USAID Southern Africa is piloting new approaches to deepen capital markets in Southern Africa
By Benjamin Butcher, INVEST Activity Associate
The Venture Capital model that has made Silicon Valley synonymous with technological innovation has inspired investors to apply similar financial approaches to emerging markets. In return for an ownership stake in the company, venture capitalists inject large infusions of money into small businesses with innovative ideas, from ridesharing to e-commerce, so that they can grow rapidly and gain market share. In developing nations, the thinking has been that venture capital can provide the funding required for new businesses to succeed, and the success of these businesses will help emerging markets overcome existing challenges, such as fragmented markets, high unemployment, and expensive or unavailable financing.
But investors living and working across Africa have noticed a trend: Silicon Valley styled investment vehicles aren’t producing Silicon Valley results. They’ve started to ask, “Why not?”
Silicon Valley may be known for its success stories, but for every unicorn there are countless concepts that never make it to market. It is a high-risk, high-return approach. To turn a profit, the returns from one successful venture need to outweigh the losses from eight or nine other companies in the portfolio. This “spray and pray” approach to investing has had tremendous success in markets swollen with capital and comprised of a wealthy, digital consumer base.
Markets throughout Africa have little in common with their American counterparts. According to a new report discussing early stage investing in the continent, African markets tend to have a consumer base with lower purchasing power, fragmented physical and digital infrastructure, and a risk environment often unfamiliar to international investors. However, that doesn’t mean that there isn’t opportunity for investors. As the report also explains, these very same challenges — large, unexploited, and rapidly growing markets; the need for locally sourced innovations; and the highly variable markets (e.g., income, rural v. urban) — actually create opportunities and make Africa an incredible testbed for innovation applicable to countries around the globe.
And while the opportunities are vast and significant, they don’t often look like an ideal Silicon Valley investment that scales quickly and delivers outsized returns. Big cash injections for equity with a five-year time horizon also don’t meet the needs of many African small and medium-sized enterprises (SMEs) and startups. These companies may seek smaller raises and more patient equity capital. Or, perhaps it’s a long-term working capital loan with less stringent collateral requirements that the company needs. Yet, in Africa, these types of funding aren’t easily available.
Globally, SMEs face a $4.5 trillion financing gap. In the last decade and a half, they have raised an estimated $57 billion, a mere two percent of the amount needed. In Sub-Saharan Africa alone, the formal SME financing gap is an estimated $245 billion. The current data suggests that current financing approaches are not mobilizing capital at the pace necessary to close this gap.
New Approaches for Persistent Problems
The USAID Southern Africa Regional Mission has teamed up with USAID INVEST to support a portfolio of four activities, implemented by two first-time and two well-established fund managers, to pilot and prove approaches that provide SMEs with the capital they need to grow on their own terms. A thriving SME sector can help address development challenges by increasing employment, creating the ability to procure goods and services locally, and improving the quality of living for families and communities.
In these partnerships, USAID support takes the form of catalytic funding. Catalytic funding is a form of funding that helps improve the risk-return profile of a transaction, thereby crowding private investors into deals that generate positive development impact.
In this portfolio, catalytic funding takes two forms, catalytic capital and operational funding. Catalytic capital support from USAID enables fund managers to build a first-loss layer into their vehicle’s capital structure, which protects private investors by absorbing losses should the investment not turn out as forecasted. Operational funding lowers the cost of launching new financial vehicles and conducting outreach to investors to raise capital. Defraying operational costs enables investment managers to devote time to new concepts and can offset a portion of management fees, making the deal more attractive for potential investors. Both catalytic capital and operational funding can have a dual effect — catalyzing additional investment into high-impact opportunities and deepening the local ecosystem by supporting the development and expansion of new funds and investment vehicles.
From more flexible investment mandates, sustainable structures and new financial instruments, USAID’s support to these four innovative investment vehicles aims to drive inclusive economic growth in Southern Africa and mobilize an anticipated $24 million in private sector investment to support small and medium enterprises and emerging farmers in the region.
In 2019, St John Bungey, now an Investment Committee Member at Creative CFO — a business management advisory firm turned first-time fund manager— worked with Brett Mallen on Breaking the Mold, a research report that aimed to identify alternative models that could break the mold of traditional fund management and unlock appropriate levels of finance for SMEs in emerging and frontier markets.
