Catalytical Venture Capital (VC) Backing in the African Market — the Role of Sovereign Innovation Funds

1. Introduction

Africa is at a crossroads regarding its development trajectory. Business innovation offers new opportunities for the continent to pivot its growth path.

Many countries in Africa and globally are ramping up their innovation-led industrial growth strategies through support for early-stage innovative ventures, among other things. Early-stage venture creation investment programmes are being launched in response to the growing need for Africa to implement programmes to address socioeconomic and environmental impact.

2. Challenges for high-growth tech startups

While all start-ups are generally small-medium-size Enterprises (SMEs), not all SMEs are start-ups. In contrast to start-ups, the framework of categorising SMEs is well defined and generally based on annual revenue, number of employees and value of fixed assets.[1] Start-ups are types of businesses uniquely created to leverage innovation in technology or business to disrupt a much larger market.[2]

Thus, start-ups are developing technological-driven enterprises exploring their profitability and growth based on a repeatable and scalable business model.[3] Considering the possibility for scalability and the market-disruptive nature of high-growth technology-based start-up enterprises, they play a crucial role in economic growth and job creation.

Notwithstanding the immense potential for socioeconomic impact, these enterprises often fail due to their inability to raise capital funding from traditional financing institutions such as commercial banks and private equity investors. The low investment appetite in start-ups primarily stems from the high-risk early-stage nature of these business ventures, lack of collateral to secure loans, unproven business model, lack of minimum viable product, etc.

Venture Capital funding provides a lifeblood for those African start-up ventures that are both scalable (i.e. tech-based businesses that can exponentially grow their sales revenue and customer base) and frequently require time to reach profitability. The consensus in the start-up investment domain is that venture capital flow in Africa remains grossly inadequate.

According to the 2023 AVCA Venture Capital Activity in Africa Report, during the H1 of 2023, a total of 263 VC deals took place in Africa’s venture ecosystem, allocating a cumulative US$2.1 billion of capital to 258 unique companies versus the global VC investment (H1, 2023) allocation of US$144 billion during the same period. These figures represent a meagre 1.5% of global VC investment allocation in Africa.

Many African countries are implementing Sovereign Wealth Funds (SWFs) to spur innovation and increase innovation investments. These primarily government-backed funds focus on de-risking early-stage tech startup creation to generate sustainable pipeline opportunities of viable, investable, high-impact enterprises for later-stage investments by the private investor. SWFs are viewed as the source of strategic capital to reduce investment risk in early-stage startups.

3. Sovereign Wealth Fund (SWF) investment approaches and their derivatives

The Sovereign Wealth Fund is a concept first coined by Rozabov (2015) to differentiate emerging types of state-owned investment funds from other institutional privately backed investment breeds.[4] SWFs serve as investment management entities tasked to grow the assets under management (AUM). SWFs invest in various asset classes such as bonds, listed equity, real estate, private equity, infrastructure, and other alternative asset classes such as venture capital.[5]

However, in 2015 Bortolotti, Fotak, & Megginson (2015)[6] redefined an expanded definition of SWFs to include the following considerations:

1. “an investment fund rather than an operating company;
2. that is wholly owned by a sovereign government but organised separately from the central bank or finance ministry to protect it from excessive political influence;
3. that makes international and domestic investments in a variety of risky assets;
4. that is charged with seeking a commercial return and
5. which is a wealth fund rather than a pension fund –meaning that the fund is not financed with contributions from pensioners and does not have a stream of liabilities committed to individual citizens.”

According to the (Sovereign Wealth Fund Institute), there were more than 100 SWFs by the end of 2022. SWFs have over $11.5 trillion in assets under management as of February 2023.[7] Kern (2007)[8] argues SWF seek to provide inter-temporal stabilisation, diversification and risk-adjusted investment for the nation’s wealth, and these investment pillars are driving the growth of these funds across the globe.

The 2008 OECD Emerging Markets Network Working Report estimates that, on average, the SWFs asset allocation split comprises fixed-income securities (35–49%), equity securities in listed corporations (50–55%) and the remaining (8–10%), is allocated to alternative investments such as hedge funds and private equity companies.

Recently, there has been evidence of emerging markets incorporating SWFs, as shown in Figure 1 below.

Figure 1: SWFs globally managed (Source).

SWFs and their derivatives (Classification and investment models)

Based on the funding source, SWFs can be broadly classified as either commodity or non-commodity and vary significantly in size and objectives.

