The “FIERCE” Risks of Investing in Emerging Markets: Fraud
At VestedWorld, our unique model means we frequently rub shoulders with the full range of participants in the early-stage, emerging-markets investment ecosystem: the entrepreneurs, professional-investor set, and, perhaps most importantly, the base source of capital — so-called retail investors[i], including high-net-wealth individuals and families, and other accredited investors. While most investment funds in our space interact just as much as we do with the entrepreneurs, they rarely see much beyond their own backyard with respect to the retail investors.
This post will touch on the motivations and level of engagement of the different players in the ecosystem; however, it will primarily focus on accredited retail investors and our conversations with them about the perceived risks that prevent them from allocating more capital to the geographies we focus on.
Entrepreneurs and Professional Investors in Emerging Markets
Since the bread and butter of our existence is finding and funding entrepreneurs in emerging markets, we understand the many reasons why these entrepreneurs start businesses: to work for themselves, for the high-risk/high-return profile of the outcomes, to take advantage of an oft-overlooked friction in a local market, and, not least, to benefit their communities and home-country economies. We’ve found no shortage of entrepreneurs willing to make “the leap” (including locals, members of the diaspora, and internationals) — the number of inbound funding requests we will receive this year will number in the hundreds.
Similarly, there is no shortage of professionals desiring to enter the emerging-market investing space, as evidenced by the growth of communities such as GIIN and TONIIC, as well as by the strong demand for these types of positions out of investment banks and consultancies, and business, law, and public policy schools. Whether you attribute it as a side-effect of the catastrophic use of financial instruments in the run up to the great recession, as part and parcel to a wave of generational change in attitudes towards the purpose of capital, or as a natural byproduct (under a different name) of the crowding-out of the investment opportunities in the U.S., E.U. and Asia, the end point is the same: professionals are increasingly interested in the career of investing in opportunities in emerging markets.
If recent years have seen an increase in the multitude of entrepreneurs seeking funding and an ever-growing number of professionals seeking to find, due diligence and invest in emerging-market, early-stage businesses, the result (you might think) should be a dramatic increase in the number of transactions being executed. This is, sadly, not the case. While the funding faucet appears to be unclogging itself bit by bit, the numbers are still infinitesimally small relative to the demographic economic weight of these countries. As we’ve highlighted here before, the funding gap between early-stage U.S. companies and those in sub-Saharan Africa is enormous ($80 billion vs. $200 million in 2015).
The “FIERCE” Risks of Investing in Emerging Markets
So what then, is the issue? As a fund that speaks to these investors on a regular basis as part of our syndication platform (which provides the opportunity for accredited investors to get foot-in-the-door exposure to our markets at commitment levels as low as $1,000), we’ve come to believe that it is due, in part, to a failure to engage and to educate the accredited retail-investor class about the risks associated with investing in emerging markets and things you can do to mitigate those risks. Here at VestedWorld, we refer to these risks as the “FIERCE” risks: Fraud, Instability, Expropriation, Regulatory, Currency and Enforcement of Contracts. I’ll touch briefly on the first of these risks, fraud, in this post and leave the rest for other posts.
While we chuckle with the rest of the viral-media-watching-World at tongue-in-cheek jokes of fraud in emerging-market countries, we also know that it is no laughing matter — while we were ultimately successful in bringing on $95,000 in retail commitments to our most recent syndication of Beacon Power Systems, many of these conversations focused on the question of whether investing in Nigeria was safe from “fraud.” Commercials like these, while based off real-life incidents, reinforce the negative perceptions that U.S.-based investors already have of places like Nigeria. And it’s not just Nigeria: we will likely have many of the same conversations about the same risks when we speak to our VestedAngels about the opportunity to invest in Ghana with MoringaConnect.
The “F” in FIERCE: The Risk of Fraud and How We Mitigate that Risk
So how do we think about and mitigate the risk of fraud?
