Opinion: Winter is coming for emerging markets venture capital

As usually happens this time of year, people who live in developed markets in the Northern Hemisphere are grateful for the end of winter and are eagerly looking forward to the approaching summer. Only this year, rather than being excited by warmer weather and potential summer travel plans, citizens of developed markets are eagerly anticipating the prospect of reduced Covid-19 cases, a reopening of their economies, and a return to some semblance of “normal”.

Yet in emerging markets, particularly those in the Southern Hemisphere, winter is coming, both literally and figuratively. The Covid crisis is poised to impact these economies in a way never seen before and to expose many of the structural economic issues these markets have.

This crisis will have an enormous impact on the Private Equity and Venture Capital industry in emerging markets. But before we get to the specifics of that, it is useful to look at the broader impact that the Covid crisis will have in emerging markets in terms of: 1) the healthcare impact, and 2) the impact on their economies overall.

The Healthcare Impact of the COVID Crisis in Emerging Markets

First, in terms of healthcare, while data is scarce in most emerging markets, what is clear thus far is that the number of actual Covid cases far exceeds the number of reported cases. And by “far exceeds” I am not referring to differences like 20%, 50%, or even 100%. In these markets, the number of actual cases is likely 10-100x higher than the number of reported cases. Researchers in Brazil, for example, estimate that the number of actual cases in the country is 12x the number of reported cases.

In countries like Nigeria, the number of confirmed cases currently stands at less than 2,000, which is roughly the same number of confirmed cases as the state of Idaho in the United States. The difference is, whereas Idaho has fewer than 2 million inhabitants and is one of the least densely populated states in the United States, Nigeria has a population of approximately 200 million and is one of the most densely populated countries in the world. Suffice it to say, it would not be surprising to learn that the number of actual Covid cases in Nigeria is >100x worse than what is currently being reported.

And, unfortunately, the health component of the Covid crisis looks like it is only going to get worse in emerging markets over the coming months. For while the United States, Europe, and most of Asia are expecting Covid to plateau as the weather gets warmer and they enter their summer, large parts of South America and Africa will start getting cooler as they enter their winter. Sao Paulo and the surrounding area in southern Brazil, for example, which is home to approximately 70 percent of the country’s GDP, gets significantly cooler in June and July.

And while the data on how temperature affects Covid transmission is still emerging, most studies agree that cooler temperatures between 5-15 degrees Celsius tend to accelerate transmission of the virus. So for much of South America, Africa, and South Asia / Oceania, instead of plateauing, in all likelihood, the number of Covid cases will continue to increase over the course of June/July/August.

Sadly, these markets are largely unequipped to deal with a worsening Covid health situation. Which brings us to the economic impact of this crisis.

The Economic Impact of the COVID Crisis in Emerging Markets

Let’s first try to understand just how severe this crisis is relative to other global economic crises. The most recent (and relevant) precedent is the 2008-2009 financial crisis, which was the worst economic downturn since the Great Depression. During that crisis, governments took unprecedented action to inject stimulus into their economies to try and stimulate activity. The United States, for example, injected fiscal stimulus equal to 5.7 percent of GDP into its economy over the course of 2008-2009. For the current COVID crisis, thus far the United States has already injected a fiscal stimulus equal to 11% of GDP into the economy. So already roughly ~2x the response to the Financial Crisis.

It is absolutely jarring to think that in ~2-3 months the US has injected ~2x the fiscal stimulus that it did over the course of ~2 YEARS during the 2008-2009 crisis. This is uncharted territory. And the US isn’t alone. Across the board, the governments of most major economies have responded to the Covid crisis with fiscal stimulus that is already ~2-5x the level of their prior response to the 2008-2009 crisis:

Figure 1: Fiscal Stimulus as % of GDP for Covid Crisis vs. Global Financial Crisis

Source: Statista, “A Review of Global Fiscal Stimulus” (International Labor Organization, International Institute for Labor Studies)

Based on the data thus far, it seems highly likely that the economic impact of the Covid crisis for emerging markets will be at least ~2-5x as bad as it was in 2008-2009. The capital outflows we have seen in emerging markets over the last few months already reflect this expectation. As recently reported in the Financial Times, capital outflows across emerging markets have reached a level never seen before, with equity and bond outflows across the 21 large emerging economies of US$95 billion over the last 2.5 months, which is >4x the amount that left in the same period after the start of the global financial crisis in September 2008:

Figure 2: Capital outflows in emerging markets during Covid Crisis

So, if the Covid crisis is already ~4x worse than the 2008-2009 crisis for emerging markets, how prepared are these economies to deal with this situation? The data is not reassuring.

According to data collated by the IIF, from 2010 to 2019 the total debt of the 30 largest emerging markets rose from 168% of GDP to 220% of GDP, equating to a ~1.5x higher debt burden today than they had at the end of the last economic crisis. At the same time, and making matters worse, whereas in 2008-2009 the crisis primarily impacted the financial sector, this time around key industries in these countries like oil and tourism are suffering the most in this crisis, reducing governmental tax revenue from those sectors.

The net effect is that these governments will have meaningfully less revenue and more debt than during the last crisis. This, in turn, will dramatically impede the ability of these governments to use quarantine measures to shut down parts of their economy (precisely as Covid transmission starts to potentially accelerate) or to use stimulus measures to resuscitate their economies once the recession begins to set in.

