“All that glitters is not gold” — Growing valuation bubble of Indian start-ups

by Sandeep Kumar | June 16, 2021

Keep up to date with the latest research

 The valuation game

The Venture Capital valuation is a simple game, but never an easy one. While there is little to learn, to play it perfectly takes years, if not decades of experience under the belt.

So how do the VCs arrive at that valuation figure? Market Opportunity? Product Market Fit? Strong Founder Team? Disruptive Product Offering? Extensive Network Economics?

Nah.

Capital invested divided by the stake diluted. That’s it!

The VC chooses the amount of capital he is ready to deploy and the stake he wants to have in the company. Of course, the wish is to part with the least capital for the most stake. Now coming up with these two numbers, the capital chunk to invest and the amount of stake to buy, this is where experience comes in.

The winning bet in your portfolio

Most VCs have personal favorite ranges which they are comfortable with. Some VCs may like to hold only a few concentrated bets while others may want to deploy small amounts into numerous startups. The premise is the same. Each VC wishes to hold at least one winner in its portfolio, the winning bet that ‘returns the fund’.

This gets us to staging. The valuations do nothing to the VC portfolio, except increase the unrealized returns section, which, as the name suggests, are ‘unrealized’ and don’t mean anything unless the company makes an exit from that valuation.

But what if the company is not yet ready for an IPO or a buyout?

The VCs of course know this. Hence when they get together to finance a startup at some stage, let’s say series A, they are offering just enough money to take the startup to the next funding stage. This continues until the IPO or buyout.

Nowhere do the VCs use the DCF or any other model to find a fair value of the shares of the startup. Startup valuation is not a valuation game, it’s a pricing game. It is not about finding a startup trading at a lower than its fair value price and hoping the market corrects itself, the game is about finding another buyer who will be ready to pay higher. All this has nothing to do with cash flows generated from the assets held by the startup, adjusted for the underlying risks of all sorts (DCF basically). All these valuations are nothing more than exhaust fumes as suggested by Fred Wilson, an NYC based VC:

“Early-stage valuations aren’t valuations. They are the exhaust fumes of negotiation about two things — the amount raised and the amount of dilution.”

The information asymmetry

Now let’s take a look at what we have: You are a VC that is trying to get a stake in some startup. What do you do to get an idea of how much you should pay? You don’t have DCF or any other model to help. So, you look at what similar companies have been valued at. With new business models operating in diverse geographies, you realize that it is hard to say how you can define a similar company. Let’s say you came up with food delivery as one category. Despite the difference in the business models, one can hardly cobble together a list of 4–5 startups in the Indian space.

So, the VC game is plagued with opaque, inconsistent deal information. While the figures the VC arrives at are most probably wrong and have nothing to do with reality, they have nothing to worry about as long as they are able to find someone who’s ready to buy at a higher price from them.

The Indian startups in numbers

The past few years have been a gala time for the Indian startups who have managed to secure funding unabated despite the pandemic and its blues.

Startups in India managed to raise $7.8 Bn until April itself. This is a significant number almost 70% of the total $12.1 Bn raised in 2020 and more than 50% of $14.2 billion raised in 2019.

The average funding size has increased to $25.21 Mn, up from $14.94 Mn in 2020. There have been 402 funding rounds until April itself, against 1,114 deals in 2020 and 1,036 in 2019.

Overvaluation and the global landscape

The push towards absurd overvaluations has been a result of the negative interest rate environment. Post the GFC, there was heavy lending and even more borrowing. So much so that people had to pay up money just so that they could lend money. Of course, this led people to look for alternative avenues to park their money and generate juicy returns. The baseless optimism and hollow belief in spotting the next Bezos, Zuck, or Musk have led to an audacious amount of money flowing in, creating completely senseless valuations, having no roots in reality.

