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Why exposure to the digitalisation of large truly nascent ecosystems deserves a spot in an institutional VC program
Strategy Breakdowns - investing in "digital supercycles"
To start with a clarification, Limited Partners (LPs) are far better placed than General Partners (GPs) to dictate how they should build their institutional VC programs. When meeting a new LP, our job as a GP is to clearly articulate our vision (in a historical context) and demonstrate we are the best option for executing our strategy. We do this by clearly articulating a well-thought-out investment strategy and displaying a consistent track record of execution. LPs take away the information we provide to make informed decisions on what is right for their portfolio as per their respective mandates.
My passionate belief (mirroring that of the entire team) is that exposure to the digitalisation of nascent digital ecosystems deserves a dedicated allocation in an institutional portfolio. My conviction in this belief has deepened over the last +15 years, starting at the academic level before beginning my career investing in the world’s leading GPs and finally investing in and working directly with startups.
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This post will begin to unpack why “nascent market digitalisation” and investing in “digital supercycles” should be considered a dedicated allocation to drive returns and diversification.
The hunt for outsized VC returns – a reality check.
The distribution of returns for VC funds is multiple times larger than comparable public asset classes, making manager selection extremely important (and nothing in this blog post will change this fact). However, the data shows that it is very hard to generate truly outsized returns in VC: Cambridge Associates benchmark returns for top quartile US VCs suggest that the average DPI for relevant vintages (1997-2011) was only 2x, and the upper quartile TVPI for vintages post-2010 is only around 3x (the conversion of this to DPI is very uncertain). One striking data point (that deserves its own blog post) is that most of the top-quartile performers in a given vintage year are GPs raising one of their first few funds. VC doesn’t scale well, which we have seen at the top of every successive cycle. Over time money floods in, returns fall and never really recover, and investors should be looking to tap into the next digital supercycle.
Only a small subset of the top quarterly GPs will generate the >5x (net) fund returns we all see in GP pitch decks. The best-performing (and worst-performing) VCs will consistently execute a defined strategy and concentrate their portfolios sufficiently to overachieve, and this is the process that drives the huge dispersion in returns. Institutional LPs acknowledge this and build their VC programs to contain an optimal mix of the vintage year, sector, and management experience (among many other factors). Consideration of digital supercycles should be a factor added to the mix.
Digital supercycles - returns driven by creation, not disruption
Like their more developed predecessors, frontier emerging markets are rapidly shifting from offline to online, driven by widespread mobile and internet adoption. History has repeatedly rewarded LPs backing the best early GPs in this space, monetising the long-term secular digitalisation trend, which begins from a non-existent digital base to leapfrog towards more developed EM peers. The “digitalisation playbook” has played out across multiple emerging markets, from Brazil to India, Indonesia to Mexico. Sturgeon invests in the next wave of markets primed to follow this trend with a combined population of more than half a billion and GDP of $1tn (up to 30% of which is expected to be digitalised by 2030). At this stage of development, markets are characterised by a few small local VCs and an even smaller group of dedicated regional VCs (such as Sturgeon) which has bred major successes from the US to Indonesia, and our markets are primed to be next. The strategy is the antithesis of many developed market VC strategies that focus on the disruption of embedded incumbents and dozens of well-funded competitors. Based on a study by Alexandre Lazarow (2020), 63% of frontier start-ups are creating new industries, i.e., their users are not switching from an incumbent business. This changes the risk/return dynamic fundamentally.
From 2015 to 2022, India, Brazil and Indonesia were the biggest beneficiaries of the mobile supercycle in terms of VC-backed enterprise value (EV) created, combining for at least $428 billion in new EV. This rapid increase in value is strongly correlated to a rapid rise in smartphone penetration rates in these countries, which has resulted in almost 500 million new users being able to access internet-enabled services. Considering GDP per Capita and Smartphone users in these countries, $1.9 trillion in new ‘Digital TAM’ has been generated across these three markets. This increase in ‘Digital TAM’ and its acquisition by category-defining companies has resulted in 121 new unicorns overwhelmingly across first-wave verticals such as payments and e-commerce. The acquisition of this TAM has been financed through $149 billion in VC Funding across the three markets. Pre-Covid VC Funding stood at $58 billion, with 2015 to 2018 deal makers the biggest beneficiaries of EV growth recorded from 2015 to 2022. India being a later-stage emerging market, exhibited the biggest rounds but lowest EV generation against capital deployed in 2015-2018 at 4.4x, while Brazil and Indonesia, being earlier-stage emerging markets, generated EV against capital deployed of 18.1x and 6.6x, respectively. During the deployment period, these markets have gone through inflationary cycles, regulatory instability, and large shifts in consumer behaviour through a rise in smartphone penetration, cheaper data and ever-improving data transmission infrastructure. The combination of the former has enabled a cost-effective distribution strategy for first movers in these markets, and growth has been further optimized through compounding network effects resulting in ubiquitous brands such as NuBank, BYJU and Tokopedia. Therefore, the common thread of success in frontier markets is investing in fundamentally sound businesses at the forefront of GDP digitalisation and acquiring an ever-increasing Digital TAM. (Data sourced and from CB Insights, Sturgeon Capital Research)
History shows that digital supercycle investing has paid off
Some of the best-performing GPs/Funds entered their respective markets at analogous stages of digital development to our own markets today.
