Venture capital trends in MENA
By Abdullah Mutawi, Partner
When we released our 2022 MENA Venture Law Guide, we had just started to see the effects of the current economic downturn. The boom years of cheap money, sky-high valuations and gung-ho investing had given way to investor conservatism and a depressed valuation environment. Now, one year on, we can look retrospectively through the lens of our day-to-day advisory and transactional activity, and report back on what the market looks like today and what we have been seeing in more granular detail.
MAGNiTT recently reported that the top geographies of MENA recorded significant declines in deal flow activity of as high as 58% on a year-on-year basis. VC funding for H1 also declined, from $2bn in 2022 to $1.6bn this year. Perhaps ironically, sovereign wealth funds in the region have accelerated capital deployment and fund managers from all over the world have flocked to the region in search of fresh capital.
Companies navigating this new environment have had to make some changes. Extending runway has been the priority, with hard decisions being made for the sake of cost-cutting and capital efficiency. Data also suggests due to challenges raising funding, more companies are considering debt financing, with debt investments growing from $250m in H1 2022 to $644m in H1 2023.
Predictions for the next year are varied. Some believe we're over the worst of it, while others believe this subdued environment may continue for some time. To help you navigate the current market, below we've laid out six trends we've observed over the past 6-12 months which we believe are likely to continue for some time.
Predictions for the next year are varied. Some believe we're over the worst of it, while others believe this subdued environment may continue for some time. To help you navigate the current market, below we've laid out six trends we've observed over the past 6-12 months which we believe are likely to continue for some time.
1. MENA fund formations on the rise
We've seen a substantial increase in fund formation work over the past year as early and late stage venture capital firms look to new markets to raise capital. Undoubtedly, capital raising everywhere in the world has become significantly more challenging than it was only 12-18 months ago. With funding in the US and Europe still scarce, firms are heading to the Middle East to establish regionally domiciled funds and regulated entities to facilitate the raising of money from sovereign wealth funds, institutional investors and family offices in the UAE, Saudi Arabia and Qatar.
We're also seeing a proliferation of ‘single-LP’ fund structures backed by both corporates and sovereign or quasi-sovereign investors and have been advising several of the sponsors.
2. Distress and valuation deflation
Founders who established companies during the venture capital boom of 2020/21 are now experiencing their first downturn. Companies are under pressure, and we've represented several distressed companies (or their investors) over the past 12 months.
Fortunately, we have helped many companies and their stakeholders to live to fight another day. But it hasn’t been easy, and we've experienced hundreds of behavioural data points on both sides of the investor/investee continuum that have enabled us to identify some fascinating trends and learnings.
One of our key takeaways from this year is the crucial importance for founders, investors and their wider stakeholder constituencies to deliver real leadership in the interest of value preservation. In difficult times such as these, value-destructive behaviour is the easiest place to go for those who lack experience or an understanding of what leadership in adversity means.
We go into more detail on how to navigate stressful and challenging situations later on in this edition, including what stakeholders should focus on to give their company the best chance of survival.
3. The rise and repurposing of convertible instruments
As we observed last year, founders and investors not wishing to broach valuation discussions in the current economic climate have started to use convertible notes as structuring tools to avoid tough conversations.
Whether it is the use of a CLN to raise equity that should be priced or SAFE notes as instruments of value/exchange, we've seen a lot of off-market activity this last year. On top of that, investors are implementing full diligence exercises and demanding ever-more complex side letter demands along with warranties and disclosure upfronting the same way a priced round would involve. We’re also increasingly seeing stepped discounts and coupons which convert being used and the use of valuation caps is falling significantly.
The boom years of cheap money, sky-high valuations and gung-ho investing had given way to investor conservatism and a depressed valuation environment. Now, one year on, we can look retrospectively through the lens of our day-to-day advisory and transactional activity, and report back on what the market looks like today and what we have been seeing in more granular detail.
4. Liquipref multiples, full-ratchet anti-dilution and ‘pay-to-play’ structures
In our last guide we remarked on the marked increase in investors requesting multiples on liquidation preference to reduce their risk during the current volatility, and requests for participating preferences to support higher valuations and help start-ups to avoid down rounds.
In our experience, this trend has continued and even grown this year. Another issue we've been asked to advise on multiple times this year is how distribution waterfalls work and whether there are ways of circumventing (or renegotiating) these to enable a deal that might otherwise not make sense.
Pay-to-play structures, which were unheard of in this region only a few years ago, are now becoming more common along with other concepts that prioritise the interests of new money coming in over old money, regardless of how much downside protection old money might legally enjoy. In some extreme cases, we've seen a number of anti-dilution waivers by existing prefs with the new money imposing full-ratchet anti-dilution as a condition of investment.
5. Secondaries
Another development in the last few months has been a dramatic increase in appetite for secondary acquisition or disposal opportunities. For fund managers coming towards the end of their hold period, generating portfolio company exits can frequently become a matter of necessity equating to a higher chance of accepting a sub-optimal outcome.
For LPs exposed to funding commitments when they no longer have appetite or conviction, secondary investors offer a chance to reduce their commitments. For many investors, booking a finite loss today can be a much better result than sitting on an asset with unknown trajectory and the chance of much deeper haircuts over time.
6. Saudi Arabia leads MENA investment
Saudi Arabia is leading investment in the MENA region, with MAGNiTT reporting Saudi Arabia accounted for the largest share of total funding in the MENA region during the first half of 2023, with $446m in capital deployed. Egypt came second with $305m, and the UAE was in third place with $239m.
Investors were most interested in Saudi Arabia's e-commerce/retail space, with the sector accounting for 83% of funding ($368m) across 11 deals for H1, followed by enterprise software ($14m) and healthcare ($11m).
Market outlook
While it's been a challenging year for many, the story is not all doom and gloom. It is a particularly good time, for example, to be a Saudi founder right now with abundantly available capital finding its way into the hands of many. And anywhere in the Middle East, the globally applicable truism holds that a great founder with a real track record of success and a great product will never struggle to raise money no matter the broader environment.
Our expectation is that we'll continue to see some down rounds and distressed M&A in the next 12 months but at the same time, we've been pleased to remain busy with priced rounds, good M&A opportunities and increasing valuations for the elite founders out there, and we don’t expect this to drop off in a significant way.
