What is missing for the venture capital ecosystem in Latin America to explode
Despite the growth of venture capital investments into the region, Latin American countries need to take some steps to encourage the growth of startup ecosystems within their borders.
From 2016 to 2019 venture capital investments have been doubling year over year in the region. In 2020 despite the pandemic, venture funding sustained levels similar to 2019.
And even though U.S based funds have increased their number of investments in Latin America, they are still shy compared to their total investments.
This gap in funding in the region is not just reflected in the lack of funding of U.S funds, but total investments, including local funds and investors. Below is a table that calculates the venture funding received by different countries as a percentage of their GDP.
What can easily be seen is the difference between developed markets like the U.S which has 9 times more investment as a percentage of their GPD in comparison to the average of the Latin America (countries shown in the table as other countries in the region have funding close to 0), even India has levels 4 times higher. In Colombia, if you exclude all Rappi rounds, the average would be just 0.02%. Also, 2020 numbers should be taken with caution as in most countries the base of GDP suffered a significant decline due to the pandemic.
Below are some points of what countries should do to encourage greater levels of investments in Latin America:
1) More government support: in the U.S there were several initiatives by the government to promote innovation that led to the development of the U.S venture capital industry. Some main ones were the SBICs program of 1958 which allowed the formation of investment companies that could back small businesses not just using private capital, but capital borrowed from the government at lower rates and receive tax privileges. Afterward, in the 1970s and 1980s the government created tax incentives on capital gains, as well as the SBIR program. At this point, I do not agree that Latin American governments should be as directly involved as the U.S, nor I think it has the economic capacity, but local governments lack regulation like significant tax incentives to promote investments in this type of companies and funds, especially taking into account the amount of risk involved.
2) Increase the base of limited partners and raise risk investment profiles: a major base of the limited partners of U.S venture capital funds are endowments, insurance companies, and pension funds, according to a study made by Preqin from the top 100 LPs of venture capital funds, 42% represented pension funds for example. In Latin America unfortunately, from anecdotal experience, there is a lack of investments of these entities in venture capital vehicles (especially local ones) due to the low-risk thresholds they have. The institutions that do invest in venture capital funds mainly chose international ones, for track record purposes as well as size (the sizes of the local funds, are sometimes not big enough to meet their minimum investment requirements, or if it does their ownership percentage of the fund is above the internal limited maximum and sometimes government allowed maximums). But how are then the local funds supposed to prove a track record and increase in size, if the available addressable limited partners universe is small and highly sought?. And the problem is that as shown before international funds are not as invested in the region as it is required for the ecosystem to grow.
3) Proof of exits and more IPOs: even though on the entrepreneurial side there has been proof that successful companies can be created in Latin America like, Rappi, Quinto Andar, 99, or Nubank to name a few, which have motivated entrepreneurs to launch new companies. The amounts of exits of venture capital-backed companies have been weak (with few examples like 99, Viva Real, or Cornershop to name some) compared to the U.S which in 2020 saw USD $290bn in value via exits according to a Pitchbook/NAVCA report. This does not incentivize limited partners to invest in local funds, or outside venture capital funds to really commit to the region by opening offices and allocating a higher percentage of their total capital to Latin America, especially when they have investment opportunities in more liquid markets. There are two big factors that partly explain this lack of exits, the first one is given the low availability of capital it is hard for companies to grow and reach exit-worthy revenues. The second one is the inefficiency and illiquidity of local stock exchanges, the process to IPO is costly and complex, and there is not a good financial culture. And even though in a globalized world it is possible to list on an international exchange, there is still a lack of cases (with few exceptions like MELI) of Latam companies in US exchanges, which is probably going to grow in the next few years. For these reasons the main route to achieve exits at the moment is through M&A which is not enough, especially taking into account the fact that most traditional regional companies that are the potential buyers lack understanding of startups (the value they provide, how hard and expensive is to develop the technology in house, and how to value them, not using cash flows but rather revenue multiples). In this sense hopefully, companies like Rappi will go public soon on US exchanges and create proof that this can be achieved, getting attention from the public to venture capital, and fostering the growth of the ecosystem by promoting the creation of firms highly specialized in bringing Latin American companies to IPO in local or international stock exchanges (especially lawyers, finance and PR firms). On the other hand, in the near future, international companies (which understand better the value startups provide and how to value them) looking to arrive in Latin America might begin buying regional startups as a way of gaining local knowledge and positioning. Also, recent Latam unicorns (Loft, Quinto Andar, Nubank) are going to probably start making small acquisitions to increase their product offering or expand to new markets.
One additional element that was missing till recently was an external shock, which for the U.S. was the war as it forced the government to increase the spending on innovation which led to the creation of some of the first highly successful US-backed ventures. Today the Covid-19 pandemic has accelerated the technological adoption, according to Adobe’s report Covid-19 has accelerated e-commerce growth by between 4 and 6 years, giving Latin America the shock it needed to really start to boom in the next years. Hopefully, this shock will align with changes in the ecosystem, starting with more government support creating tax incentives.