There has been a significant slowdown in the early-stage funding ecosystem in Southeast Asia with fewer start-ups getting funded and fewer funds being created. I’ve seen a few comments that have tried to explain why it is slowing down, so I thought I’d add some colour to the discussion. There’s no doubt that there’s been some frustration on the part of LPs with how slowly existing GPs have been returning capital from their funds.

I would hazard a guess that this is because the TVPI (Total Value-to-Paid-In capital) multiples aren’t what they are advertised to be, and if they were realized, there would be a prodigious amount of shrinkage. The funds don’t want this reality because it would likely expose the fact that their total returns are lower than the S&P500, with less liquidity, which would beg the question – Why would anyone invest with them again?

TVPI reflects the current value of the portfolio compared to the capital that has been given to it. As investments are realized, the DPI (Distributed-to-Paid-In capital) will start to increase, and the RVPI (Residual Value-to-Paid-In capital) will decrease. Put another way: TVPI = DPI + RVPI.

TVPI vs DPI

Currently, I would guess that many funds are holding their investments at an elevated valuation on their balance sheets. Let’s say they are marking them at 5x TVPI. This would be great if they can realize their 5x TVPI and convert it into DPI. However, this valuation is based on the last funding round, which is problematic because venture rounds are typically priced according to the dilution appropriate for the level of funding, not based on the financial value of discounted cash flows.

To realize the 5x TVPI, the fund manager would likely need to accept a discount unless they can achieve an IPO or some exceptional trade sale—which are few and far between in Southeast Asia.

A Worked Example

What is more likely is that the 5x TVPI they are carrying is sitting pretty far back in the cap stack, as liquidity preferences from later rounds have diluted the actual value. To give an example: If a company did a round of funding and raised $1m from Fund A at a $10m post-money valuation, the fund would own 10% of the company. The company subsequently raises $10m at a $50m post-money valuation with preference shares that carried a 3x liquidity preference.

Arguably, Fund A would own 8% of the company (10% less 20% dilution, assuming the pro-rata wasn’t taken up). As mentioned earlier, the valuation at which a private company raises money likely isn’t the same price that the company would trade at in a secondary market. Continuing from the above example, if the company was then sold for $35m a year later, what would Fund A’s position be worth?

On their books, Fund A would have marked up their investment by 4-5x ($50m/$10m post-money valuation—the lower end, considering dilution). However, when they actually exit the business, the second funding round would first get paid their $30m (3x liquidity preference x $10m investment), leaving $5m for the remaining investors. Fund A’s 8% position would now be worth $400k (8% of $5m), which is less than they had invested. It’s likely that they received preference shares, so they would get their investment back, but it’s still far from the $5m they said it was worth to their investors.

This is an extreme example, but it shows how there could be a significant difference between the TVPI and DPI when push comes to shove due to the positioning in the cap stacks. What looked like a 4-5x TVPI was closer to a 1x DPI when realized (depending on whether it was a participating preferred).

The DPI Dip

Many funds are likely in this situation, where they haven’t done the cap table calculations and have instead relied on the movement of the share price to guide their internal valuations with no regard for their position in the preference stack. When they look at exiting their positions, they realize they need an irrational buyer stepping in and paying above the odds for the business for them to realize the TVPI they have been marketing.

Faced with that conundrum, they would prefer to let the investment ride in hopes of some future windfall rather than accept the reality that their DPI will never get anywhere near their current TVPI.

Conclusion

This results in funds holding onto positions longer and being unwilling to return capital to investors. If they were to return capital, their Internal Rates of Return (IRRs) would start to converge and potentially dip below those that an investor could have achieved by investing in the S&P500 but with a significant amount of additional liquidity.

Those investors are frustrated with the current situation and don’t have any capital to recycle back into new funds. This leaves us in the current predicament, with fewer investors deploying into funds, fewer funds being deployed, and fewer startups raising capital to grow and expand.