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An Introduction to Venture Capital in Emerging Markets

December 02, 2018
Historically, private capital in emerging markets has remained scarce.[1] Whether as a result of political uncertainty, alternative opportunities in developed markets, or other matters of this sort, raising funds in such environments has proven difficult. In recent years, emerging markets have exhibited strong growth. From the latter half of Fiscal Year 2016 through Fiscal Year 2017, the world experienced a period of synchronous global economic expansion unparalleled in recent history (with equity markets leading the charge).[2] However, amidst increasing trade concerns, a rising U.S. interest rate environment, and significant currency devaluation in key developing economies (e.g. Thailand, Argentina, and Turkey), emerging markets may be posed to give up recent gains.[3]

Across the emerging market space, investors have begun to ask whether the largest quarterly decline in emerging market debt on record and systemic currency/equity weakness represent the “canary in the coal mine” for global economic growth, or, rather, an aberration from the norm.[4] The million-dollar question is, “Do we risk contagion?”

Image: Weakness in Turkish lira, 3-year bond yield, and sovereign credit default swap (CDS) spread as of 08/06/18. Source: The Wall Street Journal

Image: Weakness in Turkish lira, 3-year bond yield, and sovereign credit default swap (CDS) spread as of 08/06/18. Source: The Wall Street Journal

Image: Weakness in Turkish lira, 3-year bond yield, and sovereign credit default swap (CDS) spread as of 08/06/18. Source: The Wall Street JournalImage: Weakness in Turkish lira, 3-year bond yield, and sovereign credit default swap (CDS) spread as of 08/06/18. Source: The Wall Street Journal

 

One sector where these concerns have been particularly acute is venture capital (VC). VC funds pool investor capital and invest private equity stakes in small and medium-sized enterprises (SMEs) with strong potential for growth.[5] However, beyond contributing capital, many VCs offer value-add in the form of development/management expertise. In return, depending on the size of the VC fund’s equity stake, it may sit on a company’s board of directors or, even, reserve the right to select management. Via these stakes, fund managers seek high capital gains, regardless of whether or not cash flow is positive or negative.[6] Consequently, investment horizons tend to be long-term (7-10 years) and the investments themselves illiquid. Following suit, the markets and business segments in which VC firms operate are neither broad-based nor easily accessible.

In the late 2000s, following domestic economic turmoil and intense competition in Silicon Valley, both U.S. and international VC investors began to look for new, attractive opportunities in markets abroad. In a process known loosely as “geo-arbitrage” or “tropicalization,” VC funds began to “back start-ups that take an established business model and adapt it to an emerging market.”[7] Well-known success stories can be seen with Flipkart (an Indian e-commerce site similar to Amazon in which Walmart acquired a ~77% stake in May 2018 for ~$16 billion), Baidu (a Chinese internet company similar to Google), or Alibaba (a Chinese online auction site comparable to eBay).[8][9] Now, however, new opportunities are also beginning to appear in other more fringe, regional markets, such as Latin America, Southeast Asia, and, to a lesser degree, Africa and the Middle East.

The impetus for this pivot to VC in emerging markets is because “venture capital is experiencing problems in its traditional markets.”[10] Valuations in high growth potential start-ups have become increasingly stretched, making it more difficult to generate returns. Moreover, shifting to emerging markets allows for more room to operate simply due to fewer present actors. While opportunities abroad abound, capital has, in part, remained scarce. As of May 2018, “managers located in emerging economies have closed nearly 600 venture capital funds and secured an aggregate $47 billion in the past decade, yet these figures equate to only 16% and 43% of capital raised by firms based in North America and Europe, respectively.”[11] Closer analysis of these statistics reveals, however, that this growth has been uneven.

While geographic differences have been surprisingly limited, funds that have successfully raised capital have been overwhelmingly early-stage focused. Funding at seed, Series A, and Series B stages is critical to start-up development, corresponding to proof of concept, revenue traction, and unit profitability, respectively.[12] With high return expectations (potentially as large ~50x) for these earlier rounds, capital, while limited as compared to developing markets, has been relatively accessible. However, Series C+ funding, which is necessary for achieving scale, and pre-IPO bridge funding, has been lacking.[13] Such a gap has hindered the potential for growth and now poses a significant developmental obstacle for SMEs operating outside of developed markets. Entrepreneurs are faced with difficult choices: either remain developmentally stunted, stagnating into eventual obscurity, or change their modus operandi.

