5 places to escape to this investment winter
African tech can thrive in the new normal
Team Lateral spent January assessing what season we find ourselves in for venture capital in growth markets. The reset in valuations and macroeconomic outlook has challenged us to reflect on headwinds and opportunities for innovation. As a reminder, at Lateral Frontiers, we seek to invest in talented founders building innovative companies in large, fast-growing and underpenetrated technology ecosystems.
In what follows we take the temperature for risk assets globally, and specifically in our markets. We suggest 5 “sunny” places to spend time this year in search of asymmetric returns. The potential of innovation in uncorrelated markets offers some shelter from the easy money excess unwind we are witnessing in venture capital in the west.
By focusing on opportunities in a handful of innovation themes including i) essential sectors ii) talent and tech playing to a global audience iii) mergers and acquisitions iv) credit and v) tech formalizing informal sectors in the innovation economy, investors are offered diversification via a multi-decade growth tailwind with attractive fundamentals.
Global Macro
First, let's revisit what the weather is like out there for investors in established markets. January brought some respite for battered growth investors followed by what is being interpreted as peak inflation and perhaps the end of the U.S. Fed hiking cycle? Back to normal? Not so fast. Let’s start at a high level with an extended time horizon. In his end-of-year letter to investors, Oaktree founder Howard Marks referenced the “sea change” underway as the US transitioned away from a decade of zero interest rates and the accompanying need to move up the risk spectrum in seeking returns. As this era ends he reminds us that “we never know where we’re going, but we ought to know where we are”. The key point being that we are entering the third multi-decade status quo change in his 40-year investing career.
The sea change of 2022 and the normalization of interest rates after a decade of free money and excess looks like a shift to decent returns without having to take excessive risk. At the same time, developed economies and China face meagre growth prospects and demographics.
Turning to another all-time great investor, Fred Wilson at USV framed the new normal in his 2023 projections expecting a significant startup unwind still to come in the US as mark downs and wind downs work their way through the system. His framework for startup valuations references a return to 2015 parameters with seed rounds at a ~$10m cap, A $15-$25m, B $25-$50m and growth rounds capped at 10x revenue. This rings true with the African venture ecosystem at the later stages and perhaps still looks inflated at Seed where we are more comfortable at $5m and below.
Our north star in looking for lessons learned from the last major bubble unwind is the following chart from JP Morgan Research compiled by Michael Cembalest in their 2023 outlook:
It frames the return expectations from 3 cohorts of companies that survived 2000–2004, namely i) companies that were profitable into the dotcom crash and remained profitable throughout compared to ii) unprofitable in, remained unprofitable and iii) unprofitable in but found profitability on the way out. The respective returns for the 3 cohorts over a 4 year period were i) 25% (meh), ii) -50% (ouch), 3x (yes please). Our focus on at scale positive unit economics gives us confidence in the remaining return profile of our Fund I which screened for B2B fintech and energy transition digital champions with compelling business models from the outset.
It is also interesting to note the shift towards technology as a percentage of the overall market cap of emerging markets with a significant decrease in the weighting of resources over the past decade. There is an argument in favor of a higher valuation multiple to be assigned to emerging markets given the increased concentration of technology in these economies.
Destination Emerging Markets
Is spring on the horizon? There is a growing consensus that more attractive valuations and an ongoing technology adoption cycle in emerging markets offer a compelling escape from the challenging season that US and European capital allocators find themselves in.
Let's depart from the risk and valuations framework in traditional markets. Being overweight emerging markets seems to be a consensus trade now in public assets. Taking a longer-term view, research teams at Morgan Stanley and Alliance Bernstein both published constructive forecasts for a decade of emerging markets decoupling and outperformance which underscores the longer-term opportunity for private innovation investors.