● Commodity-based SWFs “include those from oil-producing countries. Non-oil commodity producers include Chile, funded mainly from copper mining royalties, and Botswana from diamonds and mineral royalties”.[9]

● Non-commodity SWFs are “funded from reserves accumulated through non-commodity exports, capital inflows, budget surpluses, land sales and public savings, and the privatisation of state-owned enterprises”[10].

In contrast to the above classification[11], the International Monetary Fund (IMF) categorised SWFs into five types, each with a specific purpose, though many have objectives that cut across several categories (Figure 2):

Figure 2: Major SWF classifications.

According to Sharm (2017), the underlying investment principle of sovereign wealth funds (SWFs) is based on the strategic asset allocation model, which refers to a target location of assets into various asset classes based on the fund’s risk and return characteristics. Based on the strategic asset allocation principle, several distinct SWF investment models have emerged, as summarised in Figure 3 below.

Figure 3: Different SWF investment modes adopted from Sharm (2017)[12]

SWF Derivatives

A rapidly expanding group of SWF derivatives has been created under the Strategic Investment Funds (SIF) category, alternatively also referred to as Sovereign Development Funds, Sovereign Innovation Funds, etc.[13]

According to the 2021 IE Sovereign Wealth Lab Report, the SIF models typically add to the sovereign fund focus of profit-maximising foreign investment, a double bottom line of financial goals and economic development through their domestic investments. The SIF are the derivates of the SWF, and their origin can be tracked from Singapore’s Temasek and Khazanah from Malaysia, which were later followed by Russia, Senegal, Turkey, and Malta.

4. Strategic Investment Funds (SIF) as a source of catalytic capital

The 2017 Innovation Paradox Flagship Report argued that developing countries systematically underinvest in innovation activities and, as a result, cannot harness the opportunities offered by technological advances to address the developmental challenges that riddle their economies. At the centre of incentivising innovations is the need for increased investments in business innovation for incumbent firms and the generation of new innovative enterprises or ventures.

As part of innovation-led growth strategies, many countries are deploying SIF as an early-stage equity finance instrument to support the early stages of the firm life cycle. The early-stage equity finance instrument ensures that all necessary stages of the early-stage firm cycle are properly funded. Given significant financing risk barriers associated with early-stage ventures fundraising in general and innovative ventures in particular, many countries are providing state-backed risk capital[14] to catalyse the growth of early-stage business innovation and entrepreneurship.

5. Catalytic capital and impact investing

Impact investment is a powerful instrument to provide capital to address the world’s most pressing challenges. Global Impact Investing Network (GIIN) reports that the global size of impact investing capital in 2020 was estimated at $715 billion.

To mitigate against the perceived risk of low financial return, new capital access enhancement tools such as catalytic or first-loss capital[15] are emerging. Such investment structures encourage the flow of capital to impact investing opportunities by improving the risk-return profiles. The proponent of the capital access enhancement tools argues the importance of these instruments in magnifying positive impact and fostering market development. As shown in Figure 4 below, catalytic capital is a subset of the full capital continuum — investments that are more patient, risk-tolerant, concessionary, and flexible than conventional capital.

Figure 4: Tideline’s catalytical capital unlocking more investment and impact (Source)

6. Catalytic capital VC backing

MacArthur Foundation and Tideline define catalytic capital as capital that accepts disproportionate risk or concessionary returns to generate a positive impact and enable third-party investment that would otherwise not be possible. Catalytic capital can be deployed through guarantees or any traditional financial instrument such as debt, equity, or hybrid debt/equity instruments)[16].

The investors’ approach to deploying catalytic capital can either be directly to an enterprise or indirectly through a fund or other intermediary. As argued by Tide publication(2019),[17] “When traditional instruments are used as catalytic capital, they are structured to accept disproportionate risk and/or concessionary (expected) financial returns relative to the conventional requirement of market-rate, risk-adjusted returns. The motivations behind the concessionary feature are to drive a greater positive impact and enable third-party investment that otherwise would not be possible”.

As an asset class, venture capital is considered a high-risk, high-reward type of investment.[18] Many institutional investors have traditionally sought to minimise their risk exposure to this asset class. Notwithstanding the critical role of venture capital in catalysing the growth and scaling businesses in general and early-stage, high-growth enterprises in particular, the capital flow in this asset class has been very limited. This capital gap has been attributed to the challenges of the high-risk nature of venture capital as an asset class coupled with the inherent risk of investing in early-stage startups.

