Private equity (PE) funds are investing more in technology-led startups than ever before, signaling higher risk appetite from otherwise relatively-cautious fund managers during a pandemic-led boom for startup funding.
Private equity funds have participated in deals worth $6.7 billion in the first half of 2021 alone, far surpassing the $4.6 billion and $3.9 billion in all of 2020 and 2019, according to Venture Intelligence, a startup data tracker.
Funds such as Gaja Capital, ChrysCapital, Multiples, Temasek and TPG Capital have either made their first internet investments in the last year, or are doing far more deals in the space than before, led by rising internet penetration, fast-growing mature companies and a slew of hotly anticipated internet IPOs.
Private equity funds have largely flocked to consumer internet firms, as opposed to financial services or healthcare, which are other major focus areas for private equity. Recent examples include online healthcare startup PharmEasy, food delivery firm Zomato, meat delivery startup Licious and ecommerce logistics firm Xpressbees.
“Consumer sector across sub segments is a key focus area for Private equity funds. It has been for many years. And today you can’t do a consumer deal which doesn’t have tech in it. Consumer tech investments are gradually becoming mainstream for private equity firms,” said Karan Sharma, who co-heads technology investment banking for Avendus.
He has a point. Many of the assets PE firms are picking in vertical ecommerce, say Nykaa, Lenskart, etc would have been purely offline companies a decade or two ago. But most consumer-facing companies today have a separate digital strategy, and many are in fact online-led, in terms of revenue share, marketing and strategy.
“I won’t be surprised if in five years, 50 percent of PE portfolios would comprise tech companies,” he added.
Internet companies, in an era of abundant capital, also sometimes stay away from private equity firms- including pension funds, sovereign wealth funds, etc- because they tend to move slower than traditional VCs or late stage tech investors such as SoftBank. PE firms take longer time to conduct due diligence, and tend to give less aggressive valuation multiples than a Tiger Global or SoftBank. This seems to be changing though.
Two founders who recently raised money from PE funds said that while they raised over $150 million in their rounds from multiple investors, these funds moved as fast as other investors- which included venture firms and hedge funds. They requested anonymity.
In the startup world though, PE funds still have the reputation of asking questions that cut deeper than other tech investors. One fund recently asked a company what its throughput ratio is- an indicator of how much inventory can be sold at a given price at a given amount of time.
Beyond revenues, margins and growth, this metric indicates the overall efficiency of operations. One of the founders mentioned above was surprised at the question, and confessed that none of the traditional startup investors asked this question.
Encouragingly for PE funds, large consumer internet companies such as Nykaa, Lenskart, Policybazaar etc also have better unit economics than say a Flipkart or a Paytm- older but larger firms which are still not profitable.
“Most PE investors have understood that there are outsized gains to be made by investing in tech companies. Many initial challenges of investing in tech, such as exits through IPOs and M&As are being more than adequately addressed,” said Niren Shah, managing director and head of Norwest Venture Partners India.
“Late stage tech companies are also showing significant scale and good unit economics. These factors also make these deals less risky than a typical tech deal,” he added.
Unlike early stage venture funds, PE funds also majorly rely on Initial Public Offerings (IPO) to get an exit from their investments. Most PE funds in India have made their money from banks, real estate companies, pharma firms and others listing on the exchanges. In some cases, a small PE fund sells its stakes to a larger PE fund to pocket cash.
The upcoming IPOs of Zomato, Nykaa, Policybazaar, Freshworks and others are also convincing PE funds and other public market investors that they have a stable exit path down the road, and do not have to rely on a rare acquisition deal.