Bhav Bhagwan Che ?!

As I write this article today, Indian public markets are trading at all-time high levels. We are just a week away from another major milestone in the development of the country. Whereas in the private capital market, we are witnessing a plethora of activity including IPO exits on one hand and down rounds on the other. With this backdrop, I thought of penning down some reflections about my learnings from the public markets and how they compare with the private capital markets.

In the public capital markets, there is Gujarati phrase ‘Bhav Bhagwan Che’ which is followed widely. The phrase essentially means that ‘Price is God’ signifying that the price of a share is a correct reflection or representation of the company and its business. My experience in the public markets has made me realize that this is true in a lot of scenarios, but also this phrase can have different implications based on different investment time horizons. (By the way as a side note I believe Gujarati’s are stalwarts of the stock market and I highly admire them for their capital market acumen).

As Graham said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

So, if a company trades at an ‘x’ price, that price may be a good reflection of the company’s business potential, management quality, financial strength, future prospects, etc. However, can one apply the same concept to private capital markets? Can one say that a private company’s price/valuation is a true reflection of its business?

Not always in my opinion.

Over the years Indian private capital markets have seen a trend of valuation/price becoming one of the key north stars for founders/promoters and investors alike (Thankfully we are witnessing a change now given where we are in the market cycle). But there are multiple reasons why this should not be the case. I have tried to write down a few fundamental ones that can enable both founders and my investor colleagues to reorient ourselves between focusing on the playing field rather than the scorecard.

• Liquidity: Fundamentally price/valuation is a derivative of a buyer and a seller meeting at a common understanding. Public markets, by their very nature, are liquid markets with multiple buyers and sellers transacting. Thus the price is generally more reliable (of course there are edge cases of liquidity squeeze, low free float, etc.). Whereas in the private markets, the transactional price can be arrived at by a single willing buyer and seller, in effect questioning the holy grail of Bhav Bhagwan Che.

• Current Valuation v/s Future Potential: Founders raising private capital at very high valuations compared to the current reality of a business or future likelihood of projections, subject their companies to high risk and tremendous performance pressure, because those high valuations already discount a lot of the future potential of the business. This behavior of putting the valuation cart ahead of the performance horse not only results in the price/valuation becoming aggressive and unsustainable but also cannot be considered as a benchmark. Eventually, we have witnessed such companies raising subsequent financing at lower valuations and getting into a downward spiral of over-dilution, distributed captables and hawkish investor rights. More on this issue of broken captables plaguing our private capital markets in a subsequent article.

• Colour of Capital: Price/Valuation is influenced by the type of investor. A strategic investor would value a company in a different manner given the potential synergies, whereas a financial investor would value the same company with a different risk-return lens. I had written about the different hues of capital in an article here which can be a good primer to understand different investor types and motivations.

•  Shareholder Terms: Private market investing involves the company, founders, and the investors entering into Shareholders Agreements. These are private agreements with multiple shareholder rights that have a bearing on the valuation. For example: There is a right named Liquidation Preference which provides a preference to the right holders to get the liquidation proceeds ahead of the other shareholders. I have heard founders negotiating very high valuations with investors by providing them the comfort of atypical liquidation preferences of 3-4x. In effect taking the valuation away from reality.    

•  Valuation is a Craft: Given that there is a no stock exchange (like a NSE or BSE for public markets) where private market investors can transact, the investors transact between themselves by deriving the valuations based on their analysis, returns expectation and risk appetite. Thus prima facie private market valuations should not be taken at face value but should be considered alongside a wholesome understanding of the underlying asset.

Given all of these nuances of the private capital markets, I believe founders and investors should not chase ‘Bhav’ which in Hindi means both price and perception, but chase real value creation (too jargonish I know). Because one needs to traverse the long building journey to reach the arena where indeed the world will value you using ‘Bhav Bhagwan Che’.

Source of graphics: Lyrique Private Equity, Unsplash and the web in general.