New Kids on the Block - India’s Startups

If you drill down to the basics, you will realise the true reason why you invest at all. It is to generate returns so that you are able to create a nest egg for your future years. It is to ensure that your money is working as hard as you are for all your productive years, and provides you with a cushion in your time of need. So, how do you go about building a portfolio that delivers on this expectation? Lot has been written about how to build a portfolio so I will not delve deeper into that aspect. Let’s focus here on the overall complexion of your portfolio. More specifically, let’s understand why you should have startups as part of your portfolio and why it is not an asset class for the ultra-rich but a must-have for your portfolio as well.

Thinking of investments in its most simplistic form, you are investing either with the government or with private businesses by buying some kind of securities they issue. These can be in the form of bank fixed deposits, corporate debentures, mutual funds - equity as well as fixed income, direct equities, startups, real estate and gold. Alternatively, it can be some combination of these and sometimes other asset classes (commodities, etc.), if not all of them. There are well-established research studies that make it amply clear that overall portfolio returns are heavily influenced by asset class exposure rather than what specific underlying securities or commodities your portfolio is made up of. Harry Markowitz’s paper on Portfolio Selection in 1952 laid the cornerstone of what is today known as “The Modern Portfolio Theory”. Markowitz, who was awarded a Nobel Prize, explained that assets should not be weighed by their risk-reward proposition individually but, rather, by how each asset fits into an overall portfolio. Another 2000 study by Roger Ibbotson and Paul Kaplan concluded that 90% of a portfolio’s long term returns were driven by asset allocation. It is imperative that you think very carefully about how your portfolio has been put together rather than merely focus on its holdings. 

You realise that India is going through a clean-up phase. Politicians, bureaucrats, businessmen, institutions, regulators, rating agencies and auditors of all hues and shades are being Investigated and where required, brought to justice. The way business is done in India is undergoing a massive shift. Strictly from an investor perspective, since you provide capital to businesses and governments, it is important to realise that the way business is conducted has changed and this new paradigm is here to stay. A necessary part of your diligence and analysis has to be centred around understanding whether the business you are investing in has the ability to reorient itself to this new reality. You simply have to see the dwindling returns you made in the last couple of years from real estate, gold, fixed income, equities, etc. to realise that what worked so far doesn't work now. You have to realign your portfolio to the new reality. What is this new reality?

This new reality is about greater compliance and higher standards being followed by the smallest of businesses. Introduction of GST has been a great leveller that will help you understand what I’m referring to. In the past, it was common place to refer to the parallel economy or the ‘black’ economy as being more or less equal to the mainstream economy. With the advent of technology and the governments' adoption of various tech-enabled initiatives and new regulations and regulators, a significant portion of this parallel economy has become or is in the process of becoming mainstream. In addition to GST, we have RERA for real estate and IBC to consolidate the existing framework and create a single law for insolvency. One of the landmark regulatory overhauls came through the abolishment and subsequent replacement of the Planning Commission by NITI Aayog. In addition to the regulatory reforms already in place, India is keeping pace with developed countries and has come out with the Draft Personal Data Protection Bill, following the lead of the European Union and its GDPR. Post demonetisation, we have had the JanDhan initiative which has been the largest financial inclusion exercise ever executed, UPI – an instant, real-time payment system developed to facilitate inter-bank transactions, IndiaStack – a set of APIs to allow the government, businesses, startups and developers to solve India’s problems. 

These measures have given wings to a new way of doing business. India, the nation of shopkeepers and entrepreneurs has taken to this new age with gusto. We have seen hosts of tech enabled, capital efficient, new age business models being spawned across a variety of sectors. Health, education, retail (e-commerce), real estate (co-living and co-working), financial services (digital wallets), manufacturing (industry 4.0) are just some of the many sectors that have seen extensive technological adoption and pervasion. This technological evolution will result in a democratised landscape and the giant business houses that dominate these sectors may be replaced by agile, tech-savvy startups. 

Investing is all about anticipating the future and ensuring your portfolio is aligned to the new reality, to the anticipated changes. Investing is about ensuring that the present value of all future cash flows is way more than the risk you take by making these portfolio investments in the first place. The future is in innovation, technological progress, finding new ways of doing things and new things to do in a sustainable, scalable manner leading to attractive profitability. Digitisation is omnipresent.

