PMS Bazaar recently organized a webinar titled “Navigating the Dichotomies in MSME Investing - Challenges and Opportunities,” which featured Mr. Rishi Agarwal, Co-Founder and Fund Manager, Aarth AIF.

This webinar blog covers insights from Mr. Agarwal on MSME investing, including the sector’s scale and opportunities, risk-return frameworks, scenario planning, and protective measures. They discussed challenges like liquidity, governance, and volatility, Aarth Growth Fund’s data-driven approach, investment in sub-niches, formalisation benefits, and supply chain shifts. 

Key aspects covered in this webinar blog are

• The scale and opportunity in MSMEs
• Identifying investment gaps and opportunities
• The dilemmas of a fund manager
• Understanding risk and return in MSME investing
• Mitigating risk through scenario planning
• Navigating challenges and misconceptions
• Debunking common rules
• The transformational opportunity
  

Mr. Rishi Agarwal started the session by offering a clear and insightful presentation on the fund’s investment approach to India’s Micro, Small, and Medium Enterprises (MSMEs). He began by stating that the session would not be a typical one filled with stock tips or a promotional brochure of the fund’s recent performance. Instead, it was an opportunity to discuss the decision-making framework that the fund had developed through its experiences.

The Scale and Opportunity in MSMEs

Mr. Agarwal highlighted the significant scale of India’s MSME sector, sharing key statistics often cited in the media. These included the existence of 3.7 crore registered MSMEs, which employ 26 crore people, contribute 30% to the nation’s GDP, and account for nearly half of all exports and manufacturing output. However, he emphasized that while these numbers are impressive, they don't provide a roadmap for investing.

He stated that the true edge comes from understanding how government initiatives, multinational corporations (MNCs), and global scenarios translate into real-world opportunities. He cited examples like the “Make in India” initiative, which mandates that a quarter of all government spending must go to MSMEs, and the government's recognition of MSMEs as a key to creating sustainable jobs across all tiers of the country. He also mentioned policy changes like the re-rating of the MSME definition to include businesses with a revenue of up to ₹500 crore. These tailwinds, he explained, lead to cash surpluses for MSMEs, which in turn fuels their growth and re-rating.

Identifying Investment Gaps and Opportunities

Mr. Agarwal explained that their fund's job is to identify the gaps between market reality, media coverage, and macroeconomic headlines. He provided three key areas where they find their investment opportunities.

First, they identify sub-niches within every sector, looking for regional duopolies or oligopolies with strong management and a focus on exports. Second, they focus on formalization arbitrage, which gives an advantage to MSMEs through initiatives like GST, Udyam Working Capital, and interest-free loans. Third, they capitalize on the ongoing supply chain disruption, noting that companies are now diversifying their manufacturing bases to avoid shocks in the system.

Mr. Agarwal then highlighted the growth of MSME-focused exchanges like NSE Emerge and BSE SME. He mentioned that while 1,200 companies have been listed over the past decade, a significant 60% of the total capital raised (₹20,000 crore) occurred within the last three years alone. This rapid growth, he explained, demonstrates the maturity of the market and the immense wealth creation potential. He noted that the total market capitalization of MSME companies has grown from ₹1 lakh crore to ₹3.5 lakh crore, representing a 3.5x return for the entire sector.

The Dilemmas of a Fund Manager

Mr. Agarwal concluded by discussing the five key dilemmas he faces daily when evaluating potential investments.

• Risk vs. Return: He stated that they must constantly weigh the risk taken against the expected return, not just on a single company but across the entire portfolio.
• Passive vs. Active Investing: He outlined the choice between being a passive investor who holds a position for the long term or an active one who tries to capture short-term momentum and event-driven opportunities.
• Conformity vs. Contrarianism: Mr. Agarwal discussed whether to follow popular themes like AI and solar or take a contrarian view on less-favored sectors like steel or copper.
• Known vs. Unknown: He explained that most investment decisions are made with more unknowns than knowns. The challenge lies in building conviction based on the knowns while carefully estimating the downside risk from the unknowns.
• Diversification vs. Concentration: He noted the varying approaches among fund managers, with some preferring a concentrated portfolio of 20-25 bets, while others, like mutual funds, diversify across 80 or more stocks. He explained that this choice is critical in the MSME space, where liquidity and coverage must be carefully underwritten.
  

Understanding Risk and Return in MSME Investing

During an engaging session, Mr. Rishi Agarwal initiated a live poll with the audience, asking them to identify the biggest dilemma they face when investing in MSMEs. The results were revealing—while he had anticipated “risk versus return” to be the clear leader, he was surprised to see “known versus unknown” as the second most significant concern. He had expected “diversification versus concentration” to feature higher. Sharing his perspective, he noted that he had witnessed equally compelling success stories from both highly concentrated portfolios and widely diversified ones. With the poll highlighting investor curiosity around risk and return, he decided to explain the framework that his Aarth Growth fund, employs.

