Kiyan Zandiyeh – Empty Rooms: Venture Capital on the Emerging Frontier at Sturgeon Capital (Capital Allocators, EP.317)

25:43Our view is that we can manage execution risk much more proactively than if we were trying to manage any other risk, such as does the business model even make sense? What do you find in terms of valuation? Well, certainly a discount to what you would find in, let's say, developed markets, especially over the past few years, and even more so now in this current market environment. The dynamic that I think is different also in these markets relative to, let's say, the US or Europe is generally because these countries have not had a deep pool of funding available to them. The entrepreneurs from the get -go understand that basically they have to very quickly create a profitable business that can stand on its own two feet.

26:20that typically are not business models that have to rely on an excess of capital to fund losses for an extended period of time. And one of the high -level concerns I would imagine people would have is national governance in some of these countries. How do you think about the risk of something going wrong beyond the scope of the company itself? An interesting way to look at it is contrasted with traditional private equity versus venture in these two markets. wear the hats of I'm a traditional private equity I buy industrial businesses I buy mining businesses the difference is there you have a tangible asset that it relatively is operationally simple to run there's a positive correlation between the success of it and the willingness of the government to ultimately want to take it off you at some point in time because there is a real underlying tangible asset that they can take it's pretty easy to install someone that can run it and generalizing you can have governance consents if you translate it into on a technology side one you're not dealing intangible assets.

27:18There's intangible assets. There's no land. There's nothing really to take. Two, they're operationally complex businesses to run. And three, you're not really taking market share away from anyone. You are not disrupting anyone in any means. What you're doing is complementing the existing system. If I paint an example, if you look at e -commerce, what are you really doing? You're saying, I am helping the long tail of local merchants increase their revenues by helping them sell online and doing it in a transparent manner because it's digital. So tax revenue from it goes up. I have to work with the local logistics companies.

27:52And by virtue of that, I probably will be their largest revenue source. And I will force them to be efficient because I need them to be efficient to be able to work with me. And for the consumer, basically, you're allowing them to buy products at probably what will be a cheaper price than if that platform didn't exist. And you're a source of FDI and you're hiring for the youth where typically unemployment is the highest. So what you typically see is actually the governments are the largest champions of FDI, specifically in the technology sector, because they understand that it's a reset economically for their country, where they can reshape a lot of the inefficiencies that exist throughout the various different layers of those economies.

28:27What are some of the risks that you encounter investing in these businesses? I think to a large extent, the risks you see in these markets are not too dissimilar from the risks you would be if you were investing in any other market. as in the highest factor that would lead to losing capital is not making the correct assumptions on the economic model of the business, not truly understanding how much capital that business needs to be able to scale, making a bad bet on the management that's running it. So they're all the same types of risks. The one that is a bit more acute in these markets is, as I said, you do not have a deep pool of funding available.

29:02And so if it is a business model that just so happens to need a little bit more capital to get to the size that it can, you need to make sure that you have a pool of co -investors with you that have the balance sheet and the wherewithal to continue to co -invest alongside you to de -risk that downstream funding which a company may need. So some of that latter risk of not having the capital has to dovetail with, as you're talking to the investor community, people being skeptical about the markets by definition because there's capital coming in. What are some of the critiques that you hear about your strategy?

29:34Certainly, the liquidity is one. What I think we've tried to do as a firm, I like to think we do a good job of it, is basically being champions almost of these businesses in these countries and meeting investors from around the world to establish a relationship to bring them on as co -investors. And we've been lucky to co -invest alongside some very good names in these markets. And it's been the first time that they've been invested in them. So we've demonstrated the value of them participating in it. The second, obviously, is always exits and, okay, it's great building this business, but where does the liquidity come from the other side?

30:04And I think now you have enough precedent of multiple different ways of exits across multiple emerging markets throughout economic cycles that basically if you come to the conclusion, if you can build a business that earns the right for an exit, it will get an exit. If a business is just not good enough, they won't get an exit. That's fundamentally true. That also has been de -risked. And the third is, frankly, that these markets are early and we don't raise very large funds. We care a lot about performance. And I think especially in venture, size is the enemy of performance. So if you do back of the envelope maths, assuming a 50 million fund that you own, 10 % fully diluted, and you want to 5x that fund, you have to create $2 billion of enterprise value.