First, the entrepreneurs that we invest in are not who you “think” they are. Compared to their U.S.-based counterparts, they’ve been working on their business for an average of 2–3 years. They aren’t trying to raise $1,000,000 to prove that an idea on a PowerPoint slide deck will work. More often than not, they have a product, in the market, that meets a demonstrable need. Some have graduated from top-tier universities (including Harvard, MIT, and Northwestern) and others are self-taught (see #2), but all are equally imbued with a driving passion for what they do. Moreover, we often spend 6+-months getting to know the entrepreneurs that we in invest in. Legal institutions in the countries where we invest often provide us with less security than a comparable investment in the United States, so our fraud mitigation strategy means that we can’t decide to invest over dinner and our relationship must be built on mutual understanding, shared vison, and benefits that accrue equally between us and each and every one of our entrepreneur partners. Additionally, a core component of our diligence is on and off-resume discussions with an entrepreneur’s references.
Second, we universally require that the entrepreneurs we invest in have “skin-in-the-game.” For an emerging-market entrepreneur, this may not look the same as it does for a U.S.-based one and they may not have any capital to contribute to their fledgling business. Sometimes this skin-in-the-game comes in the form of passing down a well-paid job at an internationally-renowned organization (as Kwami did with NASA, as Bim did with Deutsche Bank, and as Ivan did with Citibank), other times as picking up a family and moving (sometimes home, other times to a new) emerging-market, and even others as a friends-and-family fundraising round where their community (and the entrepreneur’s reputation) is levered to the outcome of the business. We find that this last point — other stakeholders, based in the community — is especially important, and doesn’t have a ready corollary in the U.S. As has been pointed out most famously by Muhammed Yunus, reputation and standing with the community is a much-more powerful driving force than the “strictly-business” attitudes prevalent with U.S. venture capital. We see leveraging this dynamic (and aligning our incentives with other stakeholders) as a powerful way for us to prevent fraud.
Third, while we’ve only made five investments, all of those investments are into entities based in jurisdictions where we have no reservations about the rule of law and enforcement of contractual arrangements: Delaware, the United Kingdom and Mauritius. In addition, each of the countries where we’ve invested have made important strides towards encouraging foreign investment. Some countries have passed regulations ensuring that foreign investors have fair access to the country’s judicial system, while others provide favorable tax and administrative privileges for foreign investors. Overall, government officials in each of these countries understand the importance of attracting foreign capital and treating those investors fairly and that gives us a higher degree of confidence.
Fourth, arbitration is the default channel for dispute resolution in all of our agreements and each of the countries where we invest have agreed to enforce an arbitrator’s ruling. For example, the Kenya Constitution specifically allows for disputes to be settled through arbitration and also requires the relevant governmental authorities, including courts, to take all actions necessary to enforce an arbitrator’s decision in commercial disputes. Other countries have even set up special courts to process arbitration rulings.
Fifth, and perhaps most importantly, it just isn’t a realistic worry that we (or other established funds in our market), will hand your money over to someone who will run away with it the next day a la the email you received about a deceased uncle and the need for a U.S. bank account number to receive the largesse of an inheritance. However, it IS a realistic worry that what could have been a forty-cents-on-the-dollar recovery on a failed business becomes a complete loss due to the legal and institutional constraints. However, in our capacity as a service provider that helps accredited investors build the risk-on part of a well-diversified portfolio, we will not deliver returns to our investors through negotiating recoveries on failed businesses (of which there will be some), but through our successes where multiples of initial capital are returned.
Why it Matters & The Way Forward
All in all, our ability as an ecosystem to communicate to retail investors why these, and other, risk mitigation measures result in an acceptable level of risk for the potential returns from our investments will make or break the end-game of catalyzing capital inflows to emerging markets. The “trust us — we know what we are doing” model seems to have worked in U.S. private equity and venture capital, but has proven stubborn in emerging markets — while WE may understand why it makes sense to invest in a Nigerian energy efficiency company, a Kenyan motor company, or a Ghanaian cosmetic and superfood CPG company, and other professional investors may know why it makes sense to invest in an emerging-market credit-scoring company or a pay-as-you-go solar company based in Kenya, we all need to get better about communicating why these investments still make sense after a full and honest review of the risks. Until retail investors are demanding, en masse, institutional products to get them exposure to our assets, true transformation will be beyond our reach, successful “exits” will be scarce, and companies will be starved for appropriately-priced capital.
[i] I’ll use the term retail investors here to denote the individuals whom the ultimate returns of these investments will flow to, understanding that some/many may not be active participants in the market, and/or may only invest through institutional channels.