Tesla, more than $13 Bn in debt at the end of last year, recently had a market capitalization of $160 Bn, greater than General Motors and Ford combined. At the IPO price, Square was valued at close to $3 Bn, which is 50% below the $6 Bn valuations for which it had raised money from private investors a year before. Uber which in accounting terms stands at around 5x times its revenues, is also grossly overvalued as it is nowhere close to being the leader in the driverless car’s space. WeWork tried to go for a $47 Bn listing but ended up getting corrected to $8 Bn.

The WeWork fiasco was dubbed as a wake-up call in a Morgan Stanley report stating that the days of ‘’ were over.

Unicorns were considered rare. Today, however, the United States has a herd of more than 100 of them, with 100 more outside the US. Each worth a billion dollars or more.

Will history repeat itself?

Let’s talk about the Indian scenario and the startups which we believe are overvalued and most likely to come back to their intrinsic value as and when the markets correct themselves.

1. Byju’s: World’s most valuable Ed-Tech Company

Byju’s operates an online learning platform. It also creates a mobile app for pupils that offers a variety of learning activities. Exam preparation classes are also available. Original material, watch-and-learn movies, rich animations, and interactive simulations are all available to users on the site. The firm is having an EV/Revenue multiple of 17x.

It is the only major player in the Ed-Tech space in India, which has led the company to raise multiple rounds of funding and leading to an enormous increase in valuation. Knowledge in today’s world is free, however, Byju’s creates unique content with animation and the product often seems to be overpriced. In recent times there were a number of instances on various social media platforms where people questioned the pressure on the sales team and how Byju’s is so concerned about their sales when they try to push their offering in the market.

In the long run, the expected return from Byju’s is questionable. Below is the chart of the revenue and valuation of Byju’s over the last five years.

2. Cred — The borrower’s messiah

Losses in billions of dollars are nothing new for hyper-funded companies, especially when they’re chasing size and consumers at any cost. CRED’s metrics tell a tale in and of itself. CRED has made a profit of $71,000 in its second year of operation. CRED hasn’t been able to monetize its user base in FY20, despite acquiring a large customer base with a high propensity to spend and consume.

While the two-year-old company’s sales remained low, its total expenditure increased by more than 5.9 times to $52 Mn in FY20, compared to $9 Mn in FY19. The greatest cost center for the financial firm was advertisement and marketing, which accounted for 47.6% of total expenditure. From $3 Mn in FY19, such costs increased by 9.3 times to$25 Mn. During the fiscal year that ended in March 2020, CRED spent Rs 726.7 to earn a single rupee of operating revenue. CRED’s yearly loss in FY20 was INR 360.3 Crore, up 5.9 times from the $8 Mn it lost in FY19. The current cash burn is difficult to sustain, with an appalling EBITDA margin of -1979.5% in FY20, and the company will have to focus on its collections.

Despite registering astronomical losses it has attained a unicorn status by raising its valuation to $2.2 Bn in 2021. It is worth noting that the company is founded and led by Kunal Shah who is a known name in the start-up world for founding and leading numerous companies which may be an explanation behind the astronomical valuation of Cred. The graph below shows the valuation and losses of Cred over the years.

3. CarDekho — India’s leading car search venture

CarDekho helps users buy cars along with expert reviews, detailed specs, and prices, comparisons as well as videos and pictures of all car brands and models available in India. It has recently acquired an auto marketplace, Carmudi (Philippines) in late 2019 to expand business in Southeast Asia. GirnarSoft, the parent company of Jaipur-based automobile-related services behemoth CarDekho, has seen its losses increase by 155% to $45 Mn in FY2020. This comes after the company’s losses had already increased by 39% in the previous year.

Despite that CarDekho has managed to raise its valuation. Last year, Cars24, a CarDekho competitor, increased its consolidated revenue to $418 Mn and achieved unicorn valuation, and has a much lower EV/Revenue multiple. Let us now see the EV/Revenue Multiple of the peers in this game through the table below.

As per the last reported revenue and valuation figures.

We can infer from the table that CarDekho has a huge EV/Revenue multiple which signifies that the valuation of the firm is increasing at a much faster rate with respect to the revenue that the company generates, leading to overvaluation of the company. The graph below shows the valuation and revenue of CarDekho.