30:45Now, 10x that and a half a billion dollar fund, you have to create $20 billion in enterprise value to 5x that. I think it explains why the average upper quartile DPI is 1 .76. The fund sizes cannot even cope with generating that much enterprise value. So to care about performance, we have to be very capacity constrained on the funds that we do. So naturally, there are some investors where, for constrained reasons, they can't participate. What are other misperceptions that you find about the markets you're investing in? Well, clearly, if you're a follower of during emerging markets over the past 20, 30 years, which is the life cycle of it, you've seen a lot of people get their fingers burned.

31:20And so you just develop a pretty firm heuristic to say, no, I'm good. I like investing in the US and Europe. But I think that underestimates truly what is happening from a technology perspective in these countries and the speed with which so many different things will compound. So if you just think about, as I said, the median age is 28. And that's a generation that's growing up with equal access to information and knowledge the way me and you have for a very long period of time. And that youth is very hungry. The speed at which they're learning is exponential. Layer on top of that, the distribution dynamics that I said are innate in technology companies and high levels of existing inefficiency in what are relatively large economy.

32:02I think just the sheer enterprise value creation that will come from technology companies in these countries will be immense. What's the competitive environment like for the deals you're interested in? Yeah, so I think at this stage where we are in the countries, one of the criteria is that We purposely don't want too many venture firms to be in there at the start of it. So you take a country like Bangladesh, 170 million people, eighth largest smartphone user base in the world. As I said, GDP per capita higher than India. You only have two VCs in the whole country. So by just being focused and dedicated to it, you kind of have an unfair advantage when it comes to sourcing, such that if you are an entrepreneur of company of any quality, we are hopefully a natural partner for you to reach out to, to want to see capital from.

32:46That's the competitive environment today. But we then work to bring in more competition counterintuitively because we want more liquidity in these markets. So whether it's from regional investment firms, international investment firms, half of our job is capital formation. And we take that seriously. Walk me through an investment from soup to nuts. Take an esoteric country like Uzbekistan, 35 million people. If you look at the banking sector, effectively 80 % of that banking sector only does corporate and government lending. There's no real retail banking. There's no real banking to small to mid -sized businesses.

33:19Small to mid -sized businesses are about 60 % of the country's GDP. You say, okay, well, objectively, that's a pretty big opportunity to build a lending business. Our first iteration was to be, there's no existing bank or technology company to back. Let's acquire a small bank and bring a management team into it that can then run it in the most efficient manner so that we can build a market share and I'm simplifying it in consumer. And we were close to completing that transaction, but then COVID hit, and obviously, things got paused. But then six months later, we effectively came across a management team that basically all they have done over the past 20 years is build very efficient financial service institutions, technology -led, in nearly a dozen different frontier and emerging markets, and have had a very successful track record doing so.

34:02And that they would be very good partners to have. And we then brought on another investor, which was actually the Finnish Development Fund, the government fund of Finland, to provide the equity balance sheet for them to go and capture what we believe was the opportunity in SME lending. Where roughly every year you have $2 to $2 .5 billion in lending opportunity, but the largest business that is catering to it only has a balance sheet of $10 million in the country. and that you have the development institutions such as the IFC, the EBRDs of this world, that have a mandate to provide subsidized lending to this market specifically to SMEs, but they don't have a good conduit to accept that credit on their side.

34:40And that by being a reputable firm of a good management team, we could be the recipient of that capital. And on the other side, we could lend in a much more competitive rate, much more systematically, and basically capture the majority of that $2 to $2 .5 billion market share in lending opportunity. And so we incubated that company in a way where we found the investor, we found the management team. We own around 25 % of it. I'm on the board of it myself. And almost got started from scratch. And that's doing tremendously well. And it's only in a six -month operation. It already broke even. It's profitable, going back to my point, where you don't need to fund losses for a long period of time.

35:15And now we're just looking at almost a blank blue ocean of opportunity where we can really scale this business up to a loan portfolio in the hundreds of millions of dollars. As you started operating that business, what are some of the things that came up that you didn't expect along the way? In businesses where you have to obtain some sort of regulatory license, the bureaucratic process gets funky and interesting. I never realized how important stamps are, so you have to have a stamp for everything. The bureaucratic process is a bit arduous in terms of time, but at the same time, it's pretty easy to navigate once you have the process to do it.

35:48That's certainly interesting. one of the elements of this business is that you have to hire what are called junior loan officers. So effectively hiring individuals straight out of university and teaching them how to go into the market to obtain data from these offline businesses to be able to understand how to credit underwrite them because you don't have a centralized credit bureau. Now the training process is all good and well but then you have local nuances. So for example obviously being a Muslim country, we hire females straight out of university. And oftentimes, you would find their parents coming in to check if this place is a real place, what sort of environment it is, is it safe for them to work in, et cetera.

