Too much of a good thing

Written by Neelkanth Mishra | October 14, 2021 3:01:28 am

This appeared in the Indian Express on 14 October 2021 (link).

To imitate and to conform — do what others around us are doing — are common and very powerful human tendencies. Scientists ascribe the evolutionary success of these traits to benefits accruing to individuals (and hence the species), not least among them that the world is complex, and every individual cannot figure it all out, learn everything ab initio. Particularly in areas outside our expertise, it is efficient to follow what others are doing, like choosing the right subject to study at college, or more simply, the path to a railway station in Mumbai (I found the way to Churchgate by “following the herd”) or the queue for autos.

This comes with its own pitfalls, though. In financial markets, “herd behaviour” is a warning sign: When markets are doing well, people invest for no other reason than their neighbours having become wealthier (and vice versa). In the recent launch of a new mutual fund, for example, money flowed in from 93 per cent of India’s PIN codes. Even as we celebrate the deeper penetration of equity ownership and broader participation in wealth creation, it is reasonable to assume that a large part of this new capital is not as well informed as it should be: Even financial newspapers reach a small fraction of India’s PIN codes.

There is another human trait that affects markets — success increases risk appetite. If someone’s financial investments work, they are very likely to invest more, and ignore safety measures. The current rise of the Nifty is the highest without even a 10 per cent correction since 1992. This unbroken run itself is likely to have triggered larger and riskier investments, which are further pushing up stock prices.

Herd behaviour and risk-appetite-accentuation do not just affect new and amateur investors — they affect everyone. Similar frothy trends are visible in the private funding markets, where investors are assumed to be more sophisticated, and the source of funds is mostly institutional.

Theoretically, an economy India’s size is capable of absorbing the $52 billion of PE funding seen over the last 12 months, but in practice, such a rapid surge creates allocation inefficiency. As investors rush to deploy ever-larger sums of money, they appear to be running out of companies to invest in that can productively deploy this capital. The result is companies’ valuations rising manifold within months and small firms getting more capital inflows than they can deploy, often resulting in wasteful business plans.

Just to be clear, unlike some “pie-in-the-sky” businesses that got financed in the first funding-frenzy two decades back, most of these are real business opportunities, catalysed by momentous changes. Better physical infrastructure (rural roads, electrification, phone penetration, data access), several layers of innovation (universal bank account access, surging digital payments on the “India Stack”), 45 lakh software developers (largest in the world), maturing industries (for example, as research budgets of Indian pharmaceutical manufacturers have grown 10 times in the last 15 years, the ecosystem can take on more challenging projects now, versus just generic filings a decade back) and strong medium-term economic growth prospects create fertile ground for private equity investments.

For example, investors with patient capital (knowing that the businesses will not make money for several years) are now betting on and financing a faster transition to electric vehicles in both two-wheelers and cars than was earlier anticipated. In financial services, innovative methods of lending, insurance underwriting and wealth management are being experimented with, which are likely to only expand the market meaningfully. An army of Software-as-a-Service (SaaS) firms have been funded in the hope of revolutionising the development and distribution of software. There are also new-age distribution and logistics companies, education technology firms, and branded consumer goods suppliers, in addition to “normal” e-commerce, gaming and food-delivery startups.

Earlier this year, we at Credit Suisse listed 100 unicorns in India — unlisted companies with a value exceeding one billion dollars. We had not expected to find as many, and the feedback after the publication of our report suggests we missed quite a few more. We excluded private firms that belonged to established business houses, as we mapped the rapid transformation of India’s corporate landscape. Two-thirds of these firms had started after 2005, an extraordinary episode of new companies scaling up in what has traditionally been a slow process. India has never lacked entrepreneurs (even in the 1980s, new companies formed at a rapid pace), but lacked risk capital given the low per capita wealth.

Growth in private equity changed that. As savers like pension and insurance funds in the developed world responded to record-low interest rates by allocating more to PE as an asset class, private funding markets have grown rapidly in the last 15 years globally. In India, PE funding has exceeded public-market fund-raising every year in the past decade; even this year, a record year for initial public offerings (IPOs), PE funding is three times more than the funds raised in IPOs so far, touching $40 billion. While earlier, only a few business groups could muster sizeable amounts of risk capital to establish new businesses and disrupt old ones, entrepreneurs can now lay hands on hundreds of millions of dollars if the idea makes sense.

However, we believe there can be too much of a good thing in the short run — the reason business and market cycles exist. This is not uncommon in history. For example, when the Americas were emerging markets in the early 19th century, and savings from European countries were flowing in, there were repeated cycles of boom and bust. In fact, one adventurer in the 1820s even raised funds for a country that did not exist. Such outright fraud may be difficult to engineer today, but when investors rush to deploy funds, the risk of fraud rises — inadequate disclosures and weak due diligence are compounded by incentives to misrepresent financial data. The discovery of any such frauds would likely freeze funding for the industry for a few quarters.

For now, this flow of funds is a welcome booster for the economy as it recovers from the scars of the pandemic-driven lockdowns. As these firms scale, they will spend on hiring people (like software developers, teachers and delivery personnel), setting up infrastructure (data centres as well as physical warehouses), discounts or advertising — nearly all of it adding to the economy. While valuations can be volatile in the near term, we believe we are in the early stages of this reshaping of India’s corporate landscape.