VENTURE CAPITAL: DRIVING DEVELOPMENT IN LATIN AMERICA

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1 VENTURE CAPITAL: DRIVING DEVELOPMENT IN LATIN AMERICA Multilateral Investment Fund Member of the IDB Group

2 SUMMARY Venture Capital (VC) in Latin America is still in its inception but has enormous potential. The benefits for VC-backed companies are evident in terms of performance and growth opportunities. According to an independent analysis in Latin America, VC-backed companies often double their size in a four- to five-year period. These companies are also engines of job creation, both directly in terms of their own employees, as well as stimulating growth and employment among their local suppliers. The majority of VC backed companies in Latin America are working to bring new and better products and services to Latin American markets, in doing so they create even more ripple effects among local suppliers and become important new sources of tax revenue for governments. VC also promotes social mobility and the formalization of companies, fosters a more equitable access to financing, and promotes social and environmental standards. VC, therefore, not only drives innovation and entrepreneurial growth but can also be an important catalyst for inclusive forms of economic development. The present publication is a summary of the study Assessing the Impact of the MIF s Venture Capital Program in Latin America, by Dalberg Global Development Advisors. It was prepared by Oscar H. Farfan (MIF/ATF), Susana García-Robles (MIF/ATF), Rebeca Granda (MIF/ATF) and Carolina Landsberger (MIF/KSC). The opinions expressed here are exclusively those of the authors and do not necessarily reflect the point of view of the Inter-American Development Bank, its Board of Executive Directors or the countries it represents. Design coordinator: Claudia M. Sáenz (MIF/KSC).

3 1 The present publication is the summary of a comprehensive study, the first of its kind, on the impact of Venture Capital (VC) in Latin America (LA). The study was conducted in 2012 by Dalberg Global Development Advisors and covers more than 149 companies, 28 funds and 13 countries, approximately 40 of the portfolio of the Multilateral Investment Fund (MIF). The MIF is a major multilateral investor in VC funds in the region and has more than 15 years of experience and a vast repository of data on companies and funds.

4 DISTRIBUTION OF THE INVESTMENTS FROM THE FUNDS ANALYZED IN THIS STUDY. 2

5 LATIN AMERICA (LA) EL SALVADOR 4 COSTA RICA 10 PANAMA 1 COLOMBIA 5 BOLIVIA 8 CHILE 2 MEXICO 25 GUATEMALA 2 HONDURAS 5 BRAZIL 79 URUGUAY 20 ARGENTINA 8 3

6 WHAT IS VENTURE CAPITAL? Venture Capital (VC) is an approach to financing emerging companies, either in the form of equity investment or subordinated instruments, accompanied by value added advice in areas such as management, corporate governance and strategy. VC is generally channeled through investment funds managed by specialized firms with relevant operational and financial experience. VC is considered to be an important catalyst for the growth of emerging companies. 4

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8 THE INTERNATIONAL EXPERIENCE 6

9 Several international studies that analyze the impact of VC on different economies conclude that VC contributes significantly to companies development and growth as well as job creation. In the United States, VC has a significant impact on the success, survival and growth rate of start-ups according to research by Professor Josh Lerner of Harvard Business School. Other studies conducted in the United States, including those by the National Venture Capital Association (NVCA), show that VC-backed firms have much higher growth rates than other private-sector firms and can generate eight times the amount of employment. VC is an efficient instrument to channel capital to transformational or high-growth-potential companies. Unlike subsistence companies, this type of company plays a significant role in promoting economic growth and employment generation and can generate two to three times more jobs. These results have been shown in studies by Endeavor and Antoinette Schoar of Massachusetts Institute of Technology (MIT). In Germany, VC-backed firms achieve significantly higher employment growth rates due to financial involvement and services provided by venture capitalists, according to a study conducted by Dirk Engel of the Centre for European Economic Research. Engel also concluded that venture capitalists often push their firms to faster and higher growth rates compared to other investors. In Europe, a 2002 study surveyed 350 companies and found that 95 of them reported they would either have failed to survive or would have had poor growth prospects without VC investments. The study was conducted by European Private Equity and Venture Capital Association (EVCA). A study in China showed that private-equity-backed companies posted a 50 higher growth rate in employment than other firms. JOB CREATION BY STARTUP TYPE IN YEARS 1-10 Jobs created Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 High-growth entrepreneur Moderate-growth entrepreneur Low-growth entrepreneur

10 VENTURE CAPITAL IN LATIN AMERICA In general, VC in Latin America is still in its early inception. VC and private equity investments as a percentage of gross domestic product in countries in the region ranges from 0.01 to 0.18, according to data from the Latin America Private Equity and Venture Capital Association (LAVCA). These levels are still negligible and much lower than in other developed regions. Major strides have been made, however, in countries such as Brazil, and more recently in Mexico, Chile and Colombia. The potential impact of VC in Latin America is enormous considering that small and medium enterprises account for more than 95 of all firms in the region and are responsible for 60 to 70 of employment. Several of these firms at their early stages are unable 8to reach their high growth potential due to lack of long-term and flexible financing.

