The emergence of a large entrepreneurial community is essential for the development and growth of any country. For there to be a sizable number of new enterprises and for these to grow and thrive; they need funding, and this funding usually comes from venture capital (VC). In the U.S., large, venture-backed companies — Amazon, Apple, Cisco, Google, Medtronic — are major parts of the economic landscape. A recent study by the National Venture Capital Association and HIS Global Insight estimates that 11% of U.S. jobs were created by VC-backed companies.

In Latin America, on the other hand, the VC industry is still nascent. At a recent meeting at the at the Multilateral Investment Fund (the investment and granting arm of the Inter-American Development Bank), Josh Lerner of Harvard Business School said the Latin America VC industry still has to go through the growing pains that Silicon Valley did 40 or 50 years ago during its embryonic days.

The growing pains of the VC industry in Mexico, where I am based, are in two dimensions: on the fundraising side and on the investment side.

Fundraising side

VC fund managers in Mexico are still learning how to achieve trust with our investors, the limited partners (LPs). It takes transparency to achieve this objective, but too much transparency can sometimes get in the way of effective fund management activities — as VCs spend too much time keeping their LPs informed and not enough focusing on their investments. Many LPs are also still learning how best to be effective investors by providing support and demanding accountability, without micromanaging.

Mexico is also still struggling to build a big enough base of local investors to sustain its VC industry. Despite several tremendously successful Mexican venture capital investments — such as microlender Compartamos, where early investors made a 250x gain — most local investors are still reluctant to invest in early-stage ventures. And many of the family offices and institutional investors that are willing to make risky investments are hesitant to do so through VC funds — they continue to prefer to invest directly. This is partly because direct investing has become an attractive activity for family heirs. The challenge is that few of them have the relevant experience to do it well.

How could we better incentivize local family offices or institutional investors to invest in VC funds? In Brazil, the government made investment through VC funds tax-free — and the country now has approximately 130 funds. In Israel, the government put money into VC funds alongside local investors without demanding a return, thus allowing the private investors to leverage their returns and helping launch a thriving VC and entrepreneurial scene. In Mexico, the government has created funds of funds to invest in VC, which has been great help. However, it has also been investing directly in companies — making the government a competitor of VC funds and disrupting the sector’s market dynamics.

Investment side

Entrepreneurship in Mexico continues to be EXTREMELY hard. The sector ecosystems needed to enable the success of new ventures often does not exist. Think of it like this: you can have a very good business plan in the transportation industry, but if there are no roads or you can’t get access to the existing roads, you have no business. In Mexico, in the innovative sectors that entrepreneurs usually enter — mobile technology, branchless banking, housing for rural or semi-urban areas, basic services such as water, telecommunications, education, etc. — there is either a lack of “roads” or lack of access to them. This is what we call “sector ecosystem risk,” and success in the VC industry in Mexico depends on managing it well, in addition to the traditional VC skill of managing early-stage business risk.

To manage sector ecosystem risk, you need to be local. You also need senior experienced operational talent as fund managers (both for management skills and the ability to navigate complex waters where multiple parties must come together for an effective solution).

The challenge is that senior experienced operational talent in Mexico usually isn’t interested in bearing the risk and hardship of working in the still-struggling VC industry. Forgoing high current income for uncertain, high-risk return just isn’t a rational economic decision. To build this industry we therefore have to depend on idealists — mission-driven people. That will probably continue, but government could create incentives for experienced professionals to enter the field.

Another issue in Mexico is that few VC funds want to make early-stage investments. That’s understandable, since early-stage investing is the riskiest, and it’s especially risky in the Mexican environment. But early-stage ventures are fundamental for the creation of a VC industry. It is they that create the pipeline that sustains the industry. Therefore the government needs to establish incentives for VC funds to keep investing in earlier stages.

Angel investors are also important for early-stage investing. An angel investing ecosystem will take time to develop in Mexico because we do not have the benefit of a critical mass of successful VC- and angel-backed entrepreneurs. So, strong support to the current angel investing networks is key.

Entrepreneurship is essential for economic growth in Mexico. Today the two biggest hurdles in its way are lack of access to capital and difficulty in dealing with the industry ecosystem risk. To solve the bottleneck, Mexico needs more money to flow to funds, and more fund managers with business track records who can guarantee execution. One without the other won’t be enough.

More blog posts by Álvaro Rodríguez Arregui
More on: Entrepreneurship, Finance, Venture capital