This article was contributed to TechCabal by Robin Butler, a partner at Sturgeon Capital, through The Realistic Optimist.
The emerging markets conundrum
Emerging markets (EMs) have struggled to gain investors’ sustained trust. Even for the shrewd operators navigating political risk, inadequate infrastructure and low buying power, one stubborn issue remains: currency depreciation.
Many EMs, including the most promising ones, suffer from a common ailment: their currencies tend to lose value over time. And generally faster than in developed markets.
In 2014, one USD was worth 8.5 Argentinian pesos. In 2023, it was worth over 800 pesos.
In 2014, one USD was worth 101 Pakistani rupees. In 2023, it was worth over 200 rupees.
In 2014, one USD was worth 168 Nigerian naira. In 2023, it was worth over 800 naira.
This poses a serious issue for investors in these markets. Their return on investment has to beat the depreciation rate. If it doesn’t, they will have lost money. If it does, but only by a bit, they might wonder if the trouble was worth it.
Yet, these markets keep galvanising investors. The macro tailwinds are promising: vigorous economic growth, young populations and a hunger for technology. So far, however, the investment vehicle that can ride those tailwinds while delivering compelling returns has remained elusive.
Most investment options in these markets remain institutional. Over the past 10 years, the MSCI Emerging Markets Index (which captures large and mid-cap representation across 24 emerging markets) achieved net annualised returns of 3.01%. The S&P 500, which measures the performance of 500 large US companies, returned 12.39% annually over roughly the same period.
The savvy investor might ask: why take a risk on emerging markets in the first place?
The EM conundrum is the following: macro tailwinds are exciting, yet available investment options seem to deliver mediocre returns once adjusted for currency depreciation. Enter venture capital (VC).
VC as a way to beat depreciation
VC takes its roots in the whaling industry, a risky but potentially lucrative business. Investing in whaling meant betting on 10 whaling expeditions with the understanding that 9 would come back empty-handed (or not come back), while one would bring back enough riches to net a return.
That same mentality applied to tech companies gave birth to VC. This entails betting only on companies with the potential and ambition to become industry leaders while accepting that most will fail. Venture capital doesn’t invest in stable, steadily growing businesses. It’s “go big or go home” by design.
From 2010 to 2016, top quartile VCs delivered an internal rate of return (IRR) of 25.6%, compared to the S&P 500’s 12.2%. Those returns suggest investing in top-quartile VCs is a great hedge against most macroeconomic headwinds. The key skill is picking the right VC managers.
This begs the question: can VC make the case for EM investing? Investing in winning tech companies seems to be a tangible way to ride macro-tailwinds, while potential returns beat depreciation by a mile.
Primed markets
The case for venture capital in EMs presupposes certain conditions. The goal is to generate outsized returns that, even when accounting for currency depreciation, beat both S&P 500 and VC returns in developed markets.
One way to do so is to fund companies that will ride EM tailwinds: a growing economy, a young population, and increased tech penetration. The companies best placed to service these trends are tech startups. More specifically, tech startups looking to become leaders in digitally virgin local verticals.
You want to fund the startup that will digitise all of Central Asia’s logistics companies, the startup that will digitally bank every Southeast Asian SME, or the startup that will pioneer telehealth for Africa. And you want to fund them extraordinarily early, to capture the extraordinary returns you’re aiming for.
Identifying the markets in which these startups exist but aren’t sufficiently funded is a subtle science. Some indicators help.
Smartphone and internet penetration above 30% is primordial. If it’s under 30%, the potential customer pool is simply too small. Once it crosses 60-70%, there is a critical mass to build digital businesses at scale.
The early presence of ride-hailing, food-delivery and digital payments apps are another great indicator. These apps don’t have to be mature, the earlier the better. What their presence conveys is that people use their phones for more than just messaging and social media. Tech startups capitalise on that new behaviour.
Lastly, you need at least a semblance of government enthusiasm for the topic. This enthusiasm can vary in fervour, but a verbal commitment to digitising the economy is a minimum.
These are the markets in which venture capital makes a lot of sense. We call them “primed markets”.
Operationally speaking, for startups
Operating a startup in these markets requires a certain nous. The challenges faced there haven’t been faced in Silicon Valley, so the playbooks haven’t been written. Founders are writing it in real-time. One of those big, novel challenges revolves around our issue of the day: currency depreciation.
Startups have two broad ways to handle depreciation, which can be combined as the company grows.
The first is to sell their product in Western markets, bringing in “stable” currency revenue. Nigerian video-on-demand startup iROKOtv has pivoted from selling to Nigerians in Nigeria to Nigerians in the West. This makes sense from an economic perspective. However, it means abandoning the EM-specific tailwinds that got founders and investors excited in the first place. It’s one way to do it, but the startup’s EM DNA erodes as a result.
