Africa’s Hidden Growth Opportunity // Betting on Venture Debt

By Stephen Muriithi Founder, Brainhouse Capital.

What is Venture Debt?

Venture debt is primarily a loan to companies that have previously raised money from venture capital investors.

The main advantage of venture debt is that it allows a startup to extend its cash runway, prevents further equity dilution of the founder, and it allows the business to scale and expand rapidly.

Venture Debt in the USA and Emerging Markets (LATAM & India)

Approximately $20bn was granted to VC-backed companies based in the USA during each of the past three years. In Latin America, companies raised over $18bn in 2021. When we look at Asia, Venture debt raised in the Indian market was approximately $538mn in 2021.

Venture Debt in Africa

37 African startups raised approximately US $767Mn in debt funding in 2021 out of a total funding proportion of $6bn representing just 12.7% of the total funding in VC tech according to Partech Africa.

Approximately 45% of all the venture debt went to Nigeria, and FinTechs in Africa accounted for approximately 54% of the total debt raised. South Africa and Kenya follow on respectively.

It’s also interesting to note that FinTechs also accounted for a majority of the equity funding that Africa received in 2021 at 63%.

A brief overview of the venture capital landscape in Africa

Africa’s entrepreneurial ecosystem is gradually maturing and it experienced a Compounded Annual Growth Rate (CAGR) of 32% over the period 2014 and 2021

The compounded annual growth rate is supported by the fact that in 2021 alone, a total of 724 rounds of fundraising across Africa were undertaken. This resulted in a total of $6bn of venture funds raised. This is a stark illustration of the hope and promise that the continent holds. “Africa’s time is now.”

In prior years, and more specifically before 2019, Africa’s entrepreneurship ecosystem was traditionally driven by accelerators and innovation hubs that were mainly funded by grant funding. However, with tech-driven businesses becoming increasingly ubiquitous across the continent, the rise of equity and debt funding has begun to change this equation.

In Africa, Nigeria, South Africa, Egypt and Kenya are the most active startup ecosystems. These markets always receive the largest VC funding allocation in Africa.

These markets received the largest amount of venture capital funding in 2021.

When we consider African venture capital, we are now observing a pattern. In 2021, $5.2bn was raised in total equity funding, a figure that was higher than the combined amounts of funds raised in the prior two years. This is a step in the right direction, and is a demonstration of the emerging opportunities springing up across the continent.

Startup regulation in Africa

On regulation and government-sponsored entrepreneurial activity in Africa, an ecosystem driven, collaborative approach should be adopted.

This approach involves entrepreneurs collaborating and developing solutions for one another to address their needs and requirements.

This has greater utility than a top-down government-led approach that imposes solutions that ecosystem players may not find relevant to their needs and requirements. Iyinoluwa, Founder and General Partner at Future makes the case why this is so.

A top-down approach often ends up in duplication and wastage of resources that often don’t achieve the intended purpose. Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School has written extensively on why public efforts to boost entrepreneurship often fail.

Various African countries have launched or are looking to launch Startup Acts to accelerate growth and development of their ecosystems.

A Startup Act is an act of parliament developed to provide a framework to encourage growth and development of entrepreneurial endeavors across Africa. They create income and employment opportunities in scalable businesses that leverage technology.

Startup Acts provide incentives such as exemption from corporate and capital gains taxes for a specified duration of years allowing these businesses to focus on growth and expansion. Countries like Tunisia for example, have made provisions in their Startup Act to offer employees one year of time off from their current job and a salary for up to three founders during the first year of operations.

Venture capitalists will often favour markets that have clear, transparent startup regulation as they can see a path of growth and progress in these markets more easily. It signals a vote of confidence in these markets.

In Africa, Tunisia, Kenya, Nigeria, Senegal and South Africa have either finalized, or are in the process of drafting Startup Acts to guide development of their ecosystems.

International investor sentiment on African venture

International investors particularly from the USA are showing a growing interest in Africa’s vibrant tech ecosystem. We showcase a few illustrations below.

Case 1:

Lami Technologies, a digital insurance platform that enables partner businesses including banks, tech companies to easily and seamlessly offer digital insurance products to their users using an API, has recently secured $3.7Mn in a seed extension round led by Harlem Capital.

Case 2:

Mono, a fintech startup building open banking infrastructure that enables access to customer financial data and bank payments for digital businesses in Africa, announced a $15Mn Series A funding round led by Tiger Global.

Case 3:

Wasoko, an e-commerce company provides free same-day delivery of essential goods and financing to informal retail stores across Africa. Earlier this year, it closed a Series B equity round of $125Mn led by Tiger Global and Avenir Growth Capital leading venture capital firms in the USA.

International investor interest in African startups has grown over the years. American investors are leading the front on African VC investments and have participated as lead investors in a substantial number of fundraising rounds over the last twelve months. Flutterwave and Wasoko both raised $250mn and $125mn respectively, and these funding rounds were led by American investors as can be seen in the map below.