In the context of VC, catalytic capital can be used to mobilise funds from institutional investors to close capital gaps stifling the creation of new ventures. The Catalytic Capital Consortium defines capital gap as investment opportunities that mainstream commercial investment markets fail to reach, partially or fully, because they do not fit the risk-return profile or other conventional investment norms and expectations such markets require. Catalytic gaps can arise from many drivers across the investment continuum and imperatives. Building catalytic capital as an approach to closing the capital gap can have the following benefits[19]:

• Innovation: the capacity to de-risk novel products, services, or financing models;

• Early-stage: building a meaningful track record or adequate scale for a solution;

• Business model: the addressing of small transaction sizes, high transaction costs, or other economic issues related to products or services (e.g., capital intensity); and

• Venture capital: the ability to mobilise additional finance from institutional investors to support the VC market and to improve capital flow to venture capital assets.

As a capital gap-closing tool to support innovation and early-stage financing, catalytic capital has been built into a capital structure via a range of instruments in different forms, including grants, guarantees, subordinated debt and equity.

In the context of venture capital backing, catalytical capital has been used to bridge capital gaps by unlocking institutional investor capital to provide much-needed funding that can be used to finance product development, marketing, and other critical business functions.

Tideline’s 2019 report provided the following three critical interventions where catalytic capital can bridge financing gaps required to provide support at various stages of an enterprise or fund’s lifecycle (Figure 5):

Figure 5: Catalytic capital in bridge financing gaps required to provide support at various stages of an enterprise or fund’s lifecycle.

Catalytic capital can also be utilised to back venture capital as part of the blended finance approach. The global network for blended finance (Convergence) defines blended finance as using catalytic capital from public or philanthropic sources to increase private-sector investment in sustainable development. Convergence argues that blended finance as an investment structuring approach enables various investors to syndicate their investment objectives alongside each other while achieving their objectives, be it financial return, social impact, or a blend of both. Through the blended finance structuring approach, the twin investment concerns from the private investors of high perceived and real risk and (ii) poor returns for the risk relative to comparable investments are addressed.

Recently, there have been exemplary case studies where catalytic capital is part of a blended finance structure. Some of the examples highlighted by the Catalytic Capital Consortium include:

• The Prime Impact Fund[20]: catalytic capital backing is allowing the Prime Impact Fund to adopt a long-term lens in supporting high-risk, high-reward ventures at the earliest stages, thereby contributing to the urgent effort to keep global warming below potentially catastrophic levels.

• Sustainable Jobs Fund (SJF) Ventures: In 1999, SJF Ventures launched a fund to provide growth capital to expansion-stage companies focused on sustainability, employment, and competitive investor returns. At $1 million, the Principle of Responsibility Investment (PRI) served as risk-taking capital to help unlock $17 million for SJF’s first fund, giving the company a chance to prove its impact investing approach. To date, SJF Ventures has raised more than $260 million through four commercial investment funds. It has financed over 60 companies, which have created over 9,000 new jobs, particularly in underserved communities, and helped mitigate more than 2.4 million metric tons of CO2 while generating returns at or above venture capital benchmarks.[21]

7. Sovereign Innovation Funds on the continent

Several African countries have or are in the advanced stages of incorporating their respective Sovereign Funds (or the derivative versions). The scope of this section is limited to government-backed innovation or tech startup support funds, particularly those with a strong VC focus. The section looks at the background, investment model and envisaged outcome impact of these funds.

7.1. South African Innovation Fund

● Background: In 2021, South Africa’s Department of Science and Innovation piloted the Innovation Fund. The Fund catalyses the creation and sustained growth of the high-tech SME sector. The Fund focuses on de-risking early-stage SME creation to generate sustainable pipeline opportunities of viable investable high-tech enterprises for later-stage investments by the private sector. The Fund provides catalytical capital to mobilise capital flow to support SME creation.

● Investment Model: The Innovation Fund is structured to drive public and private co-investment in innovative high-tech SMEs. The Fund is implemented through the Fund of Fund (FoFs) model and leverages the investment expertise of institutions such as the Technology Innovation Agency, the SA-SMME Fund and the Public Investment Cooperation, which, in turn, drive the syndication of investment with various Venture Capital (VC) Fund management entities.

● Impact: To date, the Innovation Fund has achieved a 6x gearing effect (i.e., leveraging R6 from the private sector for every R1 investment by government) and has backed more than ten (10) VC firms, which in turn has closed more than 80 investment deals.

7.2. Rwanda Innovation Fund (RIF)

● Background: The Rwanda Innovation Fund targets information technology, healthtech, agtech, edtech and fintech sectors. It aims to drive economic development through technology and innovation. The total estimated project cost is USD 68.6 million (UA 48.65 million). The RIF addresses the financing gap that tech-enabled companies face at different growth stages. To address this gap, the project will establish affordable funding mechanisms for growth companies. It will provide equity financing for tech-enabled SMEs, train tech-oriented entrepreneurs in business planning and management and increase awareness and sensitisation for intellectual property rights.