4. Unacademy

Unacademy is a Bangalore-based educational technology startup in India. Unacademy lessons are available in the form of Live Classes, which are both free and available on a subscription basis. Unacademy earned $12 Mn in revenue but spent $53 Mn, resulting in a loss of INR 300 crore. Employee benefits accounted for 23.7% of the edtech start-up’s costs, while other expenses accounted for 75%.

While 2020 brought plenty of development, the corporation would need to significantly increase its expenditures to reverse the losses it had in the fiscal year 2020, which ends on March 31, 2020. Unacademy’s revenue in FY21 is estimated to be over $55 Mn. It’s worth $3 Bn or approximately 35 times the expected income. The graph shows the valuation and loss of BharatPe.

5. BharatPe

When we talk about e-commerce giants, PayTm, Amazon, and Flipkart all wanted payments to take place within their own closed networks. BharatPe’s goal was to achieve what all the large brands were afraid to do: simplify things for retailers by adopting a standardized interoperable QR code. It allowed shops, street food vendors, and tea vendors to accept payments using any UPI app (PhonePe, Google Pay, PayTM, and so on) without having to download the apps. It was a simple and cost-effective approach with an added layer of security. The payment system’s complexity was reduced by a factor of ten by combining multiple UPI apps into a single sticker.

BharatPe was able to achieve early success by keeping things simple. BharatPe’s product strategy is based on making things simple for merchants, and the company uses P2M transactions as a springboard for future services. Because BharatPe does not charge merchants a setup or transaction fee, its fundamental feature money collection using QR codes is essentially a loss-maker for the company. It must spend a large amount of money to manage the servers that process millions of transactions every day. However, this provides BharatPe access to merchants who are passionate about their products and eagerly accept their offers. Despite having no visible revenue stream and without even earning a penny, the valuation of the company is increasing, and currently, it stands at $900 Mn, very close to the unicorn status. The graph shows the valuation and revenue of BharatPe.

The apprehensive loop of growing valuations

The indications are all too familiar. With large markets, illustrious founders, rapid growth, and top early-stage VCs on your side, you have a good chance of raising the next big round, even if you don’t yet have unicorn status (the desired billion-dollar value). And when major acquisitions are made for unproven companies, and valuations double or triple in a matter of months, it begs the question: are we in a bubble? This is always a challenge because most people only realize they were in an economic bubble after it has burst in the past.

Rich valuation multiples have also spread from the typical suspects — consumer internet companies — to enterprise software providers. This is a first. SoftBank, for example, invested in Mindtickle last year, valuing it at $500 Mn based on estimated revenue of $20 Mn — $25 Mn. Even SaaS companies in the United States, including Slack, Zoom, Snowflake, and Cloudflare, have gone public in recent years with great success. Sentiment in India often comes straight from the United States, particularly in related industries and from funds that invest in both nations, including several of India’s leading venture capital firms. Startup valuations are also affected by how publicly traded firms trade if retail investors are ready to pay high prices for loss-making companies, whether banks financing a share issue can find enough at a given price, and so on. There isn’t a single bubble across the board. Because of the vast quantity of money available in the market, investors are willing to pay a premium for good business. But that should be done judiciously.

Investors beware

For the first time in years, it’s possible to claim that private markets are more logical than public markets. If stock markets are the yardstick, select pricey companies may not be overvalued. A closer examination of what constitutes a bubble, as well as what Indian entrepreneurs are doing, reveals a more complete picture. Growth investing has been positive in industries that have recovered quickly from the epidemic, and there has been a lot of interest in a few market leaders. At such levels, one would expect some amount of rationalization. Investors must evaluate the prospects and the future road map of a company before investing. As more investments flow into a company without a proper business model or less revenue, it results in overvaluation creating a bubble. Investors can lose a colossal sum by not choosing the right company.

