Venturing for Growth into EM

Growth has become an obsession, and rightly so. The post-recession world has at best seen only a head fake not the “global synchronized recovery”, that we were led to believe earlier this year. The onslaught of trade-wars on global supply chains is another toll on growth in the making. Businesses all over are reinventing themselves in search of growth as their traditional models are upended by a technological revolution sweeping across industries, from retailing (Amazon) to media (Netflix) to real estate (WeWork) to car rental (Uber/Lyft/Getaround) to restaurants (Blue Apron/Grubhub) and beyond. Little wonder, many investors have long been flocking to FANG stocks, though far-sighted strategic investors from Google to Goldman Sachs to Paul Tudor Jones are actively seeking direct opportunities driving change and consequently growth. Those concentrating in just FANG or BAT (in China) stocks, hoping for markets to continue according higher multiples to their growth ambitions, are exposed to market fluctuations and (now) regulatory and political risks. Short of a miracle, innovation and growth takes time and therefore investors seeking a sustainable strategy insulated from mark to market fluctuations need to have patience and adopt a longer time horizon (much like strategic investors), which inevitably guides one to private market strategies.

Private markets need no introduction to the already initiated who have gone the other extreme of endowing private equity especially DM oriented buyout, direct lending, and growth strategies with capital to the point of creating a glut with dry powder of ~$1.7 trillion, resulting from excessive capital chasing fewer, over-crowded and richly priced (11x EV/EBITDA) opportunities (Bain Private Equity 2018). And there is no stopping. Preqin’s December 2017 survey of institutional investors highlights that 92% plan to devote the same amount of capital or more to private equity in the coming 12 months, and 96% say they plan to maintain or increase their PE allocations with a preference for large mega funds encouraged by net cash flows/distributions they have enjoyed even though net asset value of PE assets might not have necessarily increased. A vicious cycle continues.

Starting from a lower base, EM led by Asia also benefitted from this dynamic and saw a growing cash pile in growth and venture capital funding especially in China. To put this in perspective, managers located in emerging economies closed nearly 600 venture capital funds and secured an aggregate $47bn in the past decade, yet it equates to only 16% and 43% of capital raised by firms based in North America and Europe, respectively (Preqin). Therefore, EM is far from DM’s dire situation as it presents a deepening pool of opportunities driven by an ever-expanding middle class fueling demands for consumerism and enabling technologies and growing infrastructure needs. Adding to this, is a growing trend of going public- to-private. While historically absent, Asia is gradually warming up to control buyouts as a generational shift is underway where families are willing to sell to financial buyers and many entrepreneurs with bigger aspirations than before, want to move on and find PE a solution to consolidate and run those businesses/adapt traditional models to the digital world. With bigger capital needs, the average companies are growing larger and allowing control transactions/path-to-control provisions, offering increased stakes from an average of 5-10% to 15-20% as well as board seats. Thus, one can see larger capital raisings though it remains to be seen if it can justify, at least at this stage, KKR’s $9.3 billion Asian Fund III (the largest-ever Asia-focused buyout fund), and Carlyle’s recently closed $6.5 billion Asia buyout fund. The typical aversion to equity dilution explains why some DM mega funds when they first arrived in say, India, had to quickly morph into private debt shops and acquire NBFC licenses to maximize their opportunity. Thus, private debt across Asia has built a better legacy than private equity where the focus has been less on buyouts and more on minority stakes in growth companies and venture capital.

Asia, home to 60% of global population, has attracted over a third of venture capital raised in EM in early stage companies over the last decade for sound economic reasons. Most industries in Asia are highly under-funded/capitalized with sufficient room for upside as many industries are growing at over 10% per annum proving a magnet for private capital (debt and equity) as public equity markets are quite sentiment-driven and debt from banks and bond markets remains a privilege for a select few. For example, according to the World Health Organization there is about $60 billion of underspend each year just to get Asia to minimum standards which makes the healthcare sector a defensive and attractive play (and partly explains the thesis of the infamous and now defunct Abraaj Fund). Capital has surely followed opportunities with Asia seeing a rising trajectory of both venture deals and deal values over the last decade across the region. More recently, Asian venture deals continue to account for over 60% of aggregate deal value across EM (40% of the global total vs. 44 % from US), with over 80% attributable to Greater China deals in internet, telecom, and software (AI, AR/VR) sectors mostly in Series A, B, D funding (Preqin).

