Venture Capital's Role in Developing Country Economies

Introduction: Defining Venture Capital

Capitalists play a critical role in the formation of businesses within a free market economy. There are many theories concerning the impact of venture capitalists as it relates to development in the private sector. The purpose of this literature review is to evaluate these theories as they relate to developing countries.

According to an article in African Business, venture capital is based on the concept of assisting "the development of small and medium size companies, creating wealth and employment, but at the same time guaranteeing a return on investment to the venture capitalist providing the capital" (Berger, 2004). Such investments can be made in both the private and public sectors. For the purposes of this discussion, the focus is on the private sector in developing countries.

Developed vs. Developing Countries

An article in the journal Law and Policy in International Business observes that there are clear differences between developed countries and developing countries throughout the world. On the one hand, developed countries are industrialized and their citizens have access to a high quality of life because a significant amount of capital is available to drive invention and continuous improvement (Sorabella, 2000). On the other hand, developing countries tend to be less industrious, the quality of life available to citizens is comparatively lower, and capital is not readily available to ensure innovation and improvement (Sorabella, 2000).

Venture Capital, Quality of Life, and Sustainable Growth

Given this disparity, venture capitalists can have a profound impact on the quality of life in developing countries. These quality-of-life issues include healthcare and education (Sorabella, 2000). The presence of venture capital can help improve educational opportunities and healthcare because countries that develop economically ultimately generate additional funding for such social services (Sorabella, 2000). If developing countries are ever to offer their citizens the opportunities afforded to citizens in industrialized countries, there must be meaningful development in the private sector (Sorabella, 2000).

Furthermore, if venture capital is to have this type of positive impact on developing countries, it must be sustainable. Even when venture capital in the private sector produces a positive impact, it can take a number of years before that impact is felt by all members of the population (Sorabella, 2000). As such, in many developing nations there is a significant gap between the rich and the poor (Sorabella, 2000). The sustained growth provided by venture capital in the private sector also makes the population more confident and encourages further investment in the nation by foreign and regional firms alike (Sorabella, 2000). Sorabella (2000) explains:

"To develop quickly, nations need access to capital to invest in industry, technology, and an educated population. However, because LDCs lack internal sources of capital, they are forced to look to outsiders. Those in control of foreign capital are primarily concerned with the risk and return of an investment. Unfortunately for developing countries, cross-border investing adds many additional levels of risk, such as sovereign risk, currency risk, and unfamiliarity with financial and market structures."

Risks of Cross-Border Venture Investment

As a result of the aforementioned risks, many developing nations must attempt to reduce these risks by providing greater security for investments (Sorabella, 2000). Alternatively, these nations could ensure that the returns offered to investors are significant enough that investors are willing to endure the risks (Sorabella, 2000). Sorabella (2000) asserts that the choice between these two scenarios reflects a significant connection between economic systems and government policy—forces that affect one another and create a certain tone in the overall market.

Indeed, there are significant risks associated with venture capital investment in foreign countries. This risk is evident in the scarcity of data on the number of venture capitalists who have invested in developing countries. According to Megginson (2001), although there is some evidence that venture capital flowing into developing countries has increased in recent years, this increase pales in comparison to the amount of Foreign Direct Investment that has occurred in developing nations over the same period. Megginson (2001) also points out that a great deal of what is classified as venture capital in developing nations can actually be defined as high-risk debt financing.

Sheela and Chua confirm that there is a great deal of risk associated with venture capital investment in foreign countries. They also note that although the overall increase in venture capital investment has been only nominal, in certain developing countries there has been significant growth. Such is the case in various parts of Asia. Because there has been a great deal of economic restructuring—combined with a reduced appeal to invest in developed countries—venture capital investment in developing countries began increasing as early as the 1990s (Sheela & Chua). Aylward (1998) found that since 1992, the amount of venture capital investment in Asia has risen significantly compared to Europe (Sheela & Chua).

Nevertheless, the increased investment of venture capital in developing countries in Asia still presents inherent risks (Sheela & Chua). These risks encompass a lack of fully developed institutions and government agencies, which can present both challenges and problems for venture capitalists with respect to corruption and elevated transaction costs (Hamori, 1999; North, 1990; Sheela & Chua). As a result, venture capitalists who invest in developing countries operate in environments that present distinctive risks and challenges. Doing business in such environments often requires a different type of venture capital model than those used in developed nations (Sheela & Chua).

Pacanins (2001) identifies two recent trends in private venture capital activity in developing nations. The first is a noteworthy increase in activity followed by a subsequent decline. The second is a shift of venture capital toward more early-stage investments (Sheela & Chua). Pacanins (2001) also asserts that "private equity investments increased in developing countries because many developing countries have implemented economic reforms, which have resulted in both economic progress and an easing of restrictions for foreign investors" (Pacanins, 2001; Sheela & Chua). Finally, Pacanins (2001) argues that the reason developed countries have experienced a decrease in venture capital investment is that there are too many investors and too few opportunities (Sheela & Chua).

Conclusion

The purpose of this literature review was to evaluate theories about the role of venture capital as it relates to developing countries. The review began by defining the purpose of venture capitalists. The literature indicates that venture capitalists assist in the formation of small and medium-sized businesses through monetary investment. The research confirms that venture capital is indeed needed in developing countries to jumpstart economies and to help countries gain greater independence while lessening the need for foreign aid. In addition, venture capital boosts the confidence of other investors and can eventually have a positive impact on the quality of life of citizens with respect to both education and healthcare.

However, the research also indicates that venture capitalists face many challenges when attempting to assist businesses in developing countries. These challenges are often linked to weak government structures and underdeveloped legal frameworks that govern how businesses are to operate. Addressing these institutional gaps remains essential if developing countries are to attract and sustain the venture capital investment needed for long-term economic growth.

References

Aylward, A. (1998). Trends in venture capital finance in developing countries (Vol. 36). Washington, DC: International Finance Corporation.

Berger, K. (2004, June). The power of venture capital: Venture capital is essential to enable entrepreneurs to expand or start new ventures. But it is risky and Africa comes top of the table in terms of high risks. However, things may be changing. African Business, 37.

Hamori, B. (1999). Dog strategies in the transition economies (Eastern Europe). Business Horizons, 42.

Jackson, T. (2004). Management and change in Africa: A cross-cultural perspective. New York: Routledge.

Koh, J. (2005). Workshop on "Technology innovation, private sector development, and economic growth." The World Bank. http://info.worldbank.org/etools/docs/library/144047/Financing_Technology-based_Firms.pdf

Lundahl, M. (Ed.). (2001). From crisis to growth in Africa? London: Routledge.

Megginson, W. L. (2001). Towards a global model of venture capital? [University publication].

North, D. C. (1990). Institutions, institutional change and economic performance. Cambridge, UK: Cambridge University Press.

Scheela, W., & Chua, R. Venture capital in a developing country: The case of the Philippines.

Sorabella, W. B. (2000). Less developed country as start-up corporation: Adopting the venture capital model for development in light of global capital market realities. Law and Policy in International Business, 31(2), 517.