Volatility is the price one pays for Listed equity; Liquidity is the price one pays for Private equity!!!

- Nimesh Salot

Dear Investors,

Hope this letter finds you in good health and spirit.

Last quarter has seen lot of upheavals in the global markets, especially with the banking crisis seeing Silicon Valley Bank (SVB) ending up as being acquired by First Citizens Bank. Till the time the acquisition of SVB was announced, the private equity and venture capital industry was literally living on the edge. These instances of banking crisis are unravelling the pitfalls of liquidity squeeze and the high interest rate regime and its likely impact on the private markets. In our Investor’s Letter of December 2022 “Happy 2023 !!! Themes to Look Out For” we had categorically mentioned a likely scenario that the private markets are going to be finding it difficult with the liquidity squeeze and one should remain cautious and careful in selecting right business models. The current situation has put many a business models in jeopardy and the fund houses may see some pain at the investee companies in next few quarters.

The year 2022 has been a mixed bag for the private markets with the first half seeing a somewhat continuance of upbeat trends seen in the year 2021, however, come June 2022 with the US Federal Reserve aggressively hiking the interest by 75 bps, four times over six months, taking the interest rate to 4% from a meagre 0.25% at the beginning of 2022. The decision on interest rate increase is continuing as of March 2023, with the latest increase of 25 bps taking the rate to near 5% after nine successive increases in last one year. This has been an unprecedented phenomenon which majority of the players in the financial services wouldn’t have had any experience of managing.

The glimpses of what’s in store have been quite visible with trends in the private markets across the globe including that of India. The second half of 2022 started seeing the major declines across the board covering, investment activity, exits and fund raising.

The Indian Private Equity (PE) and Venture Capital (VC) market for the year 2022, witnessed declines across the board with investment activity having reduced by 26% over previous year at USD 56.5 billion. The deal numbers have more or less remained flat on an overall basis (with some specific segments registering some decline) which suggests that the deal sizes have declined. If you compare the first half vs second half of 2022, the decline is quite significant with second half registering only USD 20 bn worth of investment. The decline was very sharp at 48% (y-o-y) in all Buyout transactions at USD 10.8 bn, while growth and start-up investments activity were equivalent to USD 16.4 bn and USD 18.6 bn, respectively, with y-o-y the reductions at 16% and 35%, respectively. The biggest beneficiary of this pronounced slowdown was private credit which registered investments at USD 6.7 bn, a staggering rise of 157% over 2022.

In terms of sectoral investments in 2022, financial services took the first place with investments at USD 10.5 bn, displacing technology and e-commerce from top positions which registered investments of USD 6.1 bn and USD 5.4 bn, respectively (both declined by 60% y-o-y). In contrast to this, infrastructure (USD 9 bn), real estate (USD 7.3 bn) and healthcare (USD 2.5 bn) recorded increase in investments activity at 67%, 38% and 22%, respectively.

With the current market conditions exits have suddenly dried up and registered a whopping decline of 55% at USD 18.3 bn. This was primarily on account of reduction in some of the large strategic or secondary exits. Even the PE-backed IPOs declined 78% in terms of values. From a sectoral point of view the top three sectors were financial services (USD 3.8 bn), infrastructure (USD 3.7 bn) and technology (USD 2.7 bn), in that order. Exits or availability of liquidity is the moot point in private market investments which is impacted in a major way due to the global headwinds and the macro factors prevailing. Hence, the saying “Liquidity is the price one pays for Private equity; you want your money back, but you can’t sell your investments”.

Thus, the major trends that are appearing suggests a clear evidence of valuation reset by investors, value play vs pure growth at any cost, lack of exit through IPO / secondaries, sectoral dominance by financial services, regained interest in infrastructure and healthcare, and rise of private credit as a dominant investment option.

In comparison to the above, the public markets witnessed net FII outflows of around USD 35.9 bn in 2022 (USD 12.5 bn); however, the first half registered the outflow of USD 36.5 bn whereas the second half there was a net positive flow of USD 600 mn. During the first quarter of 2023, there is net outflow of USD 6.5 bn, which if it is some indication, may not bode well for 2023.

Of the leading IPOs from 2021 and 2022, majority of them are reeling under pressure with current valuations significantly down from their peak levels. Of these the new-age companies of the likes of Paytm, Zomato or Nazara are down even from their issue price by about 70%, 33% and 53%, respectively.

With the amount of funds raised for the private markets in 2022, both in India (India-dedicated USD 17.4 bn) as well globally, there seems to be a reasonable amount of dry powder left. But for that to succeed the valuations will need to reasonable and the business models needs to focus on value and profitability, start-ups need to appreciate the value and benefit of conserving cash vs cash burn. With all this, we might see a silver lining towards the second half of 2023 in terms of pick-up in investment momentum.

There is every likelihood of the private markets witnessing strong competition for fund raise and considering the upwardly inching cost of capital, the businesses which are robust with strong cashflow generation are likely to be the winners.

Happy Reading !!!