#214 The Stakes are High

Financial Regulation of Private Firms + Emigration of Indian Talent

India Policy Watch #1: A Bonfire Of Vanities

Insights on issues relevant to India

— RSJ

One of the things we argue for over here is to let market participants do their things and have the state intervene only when there is a market failure. We aren’t free market absolutists, and we have explained our position on the market, society and individuals in multiple posts here. And, of course, we even wrote a book on it. This preamble is somewhat important because what I am going to do in this post might appear like supporting state intervention in an area left relatively free by its overreaching arms. 

I have my reasons for going down this path.  

One of the success stories of the Indian economy over the past decade has been the emergence of what’s been called a start-up culture. Many young Indians coming out of college no longer seek the comfort and assurance of a stable job in established companies. Instead, inspired by the stories of successful start-up entrepreneurs, they are starting their own companies. This is a welcome change in a country where entrepreneurial instincts were conventionally suppressed by family and society. An important catalyst for this change has been the somewhat easy availability of a thing that’s always been scarce for entrepreneurs in India. 

Capital. 

Following the global financial crisis (GFC) in 2009, central banks in most developed economies went down the path of quantitative easing (QE), which increased the availability of capital and made everything look rosy in the short term. That capital eventually had to be deployed somewhere. Simultaneously, there was the broader convergence of smartphones, cheaper telecom data costs and a booming network effect of more people on the internet, which meant you could create asset-light business models that used software to disintermediate traditional businesses. Uber and AirBnB are the two most discussed examples of this model. The availability of cheap capital meant that venture and private equity funds were raising huge rounds from family offices, sovereign wealth funds, large pension and investment managers who were on the look out for better returns. Whenever in history cheap capital meets a hot, new business model, it means only one thing. 

Mania. 

And that’s what happened between 2017-22. Making profits didn’t matter. It was all about acquiring customers and scaling up quickly (hyperscaling or blitzscaling). Build a large customer base by throwing money at them, making them addicted to your product, building a moat, a flywheel or whatever was the fancy word of the moment and hoping you will outlast your competitors to be the last company standing. And then you can laugh all the way to the bank singing that old ABBA song; the winner takes it all. Once the VCs/PEs got into this game in the US, it was only a matter of time before they looked at other markets where they could replicate these models. China was building its own version of these businesses, and by 2020, things had soured with Xi going after his own homegrown giants.

India remained a beacon of hope. With further quantitative easing in the US on the back of COVID-19, there was a huge liquidity surplus. And so the capital poured in. Between 2020-22, India saw over $200 billion of inbound flow into what are called the private markets i.e. into companies that haven’t gone public yet. It was unprecedented. We have written about this earlier. About a year back, India was looking at over a hundred unicorns (companies valued at over a billion dollars). All of this should mean a net positive for India, which needs a foreign inflow of capital to support growth, boost its forex reserves and manage the Rupee. Except for a minor hitch. Was all of this funding going into companies with sound and sustainable business models that were governed well? If they did, we were in for an economic boom with new jobs, higher productivity and better customer experience across multiple industries that were being disrupted by these start-ups. 

I’m afraid we aren’t looking at that future any more. The liquidity has dried up really fast, the business models of many of these start-ups have hit the reality of public markets where they have floundered, and while India remains of tremendous interest to global businesses, the allure of Indian start-ups has dimmed considerably among investors. In my view, more than anything else, the single biggest reason for this isn’t the global macro. It is how Indian entrepreneurs have governed these start-ups. Or how the regulations (or lack of them) and herd mentality-driven investors have let these entrepreneurs run their start-ups. And that’s a pity because we have possibly let go of a wonderful opportunity to become a global hub of digital entrepreneurship. 