Mr. Agarwal outlined that their fund’s approach to balancing risk and return is divided into three segments, with a premortem analysis forming the cornerstone. In this process, the team analyses all information provided by the promoter—expected profit after tax (PAT), projected growth rates, and market positioning. To illustrate, he offered a hypothetical scenario of a company with ₹100 crore in sales, ₹25 crore PAT, and a projected 25% year-on-year growth. At the time of investment, such a business might be valued at a 14x multiple, with a market cap of ₹350 crore. While this represents the “known” side of the story, he emphasised that real investing also requires preparing for the “unknowns.”

Mitigating Risk Through Scenario Planning

To account for uncertainties, Mr. Agarwal introduced their scenario planning model. This method evaluates possible disruptions such as contract cancellations, margin squeezes, or cash flow shortages. The team creates simplified models projecting PAT outcomes at varying levels—100%, 75%, or even 50% of the original target—and then calculates the exit price-to-earnings multiple required to at least break even. For example, in the EPC sector, a 7x P/E multiple is considered a safe benchmark, as valuations rarely fall below this level.

He explained that such models are applied not just to PAT but also to cash flows, EBITDA, and other financial metrics. For companies with a market cap under ₹200 crore, these reviews are conducted every six months, whereas for larger ones exceeding ₹1,000 crore, quarterly reviews are the norm. The purpose is to ground decisions in data rather than bias. Every team member at Aarth Growth fund is trained to constantly “re-rate” numbers, ensuring no reliance on intuition alone. Mr. Agarwal described this practice as a systematic way of “engineering and reducing risk.”

Navigating Challenges and Misconceptions

Addressing broader challenges, Mr. Agarwal recounted a conversation with a veteran investor who argued that the time for MSME investing had passed. He disagreed, highlighting how Aarth Growth Fund achieved a 40% XIRR since January despite a market correction. Failures, he admitted, are inevitable, but the magnitude of successful investments more than compensates.

He elaborated on four persistent challenges:

• Liquidity Constraints: Many MSMEs trade with low daily turnover. For a fund holding large positions, exits can take months. Hence, positions are built gradually, with deliberate diversification.
• Governance Concerns: Strong governance is non-negotiable. The fund rejects opportunities with Related Party Transactions or questionable audit notes, even at the cost of missing profitable businesses.
• Operational Fragility: Risks tied to dependence on a single plant, client, or key individual are real. However, a specialised focus can also serve as a competitive moat, offering reliable returns over time.
• Volatility: MSME stocks often see 30–40% drawdowns. Instead of panicking, the team revisits its thesis, engages with promoters, and reassesses the order book. Often, they use such downturns to add positions at lower prices, seeing volatility as an opportunity rather than a setback.
  

Debunking Common Rules

Mr. Agarwal then challenged some conventional “rules” of investing:

• Liquidity comes first: In MSME investing, valuation discipline outweighs liquidity concerns, especially with a five-year closed-end fund structure.
• Institutional holding is a good sign: Aarth Growth fund prefers high promoter holding—above 70%—which reflects commitment. Interestingly, he noted that female family members as key promoters or directors often signal stronger ethical standards.
• Stock price mirrors business health: Drawing on Jeff Bezos’s Amazon journey, he explained that market prices often diverge from actual business performance. Limited analyst coverage in the MSME space frequently leads to mispricing, creating opportunities for informed investors.
• Market always recognises growth: MSME growth stories are not always reflected immediately due to lack of visibility and coverage, further underscoring the need for patient capital.
  

The Transformational Opportunity

Shifting focus, Mr. Agarwal painted a broader picture of India’s economic landscape. He described the country as riding a “transformation wave,” much like the U.S., South Korea, and Japan in earlier decades. With a young, ambitious population, India is building robust institutions and nurturing innovation. This creates opportunities across private equity, pre-IPO stages, and public listings—each with distinct risk-return profiles.

Aarth Growth fund, a Category 3 closed-end fund, leverages this opportunity through a private equity-style approach to listed MSMEs. Their toolkit includes forensic accounting and what Mr. Agarwal termed an “inversion theory,” a process of identifying potential red flags by questioning assumptions. 

In closing, Mr. Agarwal emphasised that Investors must be patient, rigorous in due diligence, and prepared for volatility in MSME Investing. Far from being “penny stocks,” MSMEs often dominate niche sectors and have the potential to graduate to main boards, scaling both revenue and market capitalisation significantly. 

Mr. Agarwal covered all the topics mentioned above in-depth and answered questions from the audience towards the end of the session. For more such insights on this webinar, watch the recording of this insightful session through the appended link below.

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Disclaimer: The content shared in this blog is for informational and educational purposes only and should not be construed as an offer, solicitation, or recommendation to invest in any Alternative Investment Fund (AIF). As per SEBI regulations, AIF investments are allowed only for investors with a minimum commitment of ₹1 crore. Prospective investors are strongly advised to carefully review the Private Placement Memorandum (PPM), including all associated risk factors, and seek independent financial advice before making any investment decision. PMS Bazaar neither endorses nor recommends any specific fund or product mentioned herein and is not responsible for any investment decisions made based on this content.