To err is human, to err repeatedly is venture capital investments

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I find a lot of similarity (from the point of view of VC & PE investments) between the e-commerce industry of 2013-15 and the real estate industry of 2005-08. Both were sunrise sectors of their time and darling of investors. Investors believed in Indian middle class story and thought consumption of essentials & real estate will never come down. The only way was up & up for these investors before they fell flat on the ground!

Having seen both these cycles closely I thought of sharing what was wrong in both these sectors and why VCs & PEs erred in their investments.

(1) Foreign VC / PE Funds were wrong / misled in direct investments in India– Unfortunately Foreign Fund Managers have very limited understanding of Indian markets, society, culture, people and bureaucracy. Poor fellows operate from New York or Japan where stability, transparency & integrity are given. Unfortunately India has neither of these virtues. India is a very complex and opaque country. And real estate is the shoddiest of all businesses in India. Not to mention crooks who run them!

Take the case of top private equity & hedge funds by the likes of Merrill Lynch, Citibank and Wachovia which invested in real estate prior to 2008. Investments were done at obscene land valuation and in shoddy properties which eventually turned bad. Builders and intermediaries took foreign fund managers for a ride. Sadly, post 2008 fiasco foreign funds went all over the world abusing India, its bureaucrats and high level of corruption for their bad investments without highlighting zilch ground work done by them to understand the country and its businesses. Ask any builder how tough it is to raise foreign funds now for real estate in India.

I can see history repeating here in e-commerce. There was so much hype of VC investments in 2013-15 period. Valuation of companies with no revenues / profits were doubling every quarter. Funds like Soft Bank and Tiger Global were writing cheques at the drop of their hats. I read once in ET (not able to reproduce the article here) that Lee Fixel of Tiger Capital used to close deal in less than a week after meeting the entrepreneurs! How cool is that? Fund managers like him should take the blame for building the hype and valuation myth around Indian start-ups.

(2) Investment Managers have herd mentality & poor domain knowledge– There was a period when VCs were only investing in e-commerce companies. Then came the period they were investing only in food delivery start-ups, which was followed by home services companies. There was so much rush in 2013-15 period that secondary investors were not even doing basic due-diligence of start-ups. Some funds invested in few start-ups “trusting” the fact that other “fellow” funds were marketing those investment opportunities. I shall tell you why this is a suicidal strategy – Let’s take the case of Subhikhsa retail. ICICI Venture Funds Management Co. Ltd and Azim Premji-owned private equity arm Zash Investment and Trading Co. Pvt. Ltd tried to persuade overseas investors to purchase shares of Subhiksha Trading Services Ltd when they knew the retailer was in deep financial trouble!! (You can read more about it here). In fact Premiji invested in Subhiksha few months before it got busted which led them to accuse ICICI Ventures of misleading them.

On top of this herd mentality most of the investment managers have no or minimal skin in the game. There is lot of difference in investing your own money and someone else money. Look at Nikesh Arora – Soft Bank may have to write-off all the investments done under his tenure whether it is or Snapdeal. I always failed to understand any logic behind those unimaginable valuation of Indian start-ups. I mean $200 Million valuation for when its revenues was just Rs. 1.8 Crores. How do you do that? Ridiculous.

(3) Indian Middle Class story is flawed – Credit Suisse’s Global Wealth Report 2015 was an eye opener as it estimated Indian middle class size to be just around 24 millions people as against earlier estimates of over 264 millions by World Bank in 2005. Credit Suisse estimated the size of middle class on the basis of wealth rather than income. So business plans based on the consumption pattern of 264 million Indians were / are so deeply flawed as the genuine middle class size is almost one-tenth of the previous estimate!

Look at the chart above which shows the size of middle class for BRICS countries- Chinese middle class size is estimated to be around 109 millions compared to Indian middle class size of 24 millions i.e. almost 4.5 times. Additionally, the Chinese middle class holds a combined wealth of $16,845 Billion compared to $780 Billion of Indian middle class i.e. almost 21.6 times. Thus, an average Chinese middle class family’s wealth is almost 5 times of an Indian middle class family.

(4) Inexperienced & Over-ambitious Entrepreneurs – I remember DRHP of one of the largest real estate players in NCR when it came out first in 2004/05. The company had huge land banks across NCR. DRHP mentioned how they are going to develop and monetize these land banks for the next few years. What stood out was the claim of the builder to deliver target super built-up areas on an annual basis going forward which was more than the total area they had delivered since their inception 🙂 How on earth was it possible? What was more surprising is that investors bought into such stories! No wonder the company’s stock was down by over 80% within 3 years.

I can see the repeat of similar story selling in e-commerce industry. How do you ramp up so aggressively without breaking your internal processes and incurring huge losses? If you are incurring huge losses how will you ramp up without having access to private capital? You don’t build Amazon or Alibaba in a year. It takes decades to do so – step by step.

(5) Scalability vs Cash Flows – In real estate business the most important skill is to manage cash flows. I believe as a builder you can probably outsource every functionalities except sales and cash flow management. Whether the business is good or bad, cash flow management is critical as it helps a company to grow in good times and survive in bad days. Pre 2008 builders who were flushed with easy capital were focussed primarily on land acquisitions and launching new projects. However execution of projects lagged due to factors ranging from bad economy to lack of capabilities forcing PE funds, which have fixed tenures, to exit without any returns.

New age businesses such as e-commerce are no different. You can’t focus only on ramping up sales when there are no profits, because remember if sales are going up so are the losses. Additionally, you don’t do business with someone else money. At some stage the business has to start generating cash to support its expansion and survival.

Sooner the better!!

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