Turn off the lights: The IPO party is over

Nothing perhaps better describes the massive rise and fall of the new age startups that were listed on stock exchanges during 2021.

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In this piece, we consider six such companies—Paytm, Nykaa, Zomato, CarTrade, Policybazaar and Easemytrip. Any investor who would have bought one stock of each of these companies at their highest price post the listing would have spent ₹8,143 doing so. As of 4 March, this investment would be worth around ₹3,845, a loss of close to 53%.

Of course, this is only a theoretical possibility, but it does tell us what has happened to these stocks. They have been badly beaten down. The stock that best signifies this era is Paytm, the biggest initial public offer (IPO) India has seen. The company issued stocks at a price of ₹2,150 and on 4 March, they were priced at around ₹785 per share, down by more than 63% from the issue price and down 60% from its highest price post listing.

The stock that has performed by far the worst is, CarTrade Tech, a market place for both new and used vehicles. It’s down around 67% from its issue price and 66% from its highest price post listing.

So, what went wrong with these companies? And what does the future have in store for them? In this piece we try and analyse this.

A free ride

Economists often talk about public goods and the free riders they attract. Steven E. Rhoads defines public goods in The Economist’s View of the World as “goods for which consumption is non-rival (i.e. a number of people may simultaneously consume the same good).” So, only one individual can enjoy the food that they eat. But many people can walk on the same footpath at the same time. Hence, the footpath is a public good. And food is not.

The trouble is public goods attract free riders. Take the case of a residential housing society which charges a monthly maintenance charge to residents to keep facilities well maintained. A few families may decide not to pay the monthly maintenance, and nonetheless continue to use the facilities. Such people are free riders.

The companies that we are talking are similar to these free riders. They came to the stock market after the market had been going up for a while. And they cashed in on it by selling their shares at extremely high prices in comparison to the money they were making.

Of course, investors bought these shares. Retail investors are attracted towards stocks only after they have seen prices go up for a while. Take a look at Figure 1, which plots the total number of demat accounts (on the left-hand side axis) and the level of the BSE Sensex (on the right-hand side axis) from April 2015 to January 2022.

As the stock market has gone from strength to strength (represented by the Sensex), so have the number of demat accounts. In fact, in the last two years, they have moved more or less parallelly. The only possible explanation for this is that more and more retail investors and high-networth individuals entered the stock market as it went up.

As the January bulletin of the Securities and Exchange Board of India, the stock market regulator, pointed out: “Partly on account of the investors’ urge to participate in the IPOs, on an average 27.63 lakh new demat accounts are being opened every month now (i.e., 2021-22). Those preferring mutual fund route… also increased their purchases of equity-oriented schemes to ride the IPO bull run… On an average 23.91 lakh new investor folios are being added every month now with the domestic mutual fund industry.” This surge in demand helped the new age startups sell shares at very high prices.

Free ride benefits

The existing investors in the new age startups also used this opportunity to sell their shares. In case of Paytm, the total money raised through the IPO stood at ₹18,300 crore. Of this, ₹10,000 crore went to existing investors who sold the shares through the IPO. When it came to CarTrade Tech, the entire issue of ₹2,999 crore went to existing investors. In case of Nykaa, the company raised ₹5,350 crores in total. Of this, ₹4,720 crore was used to pay off existing investors. In case of PB Fintech (the parent of Policybazaar), of the total ₹5,700 crore raised, ₹1,950 crore went to existing investors. In case of Easemytrip, the total amount of ₹510 crore went to the existing investors.

Of the ₹32,859 crore raised by these five companies, ₹20,179 crore or over 61% went to paying off existing investors selling their shares. This essentially means that the companies did not really require much money to expand. In that sense, the retail investors and high networth individuals largely ended up paying for the early-stage investors exiting these companies at high valuations.

Of course, only a certain percentage of shares in an IPO go to retail investors and high networth individuals. Nonetheless, even though mutual funds and insurance companies get categorised as qualified institutional bidders, they ultimately are investing money raised from retail investors and high networth individuals. The only exception to this was Zomato. Of the total issue size of ₹9,375 crore, only ₹375 crore went to existing investors selling their shares.

