Most of India’s top venture capital (VC) firms raised successively large funds in 2015 and 2016, betting on what looked like an internet gold mine then. Most analyst reports on India’s internet business such as those by Morgan Stanley, Credit Suisse and others predict years of fast expansion.

But in the first half of 2017, early-stage funding of internet start-ups saw a sharp, unexpected slump. Additionally, while the amount of start-up funding in 2017 exceeded the levels of 2016, the volume of deals is lower.

This has led to concerns that VC firms will struggle for exit opportunities to generate returns on the funds they raised in the past two years and that the big internet companies such as e-commerce giant Flipkart, ride-hailing firm Ola and payments platform Paytm are hoarding too much capital, leaving little for smaller start-ups.

Start-ups raised roughly $10.7 billion last year, compared with $4.6 billion in all of 2016, according to data with Tracxn, a start-up tracker. The volume of deals, however, fell to 973, compared with nearly 1,300 in 2016, according to Tracxn.

Last year, 798 deals went through at the seed, pre Series A and Series A stages, which are typically the first two or three rounds of funding for a new company, Tracxn data shows. That number is far lower than the 1,137 deals at the same levels in 2016 and 1,075 in 2015, the data shows.

“Funding levels across stages have been muted," said Rutvik Doshi, managing director at Inventus Capital Partners, a VC firm. “Many of the investors who were there in 2014 and 2015 have gone quiet over the past 18 months to two years. There is a lot more scrutiny of start-ups, more focus on achieving unit economics; so, all of this has had a negative impact on deal volume. Also, some VCs like SAIF and Sequoia, who had gone very aggressive on seed investing in the previous years, have shifted their strategy towards later-stage deals, which are fewer in number."

The fall in seed and angel deals is partly because consumer internet and e-commerce companies have lost favour with investors. Both investors and budding entrepreneurs who had flocked to start consumer internet companies in 2014 and 2015 have shifted to areas such as software as a service (SaaS), business-to-business e-commerce and financial technology over the past 18 months. The newer areas can accommodate far fewer start-ups than consumer internet.

Apart from early-stage funding, even start-up formation has slumped in India.

The number of new internet and technology start-ups launched in the first nine months of 2017 fell to 800 from more than 6,000 in all of 2016, as start-up closures, the struggles of large internet companies such as Snapdeal, which is facing a battle for survival after a proposed sale to bigger rival Flipkart fell apart, and a slowdown in the growth of the e-commerce market took their toll on entrepreneurial activity.

According to Tracxn, the number of new start-ups has now dropped steeply for two years in a row. While some investors are again interested in backing new consumer internet start-ups, there is an acute shortage of such companies.

Both the slump in new start-up launches and the drop in early-stage funding are worrying developments for the nascent Indian start-up ecosystem. It’s a legacy of the go-go years of 2014 and 2015, when investors rushed to fund internet start-ups in the belief that the Indian internet market would turn out to be a gold mine in a very short period of time.

But as early as 2016, the expansion of the e-commerce market nearly halted. Since then, most e-commerce companies, which had relied on deep discounts and extensive advertising for growth, have been struggling to find the right business models for a market that hasn’t lived up to their expectations.

In 2016, the e-commerce market grew by less than 15% to $14-15 billion, according to RedSeer Management Consulting, a market research and consulting firm.

“In 2015, too many ‘me-too’ start-ups got funded and the unwinding of that still hasn’t happened fully," said Sateesh Andra, managing director of Endiya Partners, an early-stage VC firm. “I expect that even in the next year, investment volume will be similar to 2017. You should also see more consolidation as the companies that aren’t able to raise money will have to sell out."s

To be sure, after nearly 18 months, India’s e-commerce market finally picked up sharply in the second half of 2017, driven by strong growth at Flipkart Ltd and Amazon India and new entrant Paytm E-commerce.

Online retail grew by 23% to $17.8 billion in 2017, up from $14.5 billion in gross merchandise value (GMV) last year, according to RedSeer, which has estimated a jump of 60% in e-commerce in 2018. The primary factor behind the bullish estimate is that the firm expects the number of new online shoppers to increase significantly after two years of near-stagnation.

Granted, there are several factors that could hold back expansion of e-commerce. The market is still over-reliant on smartphone sales, which generate more than half of the GMV (a much-hyped e-commerce metric that refers to the value of goods sold on a site but does not account for discounts or even sales returns) at top e-commerce firms. If smartphone demand drops, e-commerce firms could take a hit. Another is whether the number of online shoppers will increase in a big way.

Yet, the consumer internet market has never been healthier, partly because of the expansion of digital payments, increasing smartphone penetration and the availability of fast and low-cost mobile internet services led by Reliance Jio Infocomm Ltd.

The volume of wireless broadband data consumed by Indians has risen sharply, from less than 200 million gigabytes (GB) a month in June 2016, to around 1.3 billion GB a month in March 2017, according to the Internet Trends 2017 report by storied Silicon Valley VC firm Kleiner Perkins Caufield Byers (KPCB). Data prices per GB have fallen from around $3.5 to $1.8 in the same period, according to the report released in June.