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12 THE IMPACT OF VENTURE CAPITAL IN LATIN AMERICA The study conducted by Dalberg Global Development Advisors identified six major areas in which VC shows a clear impact: growth, employment, wages and social mobility, formalization, equitable access to financing, and application of social and environmental standards. Overall findings confirm that VC is an efficient instrument, not only to identify and push firms with high economic impact, but also to accomplish social impact. VC is therefore a pivotal instrument for inclusive forms of economic development. 0

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14 Growth VC is, essentially, the business of making businesses grow. Venture capitalists look for companies that have high growth potential, but require flexible sources of capital and professional management. Seasoned industry experts work to identify, finance, and accelerate the growth of companies that have the potential to be competitive in national or global markets. As a result, successful VC-backed companies generally continue along a high-growth curve. Companies in the sample analyzed doubled their size in a 4-5-year period. The economic impact on the rest of the economy is also significant. One dollar invested in VC can generate up to $6.45 in economic activity through wages, payments to providers and taxes. Revenue growth rates of VC-backed SMEs often surpass a national economy s growth rate. 2 REVENUE GROWTH IN COMPANIES AS COMPARED WITH NATIONAL AVERAGES All countries 42 Argentina Brazil Honduras Mexico Nicaragua Average revenue growth of VC-backed companies. Growth of Gross Domestic Product. Source: Dalberg-MIF survey. Development indicators of the World Bank Uruguay

15 Venture Capital contributes to growth by: Optimizing internal cost structures Focusing entrepreneurs attention on profitability Facilitating negotiations with external counterparts, including providers and potentially with other strategic partners Creating a performance culture in VC-backed firms Hiring managers who act like owners Defining a clear 3-5-year investment thesis Strengthening internal accounting systems to help drive efficient use of capital Measuring key indicators that drive value Focusing on fast-growing export markets I could share all my fears and difficulties with the Venture Capitalists who invested in my company. Manager of a health services company Thanks to help from a VC fund, we now measure all types of indicators and have a clear idea of which products are profitable and which are not. In this sense, it has changed our lives. Manager of a cell phone service company This firm reported 87 revenue growth and 41 job growth during VC investment period. 13

16 JOBS In most economies, a significant number of new jobs are generated by young and growing companies, precisely the type of firm sought by VC. In the case of the sample analyzed, VC-backed companies on average increased their work force by up to 65 in a 4-year period, a much higher percentage compared to similar firms and national averages. The average VC-backed company employs 55 people and has a good chance of doubling its workforce during the 4-5-year investment period. On average, full-time positions grew 13 annually All countries 2 AVERAGE GROWTH OF WORK FORCE () Brazil Mexico Uruguay Costa Rica Nicaragua Honduras Argentina Average growth of work force in VC-backed companies. Average growth of work force in the economy. Source: Dalberg-MIF survey. Development indicators of the World Bank.

17 Wages & Economic Mobility A successful VC-backed company not only tends to grow fast, but also increases its salaries as it expands, creating social mobility opportunities for its workers. In the case of the portfolio analyzed, average salaries in VC-backed companies reported continuous growth. These firms also create social mobility opportunities for women. Venture Capitalists focus on productivity and growth appears to increase the objectivity of the contracting process and reduce the gender gap, which means that more women have access to employment. In the case of the study on VC-backed companies, employment of women presented a greater growth rate (18) than the average growth rate of overall employment (13). AVERAGE JOB GROWTH RATE IN VC-BACKED COMPANIES 18 Average job growth rate of women 13 Average job growth rate (total sample) 15 Sample of 68 companies. Results from Dalberg-MIF survey. Analysis by Dalberg Global Development Advisors.

18 Formalization Informality is one of the major barriers to growth and productivity and therefore to economic development in emerging markets. Informal enterprises in general do not pay taxes and remain small and unsophisticated. They are more a means of economic survival than an engine for growth and development. VC reduces informality By emphasizing formal management structures suitable for investors and performance-based management systems in the companies they invest, VC becomes an effective agent for formalization. All VC-backed companies in the portfolio analyzed are formalized. In addition, VC funds enable and incentivize firms to formally recognize their previously informal workers by putting them on the company s payroll and enrolling them in benefit programs, as required by labor laws and social security. 6

19 This formalization is the result of the incentive that VC-backed companies have to prevent problems for a possible future sale. However, it also benefits workers, ensuring creation of quality jobs with comprehensive social and health benefits as stipulated by national legislation. 17