Nonetheless, Zomato, since its IPO has regularly been buying up other companies. This is a weird situation where a loss-making company is using money raised through an IPO to buy other companies. In November 2021, the company had said that it plans to invest $1 billion in startups over the next two years. The company had made this clear in its draft red herring prospectus where it had said: “acquisitions and inorganic growth initiatives may be undertaken.” Of course, a loss-making company raising money through an IPO to invest in other loss-making companies exposes retail investors to a level of risk normally taken by venture capitalists. The stock market regulator has since put a cap on the part of the IPO proceeds that can be used to acquire unidentified companies for inorganic growth.

What does the future hold?

With the prices of the new age startups significantly lower than their highest levels, is it a good time to buy them?

In the long-term, the new age startups are supposed to benefit from the network effect. The humble telephone is by far the best example of it. The more the number of people who used the telephone, the more the number of people who wanted to own one. WhatsApp, Facebook, Uber, etc., are other great examples. In fact, thanks to the internet and the network effect, all these new age startups are platforms. Platforms are not in the business of producing goods but they are marketplaces which allow other businesses to sell their goods. So, once many consumers decide to order food from Zomato, it makes sense for restaurants to be on it as well. Once people start buying insurance online from Policybazaar, it makes sense for insurance companies to sell their policies on it.

Platforms are asset light. The world’s largest taxi company Uber doesn’t own taxis. The world’s largest provider of rented rooms, Airbnb, doesn’t own any rooms. Similarly, Zomato doesn’t own restaurants and Easemytrip doesn’t own any airlines.

The thing with platforms is that once a sufficient number of people start to use it and once a sufficient number of businesses are on it selling their wares, it can possibly lead to a monopoly or a duopoly kind of situation and a lot of money can be made in the process. This is the theoretical argument.

So, will these stocks give good returns in the long-term? As Jonathan A Knee writes in the Platform Delusion: “The fact that many of the best digital businesses are “platforms” does not imply either that most platform businesses deliver superior returns or that it is the platform status of the demonstrably superior businesses that is responsible for their superior results. In fact, consistent superior returns are only achievable through structural competitive advantage.”

The question is, do these new age startups have a competitive advantage? Let’s start with Easemytrip, which is an online travel company. There are dozens of companies operating in this space, offering a more or less similar product. This is a commoditised business and any talk of any competitive advantage is at best illusory. Of course, it needs to be said here that the company, unlike many other companies in this business, is profitable. But do remember we are talking about monopolistic kind of profits here. A similar argument can be made for CarTrade Tech which is in the business of buying and selling cars. There is too much competition in this space from traditional automobile dealers to companies specializing in selling used cars.

When it comes to Policybazaar it has some early mover advantage in the business of selling insurance online in the web aggregator space. Nonetheless, the competition is huge. As the recent draft red herring prospectus filed by the Life Insurance Corporation of India points out: “As of 27 December 2021, there are 24 web aggregators registered with [the] Insurance and Regulatory Development Authority of India (IRDAI).” Further, everyone from banks to individual insurance agents to websites of insurance companies are in the business of selling insurance.

Nykaa has the potential of becoming the Amazon of makeup in the long-term. It will clearly benefit if more and more women take up paid jobs. But the big risk that the company faces is outside its control. The female labour participation rate in India has been falling over the years, which basically means that more and more women who enter adulthood are not taking on paid jobs.

When it comes to Paytm, the business model of the company is simply too all over the place to be able to benefit from network externality leading to a monopoly. Also, the rise of the RBI-backed unified payments interface (UPI) will ultimately limit its growth in the digital payments space as well.

Finally, that leaves us with Zomato. It will be difficult for any new competition to quickly replicate all the infrastructure that the company has in place with restaurants and delivery. In that sense, the company has some competitive advantage. Also, it has only one major competitor and that’s Swiggy.

But ultimately, Zomato and all the other companies here are in the services business and their continued growth will be a function of how well people at large are doing and not just the well-to-do lot. In the past, economist Rathin Roy has talked about India’s economic growth being driven by the spending carried out by the top 100 million people in a population of close to 1.4 billion.

In fact, an average Indian household has five individuals, meaning, the spending capacity is largely with 20 million households. For Zomato and Nykaa to do well, this number needs to go up in the years to come. The growing inequality of the society at large remains the biggest risk they face.

In this scenario, any retail investor wanting to play these stocks is best advised to buy them as a very small part of their overall portfolio simply because on the whole, the investing premise doesn’t look too good.

Ultimately, it is worth remembering what Knee writes in The Platform Delusion: “Strong network effects are not, as commonly supposed, exhibited in all platform businesses.” That’s the long and the short of it.

Vivek Kaul is the author of Bad Money.