India PE investors double down on seeking alpha amidst shifting valuations

India PE Investors Double Down on Seeking Alpha Amidst Shifting Valuations

India's private equity landscape is dynamic, with recent headlines highlighting both the immense potential and the challenges of the market. The ongoing discussions surrounding the valuation markdowns of some prominent late-stage startups, coupled with the continued fundraising success of certain growth-focused funds, underscore the need for a nuanced approach to investing in this space.

One of the core themes is the debate about public vs. private markets. While public markets have historically been the focus for many investors, a growing number of sophisticated players are increasingly looking towards private assets, despite the acknowledged illiquidity and longer-term nature of these investments. This shift raises important questions about the drivers behind this trend and the types of investors leading the charge.

Against this backdrop, the PMS AIF WORLD – a modern, alternates-focused investment platform designed specifically for HNIs and prioritises alpha-driven strategic wealth creation - led a panel of discussion on strategic capitalization of early-to-mid stage private equity opportunities for better wealth creation.

Putting forward his reasoning behind the current investment climate, Ashish Ahluwalia, Director for Private Equity at Axis AMC, said "Smart investors recognize the value creation happening in new and disruptive industries, much of which occurs before companies go public." First, they recognize that "they are seeing new industries being formed and they are seeing traditional businesses being disrupted by new businesses," and these new businesses are "creating tremendous value for their investors."

Looking at the past decade of IPOs, he noted that "some very large businesses have come out of the private equity and venture capital," reflecting the value creation potential. Second, these investors understand that value thrives in a lot of these industries even before they have begun to navigate this market space.  Therefore, the desire to participate in this value creation emerges at an earlier stage (stage n-1) to capture higher returns, much before the IPO.

Third, allocation plays a significant role. Private companies are different than the public companies where a diverse portfolio can be easily constructed. Ahluwalia pointed out that typically, a good small cap would be raising Rs 500-600 crores of money on the IPO. He gave an instance that when these IPOs are oversubscribed, "an investor trying to get an allocation in this through a listed mutual fund a small cap or a micro-cap mutual fund will see that mutual fund getting Rs 10-15 crores of allocation in that company."

This leads investors to seek meaningful allocation, which again points to stage n-1. In short, "smarter investors have understood that there is disproportionate value being created by new businesses and they need to enter the private markets," he said. This trend is visible in "sophisticated financial markets across the world – US, Europe and later China". One needs to then start allocating a bit of the money to private markets to get this disproportionate share of new value.

Herein, the most promising sectors as per Amit Ratanpal, Founder and Managing Director of BLinC Invest, are education and financial services sectors because these are fundamental sectors of the Indian economy. "Almost 25 to 35% of the overall private equity allocation goes to financial services and education," he said. Further, he pointed out the sheer scale of the opportunity in the education sector with "about almost 150-175 billion children going to the schools," yet "the gross enrollment ratio is less than about 30%, while the developer market is more than 65%."

“You have to be patient in this sector” and be led by a long-term view, he suggested. While acknowledging the influx of funding into the education sector in recent years, he observed that almost 80% of the funding went into only two or three centres that is K-12, or tutoring services within the K-12. This leaves behind other crucial areas like "early childhood education [and] skill development" underserved and ripe with opportunity.

Turning to financial services, Ratanpal described it as "always [being] the backbone of the economy." He sees increasing robustness due to "the digital public goods which the government has been creating (for instance, Unified payment interface). With about 63 million MSMEs and the overall penetration at just about 15%, he highlighted that there’s still immense space to catch up for the investors. Besides, there is also low penetration rates for credit cards and mutual funds/depository services.

While the potential for high returns in early-to-mid stage companies remains attractive, this potential is inextricably linked to the risks involved. A critical component of mitigating those risks lies in robust corporate governance. Navin Honagudi, Managing Partner of Elevate Venture Partners, elaborated on the red flags to be avoided in this process.

"Avoid investing in 'party routes' – companies with complex ownership structures, often involving forward-driven investments", he said. As per him, there is data-driven evidence of how it can often lead to lower returns even when underlying business is good. This is because of valuations become inflated.

"Another red flag is when founders are not aligned with the long-term vision and are more focused on short-term gains," he said while pointing to the current market debate of overhyped valuations. "A lack of profitability, particularly when coupled with aggressive growth targets, can be a major warning sign," he said. "I strongly believe founders should take some money off the table at various rounds... there needs to be a limit though... of 1-2% of their shareholding per round. That is reasonable. Otheriwse, excessive selling is a red flag."

From a governance perspective, a strong board committee as per the industry is important. Even beating their own projections as close to possible is a positive sign -- not only in case of a public company but also in a private company. Even though early-stage projections can be challenging, but as companies mature, “there should be a reasonable merit towards running in the right set of projections", he said.

Ahluwalia drew some conclusions at the end of the panel discussion, with a conversation on the trends in the current space. He noted good incidence of capital going back to investors both foreign and domestic, since the last few years, and increasing sophistication and participation of domestic investors. The challenge remains with the tech sector as it continues to face the "funding winter".

A key focus of his analysis was valuation, believing that the current environment presents a compelling opportunity particularly for late-stage growth investors. “What's happening to valuations on the public markets, we're seeing that tickle down into the private markets” he said. While acknowledging that private market valuations don't perfectly mirror public market fluctuations, he sees a growing "pricing sensibility" emerging. This trend is likely to continue as companies "going for IPO is just getting higher." He believes that India's ambition to become a $10 trillion economy hinges on significant private sector participation.