Let’s start with China, the massive industrial machine which has allowed the west to deindustrialize. A normally functioning Chinese economy should be a tailwind to us all near term and relieve inflationary pressures before perhaps exacerbating inflation with pent-up consumer demand. The value destruction seen in Chinese assets in 2022 is the most extreme in history and we entered Q4 2022 with nearly 80% of Chinese corporate bonds trading at 20c on the $ or less. Since October ’22, Chinese Tech companies rallied by up to 60% (Alibaba) with a Covid Zero policy of extreme lockdowns in the rearview mirror. There is an expectation for support from the 2022 excess consumer savings of as much as $500bn (equivalent to adding an entire additional Nigeria to the global economy in terms of consumption) and the potential for close to 7% GDP growth this year. For longer term investors an expected Chinese population decline of over 50% in the remainder of this century has thrust India firmly into the limelight. India, dethroning China as the world's most populous nation in 2023 also holds the largest contribution (~80%) to the global consumer middle class over the next two decades. In recent weeks, the balance sheets and transparency of corporate India have been debated in the media with renowned short seller Hindenburg Research questioning the valuation framework of Gautam Adani’s group of companies resulting in a nearly $100bn destruction of shareholder value so far. Debates around the cash positions of India’s recently minted class of unicorns have also surfaced. The Economist highlights that while the number of Indian private companies valued at over $1bn more than doubled from 40 to 108 in the past two years, 78% of recent Indian unicorns have less than 2 months of cash runway
Large US VC funds in our network have prioritized India and Brazil among their non-US venture investments. As ‘tourist capital’ pumps the brakes on other emerging markets, local capital in frontier markets has never been more important. Brazil’s well-documented startup successes, established VCs and favorable macroeconomic backdrop (earlier rate hiking cycle to contain pandemic stimulus-induced inflation) have set up a more attractive backdrop to the US and Europe. Unlike any of the main four destinations for venture capital in Africa, Brazil is also large enough as a single addressable market (~50% of Latin American spending power) and has benefitted from investor-friendly regulatory developments, particularly in fintech. But Latin American startups face highly competitive valuations and significantly more venture funding overhang (~$30bn in VC funding across Latam in 2021–22) than their counterparts in frontier markets. Our conviction in the resilience, under penetration of capital and world-class talent in the rapidly maturing startup landscape of Africa, therefore, remains a compelling and overlooked opportunity set for investors.
5 African thematic investment destinations for 2023
As we entered 2023, we assessed the opportunity cost for emerging markets investors of allocating away from publicly listed Chinese assets (equity and credit) which are attractively valued and liquid, India and Indonesia’s growth in disposable income, Brazil’s demographic tailwinds and friendly regulatory environments or Mexico and Columbia’s ongoing roster of innovation and high growth tech companies adjacent to the US. To the north of us, the middle east is flush with cash, especially Qatar and Saudi Arabia, but this is predominantly funding US and Western European assets. How will VC in Africa in 2023 compare to other emerging markets? Undoubtedly African startups are not immune to the reset in valuations and a slowdown in funding that is anticipated globally in 2023.
The debate around hyper-growth-oriented venture investing in developed markets vs backing default break-even startups more common in developing markets seems to be settled. A focus on top-tier founders that have proven what they can do at more attractive valuations is compelling. Across the geographies we operate in we are already seeing extension or flat to down rounds at reasonable valuations for great teams that have typically grown revenue by 80 — 100% year on year. In short, capital is available for proven, high-quality builders at the right price. We estimate the amount of remaining dry powder from dedicated early-stage African VCs at around ~$1bn coming into 2023. This excludes US or European VCs with Africa as an opportunistic allocation and excludes Series B onwards mandates.
Recently the macroeconomic outlook has deteriorated in a number of African markets. For example, Ghana, the world’s fastest-growing economy in 2019 experienced 50% inflation and one of the worst fx performances in 2022 as fiscal ill-discipline prevailed while Egypt risks experiencing a similar fate to Lebanon with currency devaluation by around one-third since late October and inflation currently officially at over 20% (unofficially estimated as high as 100%) which puts government stimulus and regulatory reform at risk. Meanwhile, Africa’s economic powerhouses Nigeria and South Africa face their own challenges. Nigeria faces uncertainty into February 25th elections while the painful ~60% devaluation of the Naira seen over the past 3 years has created a liquidity crunch while South Africa’s crumbling baseload power infrastructure could have cost the economy a full percentage point of GDP growth in 2022. Nevertheless, the African Development Bank and IMF remain more constructive regarding economic growth through 2024 than in other regions. When all is said and done, the correlation between macroeconomics and venture capital remains low and entrepreneurship has prevailed despite the absence of economic tailwinds over the past 5 years. Operating in the final frontier for venture capital, we have the opportunity to access innovation ecosystems with less excess funding, a founder mindset of default profitability (since the region still attracts less than 1% of global VC dollars), and technological leapfrogging to overcome inadequate infrastructure. These factors make innovation a daily priority for domestic enterprises and the massive informal economy.
