The institutional setting in emerging markets

The institution-based view on strategy has produced a rich explanation of the contextual environment of emerging markets. Scholars such as Meyer & Peng (2005; 2016), Xu &

Meyer (2013) and Khanna and Palepu (1997, 2010) emphasize certain constraints

relating to the institutional setting of emerging market context. At different levels of the

spectre: the institutional arrangements can be "strong" if they support effective market

mechanisms, and they can be "weak" if they fail to ensure an effective market. Khanna

and Palepu (1997) coin the term ‘institutional voids’ referring to the imperfections in

the institutional framework which commonly colour emerging markets, such as if the

national environment lacks formal institutions that support effective functioning

markets, such as prevention of corruption, protection of property rights, ensuring the

rule of law, and provision of public investments and infrastructure (Khanna & Palepu,

2010; Kostova & Marano, 2019). Hence, these scholars emphasize the role and level of

quality of the formal institutions, particularly the government-related entities, and the

importance of the informal institutions such as social norms and cultures as the counterbalance.

In addition, Meyer & Tran (2004) builds on this notion, highlighting that emerging markets are highly volatile because of frequent changes in institutions, industrial structures and the macro-economy. Despite this, the economic context of emerging markets tends to be coloured by a rapid GDP growth, an increasing consumer purchasing power, a growing middle class, a high proportion of manufacturing, labour-intensive industries, and large-scale heavy industrial sectors (Sit & Liu, 2000). The rapid and widespread adoption of market-based policies is common amongst emerging economy governments and, additionally, raises important issues for the strategies adopted by private enterprises in emerging markets (Hoskisson et al., 2000).

When comparing institutional frameworks between nations, there are often certain institutions that are perceived as each others’ equivalent. Nevertheless, the institutions common to an industry in one country will not be similar to the corresponding institutions common to an industry in another country. This is because organisations in general are embedded not only in the institutional arrangements in their industry, but in the country-specific institutional setting as well, including the historic development of a nation’s rules and laws, business norms, and commercial traditions (North, 1990;

Busenitz et al., 2000; Kostova, 1997). Xu & Shenkar (2002) have used the concept of institutional distance, to explain this phenomenon. For foreign firms operating in emerging markets, the institutional theory concepts such as institutional quality, institutional voids, and institutional distance are particularly relevant (Kostova &

Marano, 2019). This is especially insightful concerning emerging markets, as it allows us to understand the distinctiveness of the market and the uniqueness of managerial and strategic challenges for the firms (Kostova & Marano, 2019). As emerging markets are by definition undergoing societal and economical development, they provide a rapidly changing environment for organizations to evolve within (Hoskisson et al., 2000). As such it becomes pertinent to understand the influence of institutions on the firm's strategy, which as it faces strong environmental pressures for change (Peng, 2003).

Specifically, scholars have highlighted issues relating to increased transaction costs,

market vulnerabilities and macroeconomic- and political instabilities as well as underdeveloped and missing infrastructures (Mair & Marti, 2009), and rampant opportunistic behaviour, bribery, and corruption (Hoskisson et al., 2000). On a practical level, the institutional perspective thus offers an approach to strategic decision-making, which will help organizations navigate the complex challenges specific to emerging market contexts.

Summary of chapter 3.2

In chapter 3.2 we have introduced the institutional approach to business strategy in

emerging markets. Hoskisson et al. (2000), Peng (2001), and Khanna & Palepu (2010)

amongst others have highlighted the applicability of the institutional theory within

business strategy in emerging markets. Exploring the roots of institutional theory, this

chapter presents North’s (1990) work on institutional economics and the organisational

institutionalism, as developed by DiMaggio & Powell (1983) and later elaborated by

Scott (1995), defining the rules of the game. Investigating the institutional setting in

emerging markets, we find that a common characteristic of emerging markets is

inadequate or lacking formal institutions, described as a weak institutional environment

and institutional voids, informal institutions tend to take crucial functions otherwise

provided by formal institutions. As such, informal institutions, such as networks and the

cultures they are embedded in, are critical components for firms to navigate the local

context.

3.3 Theoretical Framework: institutional theory and venture capital in emerging markets

Relating the previous chapters of the literature review, we combine the financial literature on venture capital and the literature on institutional perspective on business strategy in emerging markets into a unique theoretical framework.

Figure 5: Illustration of the theoretical framework as a combination of the financial literature on VC and the literature on institutional theory in emerging markets.