Every walk of life right from basic necessities like socialising, banking and finance, healthcare and education to consumer purchases, logistics, travel and ticket bookings are all getting digitised. The pace of digitisation has accelerated with the help of cheap mobile phones, computers and even cheaper data packages that come with an assurance of very high standards of security and delivery. New age business models across a variety of sectors have become economically viable. Incumbents across business sectors are feeling threatened as they struggle to provide elevated customer experiences and business solutions at reduced prices. History has shown that business longevity is not really long enough. In my opinion, this is set to reduce even further as new age business models are poised to gobble up market share and create new markets where none existed rapid enough for incumbents to react. 

There is a much sharper focus of the government and industry on this forward-looking ecosystem. The government has introduced a variety of steps to support Startups and entrepreneurs including Startup India, which aims to provide startups with a simplified process to incorporate and avail many benefits including tax shelters, legal support etc. The Government also established a Fund of Funds to infuse over US$1.5 billion into the startup ecosystem by directly investing in startups and indirectly investing in them through Venture Capital Funds. Further, the government is tying up with various institutes of higher learning and setting up accelerators, incubators and also providing grants to those students that are looking to take the entrepreneurial plunge but lack the necessary resources to get them started. Industry has come forward with even more resolve to support this nascent ecosystem. Industry bodies such as NASSCOM, TiE, etc. seek to help entrepreneurs connect with each other and foster an integrated ecosystem. In addition to that, many corporates have or are in the process to set up internal venture capital, innovation arms, accelerators and incubators. These companies have recognized that these new age businesses are the future and it would be a better idea to work with them and use their help to usher themselves into this digital age. Global and domestic investors have started supporting these new age businesses at an accelerated pace. Venture Capital funds, both domestic and international, are setting shop and growing their assets and investments in these Startups. With support from the government, industry, venture capital funds, as well as the inherent shopkeeper and entrepreneurial culture in India, you are seeing this ecosystem thriving and growing by leaps and bounds.

This brings us to the most important question from your portfolio perspective. How can you participate in this future when most innovative, technology enabled businesses in India are not listed?

We will not get into the reasons why this has come about to be as that is beyond the scope of this discussion so we can address that aspect in a separate write up. The good news is there are a variety of ways in which your portfolio can get access to startups. You can start off as a friends and family investor. If there are businesses being set up around you by people you know, that’s a very comfortable way of getting access to some startup investment. You can start off as an angel investor by investing in entrepreneurs who reach out to you for some financial investment and also look at you for strategic and operational advice. You can become an angel investor in the true meaning of the word, angel, as compared to a moneybag. You can get access to some early-stage deals that have the potential to become a large business by becoming part of any of the angel networks that are flourishing as a tribe. You can access startups for your portfolio by investing in a venture capital fund, like Equanimity. 

As you explore these various routes to powering up your portfolio with early stage companies, you have to understand what this brings to your overall portfolio. For starters, it adds a healthy dose of diversification to the overall portfolio. To achieve the optimal level of diversification, you have to be cognizant of your overall portfolio construct. A 10% to 20% exposure of your portfolio to these venture funds or startups is ideal. It is recommended that you build this size over a period of time and do not jump to these levels suddenly.

This should take away vintage risk as well so you don't have exposure to similar business models that come into the limelight and then quickly fade away. At the same time, adding startups to your overall portfolio adds risk, which is essential to bring in higher returns. Life’s basic financial rules apply here as well: risk and return are two sides of the same coin - higher risk implies higher expected returns. 

If you are invested in small-cap or mid-cap funds or PMS or in real estate either directly or through funds or PMS, getting exposure to Startups via funds can be a brilliant idea. It gets you to access this high growth ecosystem without adding too much risk to your overall portfolio. Most technology-enabled businesses are operated by professionals with experience behind them in contrast to typical family-owned listed mid-small caps and real estate developers. If you are investing through a venture fund, you can be assured that corporate governance standards will be high and in today’s changing India, that counts for a lot. Startups are also much more accessible to their investors. Venture funds remain involved with their portfolio companies on a much more regular basis than the quarterly financial reports shared by listed mid-small caps. In fact, if you so desire, you can remain involved with Startups as they respect capital that comes along with your experience and ability to add value to their business. Liquidity remains a challenge for Startups but it has also been the case with mid-small cap companies. Liquidity is particularly a large issue if you are invested in real estate. 

All things considered, you should start off on this journey of realigning your portfolio to some venture fund or Startups. India is changing for sure and it is about time you ask yourself if your portfolio is aligned to the new reality, to the new age, technology-enabled businesses that are going to be the engine of growth as India grows into a US$5 trillion economy. 

Give your portfolio the edge it deserves. Investing in startups is not a luxury anymore, it’s a must.