Dealing with next-gen listings

Investors are starting to realise that new-age companies are a completely different animal

If one were to take a step back and look at the listings of the wave of venture capital or VC-backed next-gen companies in India, they have been a decidedly mixed bag till now. Zomato hit the markets almost 18 months ago, with the issue going live on July 14, 2021. Subsequently, we had a gold rush of sorts and multiple companies listed.

It was an amazing monetisation opportunity for the VC/private equity ecosystem. India had finally arrived on the global VC stage. India had the third largest start-up ecosystem and public market investors were falling over themselves trying to get allocations in the new listings. The markets seemed mature enough to value and price all types of business models at various stages of profitability.

Unfortunately, the performance of the vast majority of the new listings has been mediocre. Most trade more than 50 per cent below their peaks and below the initial public offering (IPO) price itself. It has been a bloodbath for any investor involved in these companies after their listings. With the benefit of hindsight, valuations at listing were way too generous. Everyone in the system got carried away. This was, however, not unique to India. We have seen similar dynamics at work for new listings even in the US. Rising real rates have forced a valuation correction for all long-duration growth assets.

This mediocre outcome throws up many questions and learnings for all players involved. The narrative among market players is that somehow the equity markets were hoodwinked and sold a lemon and the VC folks made away with profits like bandits. To be fair, public market players cannot wish away their mistakes. No one forced them to buy the shares at the valuations proposed. But most could not resist the temptation to participate.

There was no fraud. This is not the regulator’s fault. The corporate information provided was adequate to make a sensible decision and the regulator continues to tighten and improve disclosures and ensure post-listing adherence to listing norms. Put simply, greed overcame judgement and FOMO (fear of missing out) prevailed.

I, therefore, do not think there is any case to regulate pricing on these next-gen company IPOs where the sellers are largely VC/PE investors. The regulator has already increased the institutional investor portion of these issues and continues to improve disclosures. There is enough information available in the offer documents to make an informed judgement and there is no systemic issue here. The markets must be allowed to clear and that is precisely what is happening. Almost every new VC/PE backed issue is today facing stiff valuation headwinds. The public markets are basically saying we do not care at what valuation you have marked this company or the last funding round. We will pay what we think is appropriate given our return expectations. I have seen multiple transactions where deal valuations are now likely to be 40-50 per cent below the initial asking price. The self correction process is underway and valuation expectations are getting reset. The new companies are also better understanding what it means to be listed and how to engage with a fragmented investor base and handle investor relations. No longer can decisions be taken in a closed room with eight to nine large investors, all of whom with a similar mindset and time horizon.

The public shareholder base is diverse in style, holding horizon and valuation methodology. The Indian equity markets have an edge in that they are still able to price and list companies/ business models that may not be immediately profitable. Few markets globally are able to value and appreciate such companies. Given that we wish to ensure that the vast majority of our companies list in India, it is important that the regulator maintain its approach of ensuring full disclosures and governance but not dictate pricing.

A related issue is that public investors are now starting to realise that they are dealing with a slightly different animal when it comes to new listings. Most of them have no promoters and the shareholding of the founding group tends to be sub 15 per cent. This means 80-90 per cent of the equity is owned by investment groups who will sell, driven by their own liquidity needs, with no coordination. We have to be prepared for a constant drip of stock from this capital base. It almost reminds one of the public sector undertaking  (PSU) stocks and the government’s initial attempts to monetise its holdings many years ago. Every six months, there would be a 5 per cent block deal. The selling pressure seemed interminable. It ultimately drove all the PSU companies to a steep valuation discount. Given this liquidity/market dynamic, should public investors demand a liquidity discount also on the new VC/PE-backed listings? Should they list at such high multiples if 80 per cent of the float will come to the secondary market in the next 12-24 months. Either that or there has to be much better coordination and visibility on the selling side. Have no doubt, float and technicals do impact valuation multiples, at least till such time as the float stabilises and the shareholding pattern matures.

^{Illustration: Ajay Mohanty}

A related governance issue is that public investors, used to promoters/large insider ownership are now realising that with a fragmented shareholding they are going to have to rely on independent boards to safeguard governance, capital allocation, and drive performance. India has a poor track record with purely board managed companies and they have been prone to chief executive officer capture.

Investors have to exercise the powers already conferred on them by the regulator to ensure that they get the directors they deserve. They must be qualified, independent and questioning. The only issue here is that when they are going to place such demands and responsibilities on the directors, one must be in a position to compensate them adequately.

Guidelines must be put into place to allow equity options and adequate compensation for all directors. They must have more skin in the game. Steps have been taken, but the regulatory framework needs to be clearer. Their role in non-promoter driven companies is even more critical. Once we get shareholder activism, signs of which are visible, all these issues will only increase in consequence.

All shareholders have to exercise greater thought and diligence when appointing directors. Shareholders may need to mutually consult and get professional advice. A time will come, soon, when quality boards will attract a valuation premium, as the strength of the board will be used as a proxy for the quality of governance. As of today, there is a vast difference in the quality and expertise of boards among the newer listings. This will attract increased attention as the VC funds exit entirely.

The days of blindly approving the slate of new directors, without considering their qualifications, competence and experience are over. The whole ecosystem is adjusting to the listing of these new VC/PE-backed companies. Their listing is a big positive for our markets and must be encouraged. We do not want to export our capital markets; and it is encouraging that the vast majority of the new companies want to list in India. Any teething troubles will and are getting corrected as all stakeholders mature. The more quality companies that list in India, the more vibrant and relevant our markets will become.

The writer is with Amansa Capital