To corroborate these sentiments, AVCA noted in its 2021 venture report that 40% of all venture capital funding coming into Africa was from North America. The largest venture capital market is the USA and as such, Americans investing on the continent will have a signalling effect on other foreign investors who may take a keen interest in Africa.

In summary, international investors have realized that there are decent opportunities to be pursued in this market. As funding allocations continue to increase, we expect to see a combination of both debt and equity rounds increasing across the continent.

The DFI venture debt equation

Development Finance Institutions (DFIs) have been instrumental in structuring debt for renewable energy companies on the continent with the International Finance Corporation, The US International Development Finance Corporation and the CDC Group being some of the major players.

Future Africa, an Africa-focused venture fund, duly notes that the venture debt market is fragmented with fintech and energytech being the main recipient of such funds, as can be seen in the figure below. As such, there is no sector agnostic venture debt offering that has a focus on the continent.

This is an interesting insight, and we expect to see venture agnostic debt offerings growing across a variety of sectors in the coming years as the ecosystem grows and matures. Logistics, Agritech, Healthtech, edtech being potential sectors of interest.

In the market map below, we see examples of debt providers and debt raisers that are the most active on the continent. Renewable energy companies form the majority of businesses that are active in the venture debt space.

A venture debt opportunity for traditional financial institutions?

Regulatory restrictions often hamper commercial banks on the continent from accepting warrants on venture debt facilities. Typically, venture debt is structured as a three to five-year term loan with interest payments and warrants. A warrant gives the holder the right (but not the obligation), to buy or sell a security at a certain price in the future.

Because venture debt facilities have warrants attached to them, if a commercial bank exercises its warrants, it would effectively become an owner in a business. Deposit lending institutions such as commercial banks are prohibited by central banks from structuring financial facilities that include warrants.

Future Africa makes the compelling proposition that commercial banks can offer term loans and standard lines of credit to growth startups as a way of navigating these restrictive venture debt terms.

I agree with this proposition. Venture debt terms are restrictive because of the warrant provisions that are attached their terms as noted earlier. If commercial banks are open to the idea of opening and building relationships with these startups by helping them set up bank accounts, they can monitor their customers cash flows and make an informed assessment on the state of their business. This assessment can later inform decisions to lend standard, traditional debt facilities (e.g., term loans) to such businesses.

Loan syndicates

Setting up loan syndicates where both commercial banks and venture capitalists pool funds together to fund various African startups also diversifies risk allowing multiple players to participate in a venture debt mechanism.

A loan syndicate allows commercial banks, venture capital firms and development finance institutions to de-risk their investments through diversification.

Examples of startups that have raised venture debt in Africa

Case illustration I: MFS Africa

Earlier this year, MFS Africa, Africa’s largest digital payments network, secured an additional US $100mn in equity and debt funding led by Admaius Capital Partners. The funding will accelerate MFS Africa’s expansion plans across Africa, its integration into the global digital payment ecosystem, and its expansion into Asia through its joint venture with LUN Partners, an Asia based global investment group.

Case illustration II: Moove

Moove, an African mobility fintech startup building the largest integrated vehicle financing platform for mobility entrepreneurs leveraging technology, raised $10mn in a debt funding round that was led by NBK Capital Partners Mezzanine Fund II to support expansion efforts across West African markets. They provide revenue-based vehicle financing to mobility entrepreneurs across Africa.

As can be seen above, venture debt is being deployed to drive growth and innovation across the continent.

B2B financial lenders

Fintech lenders on the continent make for an attractive use case of venture debt. This is because the debt they raise is often deployed to enterprises that require working capital to grow and scale.

Andreata Muforo, Partner at TLcom Capital noted at the Africa Fintech Summit held in Nairobi early this year that:-

“Venture debt is an asset class that is missing in the ecosystem. Most startups are gradually becoming lending companies. They are leveraging customer data and analytics they have about their customers to inform lending decisions.”

She further noted that:-

“Twiga Foods and Wasoko have very good data on their own merchants. They see these merchants two to three times a week, and have therefore built very good relationships.”

As lending has become a commodity, B2B lenders are now at risk as their business models are being disrupted with more innovative lending solutions being built for a large category of customers and merchants across Africa.

Venture capitalists across the continent will increasingly support tech-driven startups that embed fintech into their production proposition. This is increasingly gaining traction and startups like Twiga and Wasoko are in a unique position to take advantage of such opportunities.

This seems to be the natural progression of how startups will drive interaction and engagement with their customers. VCs in Africa are increasingly looking to fund startups that embed fintech into their product offering. This is a very powerful play and traditional B2B lenders may need to start looking at ways of innovating around their business models.

However, Andreata is not so convinced that B2B fintech lenders will go out of business. She noted that companies like Twiga and Wasoko are also looking to partner with lenders because they may actually be extracting the most value leveraging their own core capabilities and competencies.

In other words, their core business returns higher multiples relative to margins they would generate acting as fintech lenders. Therefore, there seems to be a huge opportunity for some of these platform providers to partner with traditional financial institutions, as these financial institutions are in a better position to attract better lending rates for onward lending to end customers.