36:26So you have these local nuances that, if anything, make the whole thing a bit more interesting and enjoyable. So in a business like that, how do you think about the duration of your investment? In that case, you have to be quite specific in terms of timing your exit why because let's say above half billion dollar enterprise value the list of buyers is limited from two to four hundred million dollars there's more and from 100 to 200 million there's more now clearly if you build the business of the profile that i think we are building under the economics that we have now it's a matter of time of compounding that you will breach those enterprise values and it's a matter of when you time your exit, really.

37:10Now, ideally, you want it to be in that sweet spot where there are enough buyers that you can have a competitive process, and that is within their budget range that you can actually exit. For us, when we look at this business, it's basically between five to seven years. What's another one of these examples? The company which I have the most sense of belonging to, because it was our first investment and the founders, the gentleman I mentioned, is Ferd Business. For context, to introduce a comparable business model to start. I mentioned briefly this company called Caspi listed in London. Now, that business is fascinating because Kazakhstan is a population of 19 million, and these guys have managed to build a business that is a $15 billion market cap business doing $2 billion net income a year.

37:49Now, what was the premise of what they did? They said the two largest opportunity sets in this market that haven't been exploited are e -commerce and lending. The two of them require basically means of distribution and a means of obtaining data so that you can credit, underwrite, and scale. And so what they effectively did was to build out an e -commerce platform to build out the distribution, where you have the consumers on one side that are buying, the merchants on the other side that are selling, and then you can embed a lending business into it. And then you can layer on payments, you can layer on other services such as insurance.

38:19And they got to a point where in a population of 19 million, they have 10 million monthly active users and 6 million daily active users. It's almost the operating system for the country. So that business model we became fascinated by. Zootpay, the company in question, that business model, but operating in four or five different countries, where on the initial side, we purely started with e -commerce, build the infrastructure to enable e -commerce to happen in these countries, and build up a distribution base where today we have 11 million downloads, 2 million monthly active users, and about 50 ,000 merchants that are selling on the platform, and a critical mass where we've now started to build a lending business as well, where if you're a consumer, the only way you can buy anything is even through installments or through a longer -term lending product.

39:03For the merchants, we basically took on warehouse space where we bring their product in as collateral. We can finance their working capital, and if they don't pay, we can simply sell their product on the platform and get our own liquidity. So you can manage MPLs in a very cost -effective way. And you're talking on markets that collectively, the size of the market is in the tens of billions. What I've been lucky to witness is really the founder and what masterful execution looks like. Arguably, I think probably the best entrepreneur I've ever come across in my life. And just through luck, we got to, I would say, partner with him.

39:35And that experience of building what I think will be a really tremendous business in these markets run by a very good entrepreneur has been just a really great experience and I'm sure will continue to be. What's made him such an exceptional entrepreneur? A few things. I think, one, he understands strategy and how to put stakeholders together and align incentives to get stuff done, whether that's the government -owned logistics company, whether it's the largest payments company in the country, whether it's getting banking licenses. Two, has just an energy which is beyond my comprehension. As I said, he has five kids, he's 50, travels three weeks a month, and is ruthless in execution.

40:14If there's something that needs to be done, within a day it will be done. Never seen someone that operates at the speed that he does. What do you think it'll take to bring more capital into the countries you're investing in? I think it's just a function of more and more success stories. If you take a step back and look at the more developed emerging markets, be it LATAM or Southeast Asia, and we did a study, and my colleague Alex actually wrote a report on it recently, looking at the early vintages of the venture firms that were investing in them when those markets were in their nascency. Those are some of the highest performing vintages I've seen.

40:45There were 10x, 15x, 20x funds. Now, obviously, you have survivorship bias. But once you've validated that opportunity set works, that point, inevitably, more capital comes in. And we're already seeing that. If you look at a country like Pakistan, they went, on average, for three years, raising $20 million in total for the venture ecosystem, where in 2021, it got to $250 million. In 2022, it was $300 million. And you see that growth exponentially once you prove out. And that's basically been the story of nearly every more developed emerging market. You started your journey in investing enamored with the public markets and the breadth of opportunities and have evolved into this, in the scheme of things, narrow, interesting niche in some countries many others don't invest in.

41:30What have you learned across the two disciplines? I think what unifies them is, I mean, this concept of compounding, which is still the most amazing thing. And the lens of which I always looked at it is, what is an area where I believe that as a firm, we could have an unfair advantage, where we could compound capital at a pretty high rate, and truly understand why and how we're doing so. Why and how we're doing so is, I think, the most important part of it is, there's 100 different ways you could be generating returns. I think you have to be very clear about why does that opportunity set exist for you?

