The use of alternative investment Funds to empower VC fundraising in Latin America
Capital available for funding startups in Series A/B in Latin America is relatively scarce.
Latin America has all the necessary ingredients in place for becoming a powerhouse in terms of technology startups which can become high impact companies, and create economy at scale. Still, the number of tech startups turned high impact companies l-ike Mercado Libre, Despegar, Globant- are the exception. One main reason why this happens is the relatively low availability of funding focused on startups ready for growth.
Seed funding through accelerators, company builders, and angel investing has grown significantly in the last few years, allowing the creation of record-numbers of startups. Some of those startups manage to bring their ideas, products and services to the market, prove their concepts and start growing. However, there are only a handful of VC funds focusing on the next stage, mainly for Series A and Series B stages.
Moreover, banks and financial institutions have not yet adapted their product offering for technology-based, rapid growth companies. So for those startups who did get the pre-series A funding, raising Series A/B Capital is a real challenge.
During the last months, we can observe some VC initiatives in order to empower fundraising strategies in Latin American market. These initiatives are based on the structure of Alternative Investment Funds and a new context of “Tecnolatinas” (technology- based private companies born in Latin America).
VC Funds are structured as closed-end investment vehicles, typically as limited partnerships, involving two entities:
- Limited Partners “LPs” which are the investors that contribute with capital and acquire interests of the VC Fund. The key economic incentive for LPs is the opportunity to earn a high rate of return on their invested capital through access to a portfolio of investments sourced and managed by the GP that is expert in the target sectors or geographies of the fund.
- A general partner “GP” which has the legal power to act on behalf of the investment fund. The key economic incentives for GPs are management fees and a profit participation on the fund’s investments (Carried Interest or Carry). A management company, which is often affiliated with the GP, and is appointed to provide management services to the fund.
For the consideration of this analysis “VC Funds” includes the involvement of these two mentioned entities.
In Latin America, complementary to standard VC Fund structures, other related structures may be formed for special legal treatment, tax benefits, or just to get the support of the local government. These related structures are Alternative Investments Funds (“AIF”) and can be classified such us:
- Parallel Funds
- Subsidiary Funds
- Side Car Funds, or Co-Investment Funds
- Feeder funds
This post provides a brief description of each AIF with the most recent cases and initiatives in the Latin American VC community.
Parallel funds are investment vehicles generally formed to invest and divest in the same investments at the same time as the master VC fund. They are formed under substantially the same terms as the master VC fund, with specific differences to accommodate the regulatory, tax or other investment requirements applicable to the investors in the parallel fund.
Moreover, parallel funds are often created in jurisdictions other than that of the master VC fund. For example: Cayman Islands-based fund (master VC fund) may form a Latin American Country-based parallel fund to accommodate local Latin American investors who often prefer to invest through a local –Latin American- vehicle.
Parallel funds co-invest and divest alongside the master fund at the same time and on the same terms, pro rata based on their respective committed capital. In most cases, the size of the master VC fund and any parallel funds are aggregated for purposes of any overall fund size cap, and investors in the master VC fund and any parallel funds generally are aggregated for purposes of voting under the fund agreements.
Latin American VCs formed to invest worldwide are often formed in offshore jurisdictions with favorable tax regimes and well-established legal systems, such as the Cayman Islands. In cases where these jurisdictions are undesirable, either for reasons of perception or because of “blacklists” kept by Latin American countries in which prospective investors or anticipated investments are located, alternatives may include Canada, Uruguay, or other jurisdictions providing pass through tax treatment.
