Venture Capital: Finding the local spark

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on May 21, 2018 - May 27, 2018.
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Frontier markets are risky terrains, where sussing out the right business to invest in requires looking beyond a company’s balance sheet, operations and financial statements.

It boils down to accepting that you are no expert of the local circuit and getting to know the people who run the businesses you are investing in, says Shaun Di Gregorio, founder and CEO of Frontier Digital Ventures (FDV).

This could mean not only getting to know the business partners of the entrepreneurs but sometimes, also their families — their wives, children and extended families such as their grandparents, cousins, nieces and nephews — over a meal in their home.

It is then, in a convivial atmosphere, that Di Gregorio often finds the qualities that drive the entrepreneurs in these challenging destinations. Such experiences, he says, set the tone of their investments.

“If you go through LinkedIn and make your decision based on their [entrepreneurs’] profile, you’re a sucker. We do a fair bit of external groundwork, from cross referencing and checking to researching. The good thing about the internet is people leave trails all around and you can get to know a person quite well without ever meeting.

“Beyond that, we obviously spend a lot of time meeting them [entrepreneurs] and getting to know their idiosyncrasies. We go to their countries and we often bring them here [to Malaysia] to get them out of their environment and to familiarise [themselves] with ours.

“I have met entrepreneurs, and have been invited to dinner with their families, and sometimes, their entire extended families, in their homes. I will be sitting in a family home in a place like Montevideo [in Uruguay] or some place you never thought you would go to and have dinner with some really wonderful people.”

Founded in 2014, the venture capital firm, which is listed on the Australian Securities Exchange, is backed by Catcha Group group CEO Patrick Grove and executive director Luke Elliot. FDV has spent more than US$20 million in the past four years buying online classified agencies operating predominantly in the automotive and property segments across

15 countries, including Angola, Myanmar, Pakistan and Uruguay.

“We are focused on underdeveloped and emerging markets as we see the opportunity to invest in early stage online classifieds businesses where we can work with local entrepreneurs, leveraging our experience and expertise. We saw an opportunity and a gap in the market that wasn’t really being focused on by the more established funds or investors,” says Di Gregorio.

The start-ups it invests in are those that have established some presence in the domestic marketplace. “We come in after the seed and angel rounds in order to help these businesses get to scale and hope they can attract larger global funds to grow their business.

“We are unique in the sense that we are an operating venture capital firm. We deploy capital but we are pretty active in working with the companies we invest in. That’s a fundamental point of difference for us.”

Di Gregorio views the segment as a high-growth market with relatively low levels of competition. He says the rapid uptake of mobile smartphones has enabled more people to have access to the internet and the ability to conduct commerce. “The combination of local entrepreneurs executing a well-formed business plan and our help on broader strategy and funding presents an excellent opportunity to build market-leading businesses.”

In order to build market leadership, he says it is important to get to know the people behind the business for FDV to find its best fit.

“This is really important for us — the fit. We need to know if we can see ourselves working with these guys over an extended period and if we are on the same wavelength, and such. We are never going to be on the same wavelength in all aspects, but you get a sense of people’s focus and their passion, and these [attributes] are very hard to fake. You can fake a lot of stuff — sincerity, your LinkedIn profile and business plans — but you can’t fake real passion, focus and determination.”

A qualitative assessment of how they think and their qualities is crucial as it is a sign of perseverance and conscientiousness — important factors in the precarious markets that FDV operates in.

“You get this by talking to their employees, their partners, their co-founders, and you will soon get a sense of whether they are up for the fight.

“Also, their motivation is generally pretty high, as everything is at stake for them. If we are investing in entrepreneurs in the US or Australia, for example, the worse thing [that could happen to them] if their business doesn’t take off is that they go get a job. There are social benefits and safety nets, or the next start-up because there is plenty of capital. But a lot of the entrepreneurs we work with have no safety nets.

“Their business is something they have invested their lives into and if it works, it is transformational, not just for them but for their employees, customers and consumers. If it doesn’t work, there is no fall-back plan, there are no second prizes. That, we often find, is a really strong motivator for these guys to go the distance,” says Di Gregorio.