Despite the global slowdown in 2022, venture in Africa continued to grow, with nearly $5b equity and about $1.5b debt raised in 2022 alone. 70%+ of the amount raised flowed into the key “Big 4” Markets (Nigeria, Kenya, South Africa, Egypt), with Nigeria (25%) taking the lead once again, followed this time by Kenya (23%), and South Africa and Egypt rounding out the bulk of the remainder. FinTech retained the lead on a sector basis, with $1.8b (37%) of funding received, followed by ClimateTech, with energy alone bringing in $874m or 17% accordingly. Our peer investors are calling for increased investment beyond fintech in 2023 as a realization that asset-light, copycat models alone won’t deliver returns. Energy transition continues to be an emerging sector on the continent and we see a competitive advantage here for Lateral with our ability to diligence and underwrite both hardware and software innovations.
We are already seeing a flight to quality among a slowdown in overall activity. We expect an uptick in activity in later stage (B and C) rounds for established teams that have truly proven product-market fit and perhaps crossed a border to add a second market. We expect that regionally dedicated VCs that are sitting on recently raised dry powder are more likely to deploy to later-stage companies that realistically can cross $20m+ revenue quickly. We expect seed stage deal flow to remain frosty until 2024 aside from day one investors like YC, and even there, African companies went from a total of 24 in 2021 to only 7 total in the latest cohorts.
With this backdrop in mind, we offer weary travelers 5 Places to ‘visit’ this winter to stay warm(er) as they look for an escape from the cold reality of the risk reset.
- African innovation by necessity: no dog walking apps or oversubscribed pet insurance to be seen here
We expect it will be back to basics over the coming months with a return in focus to innovators addressing the need for essential products. Our core focus sectors for our recently launched Fund II are fintech and energy transition. Starting with fintech, we have the benefit of a second mover advantage looking at a fintech ecosystem that has strong parallels to Brazil. Carbon co-founder Ngozi Dozie’s January thought piece on substack outlines the connected evolution of the two. Brazil has created a “fintech ecosystem set up for all parties to win; startups, regulators, economy and most importantly perhaps, customers”. While open finance and regulations are in varying states across Africa, with the tailwinds of the largest mobile money ecosystem globally in Kenya or comparatively friendly crypto regulations in South Africa, it is difficult to make the case that Brazil-style regulatory support has happened in any of the African fintech ecosystems to date. And yet when we engage with leading fintech founders across LatAm, Africa is regularly featured as a priority expansion destination. This is because fintech products across lending, savings, payments and remittances offer similar solutions across the regions and Africa’s credit and insurance penetration and cross-border flows remain largely untapped in spite of a handful of successful v1 fintechs. With mounting pressure on regulators to prioritize savings and solutions for disgruntled consumers in the new economic backdrop, we expect to see a fast-tracking of open finance across the African continent over the next 24 months.
Startups like Zone, which powers the digital infrastructure of the majority of Nigerian banks will continue going to build on defensible and fast-growing enterprise revenue and expand by offering more efficient ways to service the last mile to the consumer. For example, an account-to-account payments and cash withdrawal product that was launched in Q4 experienced 40% MoM volume growth and rapid uptake from the banks to satisfy customers in an economy dematerializing cash as a high priority. Built on open-source distributed ledger technology, with the backing of the Nigerian Central bank, Zone enables direct account-to-account payments reconciliation starting with ATM cash withdrawals and a stable coin-backed cross-border payments functionality is in development for the end of 2023 release. Fundamental technologies like this don’t stop growing, regardless of economic seasons and decentralized finance offers far more everyday distribution applications in Africa than speculative use cases.
Turning to the massive unmet demand for a transition to reliable and affordable clean energy, Koko Networks innovates for the everyday need of cooking fuel by offering the cheapest and most convenient alternative — Kokofuel. In contrast to overfunded 15-minute grocery delivery or consumer levered buy now pay later players in developed markets, these embedded solutions solve critical everyday needs in the informal economies that represent up to 80% of the GDP on the African continent. Simply put, there is a much higher allocation to non-discretionary spend categories in African VC than in developed markets.
