Venture Capital investments structured as near debt deals, where startups secure higher valuations in lieu of guaranteed returns to VCs, have had their share of problems in the US of late.
Many of these startups belong to the so-called list of ‘unicorns’ — unlisted technology companies with more than $1 bn in valuations. At last count, there were 144 such unicorns according to CB Insights, and 130 of them if you go by Dow Jones VentureSource. The problem stems from the exposure of the hollowness of these valuations when these startups either decide to get listed, or divest a portion of their equity to mutual funds (MFs).
A case in point is mobile payments company Square, which recently listed its shares at the NYSE with a valuation much lower than its last round of funding. The New York Times last month reported the instance of video messaging application Snapchat, which was discounted 25 per cent by Fidelity Mutual Fund. Yet another startup Dropbox, a file storage service, was devalued by the largest US asset manager, BlackRock, earlier this year. Stock market listing and MF investments hold the startup’s finances to a much harsher light than during funding by VCs and other investors. Often, what they see has little resemblance to the headline valuations highlighted by the media due to the returns guaranteed to many investors. For instance, it has been reported that a major investor of Uber received a guaranteed 25 per cent return during an early investment round. Investors also reportedly received protections during Airbnb’s $10-billion valuation round last year.
Startups flush with funds
There have been reports about structured deals with VCs by startups in India too. “Every deal is a structured deal, as all of them are unique. It is an agreement between a venture capitalist and the founder of the startup,” says Prof. Vijaykumar Nishtala of Welingkar Institute of Management, Bengaluru. Over the years, Indian startups have been able to garner the trust of Venture Capitalists (VCs) and Private Equity (PE) players. Startups here have raised funds to the tune of $7.3 billion in 2015, according to data compiled by yourstory.com. The numbers have been staggering in the third quarter of 2015. They were able to raise $3.8 billion in three months, a sequential increase of 111.1 per cent from the previous quarter.
But Indian mutual funds (MFs) have zero to little exposure in startups, and have put very little of their funds in unlisted companies. The MF industry in India had assets under management (AUM) of Rs 12.5 lakh crore as of November 2015, of which equity exposure was a significant Rs 4 lakh crore (32 per cent), according to AMFI data. Despite this, MF investments in unlisted companies, let alone VC funded startups, has been miniscule. As a result, startups in India have not been exposed to the rigour of mutual fund vetting. This is because most mutual funds are conservative when it comes to valuations.
The scenario is completely different in the US. PitchBook Data reports that the most active MF investor in US startups, by far, has been T. Rowe Price, with 60 such investments since 2010. Wellington Management with 46, and Fidelity with 33, follow. In 2014 alone, US mutual funds bought into a private company 29 times, amounting to $4.7 billion of collective investments, according to The New York Times, which cited data by CB Insights. According to Dhirendra Kumar, CEO of Value Research, an MF tracker, “Though there are some fixed income funds in India that put their money in unlisted companies, it is very hard to find equity fund investments here.”
Not that historically Indian mutual funds haven’t invested in unlisted companies. There is the celebrated instance of unlisted NDTV, whose shares were held by Taurus Starshare (from 1999) and Taurus Discovery (from 2001) funds much before its 2004 IPO, according to data shared with Deccan Herald by Value Research. But such instances have been exceptions. “India is not a mature market, where people are ready to take risks. Mostly, such investments in unlisted firms are done through alternate investment fund vehicles. Alternate investment funds are financed by high net worth individuals (HNYs),” says Karan Datta, Chief Business Officer of Axis Mutual Fund. Datta said Axis is on course to launch an alternate investment fund in the coming months, which can provide impetus to mutual fund financing for startups. He also points towards the lack of liquidity as one of the major reasons for MFs not investing in startups.
No regulatory restrictions
But what about the regulatory landscape? Are Indian MFs restricted from investing in unlisted companies and VC-funded startups? Kumar of Value Research notes that there is no ban on such investments. But he points out that Sebi restricts MFs from investing more than 10 per cent of their assets in unlisted companies. Prof. Nishtala says, “As per Sebi guidelines, MFs can invest up to 10 per cent of their assets in unlisted companies if it is a close- ended mutual fund, and five per cent if it is an open-ended mutual fund. This is because open-ended MFs require more liquidity.”
Kaustab Belakpura, Director, Fund Research, at Morningstar India, says: “There is not much of liquidity associated with investments in startups and unlisted companies. Also, most of the money in these MFs comes from retail investors. So there is a tendency by MFs to be risk-averse.” Morningstar was kind enough to share some data they could access on MF exposure to unlisted companies in India (see table: ‘MF exposure to unlisted cos’).
The valuation of unlisted companies is a grey area even in the West. The valuation is the discretion of the valuing company. “The valuation of unlisted companies is not realistic. It depends from company to company,” says Kumar. He further went on to state that mutual funds in India are more transparent as they disclose the value of their portfolio once every month. This is in contrast to the US where they are expected to do so once every quarter. Prof. Nishtala chips in, “The average of net worth per share and average capitalisation rate shall be the fair value of the share for unlisted companies, as per Sebi guidelines. You will observe that Sebi sets a very conservative approach while valuing unlisted companies which is the case in respect to US regulatory authorities also.”
The existence of MF investments in unlisted companies and startups in the West should not confuse one to believe that everyone is comfortable with it there. There are many who believe that the current trend of MFs looking for a piece of action at unicorns is beyond their original mandate, and may not be in the interest of the ordinary MF investor. But many fund managers there, who are bored with average returns generated out of conventional investments, are ready to take some extra risk in exchange for greater returns. If such investments pick up in India, one advantage is that it would bring in a lot of transparency into the valuations of hyped-up startups due to the more conservative (marked-to-market) approach followed by MFs. On the other hand, it would also bring in a lot of risk for retail investors of MFs.
MF exposure to unlisted cos
Stock Portfolio* Fund
Accord Cotsyn 0.000010 Baroda Pioneer Growth
Chennai Interactive Franklin India
Business Services 0.000010 Opportunities Fund
RBL Bank 1.591930 IDFC Dynamic Equity
Quality Assurance
Institute (I) 0.171360 ICICI Pru Technology
Crystal Cable Industries 0.000090 Principal Dividend Yield
Tirrihannah 0.000050 Principal Dividend Yield
Disclaimer: This list could also include some shares that are either delisted or haven’t been traded for a long time or listed on an exchange other than NSE/BSE.
Source: Morningstar India