– – – – –

This article has been co-authored by Sayan Mitra and  , who is in the Research and Insights team of Torre Capital.

Related Posts

The Impactful Investing: Your gateway to exclusive financing opportunities via social entrepreneurship

by Sandeep Kumar

Keep up to date with the latest research

In recent years, investors’ demand is growing and so is the need for sustainability. Modern investors now look out for investment options that not only increase their returns, but are also contributing positively to social and environmental issues. In order to make sure both the needs are fulfilled, the answer can be found in the field of sustainable finance. By funding social enterprises, investors can ensure that their money is utilised for the benefit of the society and also provides returns.

Sustainable finance for Social Entrepreneurship

For any enterprise it is important to ensure financial sustainability to carry out its operations. Social enterprises essentially try to maximise their profits in order to carry out programs that will help overcome social and environmental issues. Thus, social impact and positive financial outcome, both are equally important for such a firm. In order to achieve these objectives, sustainable financing is very important.

There are several ways in which social enterprises can raise funds- donations, grants, crowdfunding, loans. However, these methods come with some drawbacks or the other. They take time to raise funds, involve costs, or some kind of competition. Sustainable finance through impact investors are valuable to bridge the gap between social development and funding. Before we look into the benefits of impact investments in particular, let us understand what the different approaches are available in sustainable finance.

Different approaches – SRI, ESG, and Impact Investing

Different approaches in sustainable investment consists of following:

  • Socially Responsible Investing (SRI)

It includes a value based investment system, in which the investor avoids taking up options that are against his/her believes or value system. Example, a person who hates smoking would avoid investing in a firm that produces tobacco products.

  • Environmental, Social and Corporate Governance (ESG) Investing

ESG looks at the environmental, social and governance practices of the firm that would significantly impact the performance of firms’ finances, and thus the return on investments. The main objective of this approach is to focus on the financial performance of the investment.

  • Impact Investing

This approach weighs financial performance and positive social impact equally. Such funds are often used to support causes that are not directly addressed by public financial markets. 

How is impact investment different?

While the above three terms may appear similar, they are different. It is important to note that SRI and ESG investing involve publicly traded assets, whereas impact investing considers private funds. Impact investing is more transparent in terms of assessing how the investor’s funds are used. SRI and ESG are more of a screening process for social and sustainable investment; while impact investing focusses on actually generating a positive impact.

The Global Impact Investment Network (GIIN), defines impact investing as “investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return”. Impact investment is not just philanthropic, rather it combines it with rigorous analytics of traditional investing. This is achieved by expanding accessibility of goods and services to the deprived section of the society, or through the use of environment-friendly and inclusive production processes. Such investments also target a wide range of areas including agriculture, clean energy, health, education, infrastructure, etc. While public funds and philanthropic measures help in providing for the poor, the role of impact investing is to give them a push as they climb the income ladder.  

Positive Outlook of Impact Investing

The Global Impact Investing Network (GIIN), the impact investing market is estimated to be as big as $715 Bn in the year 2020. The survey also finds that investors report that their portfolios have been performing at par and even exceeding their expectations in terms of both environmental and social impact, as well as financial impact.

 Source: GIIN, 2020 Annual Impact Survey

A report by Impact Investors Council of India estimates that Indian impact investing has shown growth at 26% CAGR in the last decade (2010-2019). $10.8 Bn funds have been mobilized by 586 impact serving about 490 Million beneficiaries, most of which belong to low income communities who are underserved by traditional investors. Impact investments have seen a gradual growth over the decade, especially since 2018 with average deal size tripling from $5 Mn in 2010 to $17 Mn in 2019.

With such high growth rates and the effects of Covid-19 pandemic, investors are now making a conscious decision to move towards sustainable investing. Moreover, the growing number of fintechs and use of advanced technologies, make investing a hassle-free process for all. The adoption of modern and innovative techniques will further accelerate the future growth of impact investing.

