Funding rebound should give startups some escape velocity: Parag Gupta of Morgan Stanley
Parag Gupta of Morgan Stanley on India’s startup ecosystem and investment trends
The rebound in funding for Indian startups in 2017, especially in the consumer internet space, has changed the course of discussion that the sector was witnessing, and companies are now focused on growth, Parag Gupta, executive director for technology/information technology (IT) services and software at Morgan Stanley, said in an interview. The funding rebound in 2017 should give Indian startups the much-needed boost, he pointed out. “Lot of the talk in 2016 was about profitability, improving unit economics, and Plan Bs if funding options remained dry. These discussions have taken a bit of a back seat (now),” he said. Edited excerpts:
Big picture, when you look at consumer internet companies and startups, how has 2017 been?
This year has been good for internet-related businesses as far as PE (private equity) and VC (venture capital) investments go—there have been some large deals—Flipkart, Paytm and Ola. But outside the large deals is where we’ve seen changes—in previous years, money was being thrown across all startups, but after 2016, we’ve seen money being channelized to a few leaders within different segments. Last year, we did not see the big deals —funding was challenged for growth of the internet-led economy. So for the likes of Flipkart, Ola to raise large amounts this year is good. Investors had been waiting and watching in 2016 as to what direction some of these companies were headed, or it could be that investors were looking at other opportunities globally. A big question mark at the beginning of this year was whether funding will come back—it has come back in a pretty big way. With the rebound in funding, startups are talking about growth again. Lot of the talk in 2016 was about profitability, improving unit economics, and Plan Bs if funding options remained dry. These discussions have taken a bit of a back seat. Focus is coming back on growth, and this is important because we are still in the nascent stage in the evolution of the internet economy in India. You don’t necessarily want that to get impeded by lack of funding. The funding rebound in 2017 should give Indian startups some much needed escape velocity.
But the big deals coming back is due to a single factor—the deals were all led by Masayoshi Son and SoftBank. So, in that context, have things really changed, if not for SoftBank?
Yes and No. Yes—because the largest investor is SoftBank. No—because there is huge fund available out there, which is still uninvested, and so it does not mean that there was a splash and there is nothing more to come. Maybe, there is a lot more to come. This probably makes us believe that India is seen as a very interesting opportunity for such large investors. At the same time, we’ve also seen a couple of new investors coming in—they may not be new entirely to India, but new to some of these companies and sectors. This is also shows that most investors—be it PE/VC or strategics—are thinking of the opportunity being large enough and attractive enough. Maybe they see that this is the right time to invest here as valuations have not run crazy. On the valuation front—depends on whether you looking at it from a 1-2 years’ perspective, or from a 5-10 years’ perspective—if you are looking at near-term, they are expensive. We can’t put a number to it because it depends on what multiples you are looking at—but overall valuations in India have corrected. Most of the big deals in India this year have happened as downrounds—that indicates a correction in valuations. The 2016 slowdown was good because it got everyone to go back to the drawing board—evaluate their business plans and also look at other options if funding dried up. Importantly, with funding now getting channelized to a few leaders in each segment, it has become easier for investors to figure out which companies to back for the long-term, because otherwise, investors were lost looking at thousands of startups all around. We are now seeing leaders emerge in each sector. There is a moat that has been built around some of the sector leaders—these companies may find it relatively easier than how it was two years back. But eventually, no one can ignore the fact that it all depends on how well (these companies) execute.
When you talk about some firms being able to build a moat? Is not that differentiator largely the funding amount they’ve raised? In most sectors, if certain firms raise a massive round, even if there are competitors that execute better, or have better talent and technology, they may find it impossible to compete. So, has the game changed to how fast and how much you can raise?
Not really. It is a virtuous cycle—it is possible that the companies that have raised larger rounds than their competitors have better technology, better talent and can execute better, and this could have led to investors preferring them. Will the smaller players find it difficult—for example, let us look at vertical specialists in the e-commerce space. The horizontal guys will always be large, they will raise huge amounts and will have a much bigger addressable opportunity, but that does not mean investors in the private world don’t find vertical specialists attractive. The horizontals may not always be able to grow all sectors organically, and some of these vertical specialists will become great buyout opportunities as they understand their domain better than the horizontals. Second, there are certain categories where you can’t address that sector with the existing infrastructure that horizontal e-commerce players have—you need to build for that sector specifically. There may be verticals out there who can give you that scale, infrastructure and product to hit the ground running.
