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

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

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.

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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.