Lagos, Nigeria- September 2022; Shirley Somuah, Partner, CardinalStone Capital Advisers, in this interview with BusinessDay’s Frank Eleanya shares the different approaches to startup valuation the firm takes and the impact of the current economic meltdown on private equity funding in the ecosystem.
What are you doing to attract local investors into the startup ecosystem?
Every ecosystem has a natural evolution, and what we are seeing today is a bit more of the natural evolution of our local investment ecosystem than foot-dragging. If you look at Silicon Valley, and the earliest venture capital firms – people like Donald Valentine made tens to hundreds of pitches before they could find people who are willing to invest in tech businesses because it was a new asset class people were unfamiliar with it. Though they were seasoned investors, they simply weren’t willing to take that risk. And so it was over time. As a few early adopters started to invest in these new venture capital firms. It was as firms that received the investment started to do well and show that they could generate returns that more investors started to come. That is how some people built wealth out of this ecosystem and then find investors. Things started to accelerate.
So coming back to West Africa, to Nigeria, in particular, I think it’s just a natural evolution. We’re probably a bit over 20 years or so into when we had some of the first private equity firms, let alone venture capital firms. It is still new in our market. And so I think that’s the first thing. It takes time to get to a point where you build that critical mass of people who have the level of understanding, the level of appreciation of how it fits into the overall portfolio relative to other investment opportunities, etc.
Of course, it’s also the evolution of the investable opportunities and what sort of businesses are available. So that’s one. We’re in a market where the macroeconomic uncertainty and particularly currency instability has meant that people tend to prefer more liquid investments that allow them to be able to quickly decide if they want to move things around.
Investments in private companies, particularly through the structures offered by private equity and venture capital mean you’re making a long-term commitment. So it’s going to be either a question of time for people to get comfortable with, or perhaps some innovation in the sorts of investment structures to enable people to get to a point where they’re willing to make more of those long-term commitments. People often talk about the fact that local investors want their money where they can see it, in real estate, or in the sorts of instruments, they can come in and out of.
Finally, in terms of the dominance of international firms, many that are investing globally, have extremely large pools of capital built up over the last few years, as venture capital firms expect most of their bets are going to fail, and the few successful ones will do well. So another way to look at it is that if someone has several hundreds of millions of dollars to invest, even if it is $50 million in Africa, given the size of the market, given the potential given where we will eventually get is a small better place for the potential upside and a bet that many of them can afford to raise. If you think about local funds domiciled on the continent, there are few VC funds that have $100 million and above. The majority, particularly the early-stage funds are much smaller.
In terms of what we are doing, we are investors as well and not advisors. And so while we play a role in educating the ecosystem, it’s not necessarily our primary function. But in our fund, we have some high-net-worth individuals (HNWIs) who come in as investors. The best thing that we can do is to ensure that our fund is successful and we return capital to them. That will help to bring other people along in investing.
Talking about returning capital to them, are you concerned about the turnout of events in 2022 in terms of the trajectory of the global economy and the downturn in the funding of tech startups? What are you telling your shareholders?
As long-term investors, we live through cycles. Our job is partly to anticipate cycles and to make sure that we take the context of cycles and make investments that appropriately factor in that context, or help support our portfolio companies appropriately through this context, but mindful of what the current state of things is, and advising our businesses appropriately. So for instance, there’s been a pullback in capital. As a private equity firm, we’re counting on subsequent fundraising rounds or counting on liquidity events based on either local or global investors, which may perhaps have a tougher time.
What it means is belt-tightening by everyone. We started having conversations about this six months ago when we saw where things were going. It means everyone to some extent needs to focus more on market economics and getting the unit economics right. It means that in terms of thinking about runway if someone was anticipating that they were going to do a funding round, within the next three to six months, need to ensure that our businesses are being prudent to make sure that the capsule can last a bit longer if funding rounds are delayed, or take a little bit longer. So those are some of the key things we think about in terms of the current microenvironment.
As investors, we’re also mindful of what the fundamentals are for any business we’re going into. As private equity investors, we focus on the downside as much as the upside. So it’s not new to us to focus on the downside, but we likely will be a bit more vigilant, a little bit more cautious in what investment decisions we’re making, knowing that there’s still a lot of uncertainty as to where things will play out from a global macro perspective.
Do you agree with some experts who say that economics were sort of put on the sidelines in 2021, by investors who wanted to cash in on the FOMO in the tech industry, and so everybody was just looking at valuation? Do you agree those decisions accelerated things to where we are?
I think we are in unprecedented times. From a macro perspective, we’re still dealing with the hangover or overhang I should say, of the COVID-19 pandemic. There have been a general economic slowdown and unprecedented supply chain challenges. At the beginning of this year, we were also dealing with the fallout of the Ukraine-Russia crisis. So I think we need to remember that these things started from early 2020 into 2021. That being said, I think there’s some merit to saying that perhaps investors did get a bit too carried away with the availability of capital, the availability of cheap capital, given everything that was going on.
The opportunities for high valuations, and for future investors to take people out at higher valuations pushed the focus away from the fundamentals. But why I say it’s one of the reasons is just that the tough macro environment meant that there was less and less room for error, and we’re actually seeing more businesses fail as a result of that. If we hadn’t dealt for instance, at the beginning of this year with the Russian Ukraine crisis, which exacerbated economic conditions with higher oil prices with a pullback from emerging markets, one could argue that the fallout will not have been as bad.
How does CardinalStone Partners approach valuation in the startups they invest in?
So in all our businesses, we tend to take a similar approach to valuation. We focus first on what target returns, and what we’ve committed to investors. And so for every opportunity we look at, we ask ourselves from a returns perspective, does whatever price we’re considering support our ability to generate appropriate returns for investors on that investment, factoring in the growth of the startup factoring in risk profile, factoring in expected currency devaluation, where business earns income in local currency, those are the key factors that we think about,
Depending on the business, we may pick different valuation mechanisms. Is it a revenue-based valuation? Is it a profitability-based valuation? But I think this is why I made the point at the beginning to say it’s less about a good or bad business. It’s more about whether it is the right business for us as an investor. I may have such peculiarities which make your valuation too rich for me based on the way I think about things, and it may work for another investor. So a little bit to answer how we think about it, but also why different investors may be able to take different approaches to valuation and support different valuations.
Looking at what has happened so far, in 2022, what is your view of how the year is going to end from an investor’s perspective?
I don’t have an idea as to how things are going to go but we will make a bit of an educated guess.
Equity and venture capital asset class gives the ability to take a long-term view because these funds tend to have a longer investment horizon, and then also access to capital goods to make investments and support portfolio companies. And so I expect that investors will continue to make commitments that will continue to be compelling investment opportunities. The best startups who are focused or the best businesses I should say focused on operational efficiency, the right economics, and focused on addressing the clear market need sustainably will be able to attract investment. And we at CardinalStone continue to have a positive view of the markets and invest in them.
Finally, what has the year been for you? And how many more startups are you looking at adding to your portfolio?
It’s been a positive year for us so far. Typically, as private equity investors, we will call in two to three investments a year at most. We’ve closed one investment and are close to closing the second, and third, I should say. So we likely will do at least two more investments this year, potentially three. We expect a challenging year, but if we remain prudent in how we think about the kind of investments we expect it to be positive.