The Fine Art Of Picking Hidden Gems

While attending a conference organised by Yahoo in Bangalore in 2009, Nexus Venture Partners co-founder Sandeep Singhal happened to listen to a young man called Kunal Bahl. Those were the days when Bahl was working on the idea of discount coupons for services. Singhal recalls Bahl as cogent and articulate and was impressed by him. He made enquiries about the man and his business, and soon began the intense courtship between a leading venture capital firm and an entrepreneur who displayed an obvious spark.

The proverbial ‘I dos’ were said and what was an offline discount coupons business has famously morphed into one of India’s frontline ecommerce players, Snapdeal, led by Bahl and his friend and co-founder Rohit Bansal.

Singhal and Naren Gupta, co-founder of Nexus, make no bones about the fact that their firm chased Bahl doggedly. Now, with Snapdeal one of India’s most-watched ecommerce firms, eBay Inc. in February pumped in its second round of funding, ending up with an estimated stake of around 20 percent. Snapdeal is currently valued at around $1 billion. For Nexus, this is ratification of their long-standing view that Bahl and Bansal would go places.

Picking tomorrow’s big winners is something of a fine art, and when angel investors, venture funds and private equity (PE) firms do get it right, it is cause for much jubilation.

ENTREPRENEUR AT THE CORE
“The quality of the entrepreneur is critical,” says Singhal, recalling the Snapdeal example. It was the ability of the founders to adapt to the changing market that helped the company move from the paper coupons space to an online marketplace model. “What mattered most to us was Kunal and Rohit, who always had their ears to the ground. The business they were in told them what business they should be in.” Rehan yar Khan, the 42-year-old angel investor who made all the right moves with early investments in companies like online taxi booking service Olacabs, online lingerie company Pretty Secrets and software companies Druva Software (also backed by Nexus and Sequoia Capital) and Sapience, calls the entrepreneur the “soul in the body”. For Khan, most decisions hinge on the business founder and the way his instincts play out. The entrepreneur and the business idea cannot be disconnected, he says. “I find these amazing entrepreneurs with innovative ideas often introduce you to new spaces in the first place. It’s not as if investors had these businesses on the radar and then were looking to find entrepreneurs in them.”

Olacabs founders Bhavish Aggarwal (who featured in this year’s Forbes India 30 Under 30 list) and Ankit Bhati discovered the need for an aggregation space for taxi services in India, points out Khan. As an angel investor, and not one of the VC or private equity big boys, Khan was looking for businesses which didn’t need big funds to acquire customers. By drawing on the existing unmet demand for cabs, Olacabs was an obvious choice for him. For PE players too, often as much as 50 percent or more weightage is given to the founder while investing in a business.
 
“The dynamism of the founder, the experience he has and how he has been able to build businesses are often most important,” says Bharat Banka, CEO of Aditya Birla Private Equity, which is an investor in companies ranging from Coffee Day Resorts (which runs the Café Coffee Day chain) to the private sector RBL Bank (formerly Ratnakar Bank).

DISRUPTIVE, FRUGAL
For most savvy investors, ‘hidden gems’ are companies which fundamentally disrupt markets in ways that the market may not be aware of. This typically gets facilitated through changes in business models and the use of technology. But for the disruption to be effective, the change has to take place in large markets. Think Google, and the way it created AdSense, combining search with advertising and turning the traditional rules of the game on their head.

In India, early stage businesses have also started thinking of playing in the global marketplace, armed as they are with strategies based on frugality and innovation. “With India being a resource constrained environment, out of the box and disruptive ideas are making an impact now,” says Singhal. It helps that this can be achieved at a lower cost. “Someone in Silicon Valley will raise $10 million to build a company, but the same thing can be done for $3 million in India,” Singhal says. Consider Cloudbyte, a storage firm in which Nexus has invested. It started out with just about $2 million to build its business, later going up to $5 million. Compare that with companies in the Valley with teams that may have been drawn from global majors—they would have to raise $15-20 million to build a similar business. Smaller teams, faster turnaround time, greater efficiencies make such businesses attractive; and even if they pay big-ticket salaries to attract talent, they remain relatively frugal.

Another Nexus investee firm, Sohan Lal Commodity Management (SLCM), an agri logistics and warehouse management firm, is an example of how process shifts generate value even in tough environments like rural India. “This company has demonstrated how an existing shed can be taken and processes put in place—aeration, fumigation—which will allow them to maintain the quality of product at levels similar to silos,” says Singhal. Often, such process improvements indicate a readiness for markets outside the country where similar conditions exist. Not surprising, then, that SLCM was invited to Nigeria after the company attended a seminar in Chicago where it explained its processes. For such companies, the domestic market is becoming a testing ground for success in other emerging markets.

Significantly, smaller Indian towns are often home to businesses which have grown efficiently, using the local constraints to think differently. “Haldiram’s (the Nagpur-based sweets and snacks maker) is a great example. They have taken the best of the West and Indianised it to the extent that it really works,” says Singhal.
 