In the short term, this will lead to an inability to contain Covid, which will in turn result in an overwhelmed healthcare sector and a greater loss of human life in emerging markets relative to Developed Markets. We expect the news regarding the healthcare impact of Covid in these markets to increasingly worsen over the coming months.

In the medium term, this will also lead to a more prolonged recession and meaningfully reduced economic consumption levels by consumers and enterprises in these markets, as Emerging Market governments struggle to deal with high debt levels, reduced tax revenues, and a thinly-stretched public sector. Again, over the next 3-12 months we expect a consistent trickle of bad news in emerging markets regarding economic malaise and mounting job losses.

The Impact of the COVID Crisis on Venture Capital in Emerging Markets

If all of the above sounds terrible, well it is. The humanitarian and economic impact of the Covid crisis will be severe, especially in emerging markets, and it will leave scars for many, many years to come.

Private Equity and Venture Capital investors in these markets will not be immune to this as the economic situation further deteriorates in emerging markets over the coming months. Many PE or VC-backed companies will be forced to shut down or to sell themselves for pennies on the dollar. Many of these businesses have already cut significant costs with the hope that they will be able to survive the coming winter. Sadly, many won’t.

This is because, in recent years, in particular, many Emerging Market PE and VC investors have approached opportunities in these markets with unbridled enthusiasm. PE investors have piled money into oil, tourism, shopping mall operators, real estate, traditional retail, and other segments of these economies. While VC operators have done the same with technology-enabled companies that promise to disrupt huge segments of these same economies.

And, like the grasshopper from Aesop’s fable “The Grasshopper and the Ant”, these investors operated as if winter would never come, backing companies that lacked good unit economics and business fundamentals, and in some cases investing gobs of cash into companies with no revenues or with negative gross margins. These companies all needed the economic equivalent of a perpetual summer in order for their business models to work out, but as we all know, and as we were all reminded countless times while watching “Game of Thrones”, winter always comes eventually.

Indeed, the portfolio companies of many Emerging Market PE and VC investors will not survive this coming winter. Many PE and VC operators in emerging markets will see their portfolios collapse as their investee companies struggle to maintain existing customers or attract new customers in the wake of the unfolding economic crisis. And these companies will struggle to raise additional capital to keep them afloat as capital continues to flow out of, rather than into emerging markets.

As the valuations these firms reported to their LPs become increasingly stale and unrealistic in light of the underlying performance of their portfolio companies and challenging valuation comparables in public markets, these managers will be forced to significantly mark down their investments. This will hurt their reported returns and they will thus struggle to convince LPs to give them money for new funds. As a result, over the next 12-24 months we will likely witness a significant “thinning of the herd” in the number of PE and VC managers who operate in emerging markets.

This is unfortunate, as many of these firms have been doing very noble work in these markets, backing entrepreneurs and companies who they see as being able to build meaningful success stories for their countries. Unfortunately, the excessive optimism of recent years has led to a lack of investment discipline, and this, in turn, has left many of these investors exposed. As Warren Buffett is fond of saying, “it’s only when the tide goes out that you learn who’s been swimming naked”. Well, today, there is no shortage of skinny-dipping private equity investors in emerging markets.

This is doubly unfortunate because in light of the Covid crisis consumer and enterprise behavior is changing rapidly, and in ways that can benefit VC and PE investors. To understand what I mean by changing behavior, just take a look at how your own behavior has changed in recent weeks. Each of us are all walking anecdotes about how business communication is shifting almost entirely online (e.g. Zoom, Slack), how Netflix usage is increasing, and how online shopping (e.g. Amazon) and online food ordering (e.g. Instacart) are booming as well.

These, and other, behavioral changes provide huge opportunities for technology companies to accelerate their businesses in the midst of this crisis, as evidenced by data reported by the San Francisco Chronicle regarding how Bay Area shopping habits have already dramatically changed since the onset of Covid:

Figure 3: Changes in Online Consumption as a result of Covid

Source: San Francisco Chronicle, Second Measure

The data we see from emerging markets is similar, and the trend is unlikely to reverse itself. Now that we’ve all gotten used to buying groceries online, will we go back to the supermarket as often? Now that we’ve all gotten used to Zoom calls with work colleagues, will we require in-person meetings as often? Now that companies like Dreamworks have seen they can make more money from an online-only movie release than from a theatrical release, will they require us to go to the movies as often to see a new movie?

Indeed, as these technology trends continue to accelerate in emerging markets, as capital dries up, and as the number of PE and VC investors operating in these markets thins, it is difficult to escape the conclusion that over the coming quarters, multiple compelling technology companies in emerging markets will come out of the current crisis even stronger and will be seeking to raise money at very attractive valuations. In short, this could be a great buying opportunity.

And while history doesn’t repeat itself, it does often rhyme, and let’s not forget that during the last crisis of 2008-2009 some of the most successful technology companies ever were born, including WhatsApp, Stripe, Square, Uber, Airbnb, Tokopedia, GoJek, Slack, Pinterest, PagerDuty, Yammer, Github, Cloudflare, Waze, and a host of other unicorns. The same will be true this time around, and as we’ve mentioned previously, it is likely that many of these new unicorns will be born in emerging markets.

In the meantime, the key is remaining patient, focused, and disciplined as an investor, and not forgetting the immortal words of John F. Kennedy:

“The Chinese use two brush strokes to write the word ‘crisis’. One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger–but recognize the opportunity.”

The views and opinions expressed in this article are those of the author’s and do not necessarily reflect the views of MENAbytes.

Nazar Yasin
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