At my firm, we started looking at private investments about 15 months ago. After extensive debate, we decided to test the waters. We were unsure about whether we had any right to win in this space, or whether we would suffer from adverse selections in deal flow and access. The approach to valuation seemed vastly different, and we asked ourselves whether we would have the mental flexibility to understand and commit capital to much younger companies, most of which had never made a profit. The space also seemed to be in the middle of a hype cycle. Were we too late to the party? These were some of the doubts we had as we gingerly entered the space. We made our first investment almost a year ago. We had a great experience with the company, its senior leadership and the access and operational details they were willing to share. It gave us the confidence to look at other transactions in the private world. Over the past year, we have seen multiple transactions, across sectors and made three more investments. We have restricted ourselves to late-stage investments.
Having looked at this space now for 15 months, but with very limited prior experience, I have some rookie observations.
The variability in governance, quality and accuracy of disclosures and the understanding of value creation among the companies and founders is as wide as we see in the public markets. We had gone into the space assuming that governance would be much better than in the public markets as all these companies were incubated by venture capital and private equity firms, and the founders were typically first generation, highly educated middle-class entrepreneurs who aspired to copy the success of Silicon Valley. However, that assumption is not accurate. Companies cherry pick what they wish to show.
Accounting treatment is quite different for similar companies in the same industry. Even the governance has been surprising, with many cases of related-party transactions that would cause a severe de-rating in the public markets. It does not seem to matter who is on the capitalisation table. Like in the public markets, one has to do their own due diligence.
We have met management teams of all types. Those who fully understand return on capital as well as those who seem to take capital for granted and implicitly assume that money will always be available. They see cash burn as a strategic weapon. The difference in approach seems to depend on how easy their initial funding was. Those who struggled to raise their initial rounds, never take capital for granted and are far more disciplined on investments.
The blow-ups in the initial public offering (IPO) market are to be expected. There will always be one or two companies that will try and push the envelope on valuation. Markets will push back. I am glad that the market regulator has not felt compelled to react. The IPO guidelines for start-ups are well drafted and provide adequate protection by ensuring higher levels of institutional participation in the float.
The founders need to push back on valuations. Bankers unfortunately win mandates largely based on how high a price they promise to take the company public. Selling funds are driven by their own internal compulsions on showing returns, next fund dynamics, employee carry etc. In most cases, the founders are not selling. However, they are stuck with the sky high expectations built into an elevated IPO valuation. Most founders do not seem to understand this dynamic and have left the IPO valuation determination to the selling funds.
Founders also need to push back on the bankers and their desire to allocate to their best clients, irrespective of whether that makes sense for the company. Bankers will want to fragment allocations, especially in the anchor book to accommodate all their best clients. They rank clients on the basis of how much each pays the bank, not necessarily on the duration of their investment. For young companies it is critical they build a cohort of quality long-term public investors, who buy into the vision and business model of the founders and the inherent volatility. Such funds are not always the biggest or the highest commission payer. Instead of fragmenting allocations among 50-60 funds, focus on a few who really try to understand the company. In one recent IPO, currently down almost 40 per cent, because no fund had any significant allocation, none stepped up to buy at lower prices. Founders must take control of the allocation process. After all, they will be the ones dealing with the shareholder base. After the issue, the bankers will be gone.
The regulators must make companies define clearly the metrics they are using to showcase operating performance, as every company seems to have its own definition for customer acquisition costs, lifetime value of customers and churn. Companies must also state upfront how they plan to communicate to investors. You should not have a company go public and then subsequently state it has no time to talk to investors and analysts.
Over the past 12 months it has become clear to us that public market investors do think very differently from the private market specialists. There is some value in bringing in funds with more public market expertise as the company starts pivoting towards an IPO. Having some investors on the capitalisation table who will buy-in the issue and also in the aftermarket has benefits compared to having the entire investor base comprised of sellers.
While there is intense competition in the late-stage private space, the competition is even more intense when it comes to listing. There is limited ability to get any meaningful allocation in the listing itself.
It is surprising how suboptimal most capitalisation tables are for the companies looking to list. Most have Chinese capital, large numbers of smallish investors and there is a need to clean up the capitalisation table before the company actually lists. Small investors can hold the whole IPO process hostage.
It is important to not get carried away by the valuations in new rounds. In many cases, the vast majority of the round is taken by the existing investors, and thus may not fairly reflect the price the public markets will pay. I think public markets will learn that they do not have to necessarily price the IPO off the last fundraising.
The quality of your investor base and who is on the capitalisation table matters. If you have a large committed investor with deep pockets investing from its balance sheet as opposed to a bunch of crossover hedge funds, it does impact your strategy, time frame and resilience. The more capital the business needs, the more this matters.
There is no reason for any firm to list overseas. Indian investors have shown great maturity in willing to value new business models and the market has shown depth and liquidity.
These are just some random musings as we get to know this space. We remain excited at the type of companies going public and the variety and diversity of business models. The public markets will benefit from these companies listing. In industry after industry disruption is evident, it is time our capital markets also reflected this.
The writer is with Amansa Capital
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