‘Portals end up becoming default regulators’

After spending four years running the Catcha-controlled iProperty Group, and eight years before that building Asian online marketplaces at Australia’s REA Group, Di Gregorio felt that the classifieds business model, which worked in Malaysia and other emerging markets in the region, could be replicated in other regions barely known to investors.

Amid sluggish global growth and the end of the commodities boom a couple of years ago, frontier markets — sometimes portrayed as a vacuous simulacrum of investment — began gaining traction as the hunt for yield saw investors’ robust tolerance of risk become more robust.

However, one must be prepared to withstand erratic volatility, and more importantly, have nerves of steel owing to the underdeveloped status and illiquidity in many of the frontier markets.

“It is certainly not for the fainthearted. So, the businesses that we have invested in are typically run by local entrepreneurs, who have often grown up locally, but left for college overseas — be it the UK, Europe or the US — and returned home to start a business. These are very sophisticated individuals, smart and educated.

“Our due diligence obviously extends to political stability in some investable markets. We accept that there are risks in there being a lack of regulation. However, the twist is that in these markets where there is a lack of trust and the absence of legislative structures, automotive and property portals, for example, end up becoming default regulators of the industry,” he says.

Illustrating his point, Di Gregorio says — a real estate portal in Pakistan established in 2006 and which was one of FDV’s earliest investments — has grown to become a market leader.

“Consumers trust Zameen to help them find a property and provide information to buy a property, more than they probably trust the regulatory or the legislative environment the government is supposed to provide. Interestingly, in that vacuum, these businesses move to become more trusted conduits in a transaction,” he says.

In 2014, when FDV bought non-controlling shares in, and in automotive portal, the former was the largest foreign investor in the digital space in the Islamic republic.

Di Gregorio says it is not difficult to set up a business because the regulatory environment in these markets is pretty lax.

“The regulatory environment becomes problematic when you want to scale the business. So, when you start making revenue and becoming profitable, you start to engage the tax office, and have to be audited.” That is when the bureaucracy can be painful.

“We have invested in a couple of businesses in the Philippines, which is not exactly a frontier but an emerging market, but the bureaucracy there makes deals that would normally take two to three months, [take as long as] six or seven months. And it could be something as simple as just getting approvals from regulators.

“But we accept that. When we set out to do a deal we don’t have expectations that it is going to be done quickly. So certainly, once they scale up and become formalised, there is more at stake and more at risk,” he says.

In Myanmar, for example, FDV’s portfolio company faced hiccoughs when the government tried to spur local production by restricting the import of second-hand cars last year.

“You can’t be distracted by daily events and have to keep that long-term view. For example, Myanmar has historically imported second-hand cars, but a number of years ago, it started allowing new cars in. The government came up with the idea that in order to accelerate the uptake of new cars, it should ban the import of second-hand cars.

“Not a lot of people can afford a new car, so all of sudden, the car market came to a halt. Then the government came in and said that it would lift the ban on imported cars. Little things like that can interrupt the business but you don’t sweat the small stuff. You just focus on the long-term plan,” Di Gregorio says.

Apart from bureaucracy, corruption is a given in a lenient regulatory environment. “The one thing you can depend on is there will be a corrupt process somewhere.”

How does FDV manage to work around corruption? Di Gregorioo says there are no two ways about it. “The thing with corruption is that you engage and indulge it or you don’t. There is no grey area. We just don’t.

“If you dance with the devil, you will get caught. This makes things more difficult because we might be able to reduce the bureaucracy and the time it takes to get something processed by crossing that line, but we just don’t. Never will and never have.”

Regardless of the perception of whether these nations are basket cases or diamonds in the rough, Di Gregorio says much of daily lives and needs of the people are no different from that of the rest of the world.

“Funnily enough, when you go to some of these frontier markets and meet the entrepreneurs, they are actually really normal. When you go to Lahore in Pakistan, there are mums taking their children to school, people going to work, people drinking coffee in a café. It is a pretty normal environment.”


One size doesn’t always fit all

Compared to when FDV first started investing in frontier markets, Di Gregorio says capital inflows indicate that investors are getting better at gauging good investments from the bad.

“I think that capital, whether from venture capitalists or institutional funds, continues to get smarter. I think those investing that kind of capital recognise that emerging and frontier markets are a long play, that the economics are a challenge if you get it wrong.”