And nothing brings this mess into sharper relief than what’s transpired this week with India’s most valued start-up. Byju’s. An edtech company that aims to revolutionise education in India by making high-quality education accessible digitally to all. Except what we saw this week seems like the beginning of some kind of an endgame for a company that has done everything but make even a minor dent in education outcomes in India. This after raising and spending over $5 billion in equity capital (and possibly another $1.5 billion in debt), accumulating losses of over a billion (or more, no one knows for sure) and being valued at its peak at $23 billion. The list of travails plaguing Byju’s is long. Those who give it a benefit of doubt argue that online education had a good run during the pandemic when schools were shut, and it was difficult not to believe then that the online education trend will outlast the pandemic. Well, anyone who went a bit deeper and asked parents or teachers what they thought about the effectiveness of online education during the pandemic would have learnt that this was a huge assumption to make. Anyway, that’s a minor point in what’s hurting Byju’s. Its real problems are its own doing. And in the likely event of it sinking in the near future, it will take down the India start-up story for a while with it.

That’s a real pity.

So, what are the problems it’s facing? Well, let me begin with the basics. It has not yet filed its audited financials for more than 18 months now. That’s right. Its auditors aren’t willing to sign off on its financial statements. The company maintains this is because it has gone through multiple changes in accounting practices, which is making it difficult to finalise the final audited statement. That’s not all. The Enforcement Directorate is looking at the web of companies that it has spawned globally to manage the inward remittances of all the funds it has received. The company again maintains all such transactions were done in compliance with FEMA guidelines and that the searches carried out by ED were ‘routine’. The news reports, however, don’t suggest things are routine. Here’s India Today on the ED search operations:

Officials from ED said the searches revealed that the “company has received FDI investment to the tune of Rs 28,000 crore during the period from 2011 to 2023. Further, the company has also remitted Rs 9,754 crore to various foreign jurisdictions during the same period in the name of overseas direct investment,” said the agency. The company also booked around Rs 944 crore in the name of advertisement and marketing expenses, including the amount remitted to foreign jurisdictions.

The officials further said the company has “allegedly” not prepared its financial statements since FY21 and has not got accounts audited, despite it being mandatory. Officials from the agency added that the genuineness of the figures provided by the company is being cross-examined and tallied with banks.

The ED conducted the search after several summonses were issued against Byju Raveendran. The probe agency said he always remained “evasive” and never made an appearance during the investigation, leading to the recent searches conducted on Thursday and Friday. It is worth mentioning that the Edtech firm, which is India’s most valuable privately-held start-up, has been under the watch of the Ministry of Corporate Affairs (MCA) and the Directorate General of GST Intelligence (DGGI).

Last year, the MCA sought clarification from the company after a delay in the submission of Byju’s annual returns for FY21. The financials were then reported after a long delay. It had also come under the scanner of the DGGI in FY21 over possible evasion, but the matter was settled after the company agreed to pay its GST liabilities.

Not a good look at all. In the past week, the troubles went a bit further when Byju’s ‘elected’ not to pay the interest due to one of its lenders. I guess that’s what they call default in the start-up world these days. Here’s the Times of India on this:

In what is possibly the first action of its kind by an Indian company, BYJU’s has also issued a notice to one of its creditors, Redwood, disqualifying it as a lender. It also claims the creditor, contrary to the terms of the loan agreement, purchased a significant portion of the loan while primarily trading in distressed debt.

“BYJU’S has had to take these measures following a series of predatory tactics by the lenders, led by Redwood,” the edtech firm added. The suit filed in the New York court comes at a time when the edtech firm was expected to make an interest payment on the loan by June 5, according to a Bloomberg report earlier this month.

According to the report, creditors to Byju’s have pulled out of negotiations with the company to recast a $1.2 billion loan. The talks were called off after the creditors moved a Delaware court, accusing the firm of hiding $500 million of funds raised. It must be noted that BYJU's loan slumped to a low of 64.375 cents on the dollar on June 5, down from 78 cents on June 2, according to data compiled by Bloomberg.