Parallel Fund Case Study #1: DALUS
In October 2016, Dalus Capital (www.daluscapital.com), with Dalus Capital Fund II GP, L.P., acting as settlor and Capital DCA, S.C. as Administrator, executed a restricted public offering of “Growth Capital Certificates” (CKD), under the ticker “DALUSCK 16”. Dalus Capital is a venture and growth equity fund manager whose strategy is to finance the growth and development of innovative companies with high growth potential such as Clip (clip.mx), MFM (www.mfm.com.mx) and kubo.financiero (www.kubofinanciero.com). The CKD is part of an investment program that also includes a parallel vehicle based in Canada. The resources obtained through the issuance of the CKD are invested in the same proportion pro-rata as the resources in the parallel fund. The CKD and the parallel vehicle plan to invest around US$100m.
Parallel Fund Case Study #2: IGNIA
In November 2015 Ignea (www.ignia.mx), a leading venture capital fund in Mexico, has closed the Mexican vehicle of its Fund II, raised through Mexican publicly traded certificates known as CKDs under ticker “IGNIACK 15” up to US$90m approximately. Mexican pension funds invested in the fund, marking a first for venture capital in Mexico and demonstrating institutional investors’ confidence in IGNIA’s track record, as well as the accelerated economic growth found at the base of the socio-economic pyramid in Mexico. IGNIA’s international vehicle, a Canadian limited partnership fund, will invest alongside the Mexican vehicle. In 2016, IGNIA has completed its investment in Underdog Media, along with fintech platforms Sr.Pago and Pangea.
Subsidiary Funds are owned directly by the master VC fund, either in whole or in part with other investors. Subsidiary funds are commonly used for special legal treatment, tax benefits, or simply to be investor friendly.
Furthermore, subsidiary funds must follow the laws of the country where they are incorporated and operate, and the VC master fund carries the subsidiary fund’s financials on its consolidated financial statements.
Governmental agencies and local development banks promote and support the incorporation of subsidiary funds to facilitate the development of local entrepreneurial ecosystem.
BNDES in Brazil
BNDES (The National Social and Economic Development Bank) is the most active LP in Brazil. Last year BNDES has launched CRIATEC 3, the largest local VC focus on early-stage technology companies in Brazil.
The standard structure utilized by VCs in Brazil is “FIP” (Fundos de Investimento em Participações). FIP is a closed-end investment funds that can acquire share of any Brazilian company. FIP is regulated by the Comissão de Valores Mobilários (CVM), Brazil’s Securities and Exchange Commission, and it is mandatory for GPs to get a license from CVM to operate a FIP. Any income and capital gains earned by a FIP is exempted from the income tax in Brazil. Moreover, VC investments may be allocated by holding companies, however income & capital gains are taxable. Sometimes, International VCs prefer to offset tax costs against structure cost of a complex administration to fulfill sophisticated regulatory systems. Some examples of International VC firms utilizing FIP to carry out their investment are Redpoint (www.rpev.com.br) and Qualcomm (www.qualcommventures.com).
Other firms focusing on Latin American Market directly invests from its Master funds like Kaszek Ventures, which has recently raised u$s 200 million in its third fund to continue investing in tech-companies across Latin America.
CORFO in Chile
CORFO (Corporación de Fomento), Economic Development Agency, has implemented a line of financing oriented to promote the entrepreneurial community in Chile. VCs firms are incorporated as FIP (Fondo de Inversion Privada) a closed-end investment funds similar to Brazil but less regulated. CORFO share the risk but not the reward. This line of financing accrues interest at very low rate. On each occasion, the Fund pays out dividends to its investors and, at the same time, it pays CORFO an amount equal to the amount that results from multiplying the Debt/Fund Investment ratio, in), a accordance with the Fund balance used to calculate the dividends to be paid out by the amount paid out to investors. In 2017, CORFO has just announced the support of 5 funds which jointly reach u$s67m. They are: Social de Ameris Capital, Fondo Alaya II, Alerce Venture Capital, Mountain Nazca Ventures and NXTP Labs.