Source: Impact Investors Council of India

Since the share of impact investment in financial services has grown over the years, it has helped in fulfilling SDGs of reducing poverty, creating jobs and economic growth, gender equality, industry, innovation and infrastructure. Every dollar invested through impact funding has been able to crowd in at least twice the commercial capital. Impact investing has played a significant role in funding Seed and Series-A capital, and also provided for about 70% of the later-stage financing. Indian impact investing is largely focused on financial services. This will help achieve the goal of economic growth, which will eventually serve in accomplishment of other SDGs including poverty alleviation, gender equality, zero hunger, etc.

Sector-wise Impact (Source: Impact Investors Council of India) 

Your ticket to a positive impact

As the Covid-19 pandemic has derailed the economy, there is greater need to focus on SDGs to get back on the track of development. A broader focus on social entrepreneurship and sustainable finance options is needed to bring the economy back on track.  Social entrepreneurship is always supported by the government, since it helps them to get to the path of development by bringing a change about a change in the social and environmental issues.

Impact investing is the modern way of obtaining the twin goals of greater social impact and financial return. It is gaining popularity as more people strive for sustainability. In the Indian scenario, majority of the impact based funding is focussed on the financial institutions that help achieve global goals of greater economic efficiency and poverty alleviation. Other areas that are served through impact investing include gender equality, clean and affordable energy, better well-being through education, health, sanitation, etc. So if you want your funds to grow by bringing a positive change in solving social problems, impact investing is the way.

 – – – – –

 

This article has been co-authored by Tamanna Kapur, who is in the Research and Insights team of Torre Capital.

BYJU’s: The next big tech unicorn to curb the appetite for IPOs in the Indian Markets

by Sandeep Kumar

Keep up to date with the latest research

BYJU’S is India’s biggest training organization and the maker of India’s most famous K-12 learning application, which offers profoundly versatile, drawing-in, and powerful learning programs for understudies. Revaluating how understudies learn in the time of cell phones, the BYJU’S approach consolidates top-notch instructors, demonstrated educational strategies, creative innovation, and information science to convey customized learning across grades. Byju’s likewise offers to instruct administrations for cutthroat tests, for example, JEE, NEET, CAT, IAS, and worldwide tests like GRE and GMAT.

Since India authorized a lockdown in the nation over in late March, closing schools and other public spots, Bangalore-settled start-up Byju’s has arisen as one of the quintessential stages for school-going understudies on the planet’s second-biggest web market. It took the start-up around four and a half years to gather 40 million understudies. Since the lockdown, its client base has expanded to 65 million.

Snapshots 

  • Notable Investors: Blackstone, Blackrock, Ant Group, Tiger Global, T. Rowe Price, Silverlake
  • Last Funding Round: Series F (Nov 2019)
  • Amount: $ 1.5 Bn
  • Valuation: $15 Bn
  • Employees: 21,000+
  • Founder: Byju Raveendran and Divya Gokulnath

The market for fast-growing IT stocks

The education market in India as a whole is worth around $135 Bn with approximately 360 Mn learners. The Edtech segment of India is divided into 6 parts:

· Pre K-12

· K-12

· Test Preparation

· Higher education

· Continued learning

· B2B Edtech areas

The opportunity in the Edtech market is huge and Edtech startups are contending for a larger share of the pie. The Indian Edtech market investments in 2020 were led by big names like Byju’s, Unacademy, Toppr, etc. The market managed to garner $2.22 Bn funding in 2020 up from $553 Mn in 2019. Byju’s and Unacadmey have been the MVPs raisng over $1.64 Bn and $347.5 Mn. 

