Return of the rumble in the VC jungle

As lockdowns stretched far longer than what he had initially assumed, 100X.VC reluctantly drew up a new deal-making process. Mehta and his colleagues would do up to eight Hangout calls with entrepreneurs instead of the one or two meetings they would have done in the past. They would conduct far more extensive background checks on founders including checking credit scores, and ask for tax compliance proof.

In this way, Mehta’s team has finalised about 10 new deals, all with entrepreneurs they have never met in person.

His experience will resonate with other venture capitalists (VCs). At the start of the pandemic, investors had frozen new investments, pulling term sheets and ordering founders to cut costs. The few VCs willing to invest were demanding cutprice deals, and there was unanimity that the next year or two would be a bleak period for internet startups and investors.

But within months, the venture business has largely returned to normalcy, as greed trumps fear.

Investor confidence has revived—one of the very few V-shape recoveries seen during the pandemic, and much faster than those at their portfolio companies. VCs are again spending more time hunting for deals—for the most part over Zoom and Hangouts. While overall deal volumes are much lower than pre-covid levels, cheque sizes and valuations have largely held firm, with those in a small number of sectors like digital education soaring.

VCs now say that the funding downturn that was expected even before the pandemic may not be as severe as previously feared. This is thanks to a combination of factors: a rebound in public markets globally; a boom in US and Chinese technology stocks; an acceleration of digitisation across sectors; and large capital reserves at many unicorns. Ergo, Indian internet startups—and their backers—could avoid widespread value destruction that looked inevitable earlier this year.

With large amounts of global capital available, growth will be rewarded, especially at tech companies that are expanding their reach, said G.V. Ravishankar, managing director, Sequoia Capital India. “We’re not seeing (a significant fall in startup valuations) right now, and if the US continues in this way, where markets and particularly technology stocks are doing so well, we don’t know if there’ll be any significant correction," he added.

Though venture funds seem to have taken the covid-19 crisis in their stride, it is triggering some major changes within the business. In sectors like digital advertising, e-commerce and software products, the pandemic has had a deep, uneven impact that has increased the dominance of the biggest companies like Amazon, Facebook, Google and Microsoft. In venture capital, too, something similar is afoot.

Concentration of power

Until 2014, with the exception of Accel Partners, Silicon Valley-based global investors like Sequoia Capital, Matrix Partners and Lightspeed weren’t firm believers in India’s tech entrepreneurship scene. They only invested part of their funds in internet companies. Some like Canaan Partners and Kleiner Perkins gave up on the market entirely.

Tech investing was dominated by Tiger Global, a New York-based investment firm whose prolific, high-risk bets on companies like Flipkart, Myntra, Ola and others helped bring the Indian startup scene to the attention of large investors.

In mid-2014, India witnessed its first major funding boom, which not only drew late-stage tech investors like SoftBank and DST Global, but also prompted the global Valley funds to get serious about tech investing here. By then, a handful of homegrown tech investors like Blume Ventures and India Quotient had entered the fray, joining older independent funds like SAIF Partners, Nexus Venture and Saama Capital.

From 2015, the Valley-based funds, which could raise capital at will to invest in India on the back of the performance of their parent firms, came to dominate tech investing at the early and mid stages. Sequoia Capital, Accel Partners and Lightspeed established themselves as the most powerful venture investors, in parallel to the dominance that the major American tech firms like Google, Facebook, Amazon and Walmart have built in their respective sectors in India.

The pandemic is allowing these funds to consolidate their power, especially with the freeze on Chinese capital that was emerging as a rival network.

In July, Sequoia announced a fresh sum of $1.35 billion to invest in India and Southeast Asia. Its asset under management in India jumped to about $5.5 billion—many times higher than most of its peers. Of this, nearly $3.5 billion has come since 2015, more than the next four funds combined.

In April, Lightspeed US raised $1.5 billion to invest in mature startups in India and other countries outside the US. Lightspeed India is separately raising a new fund this year—its third such vehicle in five years.

At the same time, fund-raising for many local VCs has become problematic. Mint learns that several independent funds including Stellaris Venture, Chiratae Partners, Blume Ventures, India Quotient and Inventus Partners India will be forced to delay fund-raising (including for opportunity funds) either this year or in 2021.

Attracting limited partners (LPs)—investment firms based in the US, Europe and Asia that invest in VCs—takes anywhere from one to three years. With travel impossible, LPs are becoming more conservative, sticking to fund managers they already know and delaying investing in new funds. “Because of the slowdown in growth, the portfolio maturity gets shifted by at least six months, so you need to postpone your own fund raise by six months to a year," said Rutvik Doshi, managing director, Inventus Capital India.