A DEFENSIBLE MODEL
There are many cases of attractive businesses that operate in sectors which have no barriers to entry: How does an entrepreneur defend his business model in such an environment? This is a question investors ask before putting their money into some of the smartest companies. “Can you defend your product or service in such a scenario? Can you defend your pricing? Can you defend yourself against competition which may come in with lots of dollars? Can you match a new entrant who undercuts your pricing and has deep pockets?” says Banka.

Apple, for instance, is a case where the company enjoys pricing power even in the wake of competition; successive new models of its products are tagged with higher prices but customer loyalty stays largely intact. For Microsoft, because of its stranglehold in some segments, newer versions of the same software can also be priced higher and the customer will still opt for them.

Café Coffee Day, started by entrepreneur VG Siddhartha, is a domestic model that has proved defensible. Despite the entry of competitors such as Starbucks, it has managed to hold its own. CCD’s ability to ‘capture’ key sites for its outlets has proven crucial. “It continues to be in an investment phase and may be some time away from tonnes of free cash-flow, but once you are in a market where you are a clear leader, maybe with another strong player, then the market is going to explode because all the hard work has already been done,” says Banka.

For an angel investor like Khan, defensibility is inextricably linked to the quality of the entrepreneur. “The really good entrepreneurs move very fast. They are way ahead of the pack. It’s really the person who creates the defensibility. Amazon is all about the magic of Bezos, Apple the magic of Jobs.”

Khan makes a fair point. Homegrown entrepreneurs like Sanjeev Bikhchandani, whose Info Edge owns jobs portal Naukri.com, successfully battled global behemoths like Monster.com, while others like Deep Kalra of Makemytrip scored in the travel space. “Indian entrepreneurs have access to funding now so there’s parity in terms of muscle. How you use the muscle and how agile you are is key,” points out Khan.

THE GOVERNANCE FACTOR
In a country like India, where capital markets are still not deep enough, investors closely scrutinise companies for governance standards. In many cases, they are ready to make a trade-off in terms of slightly lower returns if the companies are well run and transparent. “Governance is a strong differentiator,” says Banka, citing the case of the recently-listed search services company JustDial, a current market favourite. “There were many marquee investors there already, but with high governance standards, more investors will keep coming in.”

For an ordinary investor it may be inexplicable why someone would pay a hefty multiple for a company which is growing at 25-30 percent, but very often the premium is for transparency and strong governance systems.

This played an important role in tilting the scales in favour of RBL Bank when Banka’s firm was examining investments in the banking, financial services and insurance (BFSI) space.

Though a sleepy community bank till recently, the infusion of fresh energy by way of a spanking new management team, led by former Bank of America India boss Vishwavir Ahuja and former Citi India managing director Rajeev Ahuja, ensured that Aditya Birla PE entered in the second wave of new funding, with a stake of around three percent. What also worked was a professional board and widely distributed shareholding—this ensured no single shareholder or group of shareholders could stall policies.
 
THE EXIT OPTION
Do investors obsess about an eventual exit while making early stage investments? While firms like Nexus have a liquidity horizon of 5-7 years, exits can take place by way of either a listing on the capital markets or strategic M&As or being bought out by another set of new investors.

IPOs, though, are typically the dream for any investor who puts money into an unlisted, promising company. “As a PE industry member, a public listing is always an aspirational exit since that is ratification that the idea one backed has found large scale acceptance,” says Banka. Sale to a strategic player after the business has been built is also satisfying as it endorses the fact that the PE player thought like a businessman and created a valued company.

Then there is the trade sale, or sale to another PE player. Another non-IPO exit is a buyout by either the company or the promoter group. This usually happens when other options are not possible.

Pressure from investors to list often causes problems for founders. “Usually the founder decides whether to list or not. If it is merely serving the purpose of providing an exit to investors, he may at times find it sub-optimal,” concedes Banka.

Because such hidden gems aren’t in the public domain, they are often in a better position to tune their business to what the market will handle. “There’s no quarter-on-quarter pressure. The investor has also got to be mindful of what the market can bear. The pressure to exit often makes you do things which takes away the exit itself,” says Singhal.

UNCOVERING GEMS
The broad consensus is that more hidden gems will get ‘uncovered’ as the hunger for growth in Indian entrepreneurs manifests itself and global ambitions come to the fore. Besides, with a new government in place armed with a mandate to push through reform, the investing community is betting that the next five years will see a spike in fund raising from the public markets.

Banka is quite emphatic about this and believes as much as $15-20 billion will be raised from the public markets annually over the next three years. Some companies, he says, will also take funds from PEs for the first time, while others will get listed and offer exits to investors.

“There’s been enormous hunger for the past five years. So, for the next five years, fund raising will be like a spring out of a box which has just been opened,” he says. “The trajectory may differ, but the broad trend is upward in the markets.” Investment circles are animatedly talking about more companies in the genre of Page Industries, JustDial or Flipkart which will want to tap the public markets.

Ambition will be a key driver for Indian entrepreneurs, they say. “I see a different scale emerging. Every entrepreneur is saying, how do I achieve scale?” says Singhal. The earlier concern for VCs was Indian entrepreneurs may sell too early, when the business had grown to, say, $15-20 million. “Today, the ambition is of building a billion dollar business and the entrepreneur making $100-200 million for himself,” he adds.

The bar has been raised.