20 Equitable access to financing In most emerging markets such as those in Latin America, it can be extremely difficult to access financing to launch a start-up or make a young company grow. Promising entrepreneurs who are not well connected or do not know the right people are often unable to obtain financing and establish themselves in the market, even with a viable business idea. By professionalizing the process of identifying and financing new companies with high growth potential, VC promotes a more equitable access to financing, making resources more available to entrepreneurs with viable ideas. In doing so, VC promotes a more inclusive form of economic development. 8

21 Social and Environmental Standards VC improves companies social performance VC makes a positive social impact through job creation and the externalities generated in local economies. VC-backed companies have greater possibilities of survival and show higher growth and job creation rates. Many are focused on providing innovative services to the base of the pyramid; they incorporate small producers and distributors and create employment and income generation opportunities in the communities where they act. VC funds also tend to emphasize social and environmental responsibility. Many of the VC-backed companies analyzed are focused on export markets and are required to meet strict environmental standards, especially in the case of forest-based or agricultural products. Others tend to be more likely to adopt clean technologies and energy-saving methods as a way to increase efficiency. As a result, VC funds work with their companies to meet environmental protocols and incorporate better environmental and safety practices. Some managers go even further, offering financing and assistance to companies to reduce negative environmental impact or find innovative ways to involve low-income producers in value chains. If I help create new companies that are growing, creating jobs and improving the market, then I am having an impact on people. Fund Manager, Brazil. Compliance with national and international environmental standards not only is important from an altruistic sense of corporate responsibility, but businesswise it also makes sense to avoid possible contingencies such as regulatory violations or lack of environmental permits, which could endanger or impede a transaction or sale through a strategic purchaser. Fund Manager, Central America. 19

22 METHODOLOGY The study was based on data from 28 funds that cover 149 companies in 13 countries. An IRIS (Impact Reporting and Investment Standards) survey was used to compile the data and determine social, environmental and financial impact. In all, 11 indicators were selected that covered social, environmental and financial aspects. To evaluate the aggregate and systematic impact of VC, the study used an analysis of multiplier effect of the VC investments, which measure the indirect impact on the economy through wages, payment to local supply chain providers, and taxes. The study also applied a test for plausible attribution to isolate the impact of VC on firm performance by establishing a counterfactual baseline. 20

23 To access the complete report go to: 21

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25 CONCLUSIONS VC is a relatively new phenomenon with enormous potential to generate economic and social impact in Latin America. VC is a useful tool to facilitate the discovery process and channel capital to high-potential transformational companies. VC-backed companies tend to show higher levels of growth and employment generation and a high multiplier effect on local economies. VC-backed companies incentivize formalization of employment and promote economic mobility through incremental raises in average salaries. VC-backed companies tend to be proactive in terms of social and environmental responsibility. 23

26 MIF The Multilateral Investment Fund (MIF) supports development led by the private sector to benefit poor and low-income populations: their households, farms, and businesses. The purpose is to help low-income populations access tools to increase their income. A central point of MIF s mission is to serve as a laboratory for development, experimenting, innovating, and assuming risks to construct and support successful business models for microenterprise, small and medium businesses. The MIF has been a pioneer in VC in LA, launching its investments in 1996 when the industry was practically nonexistent. MIF s support has been instrumental in developing this industry in the region. Since 1996, the MIF has invested in more than 65 VC & seed funds for more than USD $250 million, which has been invested in at least 450 companies in 21 countries. The MIF has also made an important contribution to developing local human capital in the industry, supporting more than 38 new VC/seed fund managers. MIF s role as key investor in a numerous funds has helped attract significant volumes of investment into the region (in the current portfolio, MIF investments have mobilized four times the capital invested, approximately USD $920 million). MIF s work has helped develop high potential companies that stand out in their respective countries in terms of economic, social and environmental impact. 24

27 DALBERG GLOBAL DEVELOPMENT ADVISORS Dalberg Global Development Advisors is a strategic consulting firm dedicated exclusively to international development and innovation. Founded in New York in 2001, its mission is to mobilize effective responses to the most pressing global problems and improve living standards in developing countries. Dalberg works to achieve social impact creating value for our clients. Dalberg has 10 offices located in Africa, Asia, Europe and North and South America. Dalberg has a long history of success in the public and private sectors. It works with the vanguard of development, collaborating widely with social innovators such as the Bill & Melinda Gates Foundation, the Rockefeller Foundation, and the Skill Foundation with a wide range of international organizations, including the Global Fund, Human Rights Watch and the World Wildlife Fund. It advises and associates with a wide range of clients in the private sector, such as PepsiCo, Vodafone, Equity Bank and Fortune 500 companies, advises governments of developing countries and regional and international financial development institutions, including the Multilateral Investment Fund, the Inter-American Development Bank, the World Bank, the International Financial Corporation, the African Development Bank and the Asian Development Bank. It also supports numerous U.N. agencies at United National Headquarters as well as in the field. For more information and copies of our most recent studies and reports, please visit our website: 25

28 MULTILATERAL INVESTMENT FUND 1300 New York Avenue, NW Washington, D.C