“We knew that funding SMEs out of traditional fund structures was just not working in Africa,” he says.
Their findings suggest that in traditional investment models, the high cost to invest in SMEs in emerging markets, due to the small deal size compared to the potential return, is partly responsible for the muted success of investing in SMEs in Africa.
Bungey recognized that South African challenges require homegrown solutions.
“While working on the report, I met the team at Creative CFO, who were seeing the same things in the market,” Bungey says. “We were able to take the lessons from the research and apply them to their new Fund.”
Conventional investment mandates often limit a fund manager’s offering to a single investment product, whether debt or equity, targeted at a specific stage or size of business. Instead of following these traditional investment mandates, Creative CFO structured their first fund, Creative Growth Capital Fund I, to offer an assortment of financial instruments, ranging from traditional debt, equity, and mezzanine structures to tailored instruments like working capital, short-term loans, asset-based financing, revenue-based investing and convertible note agreements. This approach allows each investment to be structured to promote the unique growth requirements of each portfolio company that Creative CFO plans to support.
To help raise capital for its first Fund, USAID support enabled Creative CFO to build a tranche of first-loss capital into the Fund that significantly improves the traditional risk-return profile for commercial investors. Creative CFO also provided a second-loss investment. Combined, these two layers will significantly de-risk investments and improve the risk-return profile for commercial investors. The Fund will invest in SMEs across South Africa to create well-paying jobs and promote inclusive business practices for women and marginalized groups.
Another constraint of the Silicon Valley model is the inflexible investment horizon of fixed-term funds. In other words, fund managers must exit deals after a predetermined period, regardless of whether the investment has reached its potential. While well-suited for developed markets where investors can easily make subsequent investments into the company, fixed-term funds are not well suited for some sectors in emerging market.
“The fund concept with a predetermined life hasn’t really worked very well for investments in primary agriculture,” says Goncalo Neves-Correia, CEO of Third Way Africa, an asset manager and advisory firm.
ThirdWay Africa has structured and deployed the ThirdWay Africa Rural Development Corporation (RDC), a permanent capital vehicle that aims to solve for some of the challenges traditional funds have encountered in agriculture. Neves-Correia explains, “A permanent capital vehicle offers longer-term flexibility and doesn’t force a fixed life of the investment horizon of the overall vehicle, as a private equity fund would have.”
USAID’s support will enable ThirdWay Africa to develop and apply Environmental, Social, and Corporate Governance (ESG) and Impact policies to their investments, facilitating community-investor partnerships that are commercially viable and mutually beneficial. The vehicle will invest in the enabling conditions required for successful agriculture, including access to inputs, irrigation and markets, starting in rural Mozambique and expanding to other countries in Southern Africa.
ThirdWay has an ambitious vision to knit smallholder farmers together into independent, mid-sized nucleus farms, creating a scalable model of agribusiness that combines community impact, environmental stewardship, and a sustainable commercial outlook. The idea is that the farms selected for investment will become a center of economic activity for the rural communities in which they operate, attracting other investment into other development-aligned projects, such as infrastructure, food security, and energy projects.
With a sustainable foundation rooted in their ESG and Impact standards, ThirdWay Africa is receiving additional USAID support to develop a range of marketing materials, financial models, and outreach strategy to engage investors and raise capital for the Rural Development Corporation.
Debt financing in Southern Africa can be very expensive for growth stage companies and usually requires hefty collateral that many companies and their owners simply do not have. Meanwhile, equity financing can be highly dilutive as a result of risk aversion in emerging markets, and investors may require businesses to give away a lot of equity in early fundraising rounds. With heavy ownership dilution, entrepreneurs can lose control over the direction of their company. Linea Capital’s team recognized that the perception of South Africa as a high-risk environment causes equity investors to ask for even larger stakes than in other emerging markets abroad. Clearly, existing instruments are not always adequate for the needs of many local businesses seeking affordable growth capital.
“Linea Capital started off five years ago on the hypothesis that there were different and innovative ways of financing high-growth entrepreneurs within a Southern African and broader African context,” explains Julia Price, director at Linea Capital.