42:05And why is it that you are uniquely able to execute on it over an extended period of time. And that translates both to the public market side and to the private side. The thing that I've come to appreciate by being an operator is that I think public market investors lose a bit is the variance in outcomes being a function of the quality of execution of management. And that there's very wide variance in that quality of execution. and that when you come across someone that is a masterful executioner, operating in a very large market of attractive economic dynamics, those are typically the best situations that you want to be in because it means you can compound capital at a very high rate of return over a very long period of time.

42:53Are there opportunities in the public markets in the countries that you're investing in privately? Yes, there are. So increasingly what you're seeing is that going back to that point of the government recognizing that building the technology ecosystem is important. What you see is that the stock market's starting to make it easier for companies, for example, to be able to IPO even at a much earlier stage. Not necessarily that that's the right thing to do, but what you then do see happening is that more and more technology companies appearing on their public markets, and if not failing that, once they get to a certain size, appearing on public markets internationally.

43:27The main reason for that is if you take who is on the other side of that trade, public equity, emerging market managers that typically have not had the most attractive investment universe available to them to invest in because largely they've been these old industrial businesses or previously state -owned businesses that were normally cheap but extremely cyclical at best. And so there's a lot of capital or balance sheet that's willing to underwrite IPOs of these sort of companies once again they earn the right to it and they're large enough to do so. Have you thought about participating in the public market as part of what you're doing?

43:58Not intensely. I think there will come a time where there'll be enough of the universe where by virtue of being on the earlier state side, we have a very good understanding of what models are working and not working and the evolution of such that probably you could do a public market fund as well. But at this stage, it's not an immediate focus. I think that's probably 10, 15 years away. As you look out over those next couple of years for Sturgeon, what are you hoping to accomplish? I mean, at the core of it, I still believe our job as investors and allocators of capital would like to really be a great investment firm that is building really unique companies in a world where impact has become a boxing exercise, we can meaningfully say that we're having impact in these countries.

44:42That's all we need it. The way I see our venture business, it's high octane. It's where we demonstrate to investors what our purpose is of being decorrelated alpha. Now, that's capacity constraint. Now, is another element to the business where when you look at emerging markets, you have a lot of institutions and corporates that allocate capital into these markets. But oftentimes performance is a secondary factor. They have a strategic reason why they're allocating to it. They want to achieve a specific objective. That capital probably isn't being served very well by existing players, that we could be a good partner, where in essence what we say is we understand how to put a very good team and a process together to fulfill whatever it is that is your objective.

45:22And that the revenues from that business allow us to have financial resources to really build out a very good infrastructure as a firm to continue to be very thoughtful allocates of capital across emerging and frontier markets all right cam before i let you go i'm gonna ask you a couple of fun closing questions what is your favorite hobby or activity outside of work and family the random one probably i play the flamenco guitar i've played this since about 12 years old it's enjoyable it has a lot of energy and it's a good distraction where you're also focused on the same time. When I was younger, I did a lot of sports.

45:56For about 10 years, I was on a British karate team, competed internationally, not of the weight anymore to be able to effectively do that. So we'll say those two. What did you dream about doing when you were a kid? Probably if you were to ask me when I was six years old, it would be to say I wanted to be a rally driver. But probably at the age of 12, 13, I really liked the idea of independence and self -sufficiency and basically saw business, I guess, or now I can label it entrepreneurial endeavor. I couldn't even call it that then. It was something I was really passionate about. And if you ask my parents, for whatever reason, they really liked to visit furniture shops.

46:29The immediate thing I would do when I was a kid is go to the office section and sit at the desks pretending I was running something. It was a bit of a joke. But for some reason, I liked the idea of something that entailed an input and as a result of it, an output that you had some influence over. What's your biggest investment pet peeve? for many years now what i think has been a disservice to the venture industry is this concept of product market fit what it effectively has entailed from an investment strategy perspective is that when a company reaches or sees some level of demand irrespective of the underlying economics of that demand to throw fuel on the fire and put capital into it to let it grow What has really been optimized for is business models that can scale revenues, but it's not very clear whether the underlying economics of the thing are actually attractive.

