Ascent to Development: Can Private Equity and Venture Capital Bring Bangladesh Out of Its FDI Slump?
The Asian Tiger. The Dazzling Delta. The Rise and Rise of Bangladesh
A simple google search today will return a trove of articles singing praises of the economic marvel that is Bangladesh. It was not more than some decades ago that the same country was referred to as a basket case. Long gone are the days of plaguing illiteracy and debilitating poverty, the days of a country crippled by natural disasters. Boosted by its population of 170 million strong and a growing industrial base led by the Ready-made Garments industry, Bangladesh has stunned economists with its achievements in poverty reduction and a host of human development indices. The economy has grown at a rate of over 6% for well over a decade, and has even crossed 7% in recent years. The growth engine shows no sign of slowing down, instead projected to grow even faster over the coming years.
A stroll through the capital city of Dhaka reveals the intricate clockwork of a growing economy. Cars and motorcycles zoom by the hundreds of construction projects littered throughout the city, while 20 million city dwellers go about their daily lives – spending their ever-increasing income on goods and services. The country’s GDP per capita has increased more than three-fold from USD 514 to USD 1,675 in the last 12 years . The outside world is also taking notice – HSBC has projected the country’s USD 300 billion economy today to grow to USD 700 billion by 2030, becoming the 26th largest economy in the world.
A closer look into this seemingly unstoppable rise, however, and challenges begin to surface. The bustling capital often comes to a standstill due to excess traffic, and travelling to the outskirts of Dhaka reveals an as yet underdeveloped countryside – a far cry from the meteoric rise witnessed by the capital. As the lens zoom in, the infrastructure requirements of a rapidly developing economy become more apparent – road transportation, economic zones, power generation – are few of the wide ranging areas where the country needs investments. The World Bank estimates that Bangladesh will require about USD 100 billion in infrastructure investments over the next 10 years, while International Finance Corporation (IFC) estimates a requirement of USD 320 billion in infrastructure investments to sustain the country’s growth rate. All across the board, the message is the same: There is a gap in infrastructure funding in Bangladesh, and the country needs to come up with ways of bridging this gap if it is to achieve its ambitious goals.
Historically, Bangladesh has relied on government funding and multi-lateral agencies to fuel its infrastructure projects. Even today, the mega-projects throughout the country – the Padma Bridge – linking the western part of the country to its capital, the Ruppur Nuclear Power Plant – aimed at solving the country’s growing power needs, or the Mongla Port – the country’s gambit to enhance its position in the global supply chain – all are inextricably tied to government funding. Private sector participation in infrastructure is among the lowest in South Asia – USD 1.1 billion only compared to USD 13.3 billion and USD 8.4 billion for India and Pakistan, respectively. Compared to its neighbors, Bangladesh has struggled to bring in Foreign Direct Investments (FDI) into the country – FDI into Bangladesh was only 0.98% of its GDP in 2017, while it is 6.30% for Vietnam. The Asian Development Bank (ADB) projects that Bangladesh has an annual infrastructure financing gap of USD 9 billion, while the FDI inflow is only around USD 2 billion. As the country seeks more ways to engage the private sector in infrastructure and bring in more FDI, one industry has the potential to lead the way – Private Equity and Venture Capital (PEVC).
A world of its own – How PEVC has shaped nations, and the world
An early morning check-in on Facebook, catching an Uber to work, using Gmail to catch up on e-mails - our lives are being increasingly shaped by the PEVC industry. A world run by Private Equity and Venture Capital backed companies is not some far fetched fantasy, it is the reality we live in today. Microsoft, Apple, Alphabet, Amazon, Tencent, Facebook, Alibaba - 7 of the 8 largest publicly listed companies today (by market cap) were backed at their early stages by venture capital. The industry’s reach goes far – according to estimates, Silicon Valley investments accounted for 57% of all investments into the United States, an incredible figure for the world’s largest economy . Many credit USA’s global dominance to the innovations born out of Silicon Valley, and finding anyone willing to take the opposing stance is a difficult task.
