How DFIs Should Fund Direct-to-Consumer Businesses in Emerging Markets
Development finance institutions (DFIs) and commercial investors run the same marathon but use different methods to get to the finish line. While commercial investors typically invest directly in companies that can promise high short-term returns, DFIs provide risk capital for enterprises with the goal of pursuing specific development goals in the long term. In many emerging markets, commercial investors tend to invest in B2B companies because of their perceived ability to scale more quickly. Even in developed economies like the U.S., 70% of venture capital (VC)-backed businesses are enterprise products. This set of companies are 2.4 times more likely to result in an initial public offering (IPO) than direct-to-consumer (D2C) businesses. Further, enterprise services tend to have higher margins than their direct-to-consumer counterparts. For example, Amazon Web Services accounted for 14% of the company’s revenue but 71% of its margins in 2020. However, the expansion of consumer businesses in emerging markets presents a significant investment opportunity for DFIs.
In emerging economies, D2C companies tend to be overlooked by investors due to difficulties in customer acquisition. These effects are exacerbated in crisis times like the COVID-19 pandemic, because commercial investors want to avoid taking on additional risks. Given DFIs’ dual focus on impact on mass markets and long-term commercial returns, these institutions should help bridge the gap and fund D2C businesses in emerging markets.
To determine where DFIs can fill the D2C funding gap, we must first identify how these institutions invest. DFIs typically give direct debt into funds, co-invest with funds in equity into businesses, and, to a lesser extent, provide direct equity into businesses. For example, in 2020, Norfund gave $31 million in debt financing to AfricInvest Fund IV to invest in industry-creating companies. On the equity side, in 2018, CDC UK co-invested with TLCom for equity in Twiga Foods. DFIs are often motivated by social impact and seek to finance self-reliant businesses and markets that advance development goals. Their impact-focused lens explains their willingness to make bets on investments in sectors and countries that are typically overlooked. Given this focus, DFIs tend to invest in certain sectors to pursue specific development agendas, including financial services and inclusion, power and electricity, and green infrastructure, among other areas.
For commercial investors, it may not be easy to spot successful consumer-oriented companies unless these companies have 1) invested huge sums of money in marketing or 2) are at a later stage and are more attractive for mergers and acquisitions (M&A) or an IPO. Numida is an example of a D2C business that recently underwent an acquisition by MFS. Commercial investors typically fund early-stage D2C companies on the potential of acquiring a large consumer base; however, this can be a tricky prospect, as customer acquisition is expensive, requires a large war chest, and, often, needs a long time horizon to reap returns. Consumers in many emerging markets, particularly those with lower disposable incomes, are highly price-sensitive and show low brand loyalty. This challenge may limit the margins of D2C businesses in contrast to their enterprise counterparts.
However, consumer businesses in emerging markets are on the rise due to a perfect cocktail of factors: population growth, rising incomes, access to the Internet, and growing consumerism. For example, the Kenyan micro-insurance company Turaco is capitalizing on a growing need among lower-income consumers for health insurance. Novastar Ventures led their latest raise, a $2 million seed round in 2020, and 100,000 consumers in 2 markets have bought their services.
Nigerian start-up Eden Life offers a tech-enabled service that “puts your home's chores on autopilot”, targeting professionals who want to outsource their domestic tasks. Eden Life’s app lets consumers, starting in Lagos, schedule food, cleaning, and laundry services from the convenience of their app and boasted more than 600 users at the end of Q3 2021. They recently raised a $1.4 million seed round, led by LocalGlobe and with participation from other Africa-focused VCs including Enza Capital, Future Africa, and Samurai Incubate, among others. Investors like DFIs with higher risk tolerance—and which can invest with a longer-term horizon—should pay attention to these types of companies now and cash in early, whether with direct equity or indirectly through targeted funds. For direct equity, DFIs may face certain limitations in investing in D2C companies, including access to pipeline and a lack of experience in evaluating smaller deals.
DFIs should explore new investment strategies that could prove promising for consumer-oriented businesses, which could solve some of the challenges mentioned above. One option is for DFIs to take a less common investment route and create internal VC-like arms that can directly invest in companies. This seems to be the route CDC is pursuing, given its £200 million commitment to early-stage technology businesses focused on climate change. Another option is for DFIs to convene and commit to investing directly in consumer-oriented businesses in a particular thematic area. The 2X Challenge — an initiative of the G7 DFIs to invest in women-owned and -led companies — has great potential to serve as a signaling effect for DFIs to invest in a certain way or in certain kinds of businesses that they would not have invested in otherwise. It can also help DFIs to track the performance of investments in a given area to better demonstrate the business case for others to do so as well. These efforts, among others, can go a long way towards supporting DFIs in their mission to create strong, self-reliant, consumer-oriented businesses in emerging markets at a time when demand for these companies is growing.
Liviya David is a Business Development & Research Analyst at Botho Emerging Markets Group
Faith Nyabuto is an Analytics Lead at Botho Emerging Markets Group