You can’t run away from reality forever

In 2009, when I first joined private equity investing, I found that we MBAs understood finance less than a typical Marwari businessman.

Most investors talk only about growth and multiples (usually EV/EBITDA) but rarely does anyone ask: Is this firm REALLY creating value by growing?

Why? Because we know the technical definitions but often lack intuitive understanding.

Ask a Marwari businessman to open a new shop, he will ask: Will this shop give me more profit than what I can earn by investing the capital elsewhere?

This guy just gave us the first principle of investing: Does a business generate a return on capital (ROIC) greater than its cost of capital? If yes, only then does growth create value.

Even though I learned these concepts in my MBA and at McKinsey, initially, ROIC and cost of capital were more like ‘formulas’ — the intuitive understanding took a while.

Today, all kinds of random businesses get funded because all the talk is about growth. Growth, growth, growth…nothing else seems to matter in the VC/PE world.

Early-stage investors don’t care since most young companies are unprofitable anyway, and as long as late-stage investors buy them out, why bother? Fair point.

But should the late-stage investors not care? This is a conundrum to which I have no answer.

Fundamentals matter. You can’t run away from reality forever — one day, it will catch up

– Rajan

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