With the world economy showing signs of high volatility, institutional investors are looking towards global markets to minimize risk and diversify their portfolios. Despite the potential challenges in these regions, investors can benefit from the upside of rapidly developing ecosystems. Frontier markets typically have underdeveloped stock markets, limited foreign direct capital, and extensive room for economic growth. This in in stark contrast to developed countries that have established stock exchanges and saturated investment opportunities.
Historically, some investment sectors have considered frontier markets to be the best place for early movers. However, some of those markets have continued to see somewhat stunted economic growth. That is poised to change with the gradual change in international trade restrictions. Economists are started to consider the possibilities of an integrated economy thanks to digitalization and global access.
Despite the high level of risk and volatility in frontier markets, they can provide significant opportunities for growth. Increasing levels of connectivity in frontier countries and gradually forms of technology have created new opportunities in recent years. These companies also have a pressing need for capital that can help them grow to the next level, which presents venture capitalists with an opportunity to capture outsized returns.
Undiscovered Potential of Frontier Markets
Investors from around the world are increasingly interested in frontier markets as they have proven to be among the best investment destinations of the past decade. A quarter of the world’s population and 11% of the world’s GDP already live in these rapidly expanding economies. The size of their capital markets has already reached critical levels that encourage global investors to invest in them. The importance of better understanding these new investment destinations, as well as determining what role these markets should play within investment portfolios, is increasing.
Although it is challenging to source quality online/digital businesses in frontier markets, there are a sufficient number of talented entrepreneurs who have an economically interesting business, an experienced management team, and a successful track record, but lack the capital to scale their businesses. By working collaboratively with businesses, investors are able to secure attractive valuations.
Frontier markets offer the potential for long-term growth, which is one of the main reasons to look at them. A frontier market is often called a “pre-emerging” market for good reason. One of the reasons fewer people invest in frontier markets is precisely because of the risk involved. With less competition and more yield potential, this provides another good reason for those of us with an appetite for risk to invest. In traditional markets, establishing an investment or starting a business can be challenging. The chances of success are greater in frontier markets, even for the most basic businesses. Frontier markets offer numerous opportunities for basic businesses and online services.
Real estate isn’t the only industry that benefits from a market where competition is almost nonexistent; e-commerce and simple service industries are also more likely to succeed. More businesses will likely be able to weather economic downturns without having to worry about a global financial crisis every seven to eight years, such as in developed markets.
What’s In It for Venture Capitalists?
Frontier markets offer numerous benefits to investors. Frontier markets, for instance, are often isolated from the rest of the world, making them less dependent on global monetary systems. Consequently, they tend to be immune to global recessions and depressions. As a result, frontier markets are risky on one hand, but they can also be an important part of a diversified portfolio on the other. Investors who spread their risk by investing some capital in undervalued markets that are in their infancy — markets where their investment will be greatly welcomed and needed — will be better off than investors who invest all their capital in “developed” markets, which are all susceptible to financial crises around the world.
Investing in a company from the beginning offers investors the opportunity to build it from the ground up. By leveraging the entrepreneur’s local knowledge and the investors’ background in business mechanics, venture capital firms aim to build a team that can scale up quickly, not just get a reasonable valuation.
How Frontier Markets Can Flourish Because of Foreign Investment
The development of local capital markets depends on international investment. A foreign investor provides capital to the local economy, participates in risk sharing, reduces domestic buy-side concentration, supplies liquidity to the secondary market, and may reduce price volatility in the long run. Additionally, international investors help local companies align their practices with international best practices, reducing their cost of capital and enhancing their valuation. As their investments stimulate the development of local financial markets, international investors also contribute to the growth and development of domestic economies. Investing in frontier markets offers foreign investors opportunities for portfolio diversification and access to fast-growing economies.
Frontier Market Challenges & Risks
It is inevitable that markets will face challenges even if they have all the right fundamentals. Data alone won’t give you a full picture, nor will it prepare you for the nuances of frontier market investing. Frontier markets have great demographics. Currently, the average age in Africa is 19, and that figure is expected to rise.