47:21And going back to the idea, if you want to compound capital, there has to be a profit at the end of it for capital to be compounded. And so what you often see is decks from companies or investors that a lot of the discussion and narrative is really focused around what I can do to scale revenues. And there's very little discussion around, well, hang on, what is the actual business model behind this thing that will allow me to extract abnormal profits over an extended period of time from it that independently makes us a very attractive financial investment? And that's probably a pet peeve when it comes to venture.

47:54What investment mistake did you make that you learned from and will never make again? Well, beyond the leverage example that I said, thankfully, it didn't turn out to be a mistake, but honestly, it was a bit of a nightmare. was investing in situations where you are in awe of the business model, but you've underweighted the ability of management to build against it. So if you think about it on a spectrum, it's one thing building a business that is a million dollars in revenue to 10 million to 100 million to $200 million in revenue. And either you have someone that has the ability to evolve and the intellectual honesty to make themselves better across all of that process, or they can't.

48:36And that the greatest business model cannot work with average or suboptimal management teams. Which two people have had the biggest impact on your professional life? First, pick three, if it's okay, just to be fair to them. I think I have to mention Clemente Capello, which was the original founder of Sturgeon. I mean, he, for whatever reason, took me in at 25 and almost gave me a blank canvas to take the business that he had worked on for almost a decade and say, do what you think is right with it and give me the complete freedom and trust to do it. Just have immense level of gratitude for him for doing that.

49:12Second probably would be Michael, the founder of Zootpay, which I briefly discussed. And more recently, a gentleman that has joined us actually as one of the partners that I mentioned, a gentleman called Lardo Gujinidza. So he was the CEO of a bank in Georgia, the country, Bank of Georgia, when it was going through significant reforms and took a $30 million bank and built the largest bank in the country. in the space of a handful of years and took it to an IPO of a plus billion dollars in London, was then prime minister of the country for a while because he was a pure technocrat and ran the country as if it was a business and was just incredible doing so.

49:47And then since then has been a lifelong investor and operator in financial services across emerging markets. For me, he's someone that has the widest aperture of business knowledge that I've ever come across, has a very rigorous and rational thought process to how to think about business, and is probably the best executor in business that I've ever seen in my life. And that's a very, very unique combination of someone to find that has had experience in both public sector and private sector. And there isn't a discussion that I have of them that I don't come away learning a hell of a lot from. And collectively, I think I owe a lot of my career to these three individuals.

50:25problem. What was the best advice you ever received and what context did it come to you? I don't recall if it was in a particular context, but this notion, I guess, that over the long term, your life will, to a large extent, reflect what it deserves to be in the sense that in your working life, any success that you have probably will, to a large extent, be a function of how you proactively went about it, your relationships with your friends, your loving relationship with your wife, your kids, will all be a function of how you, to a large extent, deliberately went about trying to earn the rights for it to be good.

51:04And that, as a thought process, is probably useful, universally true, and does away with relying on fairness or luck for any success in any aspect of your life. and it implies a responsibility in you as an individual to be deliberate and proactive in the way you want to manage your life. What teaching from your parents has most stayed with you? There's many specific things, but it's more a notion or a general idea. I think the overarching thing is really just unconditional love. And my parents, I am extremely lucky that when I was a kid, they went to the end of the earth to sacrifice and do best by me.

51:38I mean, to give you an example, I was a very supposedly quiet and reserved kid. So at the age of four, my dad forced me into karate. I would train five days a week. He would take me all the time. I was black belt, one of the youngest black belts in the country at age of nine. From 10, I was on the national team, won the British Championships, European Championships. And that was all because of my father. He pushed me, recognizing that it was good for me, that probably it would instill in me some confidence and discipline, and that it would demonstrate what achieving something actually looks like.

52:07So the fact that they always pushed whatever interest I had and spend the time and back to me to try and do my best in it, just instilled this sense of obligation and humbleness that you have a responsibility to do something with your life with that. Okay, and last one. What life lesson have you learned that you wish you knew a lot earlier in your life? I think it's how increasingly time becomes less, more scarce. When you're probably zero to 20, it's the period in your life where you, in theory, have less ownership externally on your time than any point in your life. And that will progressively decrease as you grow older.

52:45And not that I think I use my time unwisely, but just to really appreciate that that was a reality, that in those years, you will not get them again. Really, it's a unique dynamic and you should appreciate it for what it is. Thanks so much for sharing this really interesting story. Thank you, Ted. Thanks for listening to this Sponsored Insight. Sponsored episodes are paid opportunities for another 12 managers a year to appear on the podcast. If you're interested in telling your story in front of the largest audience of investors in the industry, please email us at team at capital allocators .com to apply for one of the slots.