Venture capital’s origins can be traced back to the 1960s with the birth of Intel, while late stage Private Equity came on its own in the 1980s. How such a young industry has such far reaching influence in today’s world can perhaps be linked to its modus operandi. PEVC backers bestow a wide range of benefits upon their portfolio companies – active management through board/CXO level participation, network benefits, and access to capital – benefits that have helped these companies outperform their non-PEVC backed counterparts. A McKinsey report showed that PEVC backed companies in India generated 20% higher revenue and 6% higher employment growth compared to their non-PEVC backed counterparts, while the difference in rate of export growth between PEVC backed and non-PEVC backed companies was even greater – a staggering 60% . The picture is the same across borders – increase in PEVC investments leads to greater growth in employment, productivity and profit.
An economy fueled by PEVC backed companies is still a distant reality for a Bangladesh – the vast majority of the country’s enterprises are family-owned businesses. However, a cursory glance towards neighboring India can make the case of why Bangladesh needs to focus on this industry. McKinsey estimates that from 2001 to 2014, approximately USD 103 billion was invested into India in the form of PEVC investments – significantly higher than the funds raised in Indian IPOs over the same period, and more stable than any other form of capital into the country. PEVC contribution to fund-raising in India has increased over the past 15 years: from 20% of total capital raised in 2001–05 to 46% in 2011–14 .
India has also made a successful case of utilizing its PEVC industry to drive infrastructure investments. In 2017, USD 10 billion out of the total USD 63 billion of infrastructure investments in India were made by PEVC funds . Walmart’s massive USD 16 billion investment into FlipKart in 2018 has further solidified that PEVC is helping to bring in FDI into the country. Looking at Bangladesh - an economy that is in dire need of capital – the question then arises – is the country’s Private Equity and Venture Capital industry in a state to attract foreign capital?
Bangladesh – Starting up?
When Pathao, a ride-hailing startup, raised USD 10 million from investors including South-East Asian behemoth Go-Jek, it turned heads worldwide. Soon after, Alipay invested an undisclosed amount into bKash, the country’s most valuable tech-based company. While the larger deals are the ones dominating headlines, smaller startups have begun to emerge across Dhaka, their young founders targeting a growing market and emboldened by stories of global successes. A handful of incubators and accelerators are guiding the hands of these young entrepreneurs. Grameenphone Accelerator – an accelerator program run by Grameenphone, the country’s largest publicly listed company, has been providing support to startups for the last 3 years, and has seen 26 startups come up through its ranks. Others have also been active in developing the ecosystem – BDVenture and Startup Dhaka notable among them. A number of major deals announced in late 2017 and in 2018 potentially signal a turning point for the country – foreign VCs have taken notice of the country, and are on the prowl for investments.
While venture capital in Bangladesh has been making waves recently, late stage private equity has not received as much attention. There is one major private equity fund operational in the country – the USD 100 million Frontier Fund managed by Brummers and Partners, a European Fund Manager (A second fund by Brummers is in the works). Other funds present in the market include Small Enterprise Assistance Funds (SEAF) which is backed by International Finance Corporation (IFC) and the United States Department of Agriculture (USDA). Notably missing is the presence of any local investors in this arena, as late stage private equity still seems to be shunned due to the challenges present in the segment.
The long path ahead
A large, young population with growing income, increasing technology and mobile penetration – these are the indicators of an economy prime for development. However, for the PEVC industry, the path has been fraught with challenges. Early signs of development have been present for some time – specially the presence of international investors in the country. But a major gap still remains in the supply of capital. The small number of international investors present in the market have not been enough to make a sizeable dent, and it is unlikely that there will be significant participation from major global Private Equity and Venture Capital firms until participation from local institutional investors increases. Regulations were formed in 2015 to help create a formal local PEVC Fund Management industry, but there has been little success in attracting local institutions and Fund Managers to come forward and spearhead the industry’s development.