As discussed in our last post “Trading Trade Wars”, China is making rapid strides (now with heightened fervor in the wake of US technology transfer restrictions) in a race for global technology innovation and venture capital dominance by developing emerging VC and start-up hot spots in Beijing, Shanghai and Shenzhen. With RMB capital raised locally from China’s corporates and the government as well as China’s angel investor community of wealthy first-generation tech entrepreneurs, China’s VC firms are also betting on high potential winners thus birthing a Chinese Silicon Valley. Moreover, most of the venture shops along Sand Hill Road, have formed China-specific funds and teams backing start-ups and emerging businesses. Also, China’s powerful BAT companies are spurring the action, in venture investing.  As a result, China’s share of the global venture capital market has risen from 5 percent to 24% (Dow Jones VentureSource) and R&D spending especially in artificial intelligence has surpassed the US, and is pacing to close the gap in patent filings. It’s ironical that once blamed to copy the US, Chinese upstarts Ofo and Mobike, have now spawned copycats such as LimeBike in Silicon Valley.

Both China and India boast of millions of internet and smartphone users but with half the internet penetration rate of the US. Venture investors are keen to capitalize on the untapped potential of the biggest ecommerce markets that will shape online consumer trends and create social unicorns — scaled-up solutions that can reach a billion or more people with high-quality, low-cost health care, abundant clean energy, resilient food supplies, etc. To add, Morgan Stanley’s 2017 report, notes that India is set to become a $6 trillion economy by the mid-2020s, driven in large part by digitization, technology, and venture capital. Moreover, an improving political environment has proven encouraging for its demographic dividend, consumption story and financial services opportunities. There are a handful of early-stage funds that are focusing not just on technology but on building homegrown Indian brands powered by its sizable and flourishing middle class. Concurrently, fintech remains an attractive opportunity in microlending or providing small loans to entrepreneurs who live outside the large metros.

While India and China both boast of entrepreneurs, the Indian private market opportunity is relatively much smaller today in part due to the size of its public market universe with ~7000 companies. ~ 40% of public companies are very small and/or rarely trade as many Indian promoters have been averse to equity dilution rendering corporate India quite insular for a long time. According to a McKinsey study, a $100 billion of PE capital came into India between 2001 and 2014, backing about 3,000 firms in capital-intensive industries in pre-GFC years. So too much money came into a shallow market buying into expensive valuations without a consistency of exits resulting in a disappointing experience and results. Those who did well had largely been in sectors like IT services, pharmaceuticals, financial services and consumer durables successful in assessing the quality of the promoter, the business model and the scale of opportunity. Raging capital markets and strategic activity in 2017 enabled private equity investors to show record deals, exits (trade sales and IPOs) and real cash returns to their LPs.  As a result, a handful of elite India-focused funds raised an aggregate $6 billion in 2017 (vs. all of Europe at $7.2 billion per Economist) and saw total deals valued at $26billion (Livemint), a decade-high.

While Asia gets a lot of attention, PE activity in Africa has increased significantly in the last 30 years. From a dozen or so active GPs in the region in 1990, there are currently at least 140 GPs active in Africa (Economist). Between 2010 and 2016, GPs invested around US$26 billion mainly across telecom, media, business services, energy, etc. The general shallowness of African capital markets and the high cost of debt finance positions PE to play an important role in helping to unlock and grow the potential of individual companies. PE investment in Africa tends to focus on growth capital, helping investees improve governance, and strategy, expand their footprint and contribute to the region’s broader commercial ecosystem, for example by deepening capital markets and expanding supply chains. The focus on growth capital is different from financial engineering/leveraged buyouts in other regions. Rather than buying a business, significantly increasing its debt levels, aggressively reducing costs, and exiting after a short holding period, the approach centers on holding and scaling businesses with limited (max. a third), if any, debt capital included in deal structures. This notwithstanding, PE has low penetration relative to other regions. PE fund raising is longer and deal sizes are usually smaller ($50-100million) largely explained by the small size of the overall economy. In regions like Sub-Saharan Africa it can take a longer time to exit, as most investments will be greenfield investments and therefore the average holding periods sometimes extend over eight years. Over the last decade, the MENA region leads with the most exits across EM and highest aggregate exit value driven by deals based in Israel, as depicted most recently by the $580 million trade sale of (Preqin). South Africa is the largest and most sophisticated single PE market in Africa, accounting for around 22% of concluded transactions by volume and 13% of concluded transactions by value between 2010 and 2016 (Economist) with exit options weighted toward trade sales vs. M&A and IPOs in LATAM.

With fund raising over $700 million in 2017, up 200% year on year, LATAM committed $1 billion in venture funding to startups twice the amount in 2016 (LAVCA). Co-investments accounted for almost a quarter of all VC deals and two-thirds of VC dollars invested in 2017. 25 global investors like Softbank made debut investments in LATAM, together with a growing list of global tech companies, including Amazon, Google, Facebook, etc. Brazilian rideshare 99 closed the largest publicly disclosed round of venture capital to date in Latin America, raising US$200m over two rounds from SoftBank, Didi Chuxing, and Riverwood Capital. Also, Brazil and Mexico attracted funding into later stage deals in marketplace, fintech and transportation.

