Catalyzing the Roots of development
By Andrew McCarthy
How do companies grow from seed to maturity in the developing world? The nascent capital markets in the developing economies make it difficult for small companies to fuel their growth without ready access to capital. Root Capital aims to bridge the gap of the “unbankable” companies who are established, ready to produce, have a willing buyer, but lack the upfront capital to purchase the relevant supplies and labor.
An observation: Root Capital is considered one of the most successful non-profits in the world focused on bridging the financing gap for the ‘unbankable’; however, in 10 years it has only raised a $40 million fund. Root charges ~10% for short-term loans, has a 99% repayment rate, and has long list of prominent investors (Starbucks, Green Mountain, OPIC, Bill & Melinda Gates Foundation, et al.). Just to pick on Starbucks for a minute, they did ~$9.75 billion in revenue in the last year and have ~$1.4 billion in cash sitting on their balance sheet. If Root Capital is providing a fundamental service of promoting exports from the developing world to the developed, generate a decent financial return and have an exceedingly low default rate – why isn’t more money flooding into the space, why do they have such stunted growth?
The Root conundrum: how do you reduce the subsidy across the Root portfolio and bring more local lenders into the market, who do not have subsidy? The way that Root is able to finance itself is by bringing in cheap money at a ~2.5% cost of capital and lend it at ~10%. Even with this 7.5% spread, Root is still making a loss on their overhead because their $40 million portfolio is so small. The only way for Root to make money is to scale the fund by approximately 5x its current size. There’s no way that local lenders can match a subsidized 2.5% cost of capital, so using the same logic as above, the local lender portfolio would have to be massive in order to cover the cost and enter the ‘unbanked’ market. Root is considering breaking their current fund into three partitions, a trifecta based on the stage of the invested company. The late stage fund would have more established companies, with a greater amount of money deployed, and would have a lower subsidy rate (ie. instead of 2.5%, they would pay 5% to their investors – thereby reducing the spread to 5% but on a greater amount of money and potentially lower risk). The hope is that by gearing the cost of capital across the different stage companies, it may promote more local entrants into the market. The question racing through my head is: will this actually work and spawn development of the ‘unbanked’ capital markets?
These are the questions that our Finnovation class are seeking to understand and grapple with.
Andrew McCarthy is a first year MBA student at MIT Sloan. Prior to graduate school, he worked in private equity and investment banking in New York and London. He received a BA in Economics from Trinity College and studied at the London School of Economics.
