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Let the investment games begin

Startups have the upper hand as too much money chases too few deals

by Livia Murray

Lebanese venture capital firms (VCs) could not be more pleased. Following Circular 331 passed last August by Banque du Liban (BDL), Lebanon’s central bank, to ‘de-risk’ commercial banks’ investments in startups, the banks have opted to invest handsome sums into VCs.

Banks considered this the ideal way to benefit from Circular 331, which guarantees 75 percent of their investment either directly into startups or into startup funds. According to Stephane Abichaker, head of investment banking at Blominvest Bank, 70 percent of alpha banks are choosing to invest in funds.

Incentivizing investment
As VCs await the central bank’s approval of legal documents determining the structure of the funds, it is clear that the incentive has the potential to create dramatic change in the sector.

Investments that benefit from Circular 331 are to be in Lebanese joint-stock companies that contribute to the national knowledge economy — a term loosely used to describe any sector that makes use of creative and intellectual skills.

The move is considered an incentive for the generally conservative and risk-adverse banking industry to invest in the economy. According to Lebanese law, it is not possible for the central bank to invest in equities directly. Therefore, it has implemented a creative mechanism to advance capital to the commercial banks that would then be invested in startups.

The mechanism behind the stimulus consists of three parts, all of which happen simultaneously — a slight alteration from the one originally proposed in the basic circular. First, a bank gets an interest-free loan from the BDL. Second, using this loan the bank buys treasury bills. Finally, the bank sells back the treasury bills to the BDL at a discounted rate, which increases the present value and from which the commercial bank derives a profit. The profit is calculated to amount to 75 percent of the bank’s investment in the knowledge economy.

Total participation of a bank cannot exceed 3 percent of their capital. This amounts to a maximum of roughly $400 million of guaranteed investments being injected into the ecosystem.

Circular 331 stipulates that commercial banks must pay BDL 50 percent of profits accrued through the selling of shares or dividends.

Capital injection

Most parties hailed the stimulus as a bold move, since the incentives, if implemented properly, could potentially have a large impact in developing Lebanon’s startup ecosystem. VCs jumped at the occasion of garnering investment that they would otherwise have trouble finding, particularly in the current unstable political and security situation that is hampering demand for long-term investments such as equities.
Circular 331 saw existing VCs fundraising amounts much higher than their previous funds. After a mostly successful batch of startups in their first round, venture capital darlings of Lebanon, Berytech and Middle East Venture Partners (MEVP), are coming back for a second helping.

Berytech has already raised $26-27 million in capital pledged from the banks for Berytech Fund II, according to fund manager Paul Chucrallah. They hope to close at $30-35 million, a handsome sum compared to their first fund of $6 million.

MEVP is aiming for a $50 million fund, compared to their previous two funds MEVF I and Build Block Equity Fund which deployed a total of $17.5 million. They currently have $43.5 million pledged, all from the banks. Blom Bank, Bank Med, Banque Libano-Francaise and Bank Audi invested $10 million apiece, with another three or four banks pledging smaller amounts.

Both funds are waiting on the approval of the BDL to formally receive the money from the banks. Habib Haddad, CEO of Wamda, announced at BDL’s startup workshop on December 19 that Wamda was raising a regional fund of $75 million to be invested in Lebanon, Jordan, Egypt and Dubai. Wamda was not ready to speak about the fund, and it is not yet known how much they will invest in Lebanon. Their previous regional funds reached $20 million between the Wamda Fund and MENA Ventures.

While these three existing funds are making a comeback, several new funds that did not exist prior to the circular have emerged. A new fund has come to life to raise sums above and beyond what was possible before Circular 331. Hala Fadel, fund manager at Comgest, and entrepreneurs Henri Asseili and Herve Cuviliez are fundraising for a $100 million fund under Leap Ventures. Fadel admitted that this number was ambitious, and pegged their first objective at $50 million. The fund will mostly be made up of banks’ money, with a couple percentage points of the partners’ own investments.

Stakeholders revealed that a fifth fund specializing in fashion was on the horizon as well, but kept the details confidential.

Inflationary pressure

The artificial injection of cash raised concerns that there was too much money and not enough investment-worthy startups in the ecosystem. Stakeholders have been complaining for a long time about the ecosystem’s weak deal flow. But the increase in dollars has not been followed by a concomitant increase in deals. “It is true that there is too much money chasing too few good deals. And the risk here is that we might end up competing seriously with other funds and other investors to grab the best deals available and there are too few of them in this tiny market,” says Walid Hanna, managing partner at MEVP.

Artificial appetite for startups’ equity will likely create an inflationary pressure on valuations, as VCs outbid each other to get the few good deals.

“This is a major risk in Lebanon,” says Hanna. “Valuations are going to go up because there will be a lot of money, a lot of investors chasing very few deals. So we might overpay.”

