There has been a significant slowdown in the early-stage funding ecosystem in Southeast Asia, with fewer startups 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 that 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 realised, there would be a prodigious amount of shrinkage.

The funds don’t want this reality because to do so 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 as compared to the capital that has been given to it. As investments are realised, the Distributed-to-Paid in the capital will start to increase, and the Residual Value-to-Paid in the capital will decrease. Put another way TVPI = DPI + RVPI.

TVPI vs DPI

Currently, I would guess that there are a lot of funds that are holding their investments at an elevated valuation on their balance sheets. Let’s say that they are marking them at 5x TVPI. This would be great if they were able to realise their 5x TVPI and convert it into the DPI.

However, this valuation is based on the last round, which is problematic because venture rounds are typically priced according to the dilution that is appropriate for the level of funding as opposed to the financial value of the discounted cash flows.

Also Read: Funding frenzy in SEA: Fintech, proptech, EV startups secure millions

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

A worked example

What is more likely is that the 5x TVPI that 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 of this, if a company did a round of funding and raised US$1 million from Fund A at a US$10 million post-money valuation, the fund would own 10 per cent of the company. The company subsequently raised US$10 million at a US$50 million post-money valuation with preference shares that carried a 3x liquidity preference.

Arguably, Fund A would own eight per cent of the company (10 per cent less 20 per cent dilution, assuming the pro-rata wasn’t taken up). As mentioned above, the valuation that a private company can raise money at likely isn’t the same price that the same company would trade at in a secondary market.

Continuing from the above example, if the company was then sold for US$35 million 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 valuations, the lower end taking into consideration dilution).

However, when they actually exit the business, the second funding round would first get paid their US$30 million (3x liquidity preference x $10m investment), leaving US$5 million for the remaining investors. Fund A’s 8 per cent position would now be worth US$400k (8 per cent of US$5 million), 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 a far cry from the $5m that they said it was worth to their investors.

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

The DPI dip

There are likely a lot of funds in this situation, where they might not have done the cap table calculations and instead relied on the movement of the share price to guide their internal valuations with no regard for their position in the preference stack.

Also Read: Southeast Asia startups secure funding for logistics, anime, sustainability and more!

When they look at exiting their positions, they realise that they need to win the lottery with an irrational buyer stepping in and paying above the odds for the business so they can realise the TVPI that they have been marketing. Faced with that conundrum, they would obviously prefer to let the investment ride in the hopes of some windfall in the future rather than accept the reality that their DPI will never get anywhere near their current TVPI.

Final thoughts

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 they don’t have any capital to recycle back into new funds. This leaves us in the present predicament that we face with fewer investors deploying into funds, fewer funds being deployed, and fewer startups raising capital to grow and expand.

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