Raising capital from LPs “you never met before is going to be almost impossible" for the foreseeable future, said Karthik Reddy, partner, Blume Ventures. “Right now, our focus is on getting the portfolio in order and seeing that our winners play out well this year. We would have probably started the process of raising the next fund by the middle of 2021. But now, there could be a delay," he added.

Among independent funds, too, the Valley-based ones like Saama Capital and Nexus, which have better access to software startups and a stronger network of LPs, are prospering more than the VCs based in India.

LPs in US and Europe will become selective among their present fund managers, cutting some who haven’t performed and increasing allocations to those who have returned more capital, according to Ash Lilani, managing partner, Saama Capital.

What makes it worse for some independent funds is that LPs in India including high net worth individuals (HNIs), family offices and corporate venture arms have become even more wary than their international peers because of the uncertainty around the size of the economic contraction and the volatility in public markets. This affects only independent funds as the Valley-based VCs don’t raise capital in India.

Shakeout coming?

To be sure, while many independent VCs are facing delays, they all expect to raise their next funds at some point. Many of them have attractive portfolios and respectable track records. Still, the disparity between independent funds and the Valley-based global funds is only widening during the pandemic.

Apart from not having to worry about fund raising, the global funds have far larger teams, a wider network of investment partners and entrepreneurs who pass on promising deals. These factors that help bring them higher (and better) deal flow in normal times only exert more influence during crises.

“When deal volumes are lower, the top funds end up capturing more deals because they can always outbid smaller funds," Inventus’ Doshi said. “That hasn’t happened so far, but we’ll have to see."

Another spoiler for independent funds is that exits, already short in supply, are being delayed. With late-stage investments declining in most sectors, secondary share sales, which have become the biggest source of exits, are expected to fall too. The cutback by Chinese investors and SoftBank will further depress the secondary market.

As a result, most VCs are expected to face delays in returning funds, and will likely seek one or two-year extensions to previous fund vehicles, which typically run for eight or ten years.

However, investors insisted that these factors are unlikely to lead to a shakeout in venture capital. “Generally, investors in VC funds don’t take a 1 or 2-year view. They take a much longer term view that spans a decade or more," said Tarun Davda, managing director, Matrix Partners India. “Most investors believe that there will be a further acceleration in digital adoption across sectors leading to increased VC activity."

The art of the deal

Since June, new startup formation has slowed and there is intense competition for deals, which has sustained valuations. Most of the investors mentioned above said that they will end up with a similar number of investments this year as in 2019 (excluding the three months from March to May), even if the kind of investments may change.

“In peacetime, everyone is optimistic, and you end up investing in companies that you know may cap out at only $100 million in value. In war time, you’ll only invest if you think a company can get to $1 billion. So you’re likely to take higher-risk and higher-conviction bets," Blume’s Reddy said.

While early-stage investments are going strong, activity at the Series B-C stage has shrunk, partly as most Chinese firms have stopped investing for now. Surprisingly, late-stage investments are thriving—another distinct feature of this downturn—although it is concentrated in companies that have gained ground during the pandemic.

Ed tech startups, Byju’s and Vedantu, which raised capital last month, are already in talks to receive fresh funds from investors. Gaming and content startups, Dream11, MX Player, DailyHunt and Sharechat are all in talks to raise capital at higher valuations. Software and payments startups, too, are seeing strong investor interest.

Still, on the whole, many more startups are struggling than are doing well. Most haven’t seen revenues recover to pre-covid levels. Distressed sales, consolidation and startup closures are rising, even if lesser than previously thought.

But the experience that investors and entrepreneurs have accumulated from navigating past cycles is helping. Coming into the present downturn (before the pandemic), many mid-stage and late-stage internet companies, having seen previous cycles, had stocked up on capital. And most startups responded quickly to the pandemic by conserving cash.

“As soon as the pandemic hit, investors and entrepreneurs got together and immediately drew up cost-cutting strategies to lengthen their companies’ runway," said Harsha Kumar, partner, Lightspeed India. “Their quick reaction has positioned many startups to see out the next year."

Those companies that have enough capital will simply wait out the downturn to avoid painful down rounds, said Sumir Verma, founder, Merisis Advisors, an investment bank. But there could be a flood of Series B-C deals at the end of the year as travel starts opening up, he said.

More than the availability of capital or down rounds, what is worrying investors and entrepreneurs is the broader economy. Though the glut in capital globally is keeping funding taps flowing for now, a higher-than-expected economic contraction could force more startup closures and distressed sales.

“If a company or a fund are performing, there will be ample capital available, even if there’s a small delay," said Ritesh Banglani, partner, Stellaris Venture. “What is far more worrying is the demand slowdown. If it lasts more than a year or if there is a huge second wave of covid-19, all bets are off."