He says some investors come in with the view that business strategies that are effective in developed environments would work just as well in underdeveloped markets.

But he notes that this approach often fails, as seen in the failure of ride-hailing behemoth Uber Technologies Inc in China and Malaysia, where it applied a one-app-fit-all model and payment system in nations that lacked the financial infrastructure.

He points out that local players such as China’s Didi Chuxing and Singapore-based GrabTaxi Holdings Pte Ltd — considered the dominant ride-hailing player in Southeast Asia — were well ahead of Uber as a result of a deft business plan that catered to regional and domestic market quirks.

“There are local players who are well able to compete with big foreign internationals for market share. For example, ride-hailing company Careem Inc in Pakistan could do better in that market compared to Uber. I think there are a lot of opportunities to invest in local regional businesses that have the same business model, whether it is ride-hailing or coworking.

“There is a lot of really good local operators in the underdeveloped market space. We shouldn’t always assume that the global start-up is going to dominate every market,” he says.

For those who invested in frontier markets and were successful, he says it is a validation of their objectives.

“These success stories are fantastic for confidence when investing in these markets. I think it is great that we are seeing these businesses emerge because they are really good, competitive businesses. It bodes well for other opportunities in this market, and for the entrepreneurs as well.

“If you look at things from a macro level, issues such as military coups, change of governments, currency devaluation and more, are concerns. However, we do avoid markets that we think have irreconcilable economic, political or social issues. A lot of countries in the Middle East, for example, are markets we just wouldn’t want to invest in because of the macro picture.”

He says investments in these markets are long-term plays of between three and five years.

FDV invests anything from US$100,000 to US$5 million in each business.

“If the business is really great, we will might stay in for longer, potentially 7 to 10 years, but we are not that old. We started in 2014 so we haven’t reached the point to make a decision like that yet,” Di Gregorio says.

“A couple of the businesses we invested in in early 2014 had already been already around for a few years old. Now, they are around seven to eight years old and they are still growing rapidly.

“With our capital actively deployed in those rapidly growing businesses, we have no appetite to exit yet.

“In our industry, the businesses we have invested in, which are online classifieds, have been around for at least 25 years. In the larger scheme of things, it is a short time but in the context of the internet, it is one of the more established industries we have invested in,” he adds.

How does FDV select the start-ups it is going to work with? It categorises prospective companies into three tiers.

The first tier comprises clear market leaders with significant revenue and have been around in the market for no less than two to five years.

The second tier consists of companies that have not transitioned to full commercialisation but are on the path to doing so.

The final tier comprises investments in early-stage companies, with the primary goal of establishing market leadership. “These are the ones that can go either way, and they are often small. Unless we see a clear path to market share and opportunity, we exit those.” FDV divested its stakes in some of these companies last year.

“We have exited from four businesses in the Democratic Republic of Congo, Mozambique and Cameroon that we invested in 2014.

“You never know answers to all those questions upfront, so when we looked at these small investments again, we came to the conclusion that the guys in Congo are a pretty difficult reach. We should just focus on the businesses that are going to be larger faster. That’s just standard portfolio optimisation of any company like ours,” says Di Gregorio.

He says some of FDV’s portfolio companies have been valued at 40 fold from their initial valuation.

“For a business to increase its value five times over the journey would be a very standard outcome. These are high-growth businesses. The great thing about our model is that if you get it right, you can turn an investment into something significant.

“In each of these markets, you need to be the market leader. There are no prizes for number two. This theory is true for 99 out of 100 markets out there, with very few exceptions, and most of these exceptions are in very large, developed markets, where there is enough to go around.

“But in frontier markets, market leadership is everything, not just from the perspective of commercialisation, but also the position a business holds in these markets. Consumers are looking for someone they can trust, and they generally trust one brand, which is the best in any given industry,” he says.

Di Gregorio adds that while FDV would like to hold on to more stakes in the companies it has invested in, it does not want to disincentivise the entrepreneur.

“We recognise that we have got to keep the balance between our local entrepreneurs, which is key to our strategy, keeping them vested in the business. They run the business, and we help them do it. Ultimately, when that business grows and matures, it is not entirely dependent upon its founders. It is at this juncture where there is an opportunity to buy more of the business. Having said that, we have not reached that point in any of our investments yet,” he says.