An increase in valuation would be beneficial to the entrepreneur to a certain extent. It would change the power dynamics and give them a higher bargaining power vis-à-vis the VCs. Entrepreneurs in Lebanon have complained of low valuations and high dilution of their shares. VC funds in Lebanon usually take strong minorities in equity, with Berytech taking up to 40 percent and MEVP up to 49 percent.
It would also force VC funds to be more competitive in what they offer. MEVP is already looking to increase their competitiveness by adding non-financial services such as advice on business plans and better access to markets. “Entrepreneurs in Lebanon are going to have a blast. It’s the best time ever for them. Good for them. And may the best VC win,” says Hanna. But inflationary pressure on valuation could also lead to a crash if the companies are not investment-worthy.

Throwing darts

Stakeholders are banking on the fact that at least some companies will succeed. “You cannot miss on every investment you make,” says Berytech’s Chucrallah. “Even if you throw darts on the stock exchange pages, you still recover some of your money.”

Investing in startups is inherently risky, and there are always some investments that will fail. As a loose average, only 1 or 2 startups out of 10 succeed. In Lebanon, the success rate has been a bit higher because of the conservatism of investors. Overvaluations compound the risk of investing in startups that aren’t worth very much.

“I’d rather not invest the money than lower the standard,” says Fadel.

Earmarked for investment

Despite obvious warning signs, VCs do not seem particularly concerned, and are eager to deploy their money.

“We are competing for transactions — some people will go and talk to many funds. I don’t think it’s unhealthy,” says Chucrallah. “The danger would be if you have 5 to 6 funds totaling $500 million and they want to invest $120 million per year.” These numbers, however, match the potential injection of cash quite closely. Whether or not funds can raise this much money will only depend on banks’ appetite for investment, which already seems significant.

Chucrallah is “100 percent” confident that he will be able to deploy all of the money, and thinks Berytech can already invest between $7 and 10 million in the first year. They expect to deploy over a period of three to four years and make 10 to 20 investments in total. Their ticket size would be between $1 million and $3 million, which is significantly larger than their previous ticket size of $300,000 to $500,000, a logical increase considering the stage of growth that many Lebanese startups have attained thanks to going through the ecosystem.

“We are an ecosystem, not just a fund manager. That provides us with privileged access to a lot of things,” says Chucrallah, referencing Berytech’s role as an incubator. Besides scouting for new companies, Berytech also has opportunities in those companies they invested in from the first fund needing further rounds of funding.

“There’s no doubt that we will have the deal flow. I don’t know if there is the deal flow for $400 million, but there is the deal flow for $30 million over 4 years,” says Chucrallah.

MEVP is equally confident that they will be able to deploy their fund. MEVP plans to invest $10-15 million in their first year. They are looking to invest $43 million in 20 deals over four and a half years, with the rest going to expenses and management fees. Their average ticket size increased from their previous two funds, MEVF I and Build Block Equity Fund, from $500,000 to $900,000 to beyond $2 million.

Hanna claims that MEVP will have an advantage based on their proprietary deal flow — startups that came to them, as well as existing portfolio companies that will go to their second fund.

Comgest’s Fadel, too, says that they have 10 companies earmarked for their larger ticket sizes of $5 to 15 million, adding, “We think that there are a few companies in Lebanon that need that.”

“There could be a bubble if all of the money is invested in the same stage,” says Fadel. She claims that the Leap Ventures fund, with larger ticket sizes than the rest, would complement the ecosystem rather than compete with it. The fund will focus on companies in the “last mile before an exit.”

Other VC funds are concerned that there might not be enough larger-ticket deals, and that all of the VCs will be fighting for deals on the same level.

Avoiding the bubble

VCs have realized that they can’t only bank on chance. Awareness has grown among all stakeholders that measures need to be taken to either boost the flow in the pipeline of startups, or limit competition between funds.

“Deals come and go,” says Chucrallah, admitting that deals can easily slip through their fingers. “Things disappear, they are a function of time,” he says. Deals can easily end up in the palms of other VCs.

In order to boost deal flow, MEVP has hired Lebanese recruiters in San Francisco and Dubai to convince entrepreneurs, both Lebanese and foreign, to come to Lebanon to build their business. He admits that these would not necessarily be top deals, which are generally sucked up by big VCs, but still had the potential to be regional leaders.

Berytech and MEVP will both be investing alongside others in a community-wide incubator/accelerator, for which they are raising a combined $5 million. They plan to have two cycles of startups per year, each of which would include 5 to 10 companies. Upon graduation, the investors would own 20 percent of the company.

To limit competition, VC funds have toyed with the possibility of co-investments, though this would not be their ideal scenario. “We’re not really interested in co-investing with Lebanese banks or funds, but we might have to going forward,” says Hanna.

Whether this will be enough to prevent a venture capital bubble is still to be determined.

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Livia Murray

Livia covers business, finance and economic policy for Executive.

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