India’s painful venture capital crunch

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The writer is a financial journalist

The Indian stock market is in a sweet spot. The Nifty 50 index is up 30 per cent in the past year and 90 per cent over five years. Domestic flows into the market have now been positive for three years in what analysts at Morgan Stanley describe as a dream run.

At the same time, as the bank points out, geopolitical dynamics are driving both foreign direct investment and portfolio flows towards India.
The capitalisation of listed companies in Mumbai has overtaken Hong Kong.

But a big disconnect has emerged between the exuberance of India’s listed stocks and a painful correction under way in the country’s private markets after an extraordinary boom.

While many markets had seen a drop in venture capital funding last year, the Indian market for such finance has been hit particularly hard. Inflows fell more than 60 per cent last year from $26bn in 2022 to about $9.5bn. In comparison, flows in both the US and China VC markets fell by about a third.

Bain points out that India maintained its status as the second-largest destination for VC and growth funding in Asia-Pacific after China. But there was a decline in deal volume (from 1,611 to 880 deals) and average deal size (from $16mn to $11mn).

Moreover, the Indian start-up ecosystem only produced two so-called unicorns — companies with a valuation of more than $1bn — in 2023, compared with 44 in 2021 and 26 in 2022, according to Entrackr, a Mumbai-based data group. It said in December that the Indian start-up ecosystem saw more than 24,000 job lay-offs in 2023, up from 20,000 in 2022.

The private market is still suffering from the hangover from its 2021 bubble, which saw likes of SoftBank, Tiger Global and Sequoia India (now known as Peak XV Partners) invest heavily in young companies at steep valuations before pulling back. For example, in early 2022, edtech company Byju’s sought money at a valuation of $22bn. Today, it is valued at less than $1bn.

“The valuations in the private market were delusional. Corrections will happen,” says Ashish Gupta, chief investment officer at Axis Mutual Fund. In many cases, entrepreneurs and their financiers “lived in their own echo chamber and drank their own Kool-Aid”.

Indian private markets might have been expected to prove more immune given their weighting to the in-demand technology sector. India has long been seen as a leader in technology. Moreover, an ailing start-up ecosystem in the country is particularly counterintuitive given the close links between Silicon Valley and the two centres of Indian entrepreneurship in Bangalore and Hyderabad.

Yet, given its historically high cost of capital, it has turned out to be highly vulnerable. The Reserve Bank of India raised its benchmark interest rate from 4 per cent in May 2022 to 6.5 per cent in March 2023. Despite the fact that national elections will start next month the central bank is not likely to cut interest rates and trigger any new credit cycle any time soon. The introduction of an tax on non-resident angel investors in unlisted firms will also hurt at a time when foreign capital is needed. That will probably encourage even more local start-ups to seek their fortunes outside India.

In retrospect it is clear that the peak years when global interest rates were low, risk appetite high, and foreign capital came flooding in, were an exception to the trend. Now, as the cost of capital goes up worldwide, foreign capital has become more risk averse and has less incentive to go abroad. The exceptionalism of US markets in drawing in investment can be a curse for many emerging nation markets.

The problem is especially acute given the paucity of local angel investors when compared with either the US or China. Given the difficulty in raising significant sums of money locally, some of the smartest and most ambitious Indian entrepreneurs find it easier to start their firms on the other side of the Pacific, especially if they have gone to university in the US. 

That means that some young companies in India focus on proven business models that don’t require massive investment. “The more capital intensive, the higher probability that a start up will die for lack of funds,” says Rama Rao Sreeramaneni, the founder and chief executive of Hyderabad-based Innovation Communications Systems.

Rahul Khanna, founder of Trifecta Capital, says this year is especially critical for start-ups that raised money at peak valuations in 2021 and had enough money to keep them from needing to raise money in 2022 and 2023 in “down rounds” — funding deals struck at lower valuations than struck in previous deals.

With such buoyant listed markets though, those companies that have survived through the crunch might now find IPO conditions much more favourable.