India private capital: Why private capital in India is ready for a reset

After many years of rapid growth, India’s private capital (venture capital and private equity) market is taking a much-needed breather.

After a further acceleration in the post-COVID euphoria of 2020 and 2021, deal activity began to decline in 2022. The slowdown has continued into the first quarter of 2023.

Despite the recent downtrend, Indian private capital markets have come of age. At more than US$50 billion a year, private equity (PE) and venture capital (VC) investments represent more

than half of all FDI received by the country.

Several industries in India, such as e-commerce, food delivery, microfinance, and medical diagnostics, have been nurtured by VC and PE capital.

As private institutional capital takes on a more prominent role in the Indian economy, the industry faces some important challenges, including tightening capital conditions, increasing competition in the domestic markets, and the need for accountability on corporate governance.

The industry’s ability to adapt to the changing environment is critical for its long-term success.Profitless unicorns and the upcoming shakeout

Over the last few years, the zero interest rate environment in the west and India’s increasing attractiveness led to robust capital flows and the creation of several unicorns.

These unicorns fall into three categories (i) Exceptional businesses with profitable business models (ii) Businesses that are burning cash but have a demonstrable product-market fit (iii) Businesses with unfavourable unit economics and/or poor governance.

The first category of companies will likely grow into the valuations, the second will survive but will need to take a haircut on valuations, while the companies in the third category will need to shut down or get acquired.

Dealing with these challenges will involve M&A, significant dilution for existing investors, management changes and business pivots. A rapid resolution will be in the best interest of the industry.

From domestic to global champions

Visionary founders with strong execution skills and access to capital have helped create domestic market leaders across a range of industries such as e-commerce, financial services and consumer retail.

These Indian companies have disrupted existing incumbents and are competing successfully with domestic and global giants in the Indian market.

As domestic and global strategic players increase their investments in various domestic sectors such as electronic retail and fintech, Indian startups will need to have a stronger value proposition and look at global markets for growth opportunities.

However, with the exception of sectors such as IT services and generic pharmaceuticals, India has produced very few global leaders. Despite the good intentions of successive governments, manufacturing is stuck at 15% of GDP and exports have stagnated.

India has a global competitive advantage in many knowledge sectors, such as specialty chemicals, engineered goods, pharma R&D services and software services.

Could private capital, with its global networks and access to world-class talent, help spur the next generation of Indian multinationals?

The rise and fall of ESG

Billions of dollars have poured into Environmental, Social and Governance (ESG) themed investing. The global investment management industry’s focus on climate change, gender equality, and boardroom diversity is a welcome change.

India has benefitted from social impact capital that has supported sectors such as microfinance and agriculture. In these sectors, founders and customers have limited access to capital and market, and impact capital has played a leading role in developing the pathway for the mobilization of commercial capital.

But ESG investing is beginning to face a backlash in the western world. As with other metrics,the ESG scores are subject to manipulation and methodology flaws.

According to the rating agency S&P, Tesla’s ESG score is lower than the oil giant ExxonMobil.

Composite ESG scores and a broad-based approach to impact investing are proving to be ineffective. Investors interested in fighting climate change could focus on specific areas such as renewable energy and EV batteries.

Socially conscious investors can target businesses that serve low-income communities or are founded by women.

Investment returns across public and private markets are highly correlated to governance.

Publicly listed companies in India, such as Infosys and Marico with a reputation for high-quality governance processes, generally have the highest trading multiples amongst their peers.

Historically, Indian companies had a negative reputation in governance and accounting.

Over the last decade, with generational change in family businesses and the emergence of technocratic first-generation founders, private companies in India have made significant strides in this area. Despite this progress, as evident by the recent governance scandals in the startup world, there is room for improvement.

While charismatic founders, engaged in malfeasance and poor governance practices, are not a uniquely Indian phenomenon (see Theranos and FTX), improved levels of governance will make India stand out among emerging markets.

How do investors determine the quality of governance?
A diverse board with independent members is not exactly independent if the members are friends of the founder. Investors may need to evaluate how decisions are made in the company – Who controls the money? Who decides on compensation?

Many of these things can be determined during due diligence.
Institutional investors also have an obligation to drive positive change. These steps include the appointment of internal auditors who report to a Board subcommittee and not the CFO.

Compensation subcommittees should not rubberstamp the CEO’s recommendations and should establish oversight on key areas including, accounting, compensation and related party transactions.

For India’s a long term economic growth, job creation and innovation, private capital will play a vital role. As the industry grows, fund managers will need to expand their playbook.

(The authors are Mukul Gulat, CIO and President of Zephyr Peacock, and Pankaj Raina, Managing Director)

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