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Investing in the “Bottom of the Pyramid”

November 21, 2010 Leave a comment Go to comments

A series of coincidences led to my participation in the 10th anniversary celebrations of Boston University Alumni Association in India   Although I am not a student or alumnus of the storied Boston school, I was invited by a friend to speak at the Mumbai event.  The audience sought a venture capitalist’s perspective on investing in the so-called “bottom of the pyramid.”  For the uninitiated, that is a phrase made popular by the great, late management guru and strategist CK Prahalad.

I used a few slides at the event to speak for about 15 minutes (view them here) and some key thoughts on the subject are presented below.

How are traditional VC/PE investors looking at the Bottom of the Pyramid opportunity?

Accessing the BOP as investors is not easy.   Models that involve grants are not sustainable and are best left to charitable organizations who are tackling the most basic of needs (food, shelter, clothing).   There is a class of investors that seeks social impact returns and financial returns are expected to only sustain social objectives.   True VCs and PE investors seek traditional returns and should not be distracted by the social virtues of investing in the bottom of the pyramid.

The investors in VC/PE funds (so-called limited partners) seek outsized returns based on high-risk illiquid investments.   They are typically pension funds, insurance companies and high net worth individuals/families.    If they seek social impact or charitable giving objectives, they have other channels available to them.   When they make an allocation of their net worth to a traditional VC fund, they are looking for financial returns.   A VCs job is to generate financial returns, not social impact or alleviation of poverty.

Where are VCs looking?

In search of financial returns, VCs seek innovative businesses  since outsized returns accrue from finding non-linearities in scaling businesses borne out of innovation.

Innovation needs to provide products and services that are specific to the needs at the bottom of the pyramid.    Repackaging the same shampoo in smaller sachets (CavinCare) or providing telephony services for less are models (Reliance Telecom) that large enterprises at scale can dabble in (they have high fixed costs that they have already incurred).   This is not in the realm of start-ups that can seek VC money.

Luckily for the VCs, entrepreneurs have continued to deliver true innovation in various forms:

  • Product innovation:   None of us in the upper echelons of the pyramid have a need for solar lampsterracotta  refrigerators and clay non-stick pans, and nanotechnology based water purifiers.   But they serve the needs of the bottom very well.
  • Service innovation:  Banks cannot service someone with a low average daily balance (less than $200) very well.  But serving a group of them via a proxy banking ledger has worked well (see EKO).     Similar innovation has been observed in servicing remittance corridors where cash movement tends to be in one direction and the logistics of moving cash back has been challenging.
  • Business model innovation:  One of the best examples is microfinance which in theory uses rural social dynamics to secure small unsecured loans.

The risk associated with the opportunity are not well understood

Microfinance is the first innovation model to have provided VCs with sizeable returns but the risks are still playing out and are perhaps not completely understood.   It presents some early hints about the risks the entire BOP sector carries.

Reputation Risks

The successful IPOs of Banco Compartamos in Mexico (2007) and SKS Microfinance in India (2010) have both been accompanied by an increasing cacophony of critics alleging plunder of the poor to generate shareholder returns (ROE in excess of 35%).    The ills of unorganized money lending have been forgotten in the clamor to cast the sustainable investor centric model as the villain as stories of indigent farmers committing suicide pour in.   The association of your firm/fund’s brand with such negativity may not go down well with your conscience or your investors’ reputations.

Financial Risks

The financial risks are more murky.

Regulators have been arbitrarily capping rates in microfinance or in some cases unilaterally “forgiving” loans.   I’ve met several borrowers who have several loans and have used them for purposes other than those they are supposed to.

Moral Hazard is a natural outcome of vote bank politics where politicians tend to forgive loans or cap rates.   Borrowers have been borrowing way beyond their debt capacity, fully expecting to not have to pay.

Leverage is essential for the model to work.  For equity investors to get 30%+ returns, the innovative models here have to be supported by debt, and as other risks pile up the debt providers are increasingly getting wary of lending to BOP businesses.

What does all this mean to me?

The risks have pushed me to sit on the fence for now  (perhaps losing out on some early gains).  At the same time, I am mindful that there is money to be made selling picks-and-shovels to the participants in the gold rush.  I am looking at innovators that provide  infrastructure (products and services) supporting businesses that address the BOP.

A VCs job is to generate financial returns, not social impact or alleviation of poverty.
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Categories: Entrepreneurship
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