Honey, show me the money!

When Buddy Guy wrote “Show me the money”, he neither had the investor in his mind, nor for that matter the start-up founder. But it is equally applicable for the venture investor today. For many of them returns have been more of a mirage.

Most venture funds to India come from overseas, largely enchanted by the “India” story. But among the venture fund managers, there is widespread disillusionment today as the returns have not been as expected. Does it matter for the entrepreneurs? What a naïve question, you may ask. Of course, it does. Fund raising by itself is a difficult process and to do so in an environment of strong head winds is akin to swimming against the tide.

Exit returns

An investor in a venture makes money only when he is able to exit. Inability to exit means that the investment has to be written off, and the value, as they say, is not even worth the paper in which the shares are printed. Barring some unforeseen circumstances, a venture that is performing well would be able to provide an exit to the investors, with decent returns. Poor returns, by and large, are an indication that the performance of the venture has not been as per expectations or the macro conditions have become adverse. Any which way, the investors are flustered.

Let us look at the data. Based on a sample of 472 ventures with exits, we found the average returns were 13.25 per cent. This was during 2002–2018. NIFTY during the same period gave an annual return of around 15 per cent. This explains the disillusionment. While the venture investors would expect a premium given the additional risk that they have to bear, on an average their returns have been lower than that of public markets. Frequency distribution of returns indicates that a large number of investments have yielded negative to modest returns, with very few outliers.

Cumulative distribution of exit returns shows that close to 40 per cent of the companies have given negative returns, i.e., 197 of the 472 companies have given nil returns or lower. More than 80 per cent of the companies in the sample have given returns of about 35 per cent or lower. Thus there are a few ventures that have given supernormal returns. While individual investors might have had superior returns, as an industry there is significant scope for improvement in returns. Now, this is only for those ventures that have given an exit. We have not even talked about write-offs, where there were no exits. If such write-offs are considered, then one can imagine the effect on the portfolio returns.

Does return vary between sectors?

Entrepreneurs have often asked me why certain sectors get more venture funding and what they should do about it? Sector wise analysis of venture returns gives the answer. Water flows down the gradient, and current through the path of least resistance. Similarly, capital flows to sectors where (risk-adjusted) returns are higher.

The top three sectors in terms of maximum returns are software and internet services, consumer products and services, and fintech and payments. These are also the sectors that receive most of the funding. Some sectors are also characterised by a high amount of variability that can make the investor more cautious. For example, returns from health-tech, industrial products, internet marketplace and e-commerce have higher variability as compared to that of other sectors.

Does the city matter in returns?

While investors or entrepreneurs might tend to believe so, our results do not indicate it. Mumbai, Bengaluru, Chennai, and Hyderabad are the top four cities in that order in terms of the number of companies that have provided exits. The average returns in exits in these four cities are 11.44 per cent, 16.39 per cent, 17.62 per cent and 7.25 per cent, respectively. While the average returns did vary between the cities, the difference was not statistically significant between the cities. Being located in a particular city, thus, did not systematically affect the magnitude of returns.

Summary

Start-up founders have an onerous responsibility for providing returns to their investors to sustain the growth in investments. Many investors have burnt their fingers in their previous investments.

As risk lovers, the investors might be optimists, but if the experience continues to be sour, they will continue to move on to greener pastures. Ventures are considered as alternative assets by large institutional investors. For it to be seen as TINA, start-up founders have to play their part.

The writer is a Professor at IIT-Madras, an Associate at Harvard Kennedy School, Harvard University and co-founder of YNOS.in