However, data is not the only factor. It is challenging for investors to invest in some frontier markets. Investing in them can be difficult even if they’re not completely closed off. One of the best examples of this is Myanmar. Even though it is a promising frontier market, anyone smaller than Coca Cola will have trouble getting into it. Finding an investor-friendly country will present new challenges. Frontier markets, due to their lack of financial infrastructure, are difficult to invest in because they are disconnected from the rest of the world.
A contract can also quickly lose its value. As a result, it is always good to focus on building a network of locals who know how to make deals in their specific markets. The chances of being ripped off and finding the best deals are greatly increased when you deal with local associates. Ownership limits and trading restrictions are common regulatory hurdles in frontier markets as well. There can also be erratic trade execution and high transaction costs. Counterparty risk also remains one of the challenges presented while investing in frontier markets. In many frontier countries, central depository systems and insurance have mitigated, but not eliminated, counterparty risk. Frontier investors face additional challenges due to volatile currencies, capital controls, pre-funding requirements, and exchange fees. The stocks of frontier markets are usually thinly traded, and without careful execution, trades can send important signals to local investors at the expense of foreign investors.
Many investors consider frontier markets to be inhospitable outposts where corruption is rampant and risks are high. The risks associated with frontier market investing were recently highlighted by news that Argentina is planning to nationalize YPF, its largest company, owned 57% by Repsol of Spain. The safety and integrity of frontier markets have greatly improved over the past decade, despite this asset grab by the Argentinian government, and their growing popularity with professional investors is testament to the fact that frontier markets offer appealing risk-adjusted returns.
Current Trending Frontier Markets
There has been a drastic change in the landscape for classification of countries as frontier markets over the past decade. The improvement of economic conditions has led to several countries being upgraded to the status of emerging markets. Kuwait was the most recent country to be added to the MSCI Emerging Markets index, having been added in November 2020. Pakistan was upgraded to emerging market status in May 2017 and Argentina to emerging market status in May 2019.
Vietnam now represents 30.6% of the MSCI Frontier Markets index as a result of these upgrades. Morocco is ranked second with 13.5%. With a return of 14.6% over the past year, Vietnam has been the best performing country in the frontier markets. Vingroup JSC holds a 5.5% stake in the index.
Saudi Arabia’s Aramco to Start Offering Fundings
Recently, in an effort to attract global tech startups and diversify its economy, Saudi Aramco’s venture capital arm is turning to international investments. According to Chief Executive Officer Fahad Alidi, Wa’ed will invest $100 million this year after spending $50 million over the past nine years. In the second half of the year, the $200 million fund plans to make 11 investments. Apart from fintech and e-commerce, the firm will focus on deep tech, space technology, and sustainability. The plans reflect Saudi Arabia’s ambitions to invest internationally in order to diversify its economy and attract talent. Currently, the Gulf region lacks unicorn startups, or startups valued at $1 billion or more.
Pakistan: Great Upside Despite Risks
Startups from Pakistan, one of the world’s last untapped frontier markets, have also raised $486 million in capital since January 2021. Kalsoom Lakhani, the founder of Invest2Innovate and general partner at its sister firm i2iVentures, says that the ecosystem needs to be healthy overall, too. This includes preparing startups and investors for things such as how to expand the talent pipeline to meet these fledgling businesses’ needs, or how to make the policy and regulatory environment more conducive to their success. According to her, in order to create sustainability and longevity and to grow the startup ecosystem in the future, these pillars must be strengthened.
Among the last few untapped markets for startups and investors to offer internet-based services similar to those in other parts of the world are Pakistan, which has over 250 startups since 2015, a growing internet penetration driven by low-cost smartphones — 184 million cellphone users in 2021 — and affordable data. There are many services offered by these companies, including ride-hailing and grocery delivery.
In recent years, many first-time investors have poured money into these startups in hopes of handsome returns. For the first time, many of these startups will help bring parts of the informal economy into the formal economy and tax net.
According to the Pakistan Startup Ecosystem Report 2021, to create a supportive ecosystem in which businesses can flourish, startups should receive more attention. While growth opportunities exist, finding the right human and capital resources is a challenge due to the two million new workers entering the workforce every year.
