Part #1: What Canadian venture capitalists can learn from emerging markets
Editor’s note: This is the first part of a three-part series on what Canadian venture capital can learn from emerging markets.
Over the past two years, interest in emerging markets has exploded as a new source of customer, capital and, not least, innovative ideas. A special report in The Economist published last year profiled affordable new products from the Tata Nano automobile to the GE Healthcare MAC800 electrocardiogram, arising from the inherent scarcities of emerging markets. The applicability of such products in mature markets in the United States and Europe is a phenomenon that Vijay Govindarajan at Tuck (Dartmouth) has coined “reverse innovation.”
While the question of whether products with innovative features can be sourced and developed in emerging markets has been resolved, the more provocative question is whether the developed world can learn how to accelerate the innovation process itself?
The short answer is yes. In a recent article I co-authored with Vijay Govindarajan in the Harvard Business Review, I argued that venture capitalists globally can adopt a new approach—a “systems approach” to venture capital—from emerging markets. In brief, VCs in emerging markets are generally operating in a virtual vacuum in terms of an innovation ecosystem, with extremely uncertain exits and few co-investors to de-risk investments. In contrast to traditional venture capitalists who take a “shots on goal” approach where portfolio companies are operated and evaluated independently, VCs in emerging markets explicitly link together their investments. The approach actually improves their probability of success by helping them to demonstrate proof of concept faster, understand how business models fit together in a value chain and make exits easier.
Why does this happen?
First, the VCs are forced to take on a broader investing mandate by investing in supporting or related industries because innovation ecosystems are not as well developed. This is feasible due to the low cost of entry, high prices for the few firms that serve multinationals, and quality concerns due to poor regulatory enforcement. In effect, VCs are playing the same role government would in promoting cluster formation for competitive advantage. VCs expect to exit these service-based investments for lower multiples, with the trade-off of increased probability of success for R&D-intensive investments.
Second, local IPO markets are not well-developed yet for early-stage ventures, despite the present bubble, partly because service-based and manufacturing-based companies are actually growth businesses at this stage of China and India’s economic development. Investors are therefore reluctant to put money into early-stage enterprises centred on intellectual property with little information and few safeguards. This means that firms are expected to be able to generate revenue, or at least have a first customer, before they make an exit. Early-stage ventures are frequently paired with CROs, which creates infrastructure and retained earnings for R&D.
Third, with few other existing local financial intermediaries such as venture capital firms willing to share the risk in early-stage ventures, the benefits of syndication—effectively a form of risk-sharing peer-review among VCs—is diminished. While each portfolio firm also serves clients outside the portfolio, the interactions allow VCs to refine and assess the value each firm brings to the health-care system, kill inferior business models early and maximize the probability of success. Traditional portfolio diversification actually increases risk because VC firms in emerging markets are often the sole backer of the health-care start-up.
Here’s one concrete illustration of how life-sciences VCs have embraced emerging market-driven strategies in their investment theses:
As both IPOs and M&As have become increasingly rare occurrences globally. Exits are being pushed back, forcing VCs to think late-stage and revenue generation in some cases. But their experience in emerging markets has arguably provided a template for them to avoid building late-stage integrated firms in the traditional sense. Instead, they are scaling a project-based approach through the availability of low-cost clinical trials and manufacturing offshore. What is emerging is not a single vertically-integrated firm, but rather the creation of a portfolio of investments that form a value chain. VCs are investing in subsidiaries that do manufacturing or chemistry in emerging markets, and then linking them back to serve the initial R&D investment in the United States. The investments have potential for low-multiple exits and can be syndicated.
While it’s fascinating to look at business strategies at the portfolio firm level, there are even more powerful comparisons to be made at the industry-wide level (especially relevant given the heavy involvement of government in venture capital in Canada). These conditions in emerging markets—entrepreneurial gaps, investment illiquidity and few venture capitalists—are frighteningly reminiscent of our own life sciences VC industry in Canada. In fact, I’ve identified two “systems-minded” approaches to venture capital in emerging markets at opposite ends of the “passive” versus “active” government-involvement spectrum which could guide Canadian venture capitalists and innovation policymakers. For the sake of simplicity, I’ve termed them the “China approach” and the “India approach.”
In the next part of this three-part series, I’ll describe and analyze the two approaches being taken by these two leading emerging markets, and how they apply to Canada.