2. Africa Out: high-quality technology at lower cost for a global audience.
Let’s not curb our ambition to innovating only for African everyday needs. Over the past 5 years, African technology companies have shown their ability to compete on a global stage with high-quality, low-cost products. Perhaps the best example is African payments giant Flutterwave (founded 2 years prior to Lateral’s launch) reportedly contending to acquire UK fintech Railsbank. A successful fintech that has navigated the complexities of Africa to achieve scale in a more capital-efficient way with better unit economics is a great fit for a return to realism in innovation. Over the past 7 years, African startups have had a taste of growth-oriented investing while mostly staying grounded in the reality of their consumer bases resulting in leaner and sooner profitable business models with a handful of exceptions.
Nigeria has stood out in its ability to compete on a global scale with tremendous technical talent. We would like the global audience to become more aware of the numerous high-quality, default-breakeven African businesses that have the potential to scale and be valuable in other bigger markets. With China's demographics slowing and India becoming wealthier, the next cohort of emerging markets champions are poised to fill in the gap. While Mexico, Vietnam and Indonesia are scaling adjacent to the USA and China respectively, African startups are pragmatic rather than idealistic in their service to a global audience that increasingly is able to use their products and services. In our portfolio, we have seen SeamlessHR, a pioneer of Software-as-a-Service on the continent increasingly find its global audience. Having built a world-class product that can compete with US and European SaaS champions, SeamlessHR has operated with positive unit economics from day 1 and offers a competitively priced alternative to developed markets incumbents with no change in quality. Sparkmeter, with an existing presence in 30 emerging markets has expanded to service US customers with its smart metering grid technology that offers a better-priced, resilient alternative to incumbent OEMs.
Over the past year, talent migration from Africa to the U.K., Canada and the U.S. has accelerated. These technically astute founders are leading their companies from abroad. Colloquially referred to as “japa’ing”, derived from the Yoruba slang for running swiftly out of a dangerous situation, this trend is especially prevalent in Nigeria. Success on the continent does require a deep on-the-ground presence, but the ability to interact with a global audience is valuable as well. Exposure to international startup ecosystems and talent pools helps founders build better businesses for Africa and inspire African founders to build for a bigger global audience. When Americans comment on the burgeoning Nigerian talent in US sports including basketball and football, we encourage them to prepare for African founders winning in the global economy and markets. African startups no longer only address opportunities. Solutions are being built to be adaptable to markets beyond Africa.
3. Private Equity in overdrive
US growth private equity activity has ratcheted up over the past 6 months with strategies to take bloated moderate growers private or to recapitalize strong technology stacks that require business model pivots. In Q4 2022 Thoma Bravo’s announced acquisitions of Coupa, User Testing and ForgeRock collectively represented $12bn in those 3 deals alone. Will later-stage venture and growth equity overtake the deal volume of early-stage venture? Absolutely. Established tech companies serving Africa to be on display through 2023. We believe that in our markets transactions are less likely to represent valuation distress given that African innovators were not overextended in the way that US and European SaaS and fintech have been ($1bn companies with $6m in ARR???) and more likely to represent bolt-on acquisitions to achieve scale across borders both on the continent and beyond Africa.
Consider what $100m (growth PE minimum investment size) can buy in our markets relative to the US where that amount more often represents a swift tender offer completed in a day for a listed junior tech company. This week Egyptian MNT Halan announced a $260m secondary transaction with a group of private equity investors exchanging stakes in the company at an unconfirmed valuation of $1bn post-money. $100m theoretically unlocked at least a ~14% stake in a leading mobility fintech with 5m customers in a country with a young upwardly mobile population of 100m at what we believe to be less than 3x revenue.
A more extreme example lies in Jumia, an e-commerce leader often referred to as Africa’s Amazon, before the scrutiny of public shareholders prevailed following a Nasdaq listing and the company fell out of favor as the end of investor appetite for profitless growth set in 2022. Before a 15% and 45% rally in the share price over the past week and month respectively, the company which still trades at less than 1x sales had an enterprise value of less than $100m, down from $3.25bn in 2020 when valued at 20.4x revenue. Investors’ patience has run out for the perpetual long road to profitability and liquidity has dwindled as the company’s cash position hemorrhaged from back-to-back years with an EBITDA margin of less than -100%. Yes, Jumia spent more than $1 to generate $1 of revenue. Long considered an acquisition target for international competitors including Amazon and Walmart, a Q4 management transition exiting long time co-founder CEO’s drove home the will of the board. The business has low leverage with 30% and 15% topline growth expected over the next two years and the potential to find profitability by 2024, at least two years behind schedule. For the right investor, a take private with a combination of equity and debt funding for JumiaPay, a spinoff of the loss-making fulfillments unit and a relentless focus on cash conversion stands to generate an attractive return.
