C Meenakshisundaram, Founder and Managing Director, IDG Ventures India.

However, young companies, thinking on becoming leaders to attract capital, might drive a disproportionate focus on their growth at the expense of focus on things like customer satisfaction. So should they build companies to become a leader and attract capital or build a strong foundation for the business?

“It depends on the nature of the business. For e.g.; building an offline business equivalent of an online brand will unlikely be in a winner-takes-all market because no brand can take the entire market share. But platform businesses like, Zomato or BookMyShow where one has to aggregate lot of people/providers and search and payment platforms like Justdial and Paytm respectively are more likely to be winner-takes-all. However there are lot of companies, more so in developed countries, where availability of capital was not the only differentiator as a leader. So unless one focus on customer satisfaction and scaling up technology, it is very unlikely that only capital will make the company the leader,” says Gaur.

Distant Profitability But Soaring Valuations

Even at the cost of profitability, becoming a leader and building a war chest to expand and acquire customers through advertising and to fend off increasing competition has been the growth strategy of e-commerce ventures. Flipkart, Snapdeal and Amazon cumulative losses shoot up to a staggering amount of more than Rs 1,000 crore in FY14 due to their heavy discounting strategy.

(image) “The money invested in these companies is a bit daunting. When you are selling products at a discount or at a loss, how you will make money. These companies can actually be fundamentally profitable even if the capital is not there. But in many ways, by giving so much capital, investors are almost doing injustice to these entrepreneurs because they ask them to get market share, customers, etc, instead of turning profitable,” says Ben Mathias, Partner, Executive Director, New Enterprise Associates.

Moreover, the eye-popping valuations of big and small e-commerce companies are being driven by investors’ demand to back such companies having huge sales and capturing Tier 2 and 3 towns that have Internet access.

Looking beyond the valuations of Flipkart, Snapdeal, Jabong, etc, many niche companies like Pretty Secrets, Pepperfry, Housing.com, Urban Ladder, Happilyunmarried, Firstcry and Fashionandyou have raised $2-90 million in their multiple rounds with a valuation of around 2-2.5 times their gross merchandise value (GMV). But even experts don’t know whether these valuations will really pay off in next four-five years.

“Nobody knows whether brands being created will be disruptors ahead. The challenge is that whether an investor wants to be a part of this growth or be a bystander. Most of the VCs don’t want to be bystander. So it is a bet that they are taking,” says Harish HV, Partner, Grant Thornton.

The investment wave in both PE and VC ecosystems is expected to continue this year as well along with visible consolidation happening and companies growing inorganically amidst intensifying competition. Most funds focusing on seed to growth stage investments are looking to raise their second or subsequent India-focused funds.

Prominent investors – SAIF Partners, Kalaari Capital, Accel Partners – are looking to raise $200-350 million, while small players like IvyCap Ventures, Kae Capital, India Quotient and Blume Ventures are planning to raise anywhere between $24 and $50 million.