Adapting VC to emerging markets

The Realistic Optimist is a B2B paid publication covering the globalized startup scene.

It publishes in-depth, written interviews with founders/investors around the world.

The Realistic Optimist's paid subscribers include teams at Norrsken22, Sturgeon Capital, 54Collective and 500 Global.

Biography

Archie Cochrane is co-founder and general partner at Nascent, a top decile LATAM pre-seed fund. 

Prior to Nascent, Archie worked for global fintech PayU (acquired by Naspers) and was an investment principal at Anthemis Group.

In your articles, you speak about the importance of tailoring a venture fund’s strategy to its specific context. What does that imply?

It comes down to what product you are offering your customers. In my case, my two customers are the LPs that bought my fund product and the founders I support.

Venture capital used to be an artisanal, cottage industry. Particularly in the last decade, the asset class has grown and the average VC fund size has expanded with it. The spectrum of ‘fund products’ now goes from industrial-sized funds (ex: Softbank’s Vision Fund) to boutique funds like ours. We are all called venture capitalists but the products we offer vary enormously. Therefore, the customers that buy our product also vary enormously. Similar to a startup, building a venture fund entails building a product your customers want.

My first customer persona are LPs, the people whose money we are investing. The type of LP you target influences the returns you promise and subsequently, your investment strategy. Smaller funds tend to promise larger returns than larger VCs, since it's mathematically easier to return a smaller fund. Larger institutional LPs are happy with 10+ year holding periods whilst family offices and individuals typically prefer shorter liquidity timeframes. 

My second customer persona are the founders we support. The choice of which founder to back depends on your investor-market-fit. What specific skills/network do you have as a GP, and what type of founder can those best assist?

You set up your fund with those two customers in mind.

For example, Nascent’s partners are ex-operators. We add the most value during the company’s initial years, on topics such as go-to-market, hiring, fundraising, storytelling… Our value proposition as investors diminishes as the company scales, so we’re often happy to sell our stakes to later-stage investors once we feel that the company has outgrown what we can offer.  

That’s helpful regarding the fund construction. How do you further tailor a fund for emerging markets (EMs)?

The general parameters are the same globally: venture capital is a high-risk, high-return business. Many of your shots on goal will fail, but you aim for the few successful shots to make up for the rest. The added EM complexity is that startups there typically enjoy smaller and rarer liquidity events. 

If you’re running a $100M seed fund in San Francisco (SF), you can invest in 40 startups with less than 5% in each at exit. You aim for one or two of those companies to IPO or be acquired at an outlier (multi billion dollar) price, returning your fund even with your stake in the company heavily diluted over time. 

Expecting those mega exits makes less sense in EMs. It’s safe to assume that the median exit size of a venture-backed startup here is lower than in the US. The probability of later-stage exits, such as IPOs, is still small. Those IPO chances are further reduced by the fact that tech companies are staying private longer, even in developed markets. 

Sturgeon Capital’s analysis of some frontier market exit sizes

How does this inform Nascent’s fund construction then?

We take larger stakes, invest in less companies, get in earlier and get out earlier. This has proven successful to date. Our Fund I has a 5.2x DPI and a 6.5x MOIC.

The decision to invest in a smaller number of companies pertains to the local LATAM context. If we return to that fictional SF $100M fund example, an implied assumption is that they will find 40 quality startups to invest in within the typical 3-year deployment period. While LATAM has extraordinary founders, we don’t believe there is enough quality startup volume yet (within our investment focus) to enable such a strategy. And we don’t want to simply write checks to fill a quota. 

When considering our liquidity options, we widen the scope to secondary sales on top of the traditional M&A and IPO route. We’re happy with selling our stake to a Series B/C investor if we’ve made the return we wanted. 

Paper returns are helpful when fundraising, but ultimately worthless if they don’t convert to cash distributions. Distributions to paid-in capital (DPI) is the real North Star metric. We act accordingly. The fairytale story of joining at pre-seed and riding it out to the NASDAQ IPO sounds good but conflicts with statistical probability, particularly with more LPs demanding DPI in reasonable time horizons.

With this in mind, what type of LP is Nascent targeting?

It depends on the LP’s incentives, which go beyond just the return they’re aiming for. 

For example, large US university endowment funds have large average investment sizes. As a result, they’d rather allocate to a larger fund where they aren’t more than 20% of the fund size. They also prefer legacy firms who have a multi-fund track record so they can be sure that they can invest in subsequent vintages, reducing complexity. This means they index for stability and proven repeatable returns rather than seeking out outlier funds that are typically smaller and earlier in their journey. Most VCs make their best returns in the first few vintages of a firm’s life, when they have more to prove to the market. 

On the other hand, LPs such as exited founders, family offices and high-net-worth individuals are happier writing smaller checks but demand larger and faster returns, in exchange for the risk they are taking. They aren’t infinitely patient. Your fund multiple is only as good as the timeline it’s constrained in. 4x net of fees in 6 years is top-decile performance whilst 4x over 12 years is less impressive. At Nascent, we aim to give our LPs 5x net of fees over 7 years.

When you pitch LPs, who are you competing against?

It’s easy to be myopic and think we’re just competing against other VC GPs. Actually, these LPs have a vast array of other investment options: real estate, private equity, bonds, private credit… We're often convincing them to allocate money to venture in the first place. 

What about VCs that invest in both the US and EMs? How should they structure their fund?

Every firm is different but if it was me, I would make sure my investments in both the US and LATAM had the same return profiles, or I’d spin out a separate fund, with different objectives, for emerging markets. QED did that with its Fontes fund in LATAM for example.

