New age IPOs: Beware of the lurking gray rhinos
No other initial public offering (IPO) in recent memory has evoked such divergent views as Zomato. I have written elsewhere of the global context of the late 1990s when similar tech-enabled, disruptive ecosystems were being created in the West. With the potential advent of a new class of investors post the Zomato IPO, we are now on the verge of creating an indigenous ecosystem with our own Alibabas and Amazons. A great hope prevails in the air despite obvious risks in the environment.
This hope, though, needs calibration before making investment decisions in these companies. While I make the case for optimism despite mega valuations with bleeding financials, understanding some of the key drivers of the underlying business dynamics, and differentiating between potential outcomes of retail investors and institutional ones, is useful.
The fact is that such humongous value creation of these venture capital (VC)- or private equity (PE)-funded consumer plays would have been impossible without a closed clique of inter se investments by foreign PE funds. As global liquidity continues with near negative interest rates, this can potentially be construed as an ingenious play to generate mega returns by inflating asset prices through “investor subsidised business models”.
In privately held companies, creating the illusion of ephemeral valuations with co-investments by different funds in subsequent rounds of fundraising is fairly simple. It is ultimately the same small group of funds such as Softbank, Tiger Global and Sequoia who lead a cosy club of friendly competitors for both large-scale capital and mega deal flows. With the energy and exuberance of youthful entrepreneurs in abundance, India, with its massive virgin markets, is indeed providentially placed in this cycle of fate and fortune. Powerful investor communication in a narrative where huge operating losses are worn as a badge of honour, with icons like Amazon and Google to showcase, allows for a potboiler of an offering. The new gold rush of the 19th century revisited. Or a fool’s rush?
The trick, though, in such models is not to be the last sucker holding the can when the music stops playing. With the rush of IPOs (PayTM, OYO, Mobikwik) lined up at dizzying valuations, it is possible to conceive of a scenario that mutual funds (MFs) and retail investors could be the ones holding the bucket after PE and VC funds exit, taking their billions (and our forex reserves) to newer pastures and continuing the hunt for new suckers and avenues for value creation.
Though it is tempting to contextualise the current phase in India with that of the West in the late 1990s, where the concurrent rise of mobile, internet and e-commerce enabled the likes of Amazon, Yahoo and Google, we must realise that these companies had a massive intellectual property (IP) content and intellectual resources. Our companies cannot boast of such IPs with the only moat being huge access to capital to shut out the competition (starved, killed or acquired), and good execution capability in building scale, brand and intelligent data with demographically copacetic market dynamics.
Though these attributes are valuable, the business model risk, at these asking valuations without a definitive, proven (or forecasted) path to profitability through sound unit economics, cannot be ignored.
The core concern remains the fragile business models, hyped up through aggressive campaigns, but without either globally disruptive paradigms or significant IP, flaunting market share built on questionable economics funded by monstrous capital holding the fort from an imminent collapse. Such differentiators are unsustainable unless these companies use the runway provided by the security of global liquidity to build a credible roadmap to a sound profitability profile with distinct, sustainable competitive advantages, or the risk of value erosion after the initial euphoric phase is real. Zomato, being the first such IPO, faces the least risk as investment bankers would be keenly vested in keeping the story alive to accommodate the next IPOs in line.
Once publicly listed, these companies will lose convenient access to capital to build profitable, fully loaded unit economics as future tranches will result in dilution of capital. Creating disruption by “blitzscaling” and price subsidisation will then no longer be hidden from scrutiny. NextSpace was driven to bankruptcy by WeWork when it was private, and its subsequent extinction post listing due to such policies is well-documented. Though with a near negative interest rate scenario PEs can theoretically be infinite, overvaluing loss at the behest of scale and network effect for illusory megaprofits in a very distant utopian future is fraught with existential risks.
Michele Wucker, in her seminal work, The Gray Rhino: How to Recognize and Act on the Obvious Dangers We Ignore, enunciates the decision-making biases which make us view things more optimistically, and deny things which are scary, due to our psychological make-up. It is this escapist bias which creates gray rhinos which are highly probable, high impact-yet-neglected threats. Gray rhinos are precepts which are openly discussed, but not acted upon. The markets, in general, are in this phase and we can’t ignore that such IPOs reflect this reality too.
Given the global challenges of growing macro instability, health and social inequities, I advise companies to adopt the strategic choice of calibrated growth with predictable profitability for the next few years. Such choices would contain tail risks from black swan and gray rhino events which, at these levels, can be devastating.
Similarly, retail investors need to evaluate these contrasting narratives in the case of upcoming IPOs and decide depending on their risk profile, loss tolerance and investment horizon. The safest course perhaps, till the environment is clearer, is to treat the optionality of these opportunities to create some alpha for their portfolios but without disturbing its core asset allocation and sectoral distribution.