December 1, 2021 - As of July this year, the Wall Street Journal reported that emerging market stocks had outperformed developed market stocks over the previous 12 months, even in the context of a record-setting stock market performance globally. Yet despite these over-performing returns, venture capital investment in emerging markets accounts for only about 10% of total VC capital invested, and a significant financing gap remains for small and growing businesses (SGBs) in these environments. Why is that?
Some analysts explain this gap as the result of a lack of investable businesses. But the data points to another reason.
In 2017, the Global Accelerator Learning Initiative published the results of a study on the lack of investment in emerging markets. It showed that while small business founders in these markets were equally (or more) educated and experienced as those in developed markets, investors used practices to identify and evaluate investable businesses which artificially reduced the amount of viable investments. For example, they allowed cultural biases, like a preference for expat founders, to affect their decisions. Investors also tend to take an equity-only approach, which is mismatched with the needs of emerging market ventures and the availability of exit opportunities. In addition, a similarly-timed World Bank study showed that emerging market investors are regionally biased, gravitate toward market familiarity and similarity, and feel constrained by political factors.
Based on these findings, a solution to the emerging markets investment gap may seem as simple as changing investor attitudes: While structural reforms that reduce political and infrastructure risk and provide fiduciary loss assurances are out of the hands of investors, founder and market selection biases are addressable constraints if different data is used to locate untapped opportunities.
So, does that mean addressing investor bias will solve the problem? Not completely.
While there may be bias in finding and identifying investable businesses, this historical gap in investor focus has had a systemic impact on the investor preparedness of emerging markets businesses. As a result, there is often little track record of past fundraising experience among these business owners, a lack of verifiable financial records and sound business plans, and few internal controls to prevent fraud and provide accountability.
While the data says SGB founders in emerging markets are equally qualified, an investor has few options to assess team risk beyond seeking referrals or starting the long process of relationship-building. Unfortunately, if connections are the sole driver for investment, this reinforces and expands exclusion in markets that are already known for their lack of inclusive social structures. And if investors try to avoid this by seeking out investable SGBs via relationship-building, this can be a long and costly process requiring a physical presence in each new market, which increases the opportunity identification costs in already difficult markets.
In light of these challenges, what is being done to address this systemic problem of investor readiness?
There are several ways market development organizations, entrepreneurial support organizations and governments support investors’ efforts to identify and evaluate investable SGBs, including:
While these are necessary solutions, they are not without their weaknesses. For instance, technical assistance (TA) programs often lack market-wide assessments to identify which companies to work with (again relying on referrals). The business support services they provide are either cost-prohibitive or they lack the capacity needed to reach the majority of SGBs. Additionally, they may have their own impact metrics that may not fit with the objectives of investors.
Current data solutions also have some key shortcomings. They typically depend on gatekeepers or self-reporting, and primarily only show those companies that have been previously funded (often a list too small for the available capital). Deal rooms struggle to communicate the investability of the firms they are listing: One way they do this is by partnering with TA programs to add credibility, but they rely on these already resource-limited programs to report on companies’ current activities and relationships, even though this data is often outdated. And Crunchbase-style sites, while providing a glimpse of what is working, are reactionary and biased to success, and do not point to underutilized opportunities.
These multifaceted problems combine to make it difficult to invest confidently in emerging markets businesses. Investors know that these businesses may not be ready for investment despite high-quality founders. And the technical assistance and data solutions aimed at providing this investor confidence have capacity gaps or are designed with their own inherent biases. So while these entities work together to address the financing gap in emerging markets, systemic change is still slow to happen.
So what can be done to overcome these issues and close this gap? Since the biases that limit both investors and other SGB support organizations are often reinforced by a lack of market visibility, one unexploited solution involves using systems data to boost the visibility of the relationships that small and growing businesses have in the entrepreneurial ecosystem in which they operate.
A systems view of this ecosystem comprises the multiple entities SGBs work with, such as investors, entrepreneurial support organizations, business support providers, business associations, government offices, educational institutions, suppliers/buyers and competitors. Systems data on these different players can reveal the connections and competition between them, in order to help SGBs and their supporters understand potential risks and opportunities. This data highlights where closely networked businesses have been able to grow faster, shows gaps in the market, and points out which businesses are linked to higher-performing technical assistance. This data can also be used by policymakers, support organizations and business associations to focus their development efforts. A systems view of the market can also highlight new investment opportunities, decrease inequity in investing decisions, and yield more and better returns – all of which are needed to accelerate investment in emerging markets.
Organizations currently conduct entrepreneurial, investment and sector-specific systems mappings on an as-needed basis. This data is often seen by development finance institutions trying to understand how to deploy new credit guarantee funds, market development organizations identifying where in a market system to invest technical assistance and matching funds, and local business support organizations aiming to promote their entrepreneurial ecosystem. However, translating this systems data into a widely accessible format that investors and businesses can use has not been a priority for these organizations.
At Discovered Markets, we use systems analysis to help investors inform their strategy. For example, we worked with the Global Good Fund to map the irrigation market system in six countries in sub-Saharan Africa. The Fund used this data to identify the best country in which to launch a new pay-as-you-go solar-powered irrigation solution. We also worked with the Dutch development bank, FMO, to map the entrepreneurial and investment ecosystem in Morocco. They used this information to identify what government entities, financial institutions and entrepreneurial organizations to support in the country. Without this systems data, both organizations would have had to rely on the long process of relationship-building in markets where they do not have a physical presence. However, they would have been more likely to simply decide not to invest at all, as the cost to build these networks would be too high given the unknown opportunities in these markets.
Market systems information can be collected by using specialized research firms in systems analysis, like Discovered Markets, or by leveraging existing reports funded by development actors, where available. The return on effort in identifying these systems and acquiring this data is substantial, and involves reduced bias (and more opportunities), greater speed to market, and reduced costs. In light of these benefits to both SGBs and their funders, more investors and businesses should seek a systems view in their initial market research. Additionally, the data from these systems mappings should be publically available to improve how other stakeholders interact with the market. Then, systems data can begin to play a key role in closing the investment gap facing small and growing businesses in emerging markets.
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