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Venture Debt In Indian Startups: The Valley Of Death Or The Promised Land?

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By AltG Research On Behalf Of Taponeel Mukherjee & Poornima Vardhan

The last three years have seen a proliferation of venture debt into Indian startups. Startups of all sizes and venture debt funds in all forms ranging from Hedge Funds to Venture debt specialists, popped up with the logic that a lower equity dilution and access to cash were important.

As can be seen from the BYJU’S and PharmEasy saga around their debt, as Indian startups reset valuations, there will be significant opportunities to generate massive returns for existing and new venture debt investors and significant write-offs in the capital structure. Venture debt investors will lose and make fortunes. However, Capital Structure plays in startups is a whole new ball game from investing in traditional businesses.

Therefore, from the perspective of Venture Debt investors, what will be the biggest drivers of investment returns in the great Indian Startup valuation reset? The short answer is “the quality of the business and collateral at play”. While this might sound like stating the obvious, assigning value to the startup assets, licences, collateral, and web of subsidiaries will require a deep understanding of latent value hidden in the businesses, operations, Indian businesses and structural factors driving the market. The difference between the price of the underlying startups and the value will create massive profit-making opportunities and lead to some significant write-offs. Essentially, venture debt investors in Indian startups will see binary outcomes since not all these startups are created equal.

Both existing and venture debt investors must keep an eye on three factors while evaluating opportunities - Hard Cash Flow generating assets hidden in the corporate structure, the “Sum Of The Parts” analysis, and the rapid collapse that pure digital assets can see.

Firstly, to understand the importance of hard cash flow generating assets, let’s look at two startups that have been in the news recently, PharmEasy and BYJU’S. The majority of the value that these startups hold and essential for the debt investors to realise bumper investment returns lies in the “Offline Cash Flow” generating assets. For PharmEasy, it is in the crown jewel Thyrocare & Aknamed, and for BYJU’S, it’s in the offline tuition centre Aakash. Essentially, for existing and new venture debt investors evaluating startups, the real game is seeing the mispricings in the cash flow generating capacities of the existing offline assets versus where the market is pricing it in the panic. Additionally, what matters is not just the current ability to generate cashflows but also what’s the potential with better management.

Secondly, to understand the importance of the “Sum Of The Parts” analysis, one must look at the valuation debate around PharmEasy. The rumoured $500-600 Million valuation is for a business with highly valuable assets in a complex structure from which a potential $1 Billion can be realised. The real question is, what are Thyrocare, Aknnamed, and Medlife worth? More importantly, how much value can they create in the next year through strategic and operational improvements? The answer is a lot! If you’re a special situations investor, PharmEasy presents an opportunity that shows the “hidden diamonds” that will be mined from the Indian startup valuation reset by buying assets worth much more separately than as a whole.

Thirdly, one needs to look at the OLX deal to understand the rapid collapse of digital asset valuations. As Madhav Chanchani of The Arc tweeted on July 11, 2023, OLX was looking to sell its India auto biz for $300 Million, and CarTrade ended up buying it for $65 Million in cash. In fact, with CarTrade’s post-deal clarification, it seems it was the entire OLX India Classified business and not just the auto-classified business. Now imagine the wipeout in that capital structure! The question isn’t whether your warrants will end up in-the-money; the moot point here is “return of capital”. That said, from the other end of the spectrum, there is significant value creation potential for the bidder of OLX at $65 Million. So, there you go, rapid valuation resets create enormous mispricings between value and price and massive profit generation opportunities!

The ability to price these assets and understand the difference between the hard cash-generating assets versus the fluff can be the difference between a feast or famine. The ability to decipher the digital asset’s value, the distribution business’ value, and the operations component will be a huge factor in generating returns. The investment opportunity in this space will be through those who can differentiate between the current market price of the collateral or asset in question and the “real value” that the asset holds using an “Investor-Operator” lens. Pure capital structure arbitrageurs will struggle; however, those with an intricate understanding of both sides of the balance sheet will end up with the true Mackenna’s gold from the Great Indian Startup Sale.

For existing venture debt investors, distressed hedge funds, event-driven hedge funds, special situations hedge funds and private equity funds, whether the Indian startup valuation reset turns out to be A Valley Of Death Or The Promised Land really depends on how well you play it.


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