As there is a shift in methods of teaching there is an increase in focus on self paced learning and the idea of continued learning after college through professional courses this has been the driving force behind the innovations of the content is made and how it is delivered to the consumer. There are quite a few factors at play that led to the growth of investments in Edtech market. A major one being the increase in government spending allocation to the education sector from $ 11.3 Bn in 2018–19 to $ 13.2 Bn in 2020–21 and the launch of the National Education Policy this year. Another driver of growth is the increasing internet penetration in India especially in tier 3 and 4 cities

 

The pandemic fever

In just a matter of days, the pandemic forced people indoors that changed the way they worked and lived. Lockdown, though confining for the public at large was a gate opener for the Edtech market that was looking for a breakout in investor’s attention. An abundance of startups was able to benefit from the favorable conditions created in the market. Also, many new startups popped up across sub-segments to ride the Edtech wave this year. Large and small Edtech companies offering solutions for remote learning witnessed off-the-charts levels of activity — up by as much as 600%.

Global scenario and opportunities

Education has been one of the most traditional industries, however, that is changing in recent years we have seen applications of advanced technology in education and learning. Education is no longer only associated with the traditional classroom. The learning process now tends to leverage Edtech solutions like online classes, learning management systems, and others to make education more effective and accessible. The pandemic lead to further growth in demand for Edtech solutions sets the pace in the Edtech industry for many years to come.

 

 Source: Holon IQ

China, with the largest education market in the world, has led education VC investment growth over the past five years. China now makes up over 60% of all Global VC investment in education, the USA 15%, India, 14%, and Europe 5% in 2020. While not as large, VC investment in Indian Edtech is worthy of note, growing almost 4x since 2018.

Is it undervalued or overvalued?

A plethora of investors and VCs back Byju’s, some of the most prominent names are The BlackStone Group, Blackrock, T. Rowe Price, etc. Byju’s raised approximately $1.55 Bn in its latest funding round Series F (Jun 2021) which increased its market valuation to $15.05 Bn

 

 

Byju’s most prominent competitors namely Vedantu, Unacademy and Toppr have an average Enterprise Value to Revenue Multiple close to 136x which is way higher than Byju’s 15x.

Peer comparison

Strategic partnerships

Over the years Byju’s have had numerous mergers and acquisitions, to name a few Vidyartha, Osmo, Labin App, WhiteHat Jr. and the most recent one Aakash Educational Services Ltd(AESL). With these acquisitions, all in edtech startups having their own niche offering, Byju’s is becoming on giant umbrella encompassing everything. The acquisition of WhiteHat Jr. aims to expand its product offerings, and widen its base in India, as well as the US where WhiteHatJr already has a presence. The latest acquisition of AESL, a leader in test prep services, brings together the best in offline and online learning. They aim to create India’s largest digitally enabled, omnichannel test preparation company.

The road ahead

Going forward Byju’s is planning to launch Byju’s Future School, the startup’s international business, which will be led by Karan Bajaj, founder of WhitHat Jr., which Byju’s acquired last year. The company plans to expand internationally in U.S., U.K., Brazil, Indonesia, and Mexico next month and explore other geographies later this year. At launch, BYJU’S Future School will offer coding and math lessons. New subjects like Music, English and Fine Arts will be part of future plans. The company aims to reach 350mn users worldwide by FY 2022. The company is also piloting a model in India where schools are working with BYJU’S in imparting coding education within the school curriculum.

Conclusion

With the plans to expand its operation across cities and internationally, the company has the necessary funds for the expansion and investing in R&D of new methods of augmented learning through Artificial Intelligence, Machine Learning, and analytics. Banking on the massive subscriber base with the aim to expand it further, Byju’s will sure have data to feed its models and be able to provide truly customizable learning for each individual subscriber.

– – – – –

This article has been co-authored by Ayush Dugar and Khubaib Abdullah, who is in the Research and Insights team of Torre Capital.

Pension funds trying to change the world — is it justified?

by Sandeep Kumar

Keep up to date with the latest research

Simply put, a pension fund or a pension pot is basically a pot of money that provides retirement income. So, when you and I retire, we’re going to need to live off the money. We might have saved up but right now when we are working, we can invest money into our retirement and that is where a pension fund comes in. It is a large sum of money that is being invested in order to pay you and me when we retire.