Image: Trends in capital raised by emerging markets focused venture capital fund managers, Source: Preqin

Image: Trends in capital raised by emerging markets focused venture capital fund managers, Source: PreqinImage: Trends in capital raised by emerging markets focused venture capital fund managers, Source: Preqin

As aforementioned, “tropicalization” can be a viable business model. For example, in the greater Southeast Asian region, U.S. ride-sharing business Uber lost out to its local competitor Grab, formally exiting the market in March 2018 (largely due to Grab’s knowledge of and adaptation to local market trends).[14] However, especially with technological disruption (the overwhelming focus of many VC firms’ investments), potent risks exist.

“Copycats can easily lose share when the original company eventually enters the local market. Sonico, once the Facebook of Latin America, got ‘pummelled’ when Facebook arrived,” says Nenad Marovac of DN Capital, which was behind Sonico. “With innovation you have a global upside, but with copycat innovation you have geographical limits,” says Eric Archer of Monashees Capital, a Brazilian venture firm.[15]

The next logical conclusion, then, is to look to invest in emerging markets SMEs and entrepreneurs that, rather than mirroring innovation in the developed world, are creating their own tools and technologies. From next-generation robotics to manufacturing advances, to even emergent AI, the stage is already set for newfound growth. Instead of looking inwards, it is time to look outwards. The million-dollar questions we need to be asking are, “What is next? Who is next? And, finally, where are we going?” Grab your passport.

Student Blog Disclaimer
  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Penn Wharton Public Policy Initiative’s strategies, recommendations, or opinions.

References

  [1]https://porticoadvisers.com/wp-content/uploads/2018/03/portico-advisers-the-evolution-of-private-equity-in-emerging-markets.pdf

  [2]https://www.cnbc.com/2017/07/05/the-global-economy-is-doing-something-it-hasnt-done-in-7-years.html

  [3]http://www.lazardnet.com/us/docs/sp0/145/LazardOutlook_EmergingMarkets_2015Q4.pdf?pagename=Outlook

  [4]http://www.lazardnet.com/us/docs/sp0/145/LazardOutlook_EmergingMarkets_2015Q4.pdf?pagename=Outlook

  [5]https://openknowledge.worldbank.org/bitstream/handle/10986/11611/multi_page.pdf?sequence=1&isAllowed=y

  [6]https://openknowledge.worldbank.org/bitstream/handle/10986/11611/multi_page.pdf?sequence=1&isAllowed=y

  [7]https://www.economist.com/finance-and-economics/2012/06/02/vc-clone-home

  [8]https://www.economist.com/finance-and-economics/2012/06/02/vc-clone-home

  [9]https://www.forbes.com/sites/sharanyaharidas/2018/05/09/walmart-acquiring-flipkart-16b-india-loves-hates-amazon/#1e0d4052d72d

