Bridging the gap between PE and VC in Africa

Asif Noorani, Principal at Phatisa writes:

The past few years saw Venture Capital in Africa pick up steam and of late has become a tidal wave moving at speed and gathering momentum. In 2015, USD 0.4 billion was invested in 94 VC deals in Africa. By 2021, this had grown to USD 5.2 billion invested in 650 deals, most of it invested in the ‘Big 4’ markets – Lagos, Johannesburg, Cairo and Nairobi. However, other markets are not to be ignored – an interesting early stage / tech scene is developing in Casablanca, Tunis, Dakar, Abidjan and Kigali.?

Another notable development is the growth of the Angel networks, which in helps feed the VC deal pipeline. Traditionally, angel investing has been synonymous with very successful businesspeople who have sufficient funds to plough back into start-ups. By contrast, in Africa today, most angel networks are made up of young professionals willing to back other young local entrepreneurs. The face of the angel investor has changed.?

The role of Private Capital is clearly growing on the continent; however, this growth is in unsynchronized pockets. I only realized the size of the gap between PE and VC when I went to a mixer organized by Briter Bridges during the week of the Africa Tech Summit. I introduced myself as a Principal at Phatisa (a PE fund investing in the food value chain across SSA, managing USD 400 million across two Funds). Most of the VC investors had not heard the name which is well known in the PE world. I also tested this with a few friends in PE, who as I found, did not know many of the other VC funds in the market. One then realizes that despite all these players working to support the same entrepreneurial ecosystem, investors in the various pockets (PE, VC, Private Debt) often don’t speak to each other.??In fact, most don’t even know each other!

Somehow, we have managed to create silos in a relatively small ecosystem.

Why the gap?

The thinking, demeanor, and criteria of VC and PE investors are worlds apart. A VC investor predicts how the future will look, and whether the company can evolve and pivot to take advantage of the opportunity. Every investment they make should have the potential to achieve a 20x multiple on capital, most of it coming through growth in revenue and market share. Whereas a PE investor will evaluate growth in the context of past performance and aim at a 3x – 4x return for their investment, part of which will be attained through operational efficiencies. Both are investing in promising entrepreneurs and businesses, but they differ in their approach to risk, view of historical performance, and expected returns.?

The market seems to be talking about an opportunity for natural progression in the fundraising journey for start-ups. One could imagine the route to fundraising success running from Angel to VC, towards growth capital, and eventually into PE funding. A PE fund, providing the right support, could then exit the company to a corporate / strategic looking to enter the market – or even an IPO. However, the link between VC and PE is seems to be thin.?

PE investors on the continent struggle for good pipeline, while VC investors are starting to struggle for good exits for most of their investments. The reality, however, is that if VC funds were to exit their investments to PE, they would not get the valuation they expect. This is because VC funds are investing through SAFE notes and convertibles, valuing companies based on revenue multiples, DCF and other future cashflow-based methods, while PE is looking mostly at EBITDA multiples based on historical achievement and paying a calculated premium for growth prospects. Herein lies the major divide. Many start-ups do not get to profitability till later in their life, and while trying to do so, raise funding rounds at high valuations. Whereas, many PE funds don’t know how to reasonably value these businesses, and they consider VC valuation expectations too lofty.?

Can a solution be explored?

In a standard VC portfolio of 15 lines, seven will probably be written off or ‘rescued’, giving the exiting investor a near-zero return. Two may get the target 20x return (hopefully more), being exited to a large corporate. The remaining six companies may become profitable medium-sized businesses but would have not achieved the scale initially expected. The VC funds, however, will most likely be carrying these at valuations much higher than a PE fund is willing to pay. PE investors on the other hand, seem to have a narrow gate – the first question they ask is: ‘is the company EBITDA positive?’. By overweighting this criterion, they may be dismissing good companies.???A VC may argue that by so doing, their efforts to get a company from 'zero’ to ‘one’ are not being recognized. Are PE funds using the right metrics to evaluate their deals??

A symbiotic relationship can be built between VC and PE funds, but the solution involves both working in tandem:?

• VC funds could temper their valuation expectations for these ‘six’ companies.?
• PE funds could be more creative with how they value such companies which still have a significant growth potential, interesting market opportunity, and a team that is ready to shift gear to sustainability/profitability rather than ‘hockey-stick’ growth. Profitability is a word that PE funds find very attractive.?

In Silicon Valley, a VC investing USD 100k and another investing USD 100m could exist on the same street. Both these Funds could invest in a particular business across a different stage in its life-cycle - they both understand the start-up continuum, valuation methodologies, and the start-up entrepreneur’s mindset. In Africa (and probably in most developing regions where liquidity is limited), we have to find innovative ways to fund businesses which may eventually achieve roaring success but need more time to achieve scale. They require a shift from a pure growth mindset to one of profitability and operational efficiency.?

Africa has experienced increasing activity in Private Capital investing but has shown insufficient exits. Could there be a scenario where PE and VC funds could work together for the mutual benefit of both? For VC, exits of businesses that will not be ‘fund-makers’ but are fundamentally good companies. For PE, an interesting pipeline of tech-enabled businesses, and entrepreneurs who are passionate and understand the expectations of closed ended funds. These are diamonds in the rough that deserve a chance to harness their potential of becoming great companies.?

Let’s connect to give them that opportunity.