The insight herein thus illustrates that there is an important role for traditional B2B lenders in the ecosystem.

The conclusion we draw from here is that there is an opportunity for leveraging venture debt in Africa. If traditional financial institutions can come on board, we should see this funding category become more ubiquitous.

Data as a Pathway to accessing Venture Debt

There are efforts to make startup data better known in Africa.

Data on revenues, stage of funding for each of these startups, growth rates, data on failing startups should become more publicly available. A data repository such as an African version of PitchBook will accelerate venture debt allocations. Traditional lenders have been indifferent to this form of finance precisely because of the unavailability of reliable data to inform decisions.

Rob Eloff, Managing Partner at Lateral Frontiers VC noted in a podcast that:

“A lack of data is a problem for capital providers in Africa. The way capital providers assess risk and reward is on delivered traction or endorsement by other capital providers.”

Interestingly, he noted that the ability to solve the data problem is being addressed through the massive adoption of APIs. He noted that:

“Use of APIs allows capital providers to sit with founders and assess in-between round traction that improves visibility, especially on the revenue-based lending side. The challenge is the difficulty of getting monthly or quarterly reports (since search costs and friction are high) from startups.”

Therefore, startups such as Twiga, MarketForce or Wasoko that are building their platforms leveraging APIs are at a distinct advantage of becoming onward lenders to their merchants and customers if they choose to.

This is an important insight and it also speaks to how the growth of open banking is facilitating this effort of making data and information more easily accessible to potential and future financiers. Open Banking could potentially open up opportunities for venture debt once data becomes more and more ubiquitous, and financial institutions gain confidence in the ability of these startups to make due their monthly repayments reliably and consistently.

Solving the data problem will unlock more capital once financiers have more visibility on the operations of these businesses and their financial metrics.

Asset Backed Venture Debt

As Africa is a developing region, we are still in the process of building infrastructure and an “asset light” approach premised on the Silicon Valley model isn’t applicable in Africa. An asset light business model is one where a business outsources its non-core assets and capabilities to a third party.

A food technology business for instance, may opt to outsource distribution, logistics and manufacturing operations to a third party and instead focus on product management, sales and marketing promotions. In industrialized economies where manufacturing and infrastructure capabilities are highly advanced, an ‘asset-light’ strategy can work. Not so in Africa.

Our markets are highly fragmented, and a lack of adequate, robust infrastructure systems across the various African markets makes outsourcing various aspects of the value chain very difficult.

Because we are a growing continent, with many infrastructure bottlenecks, startups that are building infrastructure to improve operations are the type of businesses VCs need to fund i.e., businesses that are building the necessary infrastructure to optimize operations to improve a product or service offering. There is a huge demand for robust infrastructure across various sectors in Africa.

Rob Eloff noted in a podcast with Untapped Global that:

“In the Sub-Saharan Africa (SSA) tech ecosystem, whether you are building a software or a hardware business, oftentimes you are building infrastructure and therefore, asset-backed venture has the potential to return very attractive multiples.”

Therefore, businesses that have assets, and that are leveraging technology and infrastructure to scale, are a suitable option for venture debt offerings across Africa. The sentiments of building an “asset light” business in Africa are often far-fetched, misplaced and grossly exaggerated.

Conclusion

International investor sentiment is growing on the continent. Americans are taking the lead in funding African businesses using a combination of both debt and equity instruments. As a result, we expect to see other international investors following suit.

A lack of data is acting as a hindrance for traditional financial institutions from taking up debt funding opportunities. However, the growth of open banking innovations, and businesses that aggregate API data from startups will improve the reliability and access of data, and unlock much needed capital from these institutions.

Furthermore, we hope to see an emerging trend of venture debt adoption in sectors outside fintech and energytech. In addition, it will be interesting to observe whether SMEs will increasingly embed fintech products into their products, a product offering that provides lending solutions to customers and merchants.

Asset backed venture is an interesting opportunity that venture capitalists should aim to support with venture debt, as most businesses rely on hard assets to run operations. There should be caution on financing purely “asset-light” business models as these models often aren’t suited for African markets.

In summary, I am hopeful this is a funding category that will continue to grow and it will be interesting to see how policy and regulation develops to support venture funding options across the continent.

This article was first published on Medium here. Stephen Muriithi is a venture capitalist, currently working as a senior associate with the investments and fund management team at GreenHouse Capital Africa.

He holds an MBA from the WHU — Otto Beisheim School of Management, and a Bachelor’s degree in Finance from the University of Nairobi.

His work experience has mostly focused on financial services working with large multinational banks on the continent. I’m also a fellow at Included VC, an eight-month, fully-funded global venture capital Fellowship that enables individuals from backgrounds that are underrepresented in VC to gain an entry into the industry.

If you would like to have deeper conversations on the intricacies and nuances of the venture capital industry in Africa, connect with me on LinkedIn or Twitter.