What’s Next for Frontier Capital?
Experimentation and innovation in approaches to financing early stage entrepreneurs in emerging markets is growing. But it is time for the impact investing industry to come together to address the “frontier capital gap” in a more ambitious way.
In 2015’s Frontier Capital, Omidyar Network shared our perspective on the need for more risk capital to support entrepreneurs in emerging markets, particularly those serving the needs of lower income populations. We also called for the impact investing industry to explore a wider set of models of risk capital beyond traditional venture capital structures to meet the needs of different segments of emerging market entrepreneurs.
Why? Because traditional VC financing structures — and their underlying portfolio economics — are best suited for enterprises with certain attributes: those targeting a large addressable market, that have the prospect of rapid growth and scale (often asset-light tech-enabled business models with marginal incremental costs to scaling), and the potential for a timely exit. The majority of our investments — and those of our mainstream VC counterparts — are invested in such companies.
But in addition to the traditional commercial investments in our portfolio, we also recognize that many emerging market enterprises with significant impact potential don’t fit this profile — enterprises operating in what we call the “frontier plus” segment of the market. These include businesses that are pioneering unproven business models, serving lower income or hard-to-reach populations, working in asset-intensive sectors, or operating in less developed economies with fewer investor options — or sometimes all of the above. Many of these businesses have high impact potential in critically important sectors, such as education, energy, health, and housing. And indeed, many of these have tremendous commercial potential, but may require a different type of financing and support to realize that potential. As an industry, we need to seek innovative solutions to drive additional capital to this segment of the market.
And we are seeing progress as more players refine existing early stage financing models and experiment with new ones. Pioneers in small business finance such as Small Enterprise Assistance Funds, Business Partners International, and GroFin bring learnings from utilizing open-ended vehicle structures and deploying a range of non-traditional, more flexible debt instruments. They are joined by organizations such as Adobe Capital, Pomona Impact, and Village Capital are that deploying mezzanine and structured exit instruments for early stage deals.
There’s also increasing innovation among ANDE members on models to build the pipeline for early stage impact investment — USAID’s PACE partners represent a number of models for aligning tailored acceleration support with seed stage finance.
Furthermore, we’re seeing increased efforts to seed and strengthen a variety of financial intermediary structures that can deploy risk capital. The Dutch Good Growth Fund, IFC SME Ventures, and I&P all have models for taking anchor investments in local funds operating in frontier markets, and helping to catalyze more mainstream sources of capital, while Capria is deploying an innovative model to strengthen the capacity and accelerate the fundraising of first-time local fund managers.
We see these innovations and field building efforts as encouraging progress, and we give due credit to these practitioners and many others too numerous to cite here.
But despite this progress, we’re impatient. As we are still a long way away from mobilizing the magnitude of risk capital needed to fuel the growth of the diverse array of enterprises that can contribute to inclusive economic growth, positive social and environmental impact, and the achievement of the Sustainable Development Goals.
We need to move beyond experimentation, gather evidence on which of these risk capital innovations are delivering results, figure out what it takes to replicate or scale them, and mobilize the right types of capital to do so. And we believe collaboration across the impact investing industry can play an important role in this.
That’s why we’re partnering with the Dutch Good Growth Fund and the World Bank Group’s InfoDev team to bring together a set of leading impact investing field builders and practitioners this week in Amsterdam to ask the question:
How can we most effectively collaborate to increase access to appropriate capital for early stage enterprises in emerging markets?
We see this as an opportunity to start to harvest the learnings from the range of early stage financing innovations underway, and to align around a common field building agenda for early stage finance in emerging markets.
At Omidyar Network, we have four key questions to help advance this conversation:
How do we better define and segment the market for frontier capital? A tremendous diversity of entrepreneurs in emerging markets need risk capital and have promising potential for impact. From a high growth start-up FinTech company in India, to a nascent network of private health clinics in Latin America, to a small established company serving smallholder farmers in Central Africa. We know such businesses need different types of risk capital. But too often we’ve defaulted to insufficiently differentiated financing solutions. As a sector, we need to get more sophisticated in segmenting enterprises and aligning them to the right sources of early stage finance at the right time. This means looking across multiple dimensions — not only sector, stage of maturity, and profitability metrics, but also considering: What is the growth ambition and intention of the entrepreneur, and what does that mean for exit prospects? Is the entrepreneur in an established market, or pioneering a new one? What income segment is the enterprise seeking to serve and what does that mean for the pathway to profitability and scale? We see an opportunity to collaborate with other investors to develop a more robust data-driven segmentation of early stage financing opportunities in specific sectors and markets.
How do we most effectively deploy a wider set of financial tools? As noted above, we’re seeing greater experimentation with a wider set of non-traditional models that have more flexible terms, mezzanine structures that combine debt and equity elements, revenue share and royalty models, as well in some cases as blended structures that incorporate grant or concessional capital. But it remains early days and we don’t yet have a strong enough evidence base of whether and where these models are working for both entrepreneurs and investors. We see an opportunity to collaborate with others to gather proof points — of both successes and failures — in deploying alternative investment structures, and share those lessons widely.
What are the right intermediary structures and business models for delivering different types of early stage financing to different segments of the market? Multiple models are needed to meet the financing needs of diverse small and growing businesses in different contexts and at different stages of their maturity. Angel investing networks, specialized mezzanine debt providers, locally run and capitalized and seed funds, banks with specialized small business expertise, and impact venture capital all offer promise for different segments of the market. But all come up against the fundamental challenges of “frontier plus” investing, which is not for the faint of heart given factors around risk profile, investment ticket size, diligence and technical assistance costs, time horizons, and exit prospects. In order to better match expectations of risk, return, and impact, we need to learn from the pioneering intermediaries in this space about how to make these business models most effective and sustainable. We look forward to forthcoming research from the Dutch Good Growth Fund and Open Capital Advisors, as well as the Shell Foundation, ANDE, and Enclude on this important topic.
How do we unlock more capital to flow to this segment of the market? The need for more truly risk tolerant capital to finance early stage ventures and build pipeline in the impact investing industry has been a common refrain in the impact investing industry for years. We need more players willing to provide flexible, catalytic capital, combined with deeper insight on how such catalytic risk capital can be deployed most effectively — while still embracing more traditional structures that attract mainstream investors. This is an area where we see promise for greater collaboration between philanthropic and donor players in the market. In particular, we’re intrigued by early dialogue among some philanthropic impact investing players on potential opportunities to pool catalytic capital.
We won’t answer all these questions in a day. But rather, we see this as the start of a conversation on how we can better collaborate on shared goals, capitalize on the exciting progress being made, and accelerate the solutions that are working — all with the ultimate aim of moving more capital to support emerging market entrepreneurs seeking to achieve both business success and social impact.