Apart from these, it is likely its core business isn’t exactly in the pink of health. It has announced layoffs a couple of times in the past six months. It went on a bizarre acquisition spree in the past two years when it bought over a dozen different companies, spending in excess of over $2.5 billion. There’s no clarity on how these acquisitions have panned out since the audited financials aren’t out yet. Anecdotally though, it looks like it has failed to integrate most of these businesses into its existing model. It is difficult for mature companies with seasoned management teams to manage more than a couple of acquisitions in a year. It is almost impossible for a start-up burning cash, fighting lenders and regulators and struggling with its business model to handle more than a dozen acquisitions in a year. It will likely write off most of these acquisitions.

There are other complaints about its sharp selling practices where customers are saddled with expensive long-term packages cleverly bundled with a high-interest loan that’s not always made clear to them. Social media is full of complaints from customers about the quality and effectiveness of its content, the cheap tablet that’s thrown in and which accounts for 70 per cent of its revenue,s and being harassed by collections agents of financing companies for the large loan that they didn’t want in the first place. A few fintechs that backed this financing model almost went under because of the defaults by Byju’s customers. Amidst all of these, till about a couple of quarters back, the company was spending money being a lead sponsor of the Indian cricket team, hiring Messi as a global ambassador and running high-decibel TV campaigns. It is difficult to say, looking from the outside, if the firm has a system of checks and balances and a clear business plan at this moment. The firm always claims it has gone through multiple due diligences as part of its various funding rounds. This is a bit rich. During the frenzy in which it raised most of its funds, the company was calling the shots on who it would ‘invite’ to be part of its cap table. I don’t think any of those investors had a choice asking tough questions about its financials or the business model. Those who did missed the bus. 

The upshot of all this is that Byju’s will need to pull off a Houdini act to get out of the hole it finds itself in now. It is possible, and I hope they find a way. But if it doesn’t, there will be a cascading impact on the Indian start-up world. The already tight funding situation will get worse, and it is likely that good ideas and companies will be starved of the capital that they need and deserve. One way to think of this is to ask, would things have been allowed to come to this pass had it been a public company? The answer is no. Some of the egregious faults would have been flagged off much earlier, and many of the acquisition decisions would have been held up for greater scrutiny. But being a private company, the guidelines of a public company don’t apply. Because there aren’t small public investors who need protection for having invested small sums of their hard-earned money into the company. So, one way of looking at this is if Byju’s fails, it will destroy the shareholder value of people who should have known better. And this ‘creative destruction’ will mean there will be lessons learnt, and a better model will emerge from this—the usual capitalism at work story. However, I cannot help but ask, given the size of companies in the private market, the scale of their funding and their impact on a sector or the wider environment, is it enough to let them be so lightly governed? Because in these instances, there’s more at stake than just a company. 

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India Watch #2: Swades sans the Heroism

Insights on issues relevant to India

— Pranay Kotasthane

Numbers create powerful public policy narratives. A striking number can bring a “back-burnered” problem back into focus. One such number comes from a new NBER working paper, which finds that among the top 1,000 scorers on the IIT-JEE 2010, 36% have migrated abroad. Moreover, of the top 100, as many as 62 have migrated abroad. The better a person’s IIT-JEE rank, the higher the chances that they have already bid adieu to India.

Few people will find this statistic surprising. Nevertheless, a result like this forces a relook at chronic problems. This paper has had the same effect—it sparked another conversation on the decades-old problem called “brain drain”. So, how should we think about emigration from India circa 2023?

In edition #156, we discussed the gold standard book on Indian emigration, Devesh Kapur’s Diaspora, Development, and Democracy: The Domestic Impact of International Migration from India (2010). I recommend you read that edition (and then the book) to understand the aggregate political and economic impacts of emigration on India.

#156 The Republic Of Our Future

For this edition, assume that you are a fly on the wall in a government meeting discussing ways to channelise the energies of the 36% IITians who have chosen to migrate abroad. What alternatives are likely to come up?

For now, omit all the coercive options. Because emigration is a voluntary act by an individual, it is a force of immense good. As emigration is one of the partial answers to achieving yogakshemah, the Indian State must make it easier for Indians who want to leave India. No democratic republic should intervene in emigration decisions through coercive means.

