Venture capital activity in Saudi Arabia has grown significantly in recent years and has vast potential for further expansion

Tracking venture capital (VC) activity in the MENA region is a difficult undertaking. A recent report published by the MENA Private Equity Association (MENAPEA), the non-profit entity that represents the region’s most prominent alternative asset managers, estimated that up to 30% of MENA private equity (PE) and VC transactions are not announced, and that not all of the announced transactions include details regarding the size of the investment. Further opacity comes from the preference of many regional investors for VC transactions, where funding is raised on a deal-by-deal basis rather than through more broadly based VC funds investing in a range of businesses on the blind-pool model, as the data for these single-deal fundraising projects is generally sparse and therefore usually excluded from industry reports.

Definitions

In addition to the challenge of patchy data, there is also the question of definitions. While the generally accepted difference between VC and PE investment is that the former mostly invests in start-ups with high growth potential, while the latter is more concerned with mature firms that might be made more efficient, in the MENA region the relatively thin deal flow at the start-up end of the investment spectrum means that VC funds often behave more like PE vehicles, seeking out opportunities among well-established businesses.

Some clarity was brought to this issue in recent years by the MENAPEA, when it defined VC investment in the region as the provision of long-term equity investment and strategic support in scalable companies at the early growth stage, excluding in its definition seed, angel and direct investments.

Nevertheless, the border between VC and PE activity remains an essentially porous one, and in the Saudi market the tendency remains for VC operators to eschew early-stage prospects and often stray into territory that might more accurately be described as PE activity. “Most [VC] funds in Saudi Arabia… are focused on growing fruitful trees into forests, as they are more focused on later-stage start-ups,” Khalid Suleimani, head of VC at Alkhabeer Capital, said in the MENAPEA’s 2014 report.

Strong Appetite

Despite the difficulties regarding statistics on VC activity in the MENA region, it is clear that the years since 2000 have seen remarkable growth in VC transactions. The MENAPEA’s most recent aggregate data for the region shows that in 2014 VC funding expanded to reach the highest level since the global financial crisis. The combination of increasing smartphone penetration and a flourishing e-commerce market helped make the IT sector the most active arena for VC activity over the year, accounting for nearly half of all funding. Yet while IT initiatives, which appear to be the staple of regional incubators, have consistently driven VC growth in recent years, the range of sectors is broader than might first appear, encompassing health care, food and beverages, manufacturing, media and consumer goods, among other areas. The continued appetite for regional VC opportunities since 2008, despite the echoes of the global liquidity crunch and an uptick in regional unrest, is an encouraging sign. Additionally, in the case of Saudi Arabia, an expanding middle class and a young population with a track record of rapid technology uptake bodes well for future expansion.

Adding to the sense of promise surrounding the country’s VC industry is the widespread opinion that the investment community has not fully tapped into grasping the potential of one of the largest consumer markets in the region. This becomes even more clear when looking at the breakdown of VC volumes by country, as reported by the MENAPEA.

In 2014 Lebanon, which has a GDP of around $45.7bn, according to the World Bank, accounted for 27% of MENA VC volumes, while Jordan, with a GDP of $35.8bn, claimed 21% of the total. In this context, Saudi Arabia’s 6% share of regional VC volume, given a $753.8bn economy at the time, shows there is significant room for further growth.

Hurdles

In some respects, the relatively low level of VC activity in Saudi Arabia is a result of the Kingdom’s success in other areas. The easy returns arising from the region’s largest stock market and a real estate sector where demand consistently outstrips supply are often cited as the principal obstacles to more creative private sector investment. Why, an investor might understandably ask, take the trouble to branch out into the fledgling VC arena, which requires deep industry knowledge and a willingness to accept a certain level of risk, when reliable routes to yield are so readily available?

These market dynamics explain the large role played by the state in the VC arena. The government has allocated somewhere in the region of $2bn to VC activities, distributed across initiatives such as the fund operated by TAQNIA, a government entity owned by the General Investment Fund that acts as the technology investment arm of the Saudi government, and the so-called techno valleys established in locations like Dhahran, Riyadh and Makkah. The state has also played the leading role in the provision of infrastructure to the VC market, establishing a new, national technology innovation programme, Badir, in 2007 via the King Abdulaziz City for Science and Technology. In the intervening years Badir has established incubator and knowledge-transfer programmes across the Kingdom (see overview).

Even with the high level of state intervention seen to date, however, a funding gap remains. The raft of start-up-focused organisations that have emerged since the government first announced the Saudi National Science and Technology Innovation Policy in 2005 has been crucial in cementing the idea of entrepreneurship in the collective mind of the nation’s investment community and has gone a long way towards establishing the concept as a valid career choice for a new generation of Saudis. However, their focus is on the ideation, validation and launch stages of the VC start-up lifecycle. Corporate VC funds, meanwhile, tend to be more interested in the final lifecycle stage, and therefore seek out companies that have already gone through the difficult intermediate growth stage that follows the establishment of any new business, seeking future champions from already promising prospects.

Funding Gap

The efforts of the government at the seed capital stage have established a useful platform for the future growth of VC in Saudi Arabia. What is needed next is the development of a full funding universe, including Series A funding, by which the successes of seed funding programmes can be scaled up with capital from private sector VC players; series B funding, to allow businesses to further expand their sales, support, advertising and other operations; and series C funding, through which growing companies might acquire other businesses in the same field or expand outside the domestic market .

The state, however, is unlikely to wholly relinquish the important part it has played in Saudi Arabia’s fledgling VC industry. The government envisions a larger role for SMEs in Saudi Arabia’s reformed economy – an ambition that suggests it will continue to maintain a constructive presence at the early-stage end of the VC spectrum. In the Vision 2030 strategy published in May 2016, the government also revealed its intention to establish new VC funds as part of a drive to “aid entrepreneurs in developing their skills and networks”. Just what mechanism the government utilises to create and administer these funds is an interesting question, but it is likely that it will harness the know-how of established VC operators by creating funds and asking them to help implement investment policies. Here, a combination of government and private sector initiatives is expected to provide the platform for future VC growth in the Kingdom.