Balancing risk and returns in startup investing

ONE of the recent hotly debated issues among market observers was on Khazanah’s failed venture into the Indian lingerie market as the Malaysian sovereign wealth fund revealed that RM80mil investment in the online based company, Zivame, was written off.

According to its outgoing managing director, this was done as a conservative measure, which it sometimes undertake for technology investments.

While one cannot deny that not all investments made by investors will turn out as winners, especially in the technology space, the amount invested did raise some concerns as to whether Khazanah had invested too much into the lingerie e-commerce market space.

To give an idea on the type of investments venture capital, sovereign wealth funds or even, private equity investors make these days, one can look at certain market benchmarks in terms of deal sizes in the global space as the deal size in the Malaysian context may not be material for a given minority stake.

CB Insights, which is a platform that tracks the fintech and startup space globally, recently released its Q2 2018 Global Fintech Report and it was not surprising the fintech space continues to attract money into existing and new startups as well as growth in a number of transactions.

According to the report, globally, excluding Ant Financial’s US$14bil Series C fund, some US$6.34bil worth of venture capital (VC)-backed funding took place in Q2 2018 across 382 deals. On average, that works out to US$16.6mil or RM67mil per deal. The Q2 2018 figure brings the first-half year total funds that were invested to about US$12bil across some 731 deals globally, or an average of US$16.4mil per transaction, equivalent to about RM67mil.

Clearly, the fintech market has grown by leaps and bounds over the past five years as in 2013 average deal size was only about US$6.5mil or RM26mil. Since then, average deal size has grown about 21% compounded up to 2017 and based on this year’s current average deal size, the fintech deal size has grown by another 19%.

While these statistics are for fintech space, which are more related to the financial sector, it is no surprise that deal size values are rising and for Khazanah to invest some RM80mil in an Internet based startup for a 22% stake is indeed not uncommon.

Moving on from the CB Insights report, a telling sign was focus among investors remained at the early stage (normally at Series A or B) of investments where valuations are perhaps more compelling as the startup space are looking for funds to expand both in marketing as well as geographical space typically. Some 56% of the funds were invested at an early stage against 20% at mid-stage and 7% at the late stage in Q2 2018.

The growth of venture capital space as well as private equity investors has indeed fuelled startups globally, more so over the past 10 years, mainly due to cheap money generated via quantitative easing by major central banks as well as low interest rates environment. With so much money chasing deals, never mind if the startups are expected to continue to be loss making, valuations have gone through the roof for some of the investments out there, even at late stage like what we saw last week when Grab raised US$1bil from Toyota Motor Corp in its Series H funding round.

Interestingly, Grab is now a unicorn with a market valuation of about US$11bil, almost double the value when it bought Uber’s regional operations early this year. It is kind of mind boggling to think that Grab has almost doubled in value in less than six months. Meanwhile, in the fintech space today, according to CB Insights, there are some 29 unicorns valued at a staggering US$84.4bil, or an average of just under US$3bil each as five were born in Q2 2018 alone.

While not all startups end up winners as a majority of them will fizzle out in time either due to funding issues, inability to turn either profitable or at least positive operating cash flow, changing market landscape, getting disrupted by other startups as well as competition, those who make it, will truly be rewarded.

Hence, while the startup space is not a game for short-term investors, those who are in for the long haul will reap multiple benefits and if the business idea is widely recognised as revolutionary and disruptive to current market incumbents, the returns can be exponential. No wonder the number of investors in the startup space is rather crowded not only globally but even in Malaysia as our own sovereign wealth funds and other institutions too are always on the lookout for the next unicorn.

Among these investors, losing a few bets or few millions here and there is perfectly acceptable as they look for that one big winner among five or 10 or even up to 20 companies that they invest in. That one big winner will not only make back whatever losses made on other investments but still generate a healthy internal rate of return in double digits or mid-20%.

In conclusion, a write-off about RM80mil can be said to be small in relation to deal sizes or in relation to the current size of Khazanah’s investment book. Despite the setback, Khazanah is expected to continue to invest in a prudent and tactically manner in the tech space in the hope that one of its investee companies will turn into the next unicorn of the world.

Pankaj knows that unicorn is a company with US$1bil in market value, but, he is still trying to figure out what to call a US$1 trillion company, a feat achieved by Apple this week.

Pankaj Kumar , Comment