For horizontal players, one issue is to improve the unit economics. The other is to get into segments that are profitable. If a horizontal e-commerce player can be in some of the high-margin sectors, the company can improve its profile and path to profitability. If you can get a vertical specialist that can help you scale up, that is a fantastic bet for both companies.
As an investor, as long as you can make money on your investment, only that matters.
Coming to strategics, we see two sets of players in India—the Chinese internet companies and those from the Valley. Both sets of players have taken different approaches. Chinese internet companies prefer to buy stakes—diversify and even bet on multiple players, often in the same segment. The Valley players have often gone about building out their businesses in India rather than using the M&A route. How do you see this play out in 2018?
Chinese investors started getting interested in India only from 2016. If you are looking at the Indian internet era over a 15-year period, we are still early—we are only in year three. Whatever be the strategy of the Chinese players, it is good for India startups, because, at a time when it seemed that VC money was drying up, you had them as a new source. Also, from the perspective of Indian startups, getting money from strategic players—those who understand the business—is very valuable. They (Chinese internet players) not only bring in funds, but also the patience to hold on for longer because they’ve seen how that business has played out for themselves, and they’ve realized that you have to wait it out for 10 years to see the value of their investments pay off. Second, you can get advice from them on how to run the business—they are probably 10 years ahead of the Indian startups in that space. In terms of the landscape, the businesses are not that different—we are talking about similar demographics, comparable per-capita-incomes on a relative scale. The Chinese may not throw their strategy on to you, but have you run the business—and for this, you can use their expertise. Unlike strategic players, if the capital is from a VC or a PE investor, there is a limit to which they can invest. But going forward, it may not just be the strategics that are involved—we may see a wide variety of investors. As long as there is interest—which is a function of opportunity, which is large and can only grow—and second, how well are Indian startups performing. The second element is the most important part—if you are not able to execute, eventually, the investors will look at the next best available opportunities—be it Africa or South-East Asia.
GST will be a big boost for India, especially for e-commerce companies. Now for internet-based companies in India, you have a foundation being created, where the use of digital will only increase, and if India is touching that upper middle income status over the next 10 years or so, it is great for consumption. If your income is rising, the affordability of smartphones also goes up, and infrastructure is available, then online will only grow.
Sticking to digital and payments, China has leapfrogged most economies in terms of emergence of large mobile wallet companies. Chinese banks are nowhere in fray. So far, in India, we are seeing a different combination where mobile wallet firms are growing, but banks are also becoming aggressive in this space. How feasible are the business models of some of the unicorn wallet companies in India with new competitors like WhatsApp payment, Google and even Reliance Jio all eyeing this space?
We concluded in our recent paper that India won’t be like China for the simple reason that private banks in India are as efficient as anywhere in the world. Initially, it seemed like India’s private banks were trying to do everything on their own, and not really collaborating with startups, but the fact that now, some of these banks are either buying out mobile wallet companies, or are investing into them clearly shows that they accept that they may not have the best technological expertise, but are ready to own up and imbibe what is available. This shows India’s banks understand the requirements of the day, and how things are going to evolve in the next couple of years. India will see a combination of private banks, and some independent wallet companies with market shares to boast about, as they will be nimble and aggressively go after digital payment, and then later move into financial services.
Payments will be a huge opportunity—the runway or the addressable market in India is huge. In our white paper, we wrote that digital payments, which is currently at 5% of GDP, will go to 20%—so this is a $1.2 trillion opportunity in the next 10 years. So if you are acquiring customers today through discounts and cash back, the point is, you are looking at that bigger picture. Most Indian wallet startups don’t have the privilege of what happened in China, where its wallet firms were part of larger companies, and hence they benefitted from synergies. As long as Indian mobile wallet firms have investors that understand the business, and can back them up for the next 10 years, they should do reasonably well. But the point to note will be, how well they can take on the challenge from banks, and how does regulation shape up, and whether they are able to navigate through—that is more important than whether they are burning a lot of money to acquire customers now. Indian mobile wallet firms have not reached a critical mass of consumers who are actively using the platforms—so they are still undertaking the first step which is to add enough people, and the second step will be to get them to do enough on your platform—the ultimate goal for the wallet companies is to get into financial services and do online lending.
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