The Stock Exchange Board of India recently asked private equity (PE) and venture capital (VC) funds that focus on private market investments to disclose details about their valuation practices.
Over the past year, India has seen the creation of multiple unicorns as VCs and PEs have rushed to fund startups in various sectors.
In CY2021, India saw investments of nearly $39 billion, which is a four times jump from a year ago. India even surpassed China in the number of unicorns produced, with 44 unicorns created in 2021 compared to 42 created in China. However, the total amount of funding for China was larger than the funds raised by the Indian startups.
The regulatory crackdown on Chinese tech companies has also helped Indian companies gain more attention from investors. Despite the much talked about funding slowdown in the first half of 2022, India has created 14 new unicorns, while China has created 11 of them.
However, despite the optimism surrounding the Indian start-up space, SEBI has asked funds to provide details on fund valuation methodologies.
There may be various reasons why SEBI asks funds about changes in fund valuation methodologies, appraisers’ ratings, appraiser’s relationship with the fund, use of audited or unaudited data, etc.
PE and VC funds typically operate through closed-end funds known as alternative investment funds (IDAs). These funds are closed-end funds with significant exposures to non-listed companies.
Start-ups are typically loss-making, have volatile earnings, unproven business models, and have a number of other characteristics that make them difficult to value. Unlike mature companies, valuation measures such as earnings ratio, discounted cash flow, or operating earnings multiple cannot be easily applied. As a result, valuation methodologies for emerging companies vary significantly and require relatively more guesswork than the valuation of mature companies.
By inflating portfolio company valuations, fund managers could possibly show higher returns, while companies can raise money in the next round at higher valuations.
Inflated valuations mislead investors about the manager’s experience, and investors may not have an accurate idea of the fund’s actual performance. However, apart from a management fee, a fund manager only makes money on an investment after the sale of the fund’s units. Once a manager generates returns above a certain threshold, he is entitled to a percentage of investors’ returns.
Furthermore, the recent collapses in company valuations on the public market could also have fueled the SEBI move.
Most tech company IPOs were made at frothy valuations and ultimately resulted in huge losses for public market investors.
Management of the IPO-bound tech company even justified the valuations by saying that the valuations were entirely justified as private market investors had offered them a similar valuation just prior to the IPO. Realistic valuation methodologies would have prevented these companies from suffering from the severe multiple compression that these companies faced.
The recent spate of corporate governance issues at startups could have fueled SEBI’s move to look at valuations.
Using unaudited numbers for valuations could allow companies to continue to raise funds based on numbers that may not reflect reality.
A prominent company recently faced scrutiny from investors and lenders after it failed to disclose its financials and reportedly delayed payments on a deal. The company had reportedly used accounting practices that the auditors were not comfortable with.
Aggressive accounting allows companies to make their financials look better than they really are. Sometimes management is forced to continually modify financials to maintain company valuations. In recent months, several startups have gone under the radar for tax evasion, bribery, shell company payouts, inflated revenue and other issues after auditors flagged these problems.
While it is challenging to understand SEBI’s motive behind the consultation on valuation practices, there is potential for SEBI to suggest more uniform valuation practices. However, as highlighted above, the value lies in the eye of the beholder.
Given the complexity involved in valuing companies, some savvy investors may be willing to pay higher valuations for certain companies, while others may not see the opportunity. Additionally, all developed markets require a diverse set of participants who value companies differently to provide liquidity in the market and help uncover true intrinsic value.