Challenges, Expectations, Actions
As one may observe corporate venture capital is on the upswing as growth by acquisitions has become an important complement to organic growth to penetrate new markets and expand market share. With such corporate players (estimated by some VCs to represent about 18% of all venture deals globally and about a third of all dollars invested in venture) acting as cornerstone investors in opportunities and often offering GP-like services to other investors, traditional private fund managers face the additional challenge of competing against such strategics (with lower cost of capital), as well as their usual competitors, in order to source and secure the most attractive opportunities. As one India-based GP recently mentioned to ÊMA, “we need to stay ahead of the Chinese, who are arriving rapidly”. To add to the competition, multi-lateral agencies like ADB, IFC, CDC, etc. represent 70% of the most active investors in emerging markets. Sovereign Wealth Funds especially from the middle east and Asia are pursuing long term opportunities (mainly as direct and co investments) in venture capital, buyout, growth in Asia besides Europe and North America either on their own or through other large investors like Japan’s $100bn SoftBank Vision Fund, that has already secured $45bn in commitments from UAE’s Mubadala Investment Company and Saudi Arabia’s Public Investment Fund (PIF-also sponsor of NEOM-the kingdom’s silicon valley, part of its Giga-Project).

So, unless a manager has boots-on-the-ground in EM with a well-entrenched deal sourcing/origination network, cultural familiarity and can offer more than just capital in terms of broad industry insights, talent management, digital disruption management, and governance, it’s likely that mega funds from DM (with very successful capital raisings on the back of popular institutional support but lacking any of the above) with a focus on EM are going to be challenged. Local insights to drive value creation through margin expansion and acquiring market share for portfolio companies is more important to portfolio companies in Asia than unsustainable multiple expansion driving buyout values or sponsor to sponsor sales in the US. With strategic capital following opportunities in EM, it risks a shift in the balance of power toward star entrepreneurs adding pressure on VCs to befriend founders to secure a piece of the next hot startup giving them power to pick their investors. VC’s might also award super-voting (proportionately more than economic interest) shares which could give founders de facto control of the board making it more difficult for investors to push them out as seen in Uber’s case. While capital raising is likely to be robust, it’s important for the quality talent pool -from recruiting, training, retaining and compensating talent-to keep pace. With intra-regional differences in culture, language, politics, etc. it’s equally important to keep together teams that are spread out across various locations within a region. Maintaining an effective governance model with proper accountability is also essential. Lastly, it’s important to ensure that EM VCs adopt a conservative approach in valuing portfolio companies in the early stages and realistic values near exits.

For those who do, it reduces residual values unlike fair market values applied to buyout funds, which goes to explain why EM private equity (with more early stage and longer gestation venture and growth companies often held closer to historical/conservative values) have lower TVPI multiples in initial vintage years. Thus, EM venture funds of 2013-2015 vintage are closer to their North American and European counterparts at ~10% median net IRRs after a strong 25% + IRRs posted by funds in 2010-2012 vintage years, 10-15% more than North American and European venture funds (Preqin).  A similar picture is presented by Asian PE funds that saw 2009 vintage uptick to 15% IRR, with more recent vintages trending lower in the 10-11% range (Bain) based on conservative unrealized values. For those seeking more secure and visible cash flows driven by the same fundamentals of venture in EM, venture debt (backed by venture equity) offering mid-teen net (IRRs in dollar terms) is a viable option with the caveat that it is still a small and growing opportunity set.

Past is very likely no indication of future performance at least in EM private equity as the future is likely to be predicated more on a GP’s ability to identify/source both deals in the face of growing competition as well as create value armed with local insights. Therefore, trying to seek comfort in familiar EM focused mega funds by reviewing quartile rankings, is likely to be of little relevance going forward. For LPs renewing their commitments to PE in search of growth, it’s advisable to also venture into EM (with a tilt toward Asia), by continuing to diligence local/regional EM venture funds that meet these criteria rather than hope for growth in a changing climate for both DM private equity (now with longer-hold buyout funds) and EM focused mega-funds, who are trying to deploy their war-chests into crowded niches.

ÊMA continues to remain responsive to investors’ ongoing search for growth and is conducting independent investment audit on regional EM venture/growth specialists who can source local opportunities and leverage their local insights to create value for their portfolio companies to the benefit of LPs. Stay tuned.

Yours truly,

Kamal Suppal, CFA

Chief Investment Auditor

June 25, 2018

The above content is intended for sophisticated audiences as in institutional investors or family offices. Readers are advised that any theme or idea discussed above is not an offer to buy or sell any investment.