  [10]https://www.economist.com/finance-and-economics/2012/06/02/vc-clone-home

  [11]https://www.valuewalk.com/2018/05/venture-capital-in-emerging-markets/

  [12]http://docs.preqin.com/press/Emerging-VC-May-18.pdf

  [13]http://docs.preqin.com/press/Emerging-VC-May-18.pdf

  [14]https://www.wired.com/story/ubers-grab-on-the-developing-world/

  [15]https://www.economist.com/finance-and-economics/2012/06/02/vc-clone-home

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  • <h3>The Penn World Table</h3><p> The Penn World Table provides purchasing power parity and national income accounts converted to international prices for 189 countries/territories for some or all of the years 1950-2010.</p><p><a href="https://pwt.sas.upenn.edu/php_site/pwt71/pwt71_form.php" target="_blank">Quick link.</a> </p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>National Center for Education Statistics</h3><p><strong><img width="400" height="80" alt="" src="/live/image/gid/4/width/400/height/80/479_nces.rev.1407787656.jpg" class="lw_image lw_image479 lw_align_right" data-max-w="400" data-max-h="80"/>The National Center for Education Statistics (NCES) is the primary federal entity for collecting and analyzing data related to education in the U.S. and other nations.</strong> NCES is located within the U.S. Department of Education and the Institute of Education Sciences. NCES has an extensive Statistical Standards Program that consults and advises on methodological and statistical aspects involved in the design, collection, and analysis of data collections in the Center. To learn more about the NCES, <a href="http://nces.ed.gov/about/" target="_blank">click here</a>.</p><p> Quick link to NCES Data Tools: <a href="http://nces.ed.gov/datatools/index.asp?DataToolSectionID=4" target="_blank">http://nces.ed.gov/datatools/index.asp?DataToolSectionID=4</a></p><p> Quick link to Quick Tables and Figures: <a href="http://nces.ed.gov/quicktables/" target="_blank">http://nces.ed.gov/quicktables/</a></p><p> Quick link to NCES Fast Facts (Note: The primary purpose of the Fast Facts website is to provide users with concise information on a range of educational issues, from early childhood to adult learning.): <a href="http://nces.ed.gov/fastfacts/" target="_blank">http://nces.ed.gov/fastfacts/#</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>Federal Reserve Economic Data (FRED®)</h3><p><strong><img width="180" height="79" alt="" src="/live/image/gid/4/width/180/height/79/481_fred-logo.rev.1407788243.jpg" class="lw_image lw_image481 lw_align_right" data-max-w="222" data-max-h="97"/>An online database consisting of more than 72,000 economic data time series from 54 national, international, public, and private sources.</strong> FRED®, created and maintained by Research Department at the Federal Reserve Bank of St. Louis, goes far beyond simply providing data: It combines data with a powerful mix of tools that help the user understand, interact with, display, and disseminate the data.</p><p> Quick link to data page: <a href="http://research.stlouisfed.org/fred2/tags/series" target="_blank">http://research.stlouisfed.org/fred2/tags/series</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>USDA Nutrition Assistance Data</h3><p><img width="180" height="124" alt="" src="/live/image/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg" class="lw_image lw_image485 lw_align_right" srcset="/live/image/scale/2x/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg 2x, /live/image/scale/3x/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg 3x" data-max-w="1233" data-max-h="850"/>Data and research regarding the following <strong>USDA Nutrition Assistance</strong> programs are available through this site:</p><ul><li>Supplemental Nutrition Assistance Program (SNAP) </li><li>Food Distribution Programs </li><li>School Meals </li><li>Women, Infants and Children </li></ul><p> Quick link: <a href="http://www.fns.usda.gov/data-and-statistics" target="_blank">http://www.fns.usda.gov/data-and-statistics</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
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  • <h3>Internal Revenue Service: Tax Statistics</h3><p><img width="155" height="200" alt="" src="/live/image/gid/4/width/155/height/200/486_irs_logo.rev.1407789424.jpg" class="lw_image lw_image486 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/155/height/200/486_irs_logo.rev.1407789424.jpg 2x" data-max-w="463" data-max-h="596"/>Find statistics on business tax, individual tax, charitable and exempt organizations, IRS operations and budget, and income (SOI), as well as statistics by form, products, publications, papers, and other IRS data.</p><p> Quick link to <strong>Tax Statistics, where you will find a wide range of tables, articles, and data</strong> that describe and measure elements of the U.S. tax system: <a href="http://www.irs.gov/uac/Tax-Stats-2" target="_blank">http://www.irs.gov/uac/Tax-Stats-2</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>National Bureau of Economic Research (Public Use Data Archive)</h3><p><img width="180" height="43" alt="" src="/live/image/gid/4/width/180/height/43/478_nber.rev.1407530465.jpg" class="lw_image lw_image478 lw_align_right" data-max-w="329" data-max-h="79"/>Founded in 1920, the <strong>National Bureau of Economic Research</strong> is a private, nonprofit, nonpartisan research organization dedicated to promoting a greater understanding of how the economy works. The NBER is committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.</p><p> Quick Link to <strong>Public Use Data Archive</strong>: <a href="http://www.nber.org/data/" target="_blank">http://www.nber.org/data/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>Congressional Budget Office</h3><p><img width="180" height="180" alt="" src="/live/image/gid/4/width/180/height/180/380_cbo-logo.rev.1406822035.jpg" class="lw_image lw_image380 lw_align_right" data-max-w="180" data-max-h="180"/>Since its founding in 1974, the Congressional Budget Office (CBO) has produced independent analyses of budgetary and economic issues to support the Congressional budget process.</p><p> The agency is strictly nonpartisan and conducts objective, impartial analysis, which is evident in each of the dozens of reports and hundreds of cost estimates that its economists and policy analysts produce each year. CBO does not make policy recommendations, and each report and cost estimate discloses the agency’s assumptions and methodologies. <strong>CBO provides budgetary and economic information in a variety of ways and at various points in the legislative process.</strong> Products include baseline budget projections and economic forecasts, analysis of the President’s budget, cost estimates, analysis of federal mandates, working papers, and more.</p><p> Quick link to Products page: <a href="http://www.cbo.gov/about/our-products" target="_blank">http://www.cbo.gov/about/our-products</a></p><p> Quick link to Topics: <a href="http://www.cbo.gov/topics" target="_blank">http://www.cbo.gov/topics</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>