Why doesn’t SA’s VC sector do more international syndication?

Why doesn’t SA’s VC sector do more international syndication?

South Africa’s venture capital (VC) investors source most of their funding for VC deals from within the region and have limited interaction with international investors and limited experience with international syndication.

There are several reasons for this historic and ongoing phenomenon and while it has shielded South Africa venture capital professionals and their transactions from exposure to global capital market volatility, the local sector would benefit from expanding the pool of VC capital raising options by swimming in bigger, more developed markets. International syndication could, in theory, boost the growth of South Africa’s VC sector, which has historically only done a fraction of the deals that have been done developed markets like the US and Europe.

The simultaneity explanation of venture capital emergence states that the industry springs to life when three factors are sufficiently present: pools of capital, specialised financial institutions, and entrepreneurs (Gilson, 2003) - all of which are available in abundance in more developed markets.

How common is international syndication and what drives it?
Internationally syndicated venture capital investments are in theory simple transactions. The parties involved are a foreign investor, co-investing with a local investor/s into a local venture and/or management team.

Venture capitalists often co-invest with one another, much like bankers syndicate commercial loans. Syndication by VC firms is based on a desire to share and reduce risk. Sharing of risks involves including other investors through syndication at various stages of the investment.

The end goal of any syndication, apart from reducing and sharing risks, is to reduce the mean expected return on the investment. International research has shown that syndicating has been shown to achieve this result, as these syndicated investments tend to produce higher Internal Rates of Return (IRRs) for the VC investor.

Venture capitalists much prefer to invest close to their proximity. Despite that tendency, US and European venture investors began to intensify their investments into foreign markets in the late 1990s.

By crossing borders, VC professionals can exploit differences in risk-adjusted returns between home and portfolio countries. The variance in return (between home and cross border investments) must be greater than transaction costs for the investment to be justified.

What is the exact status of international syndication in SA’s VC sector?
There is merit in reviewing the reasons why international syndication in SA’s VC sector has been limited in order to understand if there are important opportunities being missed – both for local and international investors.

This is exactly what was done by John P. Causey, IV in 2014 when he conducted research into ‘An analysis of South African venture capital practitioners’ views on the motivations, benefits and constraints of international syndication’ as part of his Master of Commerce in Financial Management programme at the University of Cape Town.

The research set out to analyse the local venture capital ecosystem and to assess the readiness and willingness of local practitioners to syndicate internationally. In addition, the research sought to determine and explain the constraints to international syndication in SA. Lastly, we believe the research serves as an important tool for practitioners and policy makers to make these transactions more common and likely to occur in the future.

This was the first known piece of research to address the relatively young body of research in the field of international syndication of venture capital investments in an African context and the first to examine the suitability of the country’s VC ecosystem for international syndication.

The main research questions addressed in the study were:
Are local venture capital practitioners ready and willing to syndicate internationally, and what are the constraints to the formation of those transactions?

The issues were examined by interviewing high-level investment practitioners representing seven of the 21 nongovernmental VC firms belonging to the South African Venture Capital Associated (SAVCA).

SA’s venture capitalists are ready and willing for international syndication
It’s likely that internationally syndicated venture transactions, if properly structured, would benefit South African ventures and investors.

The research showed SA VC professionals are ready and willing to syndicate internationally, due to benefits named in the research such as access to new markets, expertise and knowledge sharing, ‘stamp of approval’ benefits and access to capital markets outside of South Africa.

Further benefits for local investors
Ventures with prominent and high-status affiliates and investors perform better. International investors from the developed VC markets often have a specialised and potent set of knowledge points and networks which can be extremely valuable to the right venture. Risks are reduced through sharing information and including investors who increase the likelihood of success of the venture.

With international investment comes a quick transfer of risk capital and specialised skills from the developed world (Patricof, 1989; Barry, 1994; Bygrave & Timmons, 1999).

Benefits to international investors

The international investors also benefit from syndication.

VC flows are greater where a domestic co-investment partner is present. A local investor’s contacts and knowledge of the market, as well as their ability to take care of certain responsibilities in a more cost-efficient manner, such as monitoring and day-to-day management of the investment.

Also, countries often differ as to the degrees and manners of legal protections offered to investors. Local investors grasp these nuances and will often have developed informal mechanisms to deal with gaps in the protections offered by the State and other local institutions.

From the perspective of an international investor, investing in the South African venture capital asset class is a way to increase geographic diversity in their portfolios to reduce systematic risk, and to increase yields. The increase in yields is possible by higher growth rates and reduced levels of competition in many developing markets, like South Africa. A properly structured internationally syndicated venture investment can be a win-win proposition for all parties involved.

Improving returns, reducing risks

Where more than one investor is involved, the selection of investments is often ameliorated due to improved screening, due diligence and decision making. Investee firms will often receive a higher level of expertise and experience compared to those firms with only one investor.

Syndicating can also mitigate governance problems and provide improved exit potential due to the markets perceived value of reputable investment firms first making the decision to invest through positive signalling.

Specific benefits of cross-border investing through syndication

The body of international research on the benefits of international syndication indicates that they can:
- reduce costs
- result in superior performance
- lead to better decision making
- provide higher levels of ongoing commitment
- transfer high social status from and to investors and ventures

Caveats and constraints to international syndication

The results indicate that South African venture capital investors are ready and willing to syndicate internationally, but there are caveats. It was found that there are significant and profound constraints to these transactions forming in South Africa.

Those constraints named by the research recipients are:
- an unsupportive regulatory environment
- negative perceptions by the international investor community of South Africa
- small domestic deal sizes
- the dearth of bankable ventures led by high quality management teams.

In addition, SA private equity and VC funders often have social impact and other governmental and governance objectives. International and serious investors are IRR focused and the differing paradigms could make co-investing with investors from a developmental aid frame of reference challenging.

The benefits of interfirm cooperation and co-investing with domestic and international investors can also be offset by the contractual risks associated with forming such partnerships, namely:

• Increased transaction costs (more negotiations, necessity to accommodate all parties)
• Higher likelihood of disagreements occurring throughout the transaction
• Difficulty in concluding the transaction due to more deal complexity.

The opportunities remain untapped, and are worth exploring

While there are valid constraints, Causey’s research shows that an opportunity exists to educate local practitioners on the benefit of syndicating internationally, including on the positive effects of having ongoing international commitment to a venture with international VC partners.

International syndication could open up international capital markets to local entrepreneurs, allowing foreign investors to participate directly in the African growth story, provide co-investment support to local investors and increase the likelihood of more truly exceptional and global companies forming in SA and other developing markets. This is a win-win proposition and a pursuit which can have substantial long-lasting and near-term impacts in places like SA.