I just spent two weeks in Brazil and, as has happened on almost every trip to Brazil since 2006 (I have been traveling there since 1999), I came back shaking my head at all the opportunities in that country.   Unless I have misread the last four years of experience or am completely delusional, the venture capital market in Brazil has reached an extraordinary moment. I compare it to the US in 1994 – an inflection point where a critical mass of startups in certain markets will grow exponentially.

 

Like the US in 1994, a healthy balance exists between the number of startups and the market for their products and services. With proper execution and sufficient capital, Brazilian entrepreneurs have the potential to build the next generation of great companies.

 

Before my optimistic investment thesis leads you to you conclude that sun and samba have damaged my brain, however, let’s review and respect the anti-thesis (I'll continue the bullish case for Brazil VC in the next post).

 

Obviously, Brazil in 2010 is not totally analogous to the US in 1994: entrepreneurialism has shallower roots there and entrepreneurs are fewer in number and generally less experienced. The startup ecosystem is more nascent and scattered – Sao Paulo is not Silicon Valley, Rio is not New York and Belo is not Boston.  Brazilian startups must cope with more burdensome tax and labor regulations than their compatriots in the US.

 

Angel investor networks have yet to fully coalesce and institutional venture capital is extremely scarce. Interest rates, while falling, remain high enough to compete for investor dollars – why invest in a high-risk startup when I can earn 11% a year buying a low-risk bond?

 

The specter of inflation never seems to go away and political risk in Brazil remains: the surprise 2% tax on FDI jarringly reminded investors of the potential for sudden moves by the government.

 

Perhaps most negatively, for the first time I feel a twinge of concern that there is too much optimism about venture capital in Brazil. I know that sounds crazy coming from a guy who hypes the market for VC in Brazil but I live by Warren Buffet’s dictum: “Be fearful when others are greedy and greedy when others are fearful.”  I now know of at least four parties thinking of or actively trying to raise early/growth stage VC funds in Brazil. Those are the only the ones I know of, so there are surely more.

 

The people interested in raising funds have a high level of talent and sophistication — that's not the issue.  The issue is whether too much early/growth stage capital would exist if all the new funds get raised:  when combined with Ideiasnet, Monashees, Criatec, FIR, Confrapar and other, smaller funds, I begin to get worried about an imbalance. 

 

Think of it as an equation, with good potential VC investments on the left side, investment funds on the right. There are only a limited number of good entrepreneurs and businesses on the left side; when too much capital pours into the right side of the equation, valuations get driven too high, more startups get funded than can succeed in the market and the venture capital asset class then fails to deliver sufficient returns on investment. 

 

Unfortunately, a problem like this cannot correct itself quickly. Venture funds have a ten-year life and their investments are in private companies (and therefore very illiquid). So, unlike the public markets, which can adjust relatively quickly to imbalances, once the venture market is oversaturated, it takes a very long time to correct itself. 

 

For a real world example, just look at the US. Since 2000, US venture capital asset class has had a negative return. Negative! VC is the riskiest asset class—LPs need a 25% IRR to justify investing in VC funds – and ten-year returns have been negative! So, of course, the US venture market is a disaster. Most LPs don't want to touch it and it will take another 3-5 years for enough tier two and tier three VC firms to disappear before a balanced equation re-forms: a sufficient number of good entrepreneurs and businesses on the left side, an appropriate amount of venture capital on the right.

 

Next post will make the bullish case for venture capital in Brazil and specifically address the concerns above.