As a result of recent reforms, including the creation of a legal framework for Electronic Money Institutions by the country’s central bank, the State Bank of Pakistan, new businesses have been able to be established and investments have increased. In January, the Digital Banking Policy was finalized, allowing digital banks to offer more than e-wallets and credit. Startups are regulated by the Securities and Exchange Commission of Pakistan, which oversees non-banking companies, and Special Technology Zones have also been established by the federal government.
Dutch-Portuguese AI Startup Raises €5M
An AI company that develops and applies artificial intelligence to increase renewable energy’s uptime and performance announced Monday that it has raised €5 million in a Series A round of funding. SHIFT Invest, a Dutch venture capital firm, led the investment. Among the other investors in the round were Rocks International Group, EDP Ventures, Gorilla Growth Capital, and Future Energy Ventures.
According to Jungle, the proceeds will be used to accelerate the deployment of its renewable energy and industrial technologies. During the next few months, 12 new positions will also be filled. Over the past year, Jungle has expanded to a much larger customer base, according to CEO Arnoud Kamerbeek. As per him, In addition to strengthening their team with this funding, they will be able to scale on a global basis.
Despite the shortage of semiconductors caused by the pandemic, companies reconsidered Russian sources of materials like neon and palladium after the country invaded Crimea in 2014. Supply chain management has become more difficult because of all these geopolitical tensions. As a result of globalization and just-in-time inventory systems, supply chains have become leaner and more efficient. As a result, many South-Asian countries have surpluses, redundancies, and multiple sources.
Duplicate supply chains have resulted in increased investor interest in South Asian nations like Indonesia, Malaysia, the Philippines, and Thailand. Rather than packing up and moving from China, companies are expanding overseas. Aside from semiconductors, Vontobel’s institutional investors have invested in Indonesia’s two largest banks, Thailand’s Siam Commercial Bank, and Airports of Thailand, where the two markets emerged from the pandemic with strength. A growing number of investors are also focusing on Vietnam, particularly in consumer brands, financial services, and real estate.
Frontier Markets Continue to Show Promise
Frontier markets offer attractive risk-adjusted returns with low correlation to developed markets. Yet, due to their diverse nature and potential pitfalls, these markets require extensive experience, strong risk controls, and partnerships with reputable global custodians and brokers. Future technology will disproportionately benefit frontier markets, as evidenced by mobile telephony and satellite communications that can bypass expensive intermediary steps in traditional telecom networks.
Frontier markets differ greatly from one another. The majority of these countries have natural resources, but a number are commodities importers, which could suffer currency weakness if crude oil prices remain high. Oil-related pressures are further magnified for companies that have a large overseas workforce, typically in the middle east. In spite of this, domestic consumer spending in countries such as Pakistan has remained resilient. The Pakistani stock market has boomed for much of this decade, and MSC reclassified it as an ’emerging’ market in 2017. The macro-economic figures are just a starting point. The biggest opportunity for active fund managers is to uncover under-researched companies with high uncertainty and potential.
As a result of the pandemic, technology and digital adoption accelerated across frontier markets. Africa has generally seen higher growth in data and digital payments this year, particularly in Kenya, where millions of users and micro, small and medium enterprises now manage payments through a telecoms provider’s platform. Additionally, a fintech company in Egypt has established itself as an e-payment platform and provides 194,000 point-of-sale (PoS) machines. Digital adoption has also increased significantly in the banking sector from the current client base, as well as among new digital customers. The banking industry has grown rapidly in Colombia. Over the past year, customers at one digital bank have more than doubled due to a surge in demand for digital transactions, even though a third were previously unbanked.
Frontier markets continue to show significant economic growth potential. Although frontier markets face short-term headwinds, many venture capitalists believe they will continue to thrive in the long run. Due to the availability of technology, the development curve is likely to be more rapid than it was in emerging markets 30 years ago. Frontier markets offer investors diversity across Latin America, the Middle East, Africa, Asia, and Eastern Europe. Frontier economies have pushed idiosyncratic reforms to support macroeconomic development. One of the highlights has been Vietnam’s recent business reforms, which focus on digitization to simplify business procedures. Frontier markets will continue to be driven by domestic dynamics that are geared toward favorable demographics and under-penetrated sectors over the long term.