After a sprint, a pause for breath

2021 not only saw record funding creating a third of the country's unicorns, but also the first major listings, providing new valuation anchors

Over the past year, India added a record 38 new unicorns (nearly a third of all ever created), taking the count to 93, with a combined value of $330 billion. This excludes 18 unicorns we identified last year that have listed or have filed prospectuses in preparation of a listing. We dropped another 21, 15 due to a change in methodology, and six because their valuations dropped below $1 billion. The transformation of India’s corporate landscape continues: 88 per cent of the unicorns in this year’s list started this century, versus 66 per cent last year, and only 15 per cent of the BSE500.

The surge in unicorns is a global phenomenon. From being a rarity not too long ago, the world now has more than 1,000 unicorns, with a combined market value of $3.3 trillion, or 3 per cent of the global equity market capitalisation. Just five years ago, this ratio was less than 1 per cent, with 200 unicorns. Among the different forms of capital, while debt has been around for thousands of years, and equity capital for at least 600 years, formal venture capital is just decades old. In its early days in the 1960s, the industry managed a few hundred million dollars in assets, nearly all of it in the US, taking small positions in early-stage companies. Since then, the industry has expanded geographically, first to Europe and China and then to India and Latin America. It has also grown in size: Venture Capital and Private Equity (VC/PE) investments rose to $50 billion in 2010 and more than $600 billion last year. There are three main drivers behind this.

First, changing demographics, growing inequality of wealth and income, and global trade pushed down inflation and interest rates, forcing institutional asset managers like pension, insurance and sovereign wealth funds to take more risks, creating large pools of capital that are chasing growth, even if at higher risk. In VC funds, very few investments drive the bulk of returns: Often 5 per cent of investments drive 60 per cent to 80 per cent of the returns. This is inherently risky, and is unlikely to be the core destination for savings of most households. On the other hand, large institutions can allocate some percentage to VC/PE strategies.

Second, as much as the increase in supply of capital, there is also a growing demand for it. Investments are increasingly into intangible assets, as value-add shifts to software, brands and supply-chain complexity from just ownership of physical assets. Intangible investments began to exceed tangible investments in the US in the 1990s. These investments are high-risk/high-reward: When they work, they can scale almost infinitely (like software). Some benefit from large network-effects: In the case of social-media platforms or ride-sharing platforms, in fact, the benefits multiply with scale. This means that profits from an industry are concentrated in a few firms. However, this also means that for several other firms in the industry that do not succeed, there is no salvage value of their investments.

Traditional sources of capital like banks would be unwilling to fund such investments. The winner-takes-all structure such industries engender fits the expected return profile of VC/PE funds, for whom a considerable number of investments fail, but a few generate super-normal returns.

Third, new technology firms are also growing larger much faster than they used to. Across the world, the combination of cheaper computing with surging internet penetration (even to rural areas, which are still large in Asia) is enabling new business models, and removing inefficiencies from value-chains.

The establishment of this pipe, which routes risk capital from the wealthy towards new technologies and new business models, is an integral part of boosting productivity globally. Most economies (including developed ones) struggle to supply growth capital to smaller firms, particularly as banks’ business models are not attuned to smaller loan ticket-sizes, and these firms own few if any assets. Such businesses may also be better off with equity rather than debt capital. VC/PE funds, steeped in the philosophy of high-risk investments, are likely better equipped to provide capital to smaller businesses.

While all these factors have structural undercurrents, it is important to note that the factors driving demand and supply are independent: The pace of innovation is unlikely to stay uniform, and neither is the supply of capital. It is natural, therefore, to find periods of excesses. Like in any market, investors are prone to herd behaviour: In particular, recent successes in the private market have attracted non-traditional funds (asset managers who earlier only invested in listed equities), driving much of the recent surge.

Last year was also a landmark one in connecting the privately funded ecosystem to the listed universe for the first time. While all initial public offerings (IPOs) saw good investor interest, stocks have corrected sharply since then. The combined value of these firms rose from $32 billion pre-IPO to $59 billion at the time of their respective listings, but is now down to $40 billion. Thus, public market investors bore losses, tempering valuation anchors, but gains for VC/PE firms mean continued flow of private investments.

In our view, capital has flowed in faster than the industry’s absorptive capacity, with non-traditional investors accounting for nearly 50 per cent of funding. This activity may slow down in the coming year or two as interest rates rise. Economic and geopolitical uncertainty have picked up, and stock prices of numerous global tech companies have seen a correction. Several funds that focused on late-stage or pre-IPO investments to deploy ever-larger sums of capital are limiting such investments.

The relative importance of India’s unicorn set to India’s economy continues to be significantly higher: Their combined market value is more than 10 per cent of the market capitalisation of India’s listed firms, versus 4 per cent in the US, 5 per cent in China and 3 per cent globally.

This reflects the importance of these flows in a capital-starved economy. Deep-rooted changes continue, which facilitate the growth of businesses funded by this capital. These are both generic, like the rapid improvement in rural infrastructure (piped water, smartphone access) and formalisation (the surge in UPI payments and FASTag transactions), as well as specific, like strong global market growth in Software-as-a-Service (SaaS). India’s unicorn list remains diverse, with new unicorns spread across fintech (including crypto), platforms, e-commerce, SaaS, edtech, consumer discretionary, logistics and healthcare. This diversification also provides resilience on the business side, keeping medium-term prospects bright even as supply of funds slows in the near term.

The writer is co-head of APAC Strategy and India Strategist for Credit Suisse