Pension funds often pool huge sums of money to be invested in capital markets like the stock and bond markets, in order to produce profit (returns). It represents an institutional investor that invests substantial sums of money in both private and public corporations. The primary purpose of a pension fund is to ensure that there will be enough money to cover employees’ pensions after they retire in the future.

The rise of pension funds

The “unseen revolution” altering corporate ownership in the United States is now evident to all, fifteen years after it was first documented. Around one-tenth of the equity capital of America’s publicly owned corporations is held by the 20 largest pension plans (13 of which are pensions of state, municipal, or nonprofit employees). In total, institutional investors — most notably pension funds — own over 40% of the common stock of the country’s large (and many medium) corporations. Public employee pension funds, which are the largest and fastest expanding, are no longer willing to be passive investors. They are increasingly demanding a say in the companies in which they invest, such as veto power over board appointments, executive salaries, and key corporate charter elements. Pension funds also control over 40% of the medium- and long-term debt of the country’s larger corporations, which is still widely disregarded. As a result, these institutions have become both the largest lenders and owners of corporate America. For years, finance texts have highlighted that the lender’s power is equal to, if not greater than, that of the owner.

One of the most dramatic power swings in economic history is the rise of pension funds as dominant owners and lenders. General Motors developed the first modern pension fund in 1950. Pension funds now have $2.5 trillion in assets, split about evenly between common stocks and fixed-income instruments, after four decades. These assets will continue to increase aggressively for at least another ten years, according to demographics. In the 1990s, unless there is a prolonged depression, pension funds will have to invest $100 billion to $200 billion in new resources per year.

Source: Financial Stability Board

 

 

 

Types of pension funds and its difference

There are two key types of pension funds. The first type is Defined contribution and the second type is Defined benefit.

Regardless of how well the fund performs, a defined benefit fund distributes a fixed income to the recipient. The employee contributes a set amount to the fund. These donations are invested prudently by the fund managers. They must outperform inflation while not losing the principal. The fund management must make a sufficient return on investment to cover the benefits. Any gap must be covered by the employer. It’s similar to an insurance company’s annuity. In this instance, the employer acts as the insurance company, bearing all of the risks if the market falls. Because of this risk, several firms have discontinued offering these policies.

In a defined contribution plan, the employee’s rewards are determined by the performance of the fund. 401(k)s are the most common of them. If the fund’s value falls, the employer is not required to pay out defined benefits. The employee assumes all of the risks.

The most significant distinction between a defined benefit and a defined contribution plan is the risk shift. The defined benefit is being rolled out because it is old school. Defined contribution on the other hand is around for the most part today. Most employers, companies, and individuals are likely to be on defined contribution pension schemes.

Country-wise comparison of pension funds

Globally, the quality of pension systems accessible to workers varies substantially. According to the Mercer CFA Institute Global Pension Index 2020, the Netherlands has the best system, whereas the United States is nowhere near the top.

· Netherlands: Its retirement income system is based on a flat-rate public pension and a semi-mandatory occupational pension tied to wages and collective bargaining agreements. The majority of employees in the Netherlands are members of these occupational plans, which are defined-benefit plans that are industry-wide. Earnings are based on an average over a lifetime.

· Denmark: Denmark features a public basic pension system, an income-related supplementary pension benefit, a fully funded defined-contribution plan, and required occupational pension plans.

· Israel: The retirement income system in Israel is made up of a universal state pension as well as private pensions with the mandatory employee and employer payments. Annuities are typically paid via the private pension system.

How pension fund diversifies its investments

By shifting their concentration to other assets, pension funds can protect themselves from a stock market meltdown. Most pension funds have typically sought growth by investing in shares, but with global stock market valuations so high, the short-term outlook appears dismal. Alternative assets, such as private credit, private equity, and real assets, may outperform a standard growth portfolio on a risk-adjusted basis.

Investors are shifting their focus to alternative credit investments in search of yield due to low bond rates and scheme demographics. As contributions fall, a growing number of schemes become cash flow negative, putting an emphasis on income-generating assets while requiring forced sales of growth assets.