INADEM in Mexico
INADEM (Instituto Nacional del Emprendedor) has approved a co-investment program with more than 30 funds in the last 4 years. INADEM started this program to support the creation of new fund managers at the seed stage by providing co-investment capital up to u$s 2.8m with a capped return at 8% annualized. INADEM only gets up to that threshold and the other investors in the fund share the excess return. A very good incentive to attract investors. Another good initiative is the Pacific Alliance Venture Capital Fund, jointly supported by INADEM & InterAmerican Development Bank-Multilateral Investment Fund, that will reach a size of u$s 100m. This regional fund will invest in Mexico, Colombia, Peru & Chile, and will be managed by Angel Ventures. VCs Firms in Mexico could utilize either a local Limited Partnership called “Fondo de Capital Privado-Emprendedor”, or a Canadian Limited Partnership structure.
FONDCE in Argentina
In March 2017, the Argentine Congress approved the new “Entrepreneurs’ Law,” with broad consensus among all political forces with parliamentary representation. The Law on Entrepreneurs promotes tax incentives for investment in entrepreneurial ventures, early-stage loans and other mechanisms to support new business creation. To develop the entrepreneurial capital industry, the law provides special tax benefits for registered investors who are committed to the development of Argentine ideas. Furthermore, in order to facilitate and streamline the financing process for entrepreneurs, the law creates a National Trust Fund for Entrepreneurial Capital (FONDCE). The FONDCE will be composed of 10 funds, 40 percent of which will represent public investment. The funds will be of a minimum of U$S 30 million each and will be ran by private fund managers who select the projects.
Side Car Funds or Co-investment Funds
Side car funds or co-investment funds may be used by GPs when the investment opportunity is too large for the master VC fund to consummate alone or when the participation of a particular outside investor (such as a strategic partner) facilitates the investment opportunity.
Side car funds are investment entities formed by the GP to co-invest alongside the master VC fund in specific fund investments. They are separate investment vehicles administered and sometimes controlled by the GP; unlike parallel funds do not necessarily have the same investment terms or fees as the fund. They are typically formed to accommodate investments made by particular investors outside of the master VC fund, and/or to create sub-set portfolios of investments.
Most of VC funds contain a customary provision to the effect that the GP will allocate all attractive investment opportunities to the master fund rather than other investment vehicles unless a deal exceeds the master fund’s concentration limit. Hence, a side car fund will expressly prove that it will have first opportunity after the master fund’s concentration limit is reached. The GP must take care to set up the side car fund in a manner that does not interfere with any pre-existing obligations to provide co-investment opportunities to particular LPs or to strategic third party investors. To minimize conflict of interest between the master fund and side car funds, the side car should co-invest in each portfolio company as to which it is allocated an opportunity on a pari passu basis.
Side car funds trend to be inexpensive to operate because they are based on investment processes related to master fund. In Latin America there are new side car funds, already structured or in structuring process. They are mostly oriented to co-invest in vertical market opportunities such us Fintech, Agtech, Edutech, and Media.
Side Car Fund Case Study: ARFINTECH
Arfintech (www.arfintech.com.ar) is a fund recently created by argentinean local bankers oriented to redefine the financial services market through technology-based with agile product development. These local bankers are investors and/or sponsors of NXTP Labs, which co-invest with Arfintech in its fintech related companies.
Feeder funds are special purpose vehicles formed to accommodate investment in the master fund. Due to the particular jurisdiction of incorporation of the master VC fund, an investor or class of investors may prefer (primarily for tax purposes) to invest in the fund indirectly through an upper-tier entity. Profits from the master VC fund are then split, or distributed, proportionately to feeder funds based on the percentage of investment capital.
The feeder funds that invest capital in a master fund operate as separate legal entities from the master fund, and may be invested in more than one master fund. Various feeder funds invested in a master fund often differ substantially from one another in terms of things such as expense fees or investment minimums, and do not usually have identical net asset values (NAV). In the same way that a feeder fund is free to invest in more than one master fund, a master fund is likewise free to accept investments from a number of feeder funds.