That leaves us only with solutions that can change emigration decisions at the margin by increasing the benefits of staying in India. Depending on the time horizon of impact, there are two categories of such solutions.

Over the long term, there is no alternative to good-quality research universities. As Naushad Forbes writes, we need to do this not because the research from universities will produce great products or start-ups but primarily so that smart researchers aren't pushed out of India. There is really no justification for the 37 national laboratories under the Council of Scientific & Industrial Research (CSIR) if they can’t take on the task of producing half-decent post-graduates. After all, government funding for R&D is justified on the grounds of “positive externality”, and a key component of this externality must be to equip the next generation of researchers.

Over the short term, there aren’t any good options on the table to prevent the out-migration of talent. Instead, the State could look at the other end of the pipeline—make it attractive for emigrants and their companies to return to India.

China’s experience in attracting emigrated talent is instructive. Through its Thousand Talents Plan, China was able to attract more than 7000 researchers to return to China over ten years. But the effectiveness of this programme has been questioned on two counts. First, many researchers agreed to spend short periods in China but returned to take up tenured jobs in their host country. Second, this plan has come under fire from host countries as a conduit for intellectual property theft and espionage.

I have my doubts about applying this approach in India. Changing residence is a complex decision that depends on, amongst other factors, the quality of living standards and opportunities for spouses. Given that these remain broken in India, governments merely promising financial incentives to returnees may, in fact, pose a moral hazard—the researchers this plan would attract might not be the desirable ones.

It is perhaps better to accept the reality that these impediments aren’t going to be solved over the next decade and get researchers to contribute without them having to move back to India. China’s Offshore Entrepreneurial Bases and Overseas Chinese Scholar Parks acquire technology and know-how from scholars even as they continue to stay put in their host country. Apart from legal means of research, this method has again come under the scanner in recent times for promoting industrial espionage and extra-legal technology transfers.

India must avoid China’s abrasive methods. But it might achieve the same effect by utilising its geopolitical favourability. More joint research programmes where students in India can easily access established Indian guides and scholars from abroad might be one way out. Another way out might be to create hubs of excellence for Indian emigrants outside India in more geopolitically favourable and livable places such as Dubai, Singapore, or Melbourne (thanks to a colleague of mine for this idea). A third way out might be to relax technology transfer controls among trusted partners.

A second part of the puzzle is to make it easy for companies to relocate their headquarters to India. Siddharth Pai and Mohandas Pai in Financial Express identify the regulatory barriers that discourage start-ups from redomiciling in India. Given the significantly better valuations in the West, it is only natural that most companies by Indians will not be Indian at birth. The key is to enable them to come back easily at a later stage of their development.

These are just a few short-term strategies to manage the effects of emigration at a national level. Finally, people will return in large numbers only if India offers unique opportunities that other countries cannot match. In the Bollywood movie Swades, NASA scientist Mohan Bhargava returns with a sense of guilt and stays with a sense of sacrifice. In real life, though, only better opportunities in India can have that effect. Swades, sans the sacrifice.

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HomeWork

Reading and listening recommendations on public policy matters

1. [Book] Internal Security in India: Violence, Order, and the State is a terrific new book on an under-appreciated aspect of Indian public policy. The book has chapters by top-notch scholars on various facets of internal security. Though packed with data and charts, the book is quite easy to read, and also works well as an introduction to the subject. A Puliyabaazi with the editors will be out soon.

2. [Article] Manish Sabharwal’s article on the five pillars of soft power that need renovation offers much food for thought.

3. [Podcast] Going with two excellent EconTalk episodes this week. Michael Munger’s latest appearance on the “directionalists vs destinationists” distinction is valuable for all public policy learners. The episode with Luca Dellanna on ergodicity is also insightful.

4. [Report] A useful report covering the PLI scheme on ICT products by International Cooperation Center, Taiwan.

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