Editor's Choice, January 2016: which capital for which inclusive business? A huge step forward in answering the question
Which capital is suitable for which business model at what stage? A perennial question[i] faced by entrepreneur and investor alike. If you have any interest in the evolving answers to that question, then this months Editor’s Choice, ‘Frontier Capital’ is a must read.
Its focus is risk capital that supports innovation to improve the lives of low and middle income people[ii] in emerging markets. With this report you can – and should - remind yourself how far and fast this sector has evolved, read a great summary of an array of good practice, and set the compass for the next 5-10 years. Published by Omidyar Networks, it's authors - Matt Bannick, Paula Goldman and Mike Kubzansky- draw on Omidyar's own investment experience plus an overview of market trends and real time data.
Ostensibly, this report has a clear purpose: it provides a ‘clarion call’ for more risk capital, and it answers the related question ‘what types of risk capital are most appropriate for this purpose?’ The first it does reasonably well, as do several others. The latter it does superbly, building on what others have been saying, but taking it further with evidence and analysis. It provides a categorisation of three types of capital, which I think will become common language.
The report does two more things too. Amidst the detail and examples, it also sheds light on what makes businesses more scalable, lower risk and more investible, with details useful for business model design or deal appraisal. And big picture, it marks an important point in the development of the eco-system. More on these points below, but first, I’ll briefly recap the three types of capital defined by the authors, though I cannot do better than the report’s own executive summary, so read it yourself.
Three segments, also shown in the diagram are defined:
1. ‘Replicate and adapt’ capital is for proven venture capital models, and reflects the majority of existing VC money in emerging markets. Technology and evidence of exits are scaling opportunities for this segment.
2. ‘Frontier’ capital is for business models that are unproven, but investible and scalable because they are asset-light, serving both low income and middle income markets. There is huge opportunity here for VC structures. Companies such as Xoom (in remittances), Geekie and Siyavula (in edtech) and Dailyhunt, Jugnoo and Zimmer (in consumer internet and mobile) epitomise the opportunities for Frontier Capital.
3. ‘Frontier plus’ capital is for unproven business models that offer huge impact potential but greater challenge and need creative financing. These unproven models may serve only low-income groups, be asset heavy, or operate in countries with weak capital markets, all of which may further deter conventional investors.
The bulk of the report is devoted to expanding and exploring each of these categories. A comparison of Frontier and Frontier Plus capital explains the key factors that the authors have identified that make an unproven business model more or less investible, which is equally useful for entrepreneurs and investors.
Businesses in the Frontier category can offer less risky returns because they tend to:
- serve mass markets comprising both middle income and low-income clients, so can tap economies of scale, often tap economies of scope (harnessing existing infrastructure), and gain early adopters from the middle income clients.
- expand distribution sales and marketing through electronic means rather than through high-cost logistics, physical infrastructure and assets. Because they are asset light, they can scale more quickly, can better survive the capital scarce (and particularly debt-scarce) environment, have more chance of strong cash flows and investors have less risk of dilution as the company grows.
The arguments for combining middle income and low-income clients to enable faster scale is well made, though the authors do point out that ‘not all start-ups that successfully serve the middle class can expand down market’. And indeed several have abandoned such plans. They also provide examples where maintaining a clear focus on low-income clients has protected strong and evidenced social impact at the cost of slower revenue growth. Living Goods is a case in point.
Perhaps the most interesting part of the report covers ‘Frontier Plus’ capital. Indeed, I feel this section could deservedly be another report in itself as it raises as many questions as it answers.
The idea that this sector cannot generate returns is countered, with examples of exists (from Rangsutra, Servals Automation, Shree Kamdhenu Electronics, and RuralShores) that produced 5x or greater returns. But the challenges and uncertainties of this sector are laid out clearly too.
Uncertainty is huge, particularly on the most central question of all in this segment. Which businesses have ‘strong commercial promise (and just may need more creative financing’, and which are ‘those where investors may not be fully compensated for the risks they take in conventional VC time horizons’ (and by implication need hybrid finance)? I look forward to the day when we have a report of this quality on this vexing question, as the difference between ‘just low’ and ‘just slow’ returns is something that crops up across my work in this space.
The recommendations are nevertheless crystal clear for developing this segment:
- Don’t rely exclusively on the traditional venture capital model when financing frontier plus businesses
- Develop longer time horizons. These unproven risky businesses cannot provide sufficient return capital within a fund life of say 8-10 years, but a longer time horizon can enable larger gains. Examples of fund managers shifting to longer terms or into holding companies show this trend has started.
- Expand Venture Debt, which accounts for 10% of the venture equity ecosystem in the US, but only 3-3.5% in India and much less elsewhere. Philanthropic and donor backed sources can accelerate this through provision of guarantees.
- Develop quasi-equity: models in which investors take some risk and share in the upside, but are structured in ways that better meet business stage and needs. Uses and advantages of the ‘royalty model’ (payments based on a percentage of revenue) are well explained.
- Think creatively. I love this comment, which relates to what happened when fund managers approaches LPs about longer-dated funds, but could probably apply to much else: ‘they received pushback, which often had little to do with return expectation and more to do with a resistance to non-traditional structures.’
So, investors, enjoy the categorisation and working out how you fit in better. Philanthropic investors, challenge funds, and others with concessional capital, dig into the Frontier Capital section and work out how to collaborate. Entrepreneurs, steal this analysis to make your own deal more impactful and/or investible and know which investment to chase.
Why do I think this is a turning point? Last year I heard nothing but calls for more differentiation of the broad tent of impact investment and more creative financing structures blending different types of capital.[iii] Examples are now emerging. This report marks a point at which the differences in investor profiles and business needs are marked in the sand. The names of the categories may not be set in stone, but the concepts, early examples and reasoning are there, enabling players in the space to sharpen their own role and more collectively align.
This post is a part of the January 2016 series on Access to Finance for Inclusive Business. View the whole series for more blogs, information and stories to help you navigate the finance landscape for businesses and investors, in partnership with Inclusive Business Accelerator.
[i] This article is part of our January 2016 series on Access to Finance for Inclusive Business available here. For more on the provision of capital in the Frontier Plus segment, see an interesting blog by Hugh Scott, Director of The African Enterprise Challenge Fund.
[ii] Low and lower-middle income (LMI) is defined as people living on $2-10 per person per day. This excludes the ‘poorest of the poor’ and includes the ‘low-income groups’ earning (sic) $2-5 per day and lower-middle groups earning $5-8 per day. This is not the report’s strong point, as it muddles ‘earning’ and ‘living on’ (poverty lines are based on what people live on, per person not what one family member earns), and does not make any reference to Purchasing Power Parity (PPP) even though in almost 40 countries, $8 in PPP is more than $16 in market prices, so we don’t know which lines were used in analysing market segments. See my more general moan about data problems in the sector, here.
[iii] There is a great diagram showing the spectrum of investment, from finance first to impact first, which was originally from Bridges Ventures, emerged in the G8 Taskforce on Impact Investment reports, and is now widely used, which helps clarify the range. In a report that I co-wrote, a survey of the Impact Investment Market in Sub-Saharan Africa and South Asia, one of the strongest themes from respondents was the need to not treat everyone in the broad tent as the same, and to both differentiate and co-create.