In a feeder fund arrangement, all management fees and any performance fees due are paid by investors at the feeder fund level. The primary purpose served by the feeder fund-master fund structure is reduction of trading costs and overall operating costs. The master fund effectively achieves economies of scale through having access to the large pool of investment capital provided by a number of feeder funds, which enables it to operate less expensively than would be possible for any of the feeder funds investing on their own.
The use of this two-tiered fund structure can be very advantageous when the feeder funds share common investment goals and strategies, but are not appropriate for a feeder fund with a unique investment strategy or aim, since those unique characteristics would be lost in the combination with other funds within a master fund.
Crowdfunding platforms oriented to retail investors may be structured as feeder funds to be part of a master VC fund. A good example is the following case study.
Feeder Fund Case Study: Flex Fund ETP
Flex Fund ETP – Exchange Traded Products – (www.flexfundsetp.com) securitizes a portfolio of publicly traded assets. The portfolio is actively managed by an appointed Portfolio Manager, and participations are globally distributed through a Euroclearable listed security. Investors access these securities from their existing brokerage accounts. Each issuance is designed according to customizable terms and conditions. The FlexETP program provides price (NAV) calculation and distribution, an International Securities Identification Number (ISIN), Bloomberg listing, trustee and audit services.
As part of its fund raising strategy, NXTP Labs has launched a financial vehicle called EMHITS (Emerging Market High Impact Technology Startups) oriented to private bankers. EMHITS is an Exchange Traded Product, based on Flex Fund platform that contains an underlying asset that is a NXTP Labs Fund share. EMHITS can be bought by any Bloomberg terminal with ISIN XS1121503822, and is listed at the Vienna Stock Exchange. The price of EMHITS is based on the NAV of NXTP Labs, which is based on the value appreciation of NXTP Labs’ company portfolio through the incremental value determined by third investors in subsequent financial rounds of our companies.
A Combination of Alternative Investment Funds
In order to optimize fund raising strategy, Latin American GPs may implement a combination of Alternative Investment Funds. NXTP Labs is an example of a Latin American VC that had to synchronize the implementation of four types of AIFs to approach different types of investors.
NXTP Labs Case Study.
NXTP Labs has received capital contribution from IDB-FOMIN (InterAmerican Development Bank – Multilateral Investment Fund) & IFC (International Finance Corporation – World Bank) which allocate their investments in the master fund. Complementarily, the Firm has structured the following alternative investment funds:
- Mexican & Chilean subsidiary funds to co-invest with INADEM and CORFO (Government Agencies)
Side car funds oriented to vertical markets Agtech & Fintech to approach Farmers, Bankers & Corporate Investors looking for investment opportunities in tech-innovation and digital transformation.
- Feeder Fund though Flex Fund Platform to facilitate retail investors from private banking sector to invest in a well-diversified tech-company portfolio.
- Parallel Fund in Argentina authorized by CNV (Argentinean SEC) to receive investment from qualified investors like pension funds and insurance companies. This Fund is in process of formation.
About NXTP Labs:
NXTP Labs has been actively investing in early-stage technology companies in Latin America for the past six years. The firm, through its $38m Fund 1, has invested in almost 200 start-ups and got twelve exits. Moreover, it has carried out 80 follow-on Investments with more than 100 qualified investors. The cumulative amount raised by company portfolio is over U$S 400 million. NXTP Labs’ portfolio spreads throughout different tech-related industries. It has shifted its investment focus from pure- digital companies towards companies that use technology that are helping to close the gap in traditional industries such as agriculture, financial services, media, tourism, retail and education. The firm is in process of launching NXTP Fund 2, with target size of us 120m, to continue co-investing in Series A, B & C over best performer companies.
NXTP Labs investments and ecosystem building activities have yielded a regional platform that is its main asset to add value to its companies. The firm has presence in Argentina, Brazil, Chile, Colombia, Mexico, Uruguay and USA. This platform helps companies help expand their operations. NXTP Labs innovative investment strategy is a Harvard Business School case study.