Emerging Markets Private Equity and Venture Capital

Emerging Markets Private Equity and Venture Capital

Venture Architecture
May 4, 2018

When developed markets become over-saturated many institutional investors turn their attention towards emerging markets. International exchanges host a myriad of companies that may seem completely alien to most investors, however the bulk of the regional business value may not even be represented. Many countries stock exchanges do not function with the same efficacy as they do in Western Europe or North America. Fundraising through an IPO isn't worth the trouble. Companies have other means of securing finance: government grants, bank loans, and organisation loans are the primary mechanisms by which companies seek financing, while the preferred methods are still through angel investors, and family and friends loans.  Most companies will never even hear or consider crowdfunding or ICOs as prospective funding alternatives.

Emerging Market Start-Ups and SMEs

In the start-up scene most Southern Eastern European (SEE) firms seek to draw the attention of a foreign investor representing a venture capital fund, or an angel investor that may take them abroad. Many foreign venture capital funds come to emerging markets to find start-ups that could bring something new to their own developed markets. In fact, 51% of US companies reaching a valuation of 1 B USD are founded by immigrants (source). However, venture capitalists are limited when they do find prospective businesses abroad by a few constraints. Distance and time difference are a huge influence as well as the lack of local connections the backer usually has abroad compared to their domestic reach. Most VCs wait until a firm has grown domestically, assess scalability, and then offer assistance in entrance to their own market - after all VCs are generally hands-on.

Getting in on the 5th floor in a company isn't as good as getting in on the ground floor, but is still better than missing out.

Private equity funds offer an alternative form of financing that is able to help companies that seek additional capital, domestic support, and are looking to expand internationally. Companies are able to commit their unlisted shares to the firm's management, splitting profits, and growing under their watchful eye. The business owner not only receives the benefit of funding and operational and managerial expertise, but they also diversify away a lot of their company risk. Private equity in emerging markets is a serious venture, but the downside for new businesses is the limited investment scope of most PE firms.

Two Types of Private Equity

Many PE firms, seeking acquisition for their own equity funds, aim either to create an instrument out of their fund for institutional investors, or to act in favour of their own growth as an activist fund. When an emerging market private equity fund narrows its investment focus to an industry sector or style it removes itself from any start-up or seed-round investment phases. Its goals are in creating a risk-adjusted investment vehicle with a stable IRR and a diverse portfolio of assets. The fund draws in capital from foreign investors, insurance companies, and pension funds, and serves the purpose of facilitating a controlled emerging markets exposure for other IFIs. Of course, a generous management fee will follow suit.

Alternatively, activist PE firms/funds will focus on majority stakes in companies, and attempt to grow the business dynamically and stay invested for longer periods of time. Their ultimate goal is to invest into any already established company that has high (speculatively high) growth potential. Investors of activist PE firms are commonly other funds, high net worth individuals, and registered investors with significant capital and lower risk aversion. Emerging market PE funds will also focus on potentially preparing the company to scale internationally. Foreign venture capital funds have been known to work with activist PE firms in using them as a local investment vehicle for their own capital. For instance, a domestic PE fund and a foreign VC fund may co-invest in a venture under an agreement where the PE firm acts as the asset management company using VC capital.

The challenge in finding under-financed and operationally sound companies in emerging markets is also difficult to overcome even for asset management companies with extensive regional experience.

Some issues encountered by SMEs in emerging markets are:

  • Lack of company policy, clear outlines, and operational goals.
  • Emotional connections built around business between suppliers and producers make transparency difficult to achieve.
  • Lack of proper bookkeeping and accounting records.
  • No established business, investment, or succession plans.
  • Many business run under the direct hands-on management of a single person. Although the business might be successful - only the owner knows what truly happens within the company.
  • Signs of complacency in management through mediocre performance.
  • High levels of debt.

Other challenges encountered in emerging market companies that have been mismanaged:

  • Poor past financing strategies.
  • Legal issues effecting potential future results imposed on the owner.
  • Land disputes with the government.
  • Poor employee training.
  • Lack of corporate social responsibility.

Private equity funds must either prevent issues arising in rising SME companies or look for turnaround companies. Venture capital companies often lose interest after the initial growth phase of an emerging market company, and seldom fund at-risk turnarounds.

Although many successful start-ups have been founded by people from emerging market countries there is little interest in VC involvement in emerging market start-ups beyond funding through PE initiatives. Since VC tends to focus on innovation and funding for future growth into large market capitalisation, it does not make sense to pursue endeavours in regions where the market is very small if the product is not transferable. Identifying scalable and transferable ideas remains very difficult for VCs without the companies approaching them directly.