After extensive research, Linea Capital’s team landed on a potential solution: revenue-based financing, an investment instrument that is repaid over time through a fixed percentage of a company’s future revenue stream. Instead of a predetermined lifespan, the time to repay depends on how much revenue the company generates over time. While other funds offer traditional debt or equity lending with repayments tied to revenue, Linea will exclusively offer revenue-based financing. By centering around a “built-for-purpose” revenue-based finance instrument, Linea aims to offer a new product in Southern Africa that is complementary to the capital needs of both financiers and growth-stage firms that need additional financing but can’t take on any more debt or equity.
“This model could change the way high-growth companies are funded [in Southern Africa],” Price says, “but we have to get the tax and legal structures right.”
New approaches are costly to launch and carry more risk for investors. That’s where USAID comes in. Their support is funding the legal and tax groundwork necessary to structure and launch the revenue-based financing model. USAID is also de-risking participation for investors by supporting Linea to blend first-loss capital alongside commercial capital into each investment. The tranche of first-loss capital absorbs initial losses in the case of a default. This sort of risk-mitigation is critical to encourage investors to engage with unfamiliar approaches, particularly in emerging markets.
Deeper Capital Markets
According to Allison Collier, managing director of Endeavor South Africa’s Harvest II Fund, one persistent problem is that “there isn’t sufficient liquidity in the Southern African VC market to adequately finance Southern African businesses that are looking to scale.”
Learning from the experience of their Harvest I Fund, Endeavor South Africa, a non-profit that identifies and supports innovative, high-impact entrepreneurs in emerging markets scale rapidly, is launching a follow-on fund to finance high-growth Endeavor SA firms which are key to driving local revenue growth and job creation.
In the United States, venture capital funds typically inject large amounts of capital into a portfolio of businesses, expecting a small subset to grow exponentially and generate returns quickly. This model doesn’t meet the needs of African companies, which often aim for steady growth and need smaller injections of more patient capital to achieve growth targets. Unfortunately, fund managers must cover a fund’s operational costs, and larger fund sizes often prove more viable because the traditional VC fee arrangement, the “2 and 20” model, means that the two percent management fee is enough to cover the fund’s overhead.
With Harvest Fund II, Endeavor aims to use a co-investment model to adjust the fund economics so that its operating model both aligns with the needs of investors and its portfolio companies. Endeavor has refined a rigorous entrepreneur selection and mentoring program that’s yielded a pipeline of vetted, impact-oriented high-growth firms in South Africa with a need for equity capital. The co-investment model is designed to connect this quality pipeline with investors that have capital ready to deploy. These investors leverage Endeavor’s selection process and the ongoing business mentoring provided by Endeavor, which minimizes both investors’ costs and operational risk.
Under Harvest Fund II, Endeavor acts as the follow-on investor instead of a lead investor. Lead investors set the price and terms of the investment, which requires the investor to incur due diligence costs for necessary financial analysis and valuation, legal advice, and price negotiation. As a result, the lead investor will have control over the terms of the Fund’s investments, and Endeavor will match the terms. Through the co-investment structure, both Endeavor and its co-investors benefit from lower costs, which allows for a more scalable fund that can still deliver the smaller check sizes dictated by the needs of local investment climate. Harvest Fund II will invest in four times as many companies than Harvest Fund I.
USAID Southern Africa’s catalytic contribution will cover the operational costs of launching the fund and conducting outreach to investors, which enables Endeavor to waive the success fees typically imposed on investors for the set-up of a fund and cap the management fees thus creates more attractive investment terms for commercially minded investors. In addition, Endeavor will reinvest its 20 percent carry into supporting the next cohort of Endeavor SA portfolio companies, thereby making the model sustainable without future USAID funding.
Endeavor’s approach, Collier says, will “shine a light on both the commercial returns and impact, in the form of revenue growth and job creation that firms in the region generate, attracting more private investors and creating a more sustainable entrepreneurial environment in Southern Africa.”
Endeavor’s investments aim to add hundreds of jobs and grow high-impact firms, first in South Africa and then throughout the broader region.
The Path Forward
Catalytic funding, when deployed by donors like USAID, can help pilot and discover new solutions for persistent problems in emerging markets that traditional investment mechanisms to date, have been unable to solve.
With this funding, USAID can test and evaluate new approaches that deepen local financial ecosystems and improve access to finance for local businesses. Moreover, by testing these approaches, USAID gains insights into how partnerships with private sector actors can create jobs, sustain economic growth, increase the local standard of living, and better the lives of people around the world.