The second is straightforward: grow faster than depreciation. In primed markets, startups aim to dominate digitally virgin industries. If they get it right, their growth should comfortably surpass depreciation. Sturgeon Capital’s fund I portfolio startups have grown revenues at a weighted compound annual growth rate (CAGR) of 92% in dollar terms, despite simultaneous depreciation in our markets. This math, our aim CAGR vs local depreciation rates, is built into our investment philosophy.
Operationally speaking, for VCs
VCs have to adapt in two aspects.
First, factor in currency depreciation when negotiating a startup’s valuation. VCs should factor depreciation into the founders’ USD financial projections. Doing so builds a margin of error for both the founders and investors, increasing the probability of success for both parties.
Second, VCs need to take the average exit size into account. In primed markets, the startup phenomenon is new and mechanically, so are exits. There are some exciting right-tail examples, such as IPOs from Grab (Singapore), Nubank (Brazil) and Kaspi (Kazakhstan). But realistically, the average exit size will be lower than in more mature markets. This should nudge VCs to take larger percentage ownerships in their startups, to ensure relevant returns in the case of said exit.
In these markets, valuation is the best form of risk management. Currency hedging solutions such as TCX could theoretically also be used, but they are expensive.
The adequate founders
Choosing the right founders is also tricky. That being said, promising founders will most likely fall into one of two buckets.
The first consists of foreign-educated and foreign-trained founders, who might know startup jargon like the back of their hand but might not necessarily possess localised business acumen. The other consists of locally born and trained founders, sagaciously operating locally but lacking the language and demeanour investors like to hear.
How an investor mixes and matches both types is more of an art than a science. Generally, if you have to ask yourself whether the founder is great, they aren’t.
Who is buying this thesis?
The thesis exposed so far states that VC in specific EMs, namely “primed” ones, is an appropriate vehicle to finally capitalise on their potential. As a VC, holding that thesis dear is of little use if no Limited Partner (LP) buys it. Here are the ones that are most likely to resonate.
Let’s take local money, first. Think industrial conglomerates or family offices based in a primed market. They are tough to convince. These investors typically prefer to invest in real estate or back into their business rather than funding local startups that haven’t shown exit potential (yet). However, a small window of opportunity exists in these local business magnates’ offspring.
The Western-educated heir to the business might be more inclined to see the value in tech startups. They generally have a small amount of discretionary money to invest. If they can get their foot in the door, and you deliver on your promise, maybe they can convince their father (it’s often the father) to follow suit. One last caveat: local business is often closely tied to politics. As an internationally regulated firm, taking money from politically exposed individuals will be problematic. Tread wisely.
Onto foreign investors. Who buys this thesis?
We can assume that 90% of investors simply don’t have the risk appetite or intellectual curiosity to dive into these markets. No need to try to convince them. For large institutional investors, ticket and potential exit sises might just be too small in those markets. Once again, potential investors fall into one of two buckets.
The first bucket consists of investors who have made money in other EMs. They know that being early is everything. Since startup business models across EMs tend to resemble one another, they will be reassured by investing in something they’ve already seen works elsewhere.
The second bucket consists of very large LPs looking to diversify their portfolio. They might be curious about these markets but don’t have the bandwidth to set up a fund for them, so they will entrust a specialised VC to do so.
Political risk
A common pushback when pitching foreign LPs is the political risk: what happens if there’s a coup? What happens if political instability rocks the country?
While valid points, the following also holds true: digitalisation is secular. It doesn’t pledge allegiance to any side. As long as internet penetration grows, startups will have a market despite who is in power. As seen during the pandemic, deep societal shake-ups are a nudge for people to alter their habits. In some deeply troubled countries such as Sudan, tech startups have been essential to fill the void left by crumbling legacy infrastructure.
Conclusion
Excitement surrounding EMs has often been subdued by cold facts: investments have not justified the risk associated with them. Even fast-growing businesses can have their returns wiped out by currency depreciation.
Venture capital heralds a new way. Tech value creation is a far greater force than macro-volatility. Betting early on companies digitising entire industries amidst a fast-growing economy makes sense. VCs that targeted markets such as LATAM when they were “primed” are among the most consistently high-performing across all VCs.
As the tech startup phenomenon globalises, VC in these markets is also significantly derisked. People’s needs worldwide are the same, and there’s no reason to reinvent the wheel. The more track record a business model has globally, the more enlightened founders will be at implementing it locally.
When there’s a will, there’s a way.
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Robin Butler is a partner at Sturgeon Capital, a London-based VC investing in frontier and emerging market startups. He is also on the board of several companies, including Trukkr (Pakistan) and Bills (Uzbekistan).
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The Realistic Optimist is a paid newsletter covering the globalised startup scene. The Realistic Optimist’s work is provided for informational purposes only and should not be construed as legal, business, investment, or tax advice.