● Investment model: The Government of Rwanda (GoR) appointed fund manager Angaza Capital[22] to manage RIF. The investment relationship is managed by executing an MOU between GoR and Angaza Capital. Under the MOU, the fund manager is required to raise USD 70 Million from private investors to achieve a target fund size of USD 100 million. Overall Commitment: The fund will mobilise Limited Partners’ (LP) commitments from public investors and target private investors (led by the fund manager) — initial US$60 million and target fund size of USD100 Million, including the fund manager’s 1% commitment. The structure of the fund is shown in Fig 6 below.

Figure 6: Rwanda Innovation fund structure (Source)

● Impact: The Fund is expected to support 150 companies at various stages of growth, invest in about 20 early growth stage opportunities, and create roughly 2000 direct jobs and about 6000 indirect jobs throughout its lifecycle, 10 years + two years. The Technical Assistance Pool (entrepreneurial ecosystem capacity) will provide capacity building to a range of seven (7) to 10 incubators and accelerators, facilitate three to five additional angel networks, and train approximately 30000) entrepreneurs across the region.

7.3. The Sovereign Fund of Egypt (TSFE)

● Background: The Sovereign Fund of Egypt (TSFE) was established in 2018 to attract private investments to Egypt and promote and co-invest in state-owned and aims to:

o Deliver sustainable financial returns over the long term through a balanced and diversified portfolio constructed to optimise risk/return profiles across the portfolio. TSFE will also deliver socioeconomic impact through all investments.

o Catalyse investment in local priority sectors from a diversified set of local, regional, and international investors and operators through these products and unlock wealth through operational improvement, greenfield, and brownfield development.

o Proactively identify and prioritise assets with the greatest potential for value creation through private ownership and capital, as well as collaborate with investors and operators to create structures to meet their investment demand and criteria.

● Investment Model: The Fund is independently managed by the private sector and selects investable assets from public stakeholders to promote and co-invest with local and foreign specialised financial partners to create value and increase the private sector’s role in the economy and job creation. The Fund is overseen by a board of directors and a general assembly, both bodies having majority private sector members. TSFE was established under Law 177 of 2018; its articles of association were published in February 2019 by Prime Ministerial Decree 555 of 2019.

7.4. Moroccan Innov Invest Fund

● Background: The Innov Invest Fund in Morocco was established by the Ministry of Economy and Finance (MEF). MEF designed the initiative, set up the fund, consulted the various stakeholders to develop ownership and mobilised resources (debt, grants, TA). A US$ 50 million loan from the World Bank was signed in 2017.

● Investment Model: The Innov Invest Fund is managed by the Caisse Centrale de Garantie (Central Guarantee Fund) (CCG) and sees the partnership of Venture Capital Funds and Programmes (SEAF, DGCF), DFIs (KfW, AfDB), Moroccan banks and pension funds, incubators and accelerators. CCG allocated an envelope of 500 MDH to support the financing of innovative startups through aid, loans and investments.

● Outcome impact: CCG has launched three funds in private/public partnership with key international players. To date, the Fund has raised $70 million in equity funds for startup investments and funded 230 startups and projects. More recently, the fund invested in Equity Tickets, targeting individuals (health care) and IT startups.

7.5. Tunisian ANAVA Fund of Funds

● Background: Tunisia was the first African country to pass a Startup Act in 2018, which has since been implemented in 10 other African countries. The Act aimed to position Tunisia as an innovative business hub for startups. It successfully jolted Tunisia’s startup ecosystem, which had seen only a handful of venture capital deal activity before 2019.

● Investment Model: In 2022, KfW Development Bank subscribed €20 million to the ANAVA fund, which reached €60 million. ANAVA invested in two prominent VC funds in 2022: 216 Capital Fund I, a seed-stage fund that backs Tunisian tech startups managed by 216 Capital Venture, and Badia Impact Squared, a late-stage fund investing in startups across MENA and managed by Silicon Badia. The Fund has a target size of EUR 100 million and aims to invest in more than 13 investment funds dedicated to startups at each stage of development. The fund’s strategy is rolled out at several stages of maturity for startups to diversify risks and maximise performance on a large scale.

Figure 7: Tunisia ANAVA Fund of Funds Investment strategy (Source)

● Impact: Since 2018, Tunisia has officially recognised more than 650 startups, launched a €100 million fund of funds, and started the Flywheel program to support the ecosystem. Startup Tunisia offers grants of up to TND 200,000 ($63,000). Air2 offers up to TND 200,000 ($63,000) to seed-stage startups to support them as they raise larger amounts.