At the earlier stage, portfolio company Lipalater, a leading consumer finance technology company focused on productive assets (smartphones, tablets) strategically acquired East African e-commerce and fulfillment startup SkyGarden. We are confident that at a minimum, competition in VC will shift to the beyond Series A stage with priority given to established teams with proven product-market fit and perhaps a cross-border expansion under the belt rather than undisciplined FOMO driven seed stage investing led by bulge bracket foreign VC’s. In this thoughtful article published over the weekend, Abraham Augustine at TechCabal’s NextWave made the case for venture capital in Africa to lean into the private equity discipline of assessing current rather than future business models. Specifically, the entry of bulge bracket US VC into the ecosystem shifted focus from business models to growth at all costs unlocking potential future unicorn outcomes. “What we missed as venture investing in Africa gained momentum — a rigorous analysis and attempt to identify exits — opting instead to sit back and hope to sell growth deals to pre-IPO investors from California”.
Consider this an open invitation to General Atlantic, Thoma Bravo and Vista equity partners to tour Africa with us. In the meantime, there are plenty of sound business models at work at the earlier stages. Finding them simply requires looking beyond copy and paste fintech inspired by business models in the west.
4. Credit where it is due
In 2022 we backed B54, an African startup solving the dual problem of regulatory KYC and access to debt for African fintechs. We piloted debt investments in our Fund I and have learned that credit for high recurring revenue companies with sound leadership is often mispriced. Startups in emerging markets that have found growth and sustainable economics are great candidates for higher-yield credit. For folks that have an appetite for local currency debt at very attractive yields, rather than expanding across borders or hiring for vanity using venture dollars, we see a huge need for 12–24 month debt. This will lead to deeper penetration in local markets rather than growth at all costs. In 2022 of the $6.5bn of total venture funding deployed in Africa, ~$1.7bn was debt. While this represents the sharpest historic increase in venture debt to the continent, doubling in dollar value across 71 deals including 4 mega deals, 26% ecosystem leverage seems low given the strong asset performance we continue to see. This may be a sunny place to hang out while it's cold elsewhere given the tendency for default breakeven business models compared to other regions.
5. Make it formal
Much has been written about the scale of the informal economy in Africa. Again referencing Ngozi, consider that Nigeria has ~$4.5bn of cash in circulation, 83% of this ($3.6bn) is held outside of banks, largely managed by agent networks around informal markets. Startups like Moniepoint, Kuunda and Waynbo which offer tools for agents to provide tailor-made solutions bring efficiency and velocity to these large informal value chains. The challenge that continues to limit startups looking to digitize the informal market is the approach to deploying technology. Many try to adopt the next cutting-edge technology when users don’t want over engineered complexity. Startups that have done well have honed in deeply on market dynamics, the informal community, the relationships and unspoken rules. They’ve also learned to integrate effectively and incentivize incumbents to adopt the efficiency they provide as partners.
4G Capital is a great example of functional technology combined with an agent network to formalize the informal SME financing market that needs access to credit for working capital. No one better understands the car marketplace, the community around it, and the broader ecosystem than Autochek — the #1 online vehicle marketplace on the continent. On the consumer side, we continued to underwrite the team at Carry1st in their January Series B. Carry1st are the leaders in bringing content and payments together to service the African gaming market which is set to surpass 200m gamers over the next 2 years, 95% of which use smartphones and require frictionless payments.
In conclusion, the investable universe of innovators in frontier markets has become more mature, better priced and primed for a role on the global stage through the evolution of the last cycle. We remind ourselves daily that the best returns came from these environments, and that this is a healthy change back to discipline and sustainable growth. Fortune favors the disciplined brave. Don’t miss the sunshine in emerging markets innovation this winter. Please get in touch to go deeper into any of these opportunities, we would love to hear from you.
Olumide in Kenya and Rob in California
