Venturing into virgin territory
It’s like the law of gravity that money falls to the biggest and quickest returns, and in South Africa those returns are million-dollar investments in mid-cap and large corporates.
So far the main driver of economic activity in South Africa in recent years has been the empowerment of blacks through often esoteric financial structures. Black economic empowerment legislation such as the country’s Broad-Based Black Economic Empowerment Act and various industry-specific charters (effectively agreements between government and sectors of the economy) have provided for equity and asset ownership, and employment and procurement requirements on local businesses.
Part of the challenge in structuring empowerment deals has been overcoming problems associated with a lack of funding on the part of empowerment investors. The beneficiaries have however been later stage (established) investments, leaving a glut of potential small entrepreneurs out in the cold.
The trouble, according to Julia Long of venture capital firm HBD Capital, is that South Africa is still bedraggled with a negative risk perception, and the slew of independent equity funds that operate in South Africa tend to favour mature investments. “The result is most equity fund managers tend to go for secure empowerment investments where they see more secure opportunities. The transactions are larger and there’s greater certainty of more money in return for the investment,” says Long.
Institutional funders like banks and financial services providers are also averse to small risky investments, opting instead for leveraged buyouts, the most commonly used option for large transactions being loans involving senior and junior debt classes and mexxanine finance. HBD Capital, an initiative of Mark Shuttleworth, was established in 2000 to fill the gap between later stage and early stage investments given the stark reality of an embryonic venture capital industry to fund smaller, early stage businesses.
There are what in the parlance is called ‘collective investment schemes’ typically aimed at individual investors who have traditionally been excluded from participation in the private equity market because of the high entry levels specified by independent funds, but they constitute a mere 6 percent of all private equity in South Africa, according the South African Venture Capital Association. Shuttleworth’s philosophy from the outset was to establish a fund that would remove some of the obstacles to entrepreneurship, the primary one being education, says Long.
“We realised that the gap was in the demand by educated people for funding to start up their own businesses.” The talent deficit was acute in maths and science and may well account for why the rate of entrepreneurship in South Africa has been low and Venture Capital firms have not slid into the market in their droves. At the end of the day, the South African and African market is simply not mature enough for Venture Capital because of the risks associated with start-up enterprises. Which is why HBD Capital targets specific sectors in the economy. Since 2000, the firm sold one of its investments and currently has two funds that are operational. Fund one, valued at ZAR70mn, is dedicated to financing initiatives from inception to six months, helping entrepreneurs market the idea. Fund two, amounting to ZAR40mn, is committed to later stage investments.
These are dots on the equity largesse where an average ZAR100mn fund in the venture capital game is more than adequate.
“But it’s good enough,” says Long. Then again, there isn’t much action at the early stage investment level in South Africa and far too few success stories to justify larger funds. “It simply does not make economic sense,” says Long. The deal structure is usually an equity stake in the investment for a 2-5 year period and an exit strategy either in the form of dividend returns or the voluntary liquidation of technically insolvent companies that fail.
Either way, the return might be less gratifying than large buyouts, taking up to three years before companies are ready to sell products, says Long. This is in stark contrast to markets like the US where venture capital is a mega-buck business. “The difference,” says Long, “is that firms in that market can afford to focus on specialised investment niches. In South Africa the level of economic development and skills problem militates against this.”
So why play in a risky space where the size of start-up transactions are miniscule compared with large equity transactions? “Because it’s worth the effort in the long run,” says Long. “We are generally optimistic about South Africa’s growth prospects.”
In time we’ll probably see more venture capital firms springing up to capitalise on opportunities thrown up by greenfields investments. -Business in Africa Online
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