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Startup funding : easy money in the rear-view, is it speed breakers or spike strips ahead ?

Global liquidity driven capital flows during 2020-2021 

In 2020, the COVID-19 pandemic began decimating the global economy. Economic shutdowns occurred globally. Panic buying and supply disruptions exacerbated the situation which ultimately led to governments stepping in to provide an unprecedented amount of stimulus.  The S&P 500 took a huge 33% plunge between February 20,2020 and March 23,2020 driven by COVID induced uncertainties. Similarly, Sensex fell to a low of 27590 levels from 41000 levels between Feb 20,2022 and April 3 ,2020 as nationwide shutdowns brought economic activity to a standstill. Similar scenes played out in all major indices across the world during this period. Amidst this carnage, central banks stepped in announcing a series of unprecedented measures to help support economies and markets. For example, the Fed reduced its key lending rate to zero along with a host of other measures including repo operations, relaxing regulatory requirements for banks to encourage lending, direct lending to corporates etc. Parallelly, in India, the RBI cut repo rates to 4% in addition to rolling out various support programs including moratoriums on term loans.

This low interest rate environment spawned a situation where more money was being suddenly made available to investors. This dry powder kept the deal momentum healthy during the crisis years of 2020-21. Money therefore flowed into both the public and private markets. Stock markets across the globe rallied and investors chasing returns channelled funds into the private markets through PE funds and VCs. 

As the world adapted to a new normal, we saw unprecedented levels of capital  flowing into companies that leveraged technology and promised a parallel existence that could replace the pre-pandemic physical existence. The overall consensus was that a digital alternative could help make the new world characterised by social distancing, work from home and  online learning bearable and infinitely more manageable.  According to WSJ, venture-capital funds in the US raised $132 billion to invest in startups in 2021, nearly double the amount from 2019 and 6x the total raised a decade ago, when the number of funds was about a third of what it is today. In last year’s fourth quarter, venture capital investments reached a record $95 billion. Overall, India’s VC funding reached $38.5 billion in 2021, growing 3.8x over 2020.

Large scale global liquidity, low yields, relatively benign inflation and returning of normalcy across countries amidst increasing rates of vaccinations and falling severity of subsequent COVID waves helped the global financial markets, both private and public, record all time high values. 2021 saw global PE/VC investments decisively gravitate towards  technology led businesses as sectors like consumertech, edtech, fintech, SaaS, healthtech etc., received a disproportionate share of investments.

Dream run – The Indian Startup and VC deals landscape

2021 was a pivotal year for both the Indian startups and VC investment landscape—a convergence of heady tailwinds coming together in a record growth year as VC funding reached US$38.5B.  Investments in India grew 3.8x over 2020, faster than China’s (1.3x). Share of VC funding in India accounted for greater than 50% of overall private equity (PE) and VC investments in the country in 2021.  44 unicorns were minted in India, exceeding China’s 42 unicorns just in the year.

Investing momentum was driven by a significant confluence of factors that were several years in the making: maturing digital infrastructure ( driven by UPI -led payment rails, cheap and ubiquitous data access and Aadhar enabled eKYC). Further, as Chinese regulators tighten control over the local tech economy (fintech and edtech), capital deployment saw redirection to India.

  • A booming startup ecosystem:
50,000+ Active Startups US$ 400B in Valuation
  • Startups addressing major pain points for consumers and small and medium enterprises (SMEs)
  •  2021 also saw significant wealth creation through employee stock ownership plan (ESOP) liquidation (30+ start-ups announced ESOP buybacks).

Source: Bain & Co, EY

  • Significant new blood in the form of:
Tier 1 Global VCs Crossover Funds Domestic VCs
Global Sovereign Funds Sector Focused Funds Traditional PE Funds
  • Defining year for exits:
Total VC exits : US$14B
60% of exit value from Secondary Transactions

 (eg., BillDesk acquisition by PayU at $4.7B, and partial exit by Kalaari in Dream11 at $400M)

40% of exit value via IPOs

  • SEBI relaxed norms for listing on the public bourses
  • VC backed companies accounted for at least 5 high-profile IPOs in the year 
  • Retail investor appetite for tech stocks drove record levels of oversubscription for these IPOs (e.g., Zomato oversubscribed at 7.5x while Nykaa was oversubscribed at 12.2x for retail investors)

Source: Bain & Co, EY

Looming clouds – funding and deployment to change stripes in 2022

Although funding momentum is expected to continue given dry powder raised over 2020–21 and depth in the ecosystem, shifts in pace and quality of deals are expected due to global and domestic headwinds

Significant focus on quality assets with larger rounds, and a more measured pace of dealmaking (no deal closures in 3-4 months!) Compressed multiples in global public markets will probably see a trickle-down impact, leading to rationalisation in valuations and a focus on unit economics
Exits via public listings may also see some moderation as IPOs in the pipeline may adopt a wait-and-watch stance given global headwinds in public markets A few emergent sectors, however, will continue to see interest: Web 3.0 or crypto-based investments (especially with the Indian government’s ruling on validity of digital assets), creator commerce, and core sectors, such as agritech and healthtech
Stricter IPO norms are expected to be rolled out by SEBI, specifically focused on capping investor share offloading at IPO Regulatory shifts are likely to continue to affect a few sectors such as online gaming, cryptocurrency, and fintech
Talent attraction and retention will continue to remain a challenge for scaling start-ups

Way forward – Survival of the fittest?

Y Combinator, a Silicon Valley kingmaker which backs hundreds of young startups a year, has, in a letter to its founders this week, signalled that the market teardown that has significantly slashed the value of a large number of tech companies, including giants such as Shopify and Netflix, in recent weeks is trickling down to the early-stage startups universe. 

Looking ahead, PE/VC market in India will enter a markedly different environment with the imminent rise in interest rates, rising inflationary pressures, potentially hawkish monetary policies with winding down of stimulus programs. This is likely to impact the valuation multiples that have been on a record high over the past year and may see some downward revision in some of the overheated segments. The supply chain and rising inflation pressures have already had an impact on many of the portfolio companies of PE/VC funds and are expected to persist for longer than previously anticipated. This will increase the pressure to create favorable exit multiples amidst margin pressures. 

The ongoing Russia-Ukraine conflict has already dampened investor sentiment who are becoming more risk averse and are moving funds into safe-haven investments. As a fall-out of the conflict, oil prices are at a multi-year high driving inflationary pressures globally and for India in particular, given our high dependence on imported oil. These factors affect investment flows into India, as 85% of the funds invested in India are from global pools of capital. Also, important to watch out are the election results in some of the key states as it can have a significant impact on the Government’s policy trajectory running-up to the assembly elections in 2024.

It is clear that the rout in the public markets, especially of tech companies, will trickle down into VC investing. VCs will have a much harder time raising money and their LPs will expect more investment discipline. This slow down and higher investment discretion will have a disproportionate impact on startups, especially asset heavy companies, low margin companies, hardtech, and other companies with high burn and long time to revenue.  On the bright side, companies which manage to cut costs, control cash burn, extend their runway and can pivot if necessary to find a path to revenue will pick up significant market share in an economic downturn by just staying alive, while their competitors wither away.

References & Sources:Wall Street Journal, RBI, Brookings Research, Bain & Co , EY, Indian Venture and Alternate Capital Association, Tech Crunch, Mint

Surya Narayan

Head - Deal Advisory, Saints & Masters