Why Are Venture Capitalists (VC) Sitting On A Large Amount Of Dry Powder In India, And The Investment Has Halted?

Every piece of event is the result of a negotiation. The nature of this discussion evolves with the cycle of venture capital (VC) investing. After halting the flow of billions of dollars in investor capital into Indian enterprises, the startup ecosystem is in for a dry spell. The downturn has resulted in a paradigm change in which investors choose deal conditions over founders.

According to KPMG’s latest venture pulse report, VC financing into Indian businesses fell to $2.1 billion in the March quarter due to fewer large-ticket agreements. This is a roughly 25% decrease from the $2.8 billion invested in Indian new-age entities by venture capitalists between October and December of the previous year. In contradiction, venture capitalists invested $9.3 billion in the March quarter of 2022. In addition, VC investment in India remained slow every quarter VC investors, particularly from the United States, continued to be cautious due to global macroeconomic tensions.

This was also the joint-lowest level since the second quarter of 2018 when Indian entrepreneurs collected $1.7 billion. Even in the April-June 2020 period, VCs had deployed $2.1 billion. Moreover, VC financing fell by 25% despite heavyweights like PhonePe gaining $650 million and Lenskart receiving $500 million from ADIA in the same quarter. FreshToHome’s $104 million round, headed by Amazon Smbhav Venture Fund, Mintifi’s $110 million round, led by Premji Invest and others, and KreditBee’s $120 million round, led by Advent International and others, were the other major ticket deals that occurred in the quarter.

What has caused this shift of venture capital, aka VC drying up?

First, a little history. We monitored a large flood of cash penetrating India in the 24 months running up to 2022 due to surplus money in global markets. As a result, some wealth wound up with huge investment funds and significant capital allocators worldwide, with a portion put aside for alternative assets and developing markets. Furthermore, during the high liquidity period, every investor sought to diversify its capital pool, resulting in capital being shipped to all nations. As a result, a portion of it went to India, the world’s third-largest startup ecosystem. The figure was considerable in this developing economy.

When a rush of capital follows startups, the risk lens is typically distorted, perspectives get skewed, and expansion, rather than profitability, drives investment decisions. It also promotes FOMO (fear of missing out), where investors don’t want to miss out on an opportunity and, as a result, invest hastily. Earlier, trades took place throughout the weekend. For example, you’d meet with a firm on a Thursday or a Friday, and you’d have to decide by Saturday or Sunday since they’d usually have various term sheets. So it was more about getting inside that firm and gaining that opportunity. It provided little time to comprehend and learn about the founding team and their work.

Herd mentality also made an appearance. As the number of venture agreements expanded, capital infusion did not discriminate between the quality of firms, peer benchmarking increased, tech-savvy millennials were encouraged to take risks, and many talents moved over from established corporations to create startups. As a result, an unprecedented number of startups formed. Add to it the exponential pandemic-induced digital acceleration of enterprises, and you have a formula for a deal explosion. Funding rounds were oversubscribed, and startups raised funding at record valuations.

Several concerns, related primarily to global conditions and some local ones, have limited money flow into India-focused venture funds. Unheard of as a regarded statistic, profits are now being scrutinized. Questions have been raised about the quality of startups supported and the due diligence practises of venture capital firms. Inquiries have also been made concerning the founders’ proclivity for collecting personal assets and leading luxurious lives and the resulting collapse of corporate governance principles. Why are investors more vigilant now than earlier?

The slowdown, according to investors and analysts, would also result in a rise in specific clauses like redemption rights, which give investors the power to compel a company to repurchase its shares after a predetermined period; clawback provisions, which permit investors to reclaim vested equity if founders resign or are fired; ratchets, an anti-dilution mechanism to shield early-stage investors from dilution by subsequent fund-raisings at lower entry prices. Additionally, tranched fundraising rounds were conducted, allowing VCs to distribute funds gradually rather than all at once to lower risk.

Before making a financial commitment, investors examine startups’ cost structures to ensure that luxuries are minimized. As a result, business models are anticipated to become more realistic.

The lack of late-stage enterprises in the capital sector also contributes to the slowdown. Many of the top late-stage and growth-stage startups have over-capitalized at the peak of 2021. Since they are now concentrating on developing their businesses, they do not want to enter a sector where values are frequently disputed.

Is there any hidden advantage in VC drying up for a shorter period of time?

Lack of funding prevents imitators and copycats, which benefits inventors. When everyone’s marketing expenses are decreasing and customers have fewer distractions, a corrective cycle is when good businesses get greater customer attention. It’s also a good opportunity for startups to gather real feedback, which aids in the development of real products.

They would have developed the muscle memory necessary to deal with a slowdown and the investment professionals would mature, investors with long-term views on India and dedicated teams on the ground would continue to become bigger and better.

The need for domestic investors.

Overseas venture capital accounts for about 90% of India’s startup investment. This is just not sustainable. India has to diversify its financing source and increase local support for startup innovation.

Is there still any ray of hope for VCs making their steps towards India?

Despite the seeming downturn, it is vital to note that much is still going on in India. The macros are still excellent. Pre-series A financing is still plentiful in India. According to a KMPG employee, the country is still witnessing a lot of fresh micro funds being created, funds under $100 million with cheque amounts ranging from $1-5 million.VC investment in agri-tech is likely to increase significantly in the nation over the next 12-24 months as businesses in the area mature and garner larger funding rounds.

According to recent research from consulting company Bain, the number of active micro VC funds in India climbed to more than 80 in 2022, up from approximately 65 in 2021. Micro VC firms often have funding ranging from $10 million to $60 million. These often invest in pre-seed, seed, and Series A (follow-on rounds) transactions with checks of less than $1.5 million. Because of the proliferation of micro VC firms, the investor landscape is anticipated to witness engagement from a broader base, which is likely to push investment activity in the world’s third-biggest startup ecosystem.

Conclusion.

The news to cheer is that there is a large amount of money available for Indian startups. The global recession of 2008 and the e-commerce crisis of 2015–16 were past cycles, but Indian VC firms currently have a sizable war chest at their disposal.

There is no perfect equilibrium when it comes to venture capital, nor is there an optimal state for financial cycles. The system benefits from having a little amount of excess capital since more startups receive funding, which promotes innovation. A lack of wealth is advantageous since it promotes more discipline. Therefore, going through both cycles is extremely good.