Indian startups and Chinese investors are growing ever closer. Venture capitalists have visited India so frequently this year that some have made as many as five trips since January. 

This has led to a huge increase in Chinese venture capital investment into Indian startups, which leapt by 86% last year to $5.6 billion, according to research platform Tracxn. And it shows no sign of slowing.

India has become the second most popular destination for China’s outbound M&A investment, according to EY's China Go Abroad report, published this month. Trailing Australia, India attracted $2.3 billion Chinese capital in the first half of this year.

Accordingly, Indian startups are reaching out to Chinese investors to support their ideas. “An Indian startup doing fresh food delivery came to us and made inquiries about raising funds from Chinese investors,” Song Tengfei, head of consumer business at China Renaissance, told FinanceAsia. “They are eager to search for Chinese investors.”

Song Tengfei,
China Renaissance

Most Chinese investors still describe India as “China five years ago”. Internet businesses have enjoyed rapid growth since 2016 (thanks to the almost free telecom service provided by Reliance Jio), and there are indeed huge opportunities. But, excitement aside, a cautiously optimistic attitude seems evident among Chinese investors.

WHY INDIA?

India's VC market has been in the limelight since US retail giant Walmart's groundbreaking acquisition of Flipkart. Total India VC deal volume increased 37% last year to $7.4 billion, according to data from Preqin. And investment volumes in the first three quarters of this year are already 23.8% higher than in the same period last year.

“The Indian market is unique as it is a single big market with a huge growing population,” said Chen Renchuan, vice president of China TH Capital.

Indian startups are priced more keenly than their counterparts in China. Although the valuation of some startups did rise after the Walmart/Flipkart acquisition, the price for most still looks to be within a reasonable range.

Yet Chinese investors are selective. “As a financial adviser in India, we can see that Chinese investors will not pay a premium unless the startup has three prerequisites – a business model that has proved effective, a dominant position in the sector and rapid growth,” Chen added.

India remains a fully competitive market. There is no single unicorn that can claim to control one sector because new players continue to emerge. Take e-commerce as an example. Startups like FirstCry and Club Factory still have space to expand among big players such as Amazon, Flipkart and Paytm Mall.

“There are still opportunities in sub-sectors, thanks to the efforts of Reliance Group, which made the mobile internet more available to individuals,” Chen said. Since 2015, the number of mobile internet users in India has posted double-digit growth, according to data website Statista. These users have created a new synergy in the market and are the new targets for current Indian startups.

CHANGING ENVIRONMENT

People have a positive attitude towards the country's investment environment under prime minister Narendra Modi.

“India had a very good year for M&A in 2018,” said Pramod Kumar, head of banking for India at British firm Barclays. “Venture capital and private equity deals have increased. And we are seeing more non-traditional PE investors, such as pension funds and sovereign funds, make direct investments too.”

Pramod Kumar, Barclays

India announced a 6.8% annual growth rate from April 2018 to March 2019. It is the lowest figure for five years but is still higher than that of most of the countries.

And over the past few months, the Modi government has passed several policies to stimulate the economy and regulate the market. In August, it relaxed restrictions on foreign direct investment in retail, digital media and other sectors. And in September, it lowered the base corporate tax rate from 30% to 22%. 

“The interest of foreign investors in India is growing. Most of the global – US, Canadian and Asian –PE investors now have offices in India with fully empowered senior management teams,” Kumar said. Indeed, foreign direct investment grew 28% year-on-year in the second quarter of this year.

Investors generally feel that the Modi government is the most stable one the country has had for a decade. As a result, they tend to make relatively long-term venture capital or private equity investment plans.

“No matter whether they are financial or strategic investors, most have a long-term investment strategy, including Indian local funds and overseas funds from the US or Singapore,” said TH Capital's Chen. “They are expecting an exit in at least seven to eight years, some of them are even evergreen funds.”

HURDLES TO CONSIDER

Investor optimism comes with conditions. There are still challenges with primary market investment.

“There are three major challenges in the Indian PE/VC market for outside investors,” said Yash Rana, Asia chairman of law firm Goodwin. “Tax, currency fluctuation and regulatory risk.”

While corporate tax has been cut and regulations have been stable since the election, Yash said that currency fluctuations might be the biggest headache for foreign investors. The Indian rupee depreciated about 5% against the dollar between July and August.

Another headache for investors might be the process of exiting. “Walmart buying Flipkart is the one meaningful exit in the past few years,” Yash added. This is a headache for VC and PE investors as they need to cash out to complete their investment.

The Securities and Exchange Board of India requires three years’ profitability from startups wanting to list on the main board of Indian’s stock exchange. Startups are not that enthusiastic about listing on the SME platform of either the Bombay Stock Exchange or the Emerge board of the National Stock Exchange – both of which have softer terms for small and medium-sized enterprises.

“The exit is quite limited currently. Most Indian startups will have to consider an IPO in the US market,” said China Renaissance's Song.

As a result, profitability is another challenge for startups in India. Unlike deep-pocketed Chinese VC and PE firms, the cash flow on the Indian VC and PE market is still small. In the first three quarters of this year, only $1.2 billion was raised in India to support private equity investment.

“Unlike China, India has fewer funds to invest in the growth stage of a startup,” Song said. “Most startups are expected to turn a profit after series B fundraising, and this is the most difficult stage for a company. There are two ways to solve this challenge. Either the startup tries to turn a profit by itself, or it diversifies its resources by finding other investors who are willing to fuel the company.”

Despite the dramatic increase in numbers, Indian mobile users are not ready to pay for internet services. “Investors need to understand the addressable market,” said China Renaissance's Song. “The real market may still come from the rich middle class, which is about 200 to 300 million people.”

Although there is much talk about India’s resemblance to China, they are still two different markets. Investors, especially those who have experienced China's internet boom, cannot rely too much on their previous experiences.

“Don’t just copy and paste the experience from Chinese startups, and ignore the local unique business and cultural environment,” said TH Capital's Chen. 

Various local languages, a huge difference in culture and user habits, a different political environment should all be taken into account when making an investment. India may be the next China, but India is definitely not China.

This article originally appeared on sister publication FinanceAsia.com last week.