East Ventures was founded in 2009 when internet penetration was 13%; they have generated enormous returns investing in Southeast Asia’s digitalisation with an early initial investment in the likes of Tokopedia and Traveloka, which bear a striking resemblance to some of Sturgeon’s portfolio companies ZoodPay and GoZayaan. East Ventures was named by Preqin in a list of the most consistently top-performing VCs in the world. Other GP who successfully tapped this vein of early digitalisation includes Openspace, Wavemaker and Goldengate, all of whom have a concentrated regional approach (something we believe in passionately, and again deserves its own blog post!).
The team Kaszek cut their teeth at the early stages of the region’s growth in senior leadership positions at MercadoLibre (eCommerce platform and currently LATAM’s largest company in terms of market cap) before founding the VC in 2011. TechCrunch suggests that their MOICS range from 19x for Fund I, 11 for Fund II, 5x for Fund III. Kaszek was one of the earliest investors in Brazilian Neobank Nubank, just one of nine unicorns it has helped build over the years. Other unicorns it’s backed include MadeiraMadeira, PedidosYa, proptech startup QuintoAndar, Gympass, Loggi, Creditas, Kavak and Bitso.
In India, managing some of the top performing India-Focused VCs (2010-2018 vintages) were 3one4 and Sith Sense India. Blume is another GP whose decade-long journey mirrors the staggering growth of India’s internet economy. Many of the 145+ startups it has backed over the years have gone on to become household names: Dunzo, Unacademy, MilkBasket, TaxiForSure.com (exited post a $200-million sale to Ola in 2015). Like Sturgeon, Blumes early funds had initial check sizes of around $500k and would double down as conviction grew and operating metrics warranted it.
A brief comment on risk-return characteristics
There is a significant bifurcation between the perception and the reality of the markets in which Sturgeon invests. While all investing involves risk, it is important our strategy represents a risk that is largely uncorrelated with most VC strategies. It is also important that we show a repeated track record of providing outsized returns that are proportionate to the perceived risk.
An increasing number of leading institutional investors like WUIMC are publicly acknowledging the role of developing ecosystems in driving their exceptional returns. This investment style has been called Endowment 2.0 in that while an institutional portfolio maintains sizeable beta exposure, it is important to add high-conviction, uncorrelated bets to drive higher returns. To do this, institutions employing this model go where their peers aren’t. It is this intellectual curiosity and knowledge of recent digital history that characterises the LPs that funded the aforementioned GPs; it is also a characteristic of our own LP base.
While many perceive Frontier EM investing as Risk (Frontier Markets) on Risk (VC as an asset class), this couldn’t be further from the truth. Our strategy is a play on the inevitable trend of digitalisation from a near non-existent base: for example, riding ecommerce penetration from low single digits in a region of over 500m people. The first waves of technology value creation are a far greater force than any macro downside, as borne out by companies such as MercadoLibre, Nubank and Kaspi that were born amidst severe macro crises – because of ecommerce and banking being near non-existent).
Unlike many of our developed market (or even more developed EM) peers, we are investing a relatively modest amount of money in companies with proven revenues, teams, and unit economics. They are often zero incumbents or viable competitors targeting real problems with demonstratable customers (not disruptive bets or speculative technologies). Businesses have been built to withstand volatility and do not rely on limitless capital, with the ability to turn off growth and switch on profitability if needed. The nature of the bets is different to developed market VCs today and deserves its place as a growth driver in an institutional portfolio.
We will be following up with several blog posts unpacking this topic, but in the meantime, if anyone would like to discuss any of the items discussed in this post, please reach out to the team!
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