Human traits driving financial markets

• To imitate and to conform — do what others around us are doing — are common and very powerful human tendencies.
•  In financial markets, “herd behaviour” is a warning sign: When markets are doing well, people invest for no other reason than their neighbours having become wealthier (and vice versa).
• There is another human trait that affects markets — success increases risk appetite.
• If someone’s financial investments work, they are very likely to invest more, and ignore safety measures.

Factors driving the private equity investments

• Better physical infrastructure (rural roads, electrification, phone penetration, data access).
• Several layers of innovation (universal bank account access, surging digital payments on the “India Stack”).
• 45 lakh software developers (largest in the world).
• Maturing industries (for example, as research budgets of Indian pharmaceutical manufacturers have grown 10 times in the last 15 years.
• The ecosystem can take on more challenging projects now, versus just generic filings a decade back).
• Strong medium-term economic growth prospects create fertile ground for private equity investments.
• Investors with patient capital (knowing that the businesses will not make money for several years) are now betting on and financing a faster transition to electric vehicles than was earlier anticipated.
• In financial services, innovative methods of lending, insurance underwriting and wealth management are being experimented with, which are likely to only expand the market meaningfully.
• An army of Software-as-a-Service (SaaS) firms have been funded in the hope of revolutionising the development and distribution of software.
• There are also new-age distribution and logistics companies, education technology firms, and branded consumer goods suppliers, in addition to “normal” e-commerce, gaming and food-delivery startups.

Risks involved in a rapid infusion of capital

• Allocation inefficiency: Theoretically, an economy India’s size is capable of absorbing the $52 billion of PE funding seen over the last 12 months, but in practice, such a rapid surge creates allocation inefficiency. 
•  As investors rush to deploy ever-larger sums of money, they appear to be running out of companies to invest in that can productively deploy this capital.
• The result is companies’ valuations rising manifold within months and small firms getting more capital inflows than they can deploy, often resulting in wasteful business plans.
• When investors rush to deploy funds, the risk of fraud rises — inadequate disclosures and weak due diligence are compounded by incentives to misrepresent financial data.
• The discovery of any such frauds would likely freeze funding for the industry for a few quarters.

Why now?

• India has never lacked entrepreneurs, but lacked risk capital given the low per capita wealth.
• As savers like pension and insurance funds in the developed world responded to record-low interest rates by allocating more to PE as an asset class, private funding markets have grown rapidly in the last 15 years globally.
• In India, PE funding has exceeded public-market fund-raising every year in the past decade.
• While earlier, only a few business groups could muster sizeable amounts of risk capital to establish new businesses and disrupt old ones, entrepreneurs can now lay hands on hundreds of millions of dollars if the idea makes sense.

Conclusion

For now, this flow of funds is a welcome booster for the economy as it recovers from the scars of the pandemic-driven lockdowns. While valuations can be volatile in the near term, we are in the early stages of this reshaping of India’s corporate landscape.

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