Because interest rates on traditional assets like gilts and investment-grade bonds are so low, trustees are looking into alternative credit markets like high yield, private lending, royalties, and long-term leasing.

 

Performance of pension funds during the financial crisis

  • The funds’ investment performance all suffered in the early aftermath of the pandemic’s outbreak. Their returns, on the other hand, have fared “significantly better” than they did during the global financial crisis when they fell far short of their standards.
  • The funds’ ability to withstand shock was aided by the swift and unprecedented monetary and fiscal support provided in response to the rapid spread of Covid-19. However, improvements in the asset class mix and risk management capabilities of the funds also contributed to the funds’ ability to withstand shock.
  • Since the financial crisis, pension funds have extended their exposure to alternative asset classes such as private equity, infrastructure, and real estate, which has helped to mitigate the risk of their public assets.
  • In addition, the robust liquidity positions of pension funds have helped to protect them from market volatility.
  • During the market upheaval in the first half of 2020, these funds had minor liquidity stress, in contrast to the previous financial crisis. We feel that since then, advances in risk management governance mechanisms have been effective in protecting funds from market volatility.

Source: OECD website

 

How pension fund tackles inflation?

Inflation protection refers to assets that tend to appreciate in value when inflation rises. Inflation-adjusted bonds (such as TIPS), commodities, currencies, and interest-rate derivatives are examples of these. Although the use of inflation-adjusted bonds is frequently justifiable, some have expressed worry about the greater allocation of pension fund assets in commodities, currencies, or derivatives due to the additional idiosyncratic risk they represent.

Liability matching, sometimes known as “immunisation,” is an investing technique that compares the timing of predicted future expenses to the timing of future asset sales and revenue streams. The method has gained traction among pension fund managers, who use it to reduce the risk of a portfolio’s liquidation by matching asset sales, interest, and dividend payments to planned pension payments. This is in contrast to simpler techniques that aim to maximise return regardless of when withdrawals are made.

To supplement social security payments, pensioners living off the income from their portfolios, for example, rely on secure and consistent payments. A matching strategy would entail buying stocks strategically in order to receive dividends and interest at regular periods. A matching strategy should ideally be in place well before the retirement years begin. To ensure that its benefit commitments are met, a pension fund would use a similar technique.

Pension fund driving sustainable investing

Pension funds might be a powerful force in persuading businesses to embrace ESG goals such as tackling climate change and increasing employment justice. However, they must balance these objectives with their fiduciary responsibility to protect their members’ retirement savings. They must also overcome obstacles in the United States, such as gaps in ESG adoption measurements and misunderstanding about government restrictions on such investments. According to the paper, total assets managed by U.S. institutional investors using ESG principles have increased significantly over the last 15 years, reaching $6.2 trillion in 2020, with public pension funds accounting for more than half of that (54%). Climate change and war risks in terrorist or repressive regimes have recently risen to the top of investors’ concerns, followed by tobacco usage, corporate governance, and sustainable natural resource and agriculture practices. Investors’ appetites for ESG principles, on the other hand, oscillate between extremes.

According to the Wall Street Journal, ESG fund investors are moving their focus from growth to value companies, while other institutional investors are “lining up trillions of dollars to support a shift away from fossil fuels.”

Conservative risk measures

Pension funds make guarantees to their members, ensuring that they will be able to retire with a particular level of income in the future. This means they must be risk-averse while simultaneously generating sufficient returns to cover the guarantees. As a result, together with blue-chip stocks, fixed-income instruments make up a large portion of pension portfolios. Pension funds are increasingly looking for additional returns in real estate and alternative asset classes, albeit these assets still make up a modest portion of their overall portfolios.

– – – – –

This article has been co-authored by Sayan Maitra and Yogesh Lakhotiawho are in the Research and Insights team of Torre Capital.

Right Menu Icon
Cancle

Login to your Account

Sed ut perspiciatis unde omnis iste natus error sit voluptatem

Forgot Password?
cross

Select Country