Till date, over a dozen organizations have received licenses to operate as Fund Managers, yet not a single locally domiciled PEVC Fund has seen the light of day. Challenges lie in all directions – from an economy that has been historically reliant on debt-based financing, to an underdeveloped regulatory guideline in need of improvement – there is much to do before Bangladesh can hope to reach the level of its neighbors. Going from a debt-based economy to an equity-based economy is no simple task, and no one expects Bangladesh’s corporate culture to change overnight. The simple course of action would then be a focus on solving the puzzles of the regulatory regime - improvements that have long been requested by the increasingly vocal participants in the industry.
While the Alternative Investment regulations set forth in 2015 provided a structure for management of funds, they did not bring along with them the required changes in the tax regime. Alternative Investment Fund Managers must pay a 35% tax rate on the management fees and carry they receive, which turns away most new fund managers from entering the industry. For comparison, Asset Managers of Mutual Funds pay only 15% tax on their management fee (the tax rate has been 15% from 2013, and previously was 0% for a period of 22 years). Industry participants believe that a tax holiday on management fees (similar to what was provided for Mutual Funds) and allowing for carry to be taxed at capital gains tax rates (in line with global practices) will likely help remove some major roadblocks for the industry.
Participants have also cited the example of Mutual Funds in Bangladesh to champion the cause for similar regulatory exemptions for Alternative Investment Funds – any Trust Fund registered in the country is subject to a 2% Stamp Duty, which industry participants state to be a major impediment for launching any new Alternative Investment fund. (This requirement stems from an 1882 regulation, and has been exempted for Mutual Funds yet remains for Alternative Investment Funds).
The effort to promote the local Fund Management industry has also had, on some occasions, the unfortunate effect of turning away foreign participants. Foreign Alternative Investment funds investing in Bangladesh are subject to a 3 year post-IPO lock in, while local funds only have a post-IPO lock in of 1 year. While arguments can be made for the necessity for preferential treatment of local participants, it does not change the reality that these discrepancies are dissuading foreign participants from exploring the market – and preventing the market from accessing the expertise and global networking benefits brought in by these foreign funds.
Moving away from regulations and towards attracting new participants into the industry, the government can take pages from the Indian playbook. In 1999, regulations enacted by the Indian government allowed banks to invest up to 5% of their surplus funds in Venture Capital Funds. Similar guidelines could be a game-changer for Bangladesh - the country has around 100 banks and financial institutions competing in an increasingly crowded industry.
The immediate benefit of a structured policy approach for the industry will be increased participation from local fund managers, but it is also expected to pave the way for international firms to come forward. The industry in India has gone through many iterations to get to where it is today – a national policy framework for startups, special attention to the Ease of Doing Business Index, improved patent and intellectual property regulations – the list goes on. While all these changes have allowed local fund managers to enter the industry in greater numbers (there over 300 locally-domiciled PEVC funds operating in India), they have also had the important side-effect of ensuring increased participation from foreign fund managers – 80% of the PEVC investments in the country are made by foreign fund managers. The wealth of experience and knowledge brought in by these investors has led to the creation of the Flipkarts and the Olas of India. India’s story is an illustration of what is possible in Bangladesh – with the right environment, the country may very soon have its first billion dollar startup – a “Unicorn”.
Bangladesh’s path towards development will be long and arduous. The country faces formidable challenges –- massive infrastructure funding gaps and inadequate FDI inflow threaten to depress the country’s sustained growth. Pinning the entire country’s hopes and dreams on one sector will always be a fool’s hope. But if how the global economy has been shaped over the last century is taken as any indication, the evidence is overwhelming – a flourishing PEVC industry can help catalyze Bangladesh’s economic development and ignite the spark that the country needs to live up to its promise. The promise of 170 million people. The promise of an increasingly wealthy population whose demands are being unlocked through tech penetration. The promise of a country making its way into the global stage through its manufacturing and tech sectors. The steps taken to develop the country’s PEVC industry today will play a role in how country’s story unfolds over the coming decades. What that story is – the story of a country ascending towards development, or of a country stumbling along the path – that remains to be seen.
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