Indian Public Equity Markets: When in doubt, stay away

The buoyant mood within the Indian public equity markets have been a great positive and they are looking forward to taking their portfolio companies public enthusiastically.

By Nidhi Chawla

"Water, water everywhere, nor any drop to drink," as Samuel Taylor Coleridge famously penned. This line truly resonates with late-stage fund managers amidst today's market conditions.

The unprecedented IPO rush is supported by abundant liquidity even at soaring valuations. For PE/VC investors looking to harvest returns, the buoyant mood within the Indian public equity markets have been a great positive and they are looking forward to taking their portfolio companies public enthusiastically.

On the other hand, as an investor in late-stage companies, fund managers are finding limited opportunities for value in a market. Private companies on the cusp of an IPO are commanding valuations that mirror those of the public markets, without considerable discounts for illiquidity.

Finding Value in Late-stage Investing

Typically, a late-stage fund manager’s mandate is to invest into unlisted companies zero to 2-3 years away from an IPO where they have to invest and exit in a tight fund tenure of 5-6 years. To make money at late-stage, the fund looks for companies that have the following tenets

1. Clear IPO-ability of the company --> After heady days of 2021, "sustained profitability" is becoming a common question among public market investor

2. Strong earnings growth potential

3. Low Valuation such that there is potential for multiples rerating which adds to your returns.

God forbid, if there's multiples derating in the markets, it could significantly diminish your returns even if the company performs well in the first two areas.

The third point gains additional significance for late-stage investors at present, particularly when public market multiples are exceedingly high, leaving room for a potential derating when the current exuberance declines.

A Frothy Market With High Risk of Multiple Derating

A recently released, Kotak Institution Equities (KIE) strategy report detailed persuasive arguments about the market's overvaluation. The Nifty-50 Index's 1-year forward price-to-earnings ratio is nearly 2 standard deviations higher than the historical average. Additionally, the midcap index is trading at a significant premium compared to the Nifty Index.

It's worth noting that the companies targeted by late-stage funds are often midcap to smallcap, which are commanding these high multiples as they approach their initial public offerings.

Further, at present, the report highlights expectations of modest returns due to high valuations and potential multiples deratings coupled with limited potential for earnings growth.

Most of companies under KIE coverage are falling in the potential derating zone including the internet stocks that tend to post lofty earnings growth.

Two-track Approach to Valuation

The second challenge faced by PE investors pertains to promoters and selling shareholders, often private equity or venture capitalists. These sellers demand a high valuation during pre-IPO rounds, only to yield to the demands for lower valuations by domestic institutions during IPO roadshows.

This inevitably results in an immediate decline in returns that takes the late-stage fund a considerable amount of time to recuperate from. Recently, several IPOs have been priced at discounts ranging from 10-25 percent compared to the last funding round. This was observed in multiple sectors like insurance, automotive manufacturing, specialized e-commerce, and financial services infrastructure.

FOMO or JOMO?

Some fund managers are choosing to invest in growth rather than late-stage companies to steer clear of inflated valuations. This decision involves straying from their fund's mandate, which could be risky for funds with shorter maturities. It demands a different approach, allowing founders more time to test and learn what drives growth. However, for late-stage funds, this strategy could result in needing to extend the fund’s maturity—causing frustration among regulators like SEBI and investors—and potentially lead to lower returns when adjusted for time.

Fund managers are better off today, opting for the 'joy of missing out' (JOMO) than succumbing to the 'fear of missing out' (FOMO) while investing. Facing such a situation in today's exuberant markets, it is better to give back the capital to investors rather than make investments at these elevated valuations.

(Nidhi Chawla is Director, Private Equity at Kotak Alternate Asset Managers Limited.)

Views are personal and do not represent the stand of this publication.