Sunrise sectors

A sunrise sector is one that is only beginning. It has little history, few listed comparables and no settled economics. What it has is growth.

The workbook names the ones Indian alternative investors are positioning for. New-generation technologies and ESG are the two headings. Under them sit artificial intelligence as a subset of machine learning, virtual reality and artificial reality, green energy and renewables, sustainability and ecological conservation, and social justice and empowerment.

These are the sectors around which AIF themes are being built for the future.

The attraction is stated in the same chapter. Emerging markets are where growth and innovation happen, and there are large opportunities in handholding new ventures in sunrise industries. An investor who arrives early can earn first-mover returns.

But sunrise sectors also bend the valuation maths, and that is where the exam lives. A company with a long runway of growth ahead of it justifies a higher terminal growth rate — and the terminal growth rate can drive almost the whole answer.

Where the term is introduced. Chapter 2, section 2.3.6 (Other investments). With the emergence of new-generation technologies and ESG (Environment, Social and Governance) as sunrise sectors for investment themes, several alternative investors have started to position themselves for these sectors. The named sunrise sectors are:

• AI (Artificial Intelligence) as a subset of machine learning;
• Virtual Reality and Artificial Reality;
• Green energy and renewables;
• sustainability and ecological conservation; and
• social justice and empowerment.

Why alternatives go there (Chapter 2). While there are new opportunities in developed markets, emerging markets are the hot bed of growth and innovation, especially in emerging sectors. To generate superior returns it is necessary to look beyond traditional investments. There are large opportunities in handholding new ventures in sunrise industries and technologies, and in structured products emerging from these markets. Asset allocators should not miss out on improved diversification and stellar early or first-mover returns — high returns from investing early into new asset classes.

Where it changes the arithmetic (Chapter 12, section 12.6). In a DCF, the terminal value captures everything after the forecast period:

Terminal Value of FCF = FCF(T+1) / (WACC - g)

The workbook's guidance on g is specific. Terminal growth rates for consolidated industries are normally taken at 2-3% above the inflation rate, so if inflation is 3%, the growth rate could be about 5-6%. Its own worked example uses g = 5% with a WACC of 11.35%.

Then comes the exception that matters here: in high growth or sunrise industries which are expected to maintain significant growth for a long period of time, there is a justification to take higher terminal growth rates.

The workbook immediately warns why this is dangerous. The terminal growth rate is very significant as it influences the value of shares almost all by itself in young companies — and since venture capital and private equity funds deal with young, growing unlisted companies, g may be the single most important parameter the investor has to consider in a DCF.

And the cost of capital pulls the other way. For an unlisted company the cost of equity is built from CAPM but adjusted for the illiquidity premium of alternative assets and any further specific risk premium — so the cost of equity of an unlisted company is higher than that of a comparable listed company. A sunrise company therefore gets a higher g and a higher WACC at the same time, and the two move terminal value in opposite directions.

The company and its cash flow are illustrative; the terminal value formula, the 2-3%-above-inflation guidance, the 3% inflation and 5-6% range, the 5% growth rate and the 11.35% WACC are the workbook's.

Meridian Growth Fund is valuing Kaveri Green Hydrogen Pvt Ltd, an unlisted company in a sunrise sector. The DCF forecast period is 5 years and free cash flow in Year 5 is Rs 40 crore. The WACC is 11.35%, built as the workbook builds it — CAPM cost of equity, adjusted upward for the illiquidity premium of an unlisted alternative asset.

Case A — treat it as a consolidated industry. Inflation is 3%, so a terminal growth rate of 5% is within the workbook's 2-3%-above-inflation guidance, and matches its own worked example:

FCF(T+1)      = Rs 40 crore x 1.05          = Rs 42.00 crore
WACC - g      = 11.35% - 5.00%              = 6.35%
Terminal Value = Rs 42.00 crore / 0.0635    = Rs 661.42 crore

Case B — take the sunrise justification. The company is expected to maintain significant growth for a long period, so the analyst takes g = 7%:

FCF(T+1)      = Rs 40 crore x 1.07          = Rs 42.80 crore
WACC - g      = 11.35% - 7.00%              = 4.35%
Terminal Value = Rs 42.80 crore / 0.0435    = Rs 983.91 crore

What two percentage points bought:

A 2-point change in a single assumption moves the terminal value by nearly half. And terminal value is usually the bulk of a DCF for a young company, so it moves the whole valuation by nearly as much.

Why the denominator does it. At 5%, the gap between WACC and g is 6.35%. At 7% it is 4.35% — a third narrower. Push g to 9% and the gap is 2.35%, giving a terminal value of about Rs 1,855 crore, nearly three times Case A. That is exactly what the workbook means when it says the terminal growth rate influences the value of shares almost all by itself in young companies.

So the discipline is to say what you assumed. A fund writing an investment proposal for Kaveri records g = 7% and the reason — a sunrise sector expected to sustain growth for a long period — rather than presenting Rs 984 crore as a fact. On a Rs 45 crore cheque for a stake, the difference between Case A and Case B is the difference between a fair price and an expensive one.

Chapter 2, section 2.3.6 introduces sunrise sectors and names them; Chapter 2 also supplies the first-mover-returns rationale. Chapter 12, section 12.6 (the DCF method) is where the term earns marks, in the guidance on terminal growth rates.

Expect from Chapter 2: which sectors are named as sunrise — a list question where ESG, AI, VR, green energy, sustainability and social empowerment are the right answers. Expect from Chapter 12: the 2-3% above inflation guidance and the 5-6% figure it produces at 3% inflation, the justification for a higher terminal growth rate in high-growth or sunrise industries, and the warning that g drives the value of shares almost by itself in young companies. A numerical question can hand you FCF, WACC and two values of g.

• Sunrise justifies a higher terminal growth rate; it does not fix one. The workbook gives 2-3% above inflation for consolidated industries and says only that higher rates are justified for sunrise industries. No sunrise number is stated — do not invent one.
• The higher g comes with a higher WACC. An unlisted company's cost of equity is CAPM adjusted upward for an illiquidity premium and any specific risk premium. Raising g while keeping a listed-company WACC is double counting in your favour.
• The condition is sustained growth, not fast growth. The justification applies to industries expected to maintain significant growth for a long period of time.
• Terminal value is hypersensitive because of the denominator. The gap between WACC and g, not g itself, drives the multiple. That is why a 2-point move in g can add nearly 50%.
• ESG is listed as a sunrise sector here. In this workbook ESG appears as an investment theme alongside new-generation technologies — not only as a risk screen.
• Sunrise sector is not the same as a thematic fund or a sector fund. Those are product structures from other papers. A sunrise sector is a stage-of-development description of an industry.
• First-mover returns are a stated attraction, not a promise. The same chapter that offers stellar early returns also puts art, collectibles and distressed securities in the list of investments needing specialised knowledge.