Does this mean that later-stage VC in EMs makes no sense?

No, but it’s a different value proposition and funds should be constructed accordingly. 

Later-stage VCs typically offer different return profiles to their LPs. This might suit some LPs, such as institutionals (endowments, sovereign wealth funds, pension funds…). Later-stage VCs are generally designed to have a more concentrated portfolio and pick companies that have the potential for very large M&A or IPO events. 

I warn against not factoring local liquidity statistics into your strategy and promising mathematically unrealistic returns to LPs. 

I think that’s why many EM VCs struggle: they copy-paste the math and return profiles from an American template, without considering local market realities. Context matters, and expecting a venture fund model that is built for the US to be directly replicable in Africa or LATAM is lazy.

Alex Branton from Nodem told The Realistic Optimist that EM VCs have a scarcity of secondary options. Does Nascent have sufficient options to exit its positions?

You have to differentiate between dedicated secondary funds (such as Nodem) versus actual secondary share sale events (ie: Series B investors buying out our stake in a company).

Alex is right in saying that emerging markets lack dedicated secondary players, especially in the frontier markets he’s targeting (Bangladesh, Pakistan…). In the LATAM context, I’m seeing an increasing amount of secondary transactions and the emergence of dedicated secondary players, such as Attom Capital. 

On the secondary share sale side, my view is that if a company is performing well, there will always be investors who want to get in, and buying out earlier investors is often the preferred option.

That trend should grow. The birth of LATAM’s VC and startup scene isn’t much older than a decade or so. If we consider the average 10-year fund life, we’re only just beginning LATAM’s second ‘VC fund cycle’. The demand in secondary transactions will only increase. The market will continue to mature. 

What about LATAM’s M&A activity? Is that bound to grow?

I don’t see why not. Large American tech companies start eyeing emerging markets for expansion once they’ve saturated their US market (which admittedly can take years ) and it’s less of a hassle to expand by acquiring your local competitor. 

Visa buying Pismo and Uber acquiring Cornershop are good examples of international acquirers expanding their propositions in LATAM via local M&A. 

Local incumbents and leading local tech giants such as Nubank and MercadoLibre will also up their acquisition game as sector consolidation is likely. For example, Prosus recently announced that they are acquiring Despegar.com for $1.7bn.

How do you gauge US investors’ appetite for LATAM startups?

Many US VCs wet their lips on EMs during the pandemic, riding the zero-interest-rate policy (ZIRP) era. 

US VCs are attracted to concepts that are relatable and are proven business models. In 2021, many US VCs felt like they were bargain shopping, investing in the “X for India” or “X for Nigeria” at a supposedly discounted price. 

Despite its potential, LATAM is disadvantaged from not having English as its lingua franca (a linguistic barrier India, Asia and parts of Africa lack). If you are a global investor sitting in New York, London or Hong Kong, doing business in a region where English is not the language of business can be daunting. I believe that point is often understated in comparing international VC involvement per emerging market region. 

The pendulum of interest will swing back and forth depending on various factors. Interest rates are one of course, but others such as the quality of opportunities in the US also count. The AI boom has kept US VCs busy domestically: there was a new party to go to, so LATAM took a backseat. 

But I believe the genie is out of the bottle. 10 years ago, the majority of venture capital flowed to the US. Now, the majority of VC funding flows outside of the US. The pendulum will do its thing, but the tech startup scene is now globalized.

Source: Endeavor

What tailwinds are you betting on, in the LATAM context?

Three main ones. 

The first is the continuing digitization of economies, LATAM’s included. People invest in startups because they believe startups create and capture the value digitization brings. 

If you look at tech as % of GDP, the US is at 64%, China at 20% and LATAM at 1.8%. Even if  LATAM only gets to around 10% in the coming decades, that equates to a $600B value creation. That’s a tailwind and a half. So the question becomes not whether there is a value creation opportunity in LATAM, but who will create that value. That is what excites us at Nascent. 

Second, LATAM (Mexico in particular) sits at a bankable junction between geopolitical developments and geographical positioning. One of my favorite books is “Prisoners of Geography”, which analyzes how countries’ geographies determine their success. Lessons from the book tell me Mexico is currently in a great position. 

There’s been a bi-partisan accord in the US to decouple their supply chain from China. However, the US can’t afford to shift its entire supply-chain cost base from Chinese costs to American costs. Products would suddenly become too expensive for the American consumer. 

The next best option is Mexico. That quasi-inevitable, deepening economic relationship will seep into tech. I wouldn’t be surprised to see Mexican startups solving American problems and conquering the American market. Almost 20% of Americans are Latino after all. Just as New York emerged as a serious tech hub in circa 2013, my view is that Mexico City (CDMX) will become the next North American tech hub. In ten years’ time, my bet is CDMX will be mentioned in the same breath as New York, Miami, Austin or LA as a fertile tech ecosystem.  

The third and last tailwind is AI. We don’t view AI as a vertical to expand into, but rather as a horizontal, foundational layer on which all companies will be built. AI will enable our portfolio companies to compete on an equal footing with global competitors, all the while maintaining their LATAM cost base. It’ll turbocharge the attractiveness of the companies we invested in. 

If you’d like to learn more about the Latin American market opportunity and how Nascent is positioned to benefit, you can reach Archie at archie@nascent.vc or connect on Linkedin.

The Realistic Optimist’s work is provided for informational purposes only and should not be construed as legal, business, investment, or tax advice.

Purchase a Realistic Optimist subscription for your team here.