According to a Morgan Stanley report, India will have 915 million internet users by 2027, up from 432 million users currently.

The improvement in macro factors related to the internet may spur another wave of new consumer internet start-ups and investments within the next two or three years, some investors said.

“The consumer market has never been better because of Jio and the growth of digital payments," said Anand Lunia, co-founder of India Quotient, an early-stage VC firm. “Indian consumers are very comfortable with online services and still, you’re not seeing many investments or a sufficient number of new start-ups in consumer internet. This indicates that within the next two-to-three years there could be another bubble because you’ll see a lot of investors chasing very few start-ups."

Broadly, the investment trends of 2017 are likely to continue into 2018, investors said. One important one is that of fewer start-ups getting more and more capital. For instance, just three companies—Flipkart, Paytm and Ola—account for nearly half of all capital raised by start-ups in 2017.

Many online retailers are struggling to justify their existence. In order to boost slowing growth and to attract the next round of funds, some are hastening their offline expansion.

Over the past one year, the likes of eyewear retailer Lenskart Solutions Pvt. Ltd, furniture brand Urban Ladder Home Decor Solutions Pvt. Ltd, baby products seller FirstCry (BrainBees Solutions Pvt. Ltd) and others have changed their strategies to protect their turf against Flipkart and Amazon India.

But doubts about the viability of many specialty online retailers remain. That, along with the cash superiority of Flipkart and Amazon and their plans to expand in more categories, has led to a perception among investors that only companies that are clear leaders in their respective categories can hold their own against the giant online retailers and attract fresh capital.

“Going forward, funding is likely to get more concentrated," said Kashyap Chanchani, managing partner, The RainMaker Group, an investment bank. “What happened in 2017, where you saw large funding rounds but low deal volume, will continue for the next year at least. There’s a fairly clear dynamic now where there are companies that everyone wants to fund and there are companies that few want to touch."

Even as investment activity is relatively depressed, there’s lots of money sitting on the sidelines.

India’s top eight VC firms—Sequoia Capital, Accel Partners, Nexus Venture Partners, Kalaari Capital, IDG Ventures, Lightspeed Venture Partners and Matrix Partners—have together raised $3.8 billion since the start of 2015, according to Mint research.

This amount doesn’t include investments committed by other investors such as Lightbox Ventures, Blume Ventures, Kae Capital and Inventus Capital Partners and recently launched funds such as Stellaris Venture Partners, Pravega Ventures and Endiya Partners.

Additionally, Matrix and Inventus Capital are in the process of raising their next funds, which will only add to the glut of early-stage capital.

The war chest accumulated by VCs stands in stark contrast to the drop in investment activity. Privately, many VC firms admit they overestimated the potential of the internet market. They say the internet market will grow, but at a much slower pace than they estimated in 2015.

“It’s clear now that most funds have raised too much money. Anything more than $150-200 million and you’re going to struggle to give returns. But most VC firms have raised funds that are two-to-three times bigger. The fact is that India is just not a deep enough market to absorb that kind of capital. And that will have consequences for the return profile of funds," said a partner at one of India’s top five VC firms.

He spoke on condition of anonymity.

India’s start-up business suffers from a chronic lack of exits. At least it did until 2017.

In 2017, VC firms generated exits worth around $2.8 billion across 56 deals, an increase of 56.2% from the $1.8 billion in 2016, according to deal tracker Venture Intelligence.

But the data isn’t straightforward. Unlike typical venture exits, which comprise acquisitions or public listings, the single biggest driver behind the jump in exits in India was SoftBank Group Corp., which launched a $100-billion fund to invest in tech companies across the world late last year.

The Japanese firm bought shares worth roughly $2 billion from shareholders in Flipkart, cab-hailing firm Ola and payments platform Paytm.

Since October 2014, when it first started investing aggressively in Indian start-ups, SoftBank pumped in roughly $2 billion in Snapdeal, Ola, Housing and others until the start of this year. But its $1 billion bet on Snapdeal soured badly, prompting SoftBank to try and arrange a sale of the company to Flipkart. That proposed sale fell apart in August as the two companies and their investors couldn’t agree on the terms. Partly to salvage its India investments, SoftBank picked up large stakes in Snapdeal rivals Flipkart and Paytm in 2017.

SoftBank’s eagerness to save face helped investors such as Tiger Global Management, Accel Partners and others get attractive exits. But investors said Indian start-ups and VCs still need to prove themselves and that eventually they will be judged by their ability to generate genuine exits through public listings.

“The cycle of VCs investing in start-ups, start-ups returning money to VCs via exits and VCs returning money to LPs (limited partners, who invest in VC firms)—that cycle hasn’t happened for many VC firms in India. Secondary exits are a good stopgap measure. But VCs still have to show that India isn’t just a story that is sold on macro factors. We’ll have to prove soon that India can create successful companies by returning money to LPs," Endiya Partners’ Andra said.