8. Conclusion

The number of SWF in the continent is growing albeit slowly. These Funds differ in many respects, including the objective, governance, investment model etc. From more than ten(10) funds reviewed, at least five(5) are dedicated to supporting technology-based start through VC backing support.

Indications are that the number of these fund will increase, Recently, on 6 April 2023, the State-owned Kenya Development Corporation announced plans to establish a technology innovation fund to finance start-ups.

Notwithstanding the differences in the investment model and focus, the five innovation funds outlined above all supply risk capital to de-risk the growth of tech-based start-up and through their strategic partnership, further provide much needed VC capital flow in the continent.

Acknowledgements

My sincere gratitude to the Department of Science and Innovation for providing financial support for my participation in the 2023 DreamVC Investor Accelerator (IA) Fellowship Programme. A big shout out to Cindy Ai and Mark Kleyner for the rich venture capital landscape content over the past 20 weeks. Special thanks to Cindy Ai for guidance and edits during the writing of this article. A big thank to Brigitte Binneman for insightful contribution on various Sovereign Wealth Fund. I’m grateful to Mulalo Mathelemusa for an amazing work in trimming the article.

Sources

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[3] Luger, M. I., & Koo, J. (2005). Defining and Tracking Business Start-Ups. Small Business Economics, 24(1), 17–28. doi:10.1007/s11187–005–8598–1

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[6] Bortolotti, B., Fotak, V., & Megginson, W. L. 2015. The sovereign wealth fund discount: Evidence from public equity investments. The Review of Financial Studies, 28(11): 2993– 3035.

[7] William L. Megginson et al. Sovereign wealth funds in the post-pandemic era Journal of International Business Policy (2023

[8] Kern, S. (September 2007), “Sovereign Wealth Funds — State investment on the rise”, Deutsche Bank research, Current Issues. See also http://www.dbresearch.de/PROD/DBR_INTERNET_DE-PROD/PROD0000000000215270.pdf

[9] Orchard F (2023) Safeguarding the future fundamentals. The Rise of Sovereign Wealth Fund Think Space (https://www.gic.com.sg/wp-content/uploads/2021/04/GIC-ThinkSpace-The-Rise-of-Sovereign-Wealth-Funds.pdf)

[10] Orchard F (2023) Safeguarding the future fundamentals. The Rise of Sovereign Wealth Fund Think Space (https://www.gic.com.sg/wp-content/uploads/2021/04/GIC-ThinkSpace-The-Rise-of-Sovereign-Wealth-Funds.pdf)

[11] UN Environment: The Role of SWFs for Green Investments, December 2017

[12] Sharm (2017) Sovereign Wealth Funds Investment In Sustainable Development Sectors (https://www.un.org/esa/ffd/wp-content/uploads/sites/4/2017/11/Background-Paper_Sovereign-Wealth-Funds_16-Nov.pdf

[13] Sovereign Wealth Research (IE Centre for the Governance of Change) based on Ireland Strategic Investment Fund (2019)

[14] Catalytic capital, catalytic first-loss capital, patience capital etc. (Brophy, Paul, and Tom Waldron. The East Baltimore Revitalization Initiative: Innovative Philanthropic Financing for Community Change. The Annie E. Casey Foundation, 2014

[15] Sometime referred to risk capital, patience risk etc. (https://www.investopedia.com/terms/f/financialrisk.asp

[16] A Tideline Publication (2019) Catalytic Capital Unlocking more investment and impact (https://tideline.com/catalytic-capital-unlocking-more-investment-and-imapact/).

[17] A Tideline Publication (2019) Catalytic Capital Unlocking more investment and impact (https://tideline.com/catalytic-capital-unlocking-more-investment-and-imapact/).

[18] Bridges Ventures. Shifting the Lens: A De-Risking Toolkit for Impact Investment. 2014. http://www.trilincglobal.com/wp-content/uploads/2014/01/BV_BoA_de-risking_report_FINAL-2.pdf

[19] Armeni, A.; Ferreyra de Bone, M. (2017). Innovation in Financing Structures for Impact Enterprises: Spotlight on Latin America. Transform Finance, supported by the Multilateral Investment Fund and the Rockefeller Foundation. Available online at http://transformfinance.org/briefings/2017/9/1/innovations-in-financing-structures.

[20]invests in transformative technology companies with the potential for gigaton-scale climate carbon impact

[21] https://missioninvestors.org/resources/catalytic-capital-action-sustainable-jobs-fundsjf-ventures

[22] Angaza team, Angaza Capital www.angazacapital.com,