This paper is aimed at assessing characteristics of the institutional setting which may propose barriers to VC firms face in Kenya and what coping strategies firms adopt to circumvent these barriers. As such the theoretical framework, which will be applied to answer the first part of our research question, draws heavily on the contributions from Peng, (2002; 2008) and Hoskisson et al. (2000) under the institutional approach, considering the firm’s strategy as an outcome of the dynamic interaction between the firm and the external environment. This encompasses the emerging market characteristics, the market failures, and the institutional surroundings (Marquis &

Raynard, 2015). As Peng (2008) suggests under the institutional approach to strategy,

we will assume the institutional environment as an independent variable. Hoskisson et

al. (2000) further emphasize the institutional environment as a key influencer in

opportunistic behaviour, agency, and ultimately transaction cost, suggesting that this is

particularly the case for emerging markets where formal institutions may be weak or

absent. We aim to take departure in this notion in our study, using North’s (1990) and Scott’s (1995) categorizations of institutions to create an understanding of how the institutional setting in Kenya is affecting the VC firm’s business strategy. The lack of formal institutions in emerging markets is considered to have significant implications for firms (Peng, 2008; Hoskisson et al., 2000; Khanna & Palepu 2010; Ahlstrom and Bruton, 2006). More specifically, government intervention and regulatory uncertainties (Marquis & Raaynard, 2015), liability of foreignness, socio-cultural differences, and liability of outsidership (Khanna & Palepu, 2010; Johanson & Vahlne, 2009), and underdeveloped supportive industries, technological challenges, and weak infrastructure (Arregle & Borza, 2000; Khanna & Palepu, 2010) have been emphasized as particular challenges relating to the institutional barriers that firms face in emerging markets. We particularly consider VC firms as important providers of finance for young innovative firms, as suggested by Hall & Lerner (2010), among others, where the main strategic considerations lie within funding, screening, monitoring, and finally exiting the ventures they invest in (Rajan, 2010).

Institutional theory has been applied in emerging market contexts to explain the VC firms’ strategic decisions and ways to operate (e.g. Ahlstrom & Bruton, 2006;

Lingelbach, 2015; Li & Zahra, 2012). However, the effect of changing institutional environments of emerging markets on the VC development process has only just begun to be addressed (Ekanem et al., 2019). As proposed in the VC investment decision model (Fried & Hisrich, 1994), there would often be certain institutions that are common to the industry that will lead to uniformity among the VC firms’ behaviour. However, firms should acknowledge that these institutions do not shape the industries in similar ways once compared across countries (Busenitz et al., 2000; Kostova, 1997; Xu & Shenkar, 2002). If the institutional differences in emerging markets make VC firms’ decision process different, the traditional VC mechanisms may have to be modified (Ahlstrom &

Bruton, 2003; 2006). According to Ahlstrom & Bruton (2006), the past understanding of

the VC industry has primarily built on agency theory and stewardship theory, and

highlight that these approaches seem only to have been fit for developed country

contexts. The geographical-, cultural- and institutional distance between the VC firm’s

home country and the host country has been considered to negatively affect

cross-border investments (Li & Zahra, 2012). In addition, the concept of institutional trust is important as it reflects the need for foreign firms to build up relational trust. This is mostly reflected in the businesses’ or population’s trust in the institutions, and if this is low there is a need for more proximity and engagement with local partners (ibid.).

Hence, high levels of institutional trust have a positive impact on cross-border VC flows from developed to emerging economies (Hain et al., 2016).

Li & Zahra (2012) show a positive correlation between VC investments across countries and the development of formal institutions. Hence, they argue that stimulating the VC activity by developing the regulatory frameworks of formal institutions is beneficial as a means for promoting entrepreneurship. However, their results suggest that both formal and informal institutions are important determinants of the cross-border VC activity.

The effects of formal institutions depend on informal but powerful cultural constraints, as uncertainty avoidance and collectivism reduce VC firms’ sensitivity to the incentives provided by formal institutions (Li & Zahra, 2012). These findings support the view of North (1990) and Xu & Shenkar (2002). Also Ahlstrom & Bruton (2003) have called attention to informal institutions such as culture and norms that can substitute for potential VC unfriendly formal institutions. Local bias is considered inherent in financial intermediary activity, as there is a strong need for spatial proximity and heavy reliance on local expertise to mitigate agency problems, especially as investment in innovative activities involves considerable uncertainty and is characterized by asymmetric information at the outset and agency problems during the investment process (Hain et al., 2016).

For international VC firms to consider investments in developing countries and emerging markets, the institutional conditions as well as the characteristics of the market in general are vital considerations. Due to the chronically poor IT infrastructure, particularly related to many Sub-Sahara African (SSA) countries, investments in technology-related applications and ventures, where most investments go, calls for attention with regards to the applicability of these innovations in society, e.g. through integrating local perspective and bottom of the pyramid (BoP) approach (Hain &

Jurowetzki, 2018). Nevertheless, new establishments in internet and mobile

infrastructures are improving tech-competence and potential for domestically developed technology-intensive solutions (Hain & Jurowetzki, 2018).

Generally, East-Africa has shown a high cost of operating a fund in the region, much due to the length of time it takes to find, evaluate, and make investments (Gugu & Mworia, 2016). Additionally, lack of experience and knowledge around rapid scale-up, which tend to characterize ventures under the loop of VCs, are forcing fund managers in the region to take on roles that are not typical of conventional fund management.

Furthermore, challenges related to screening and exit have also been highlighted as an

inherent part of the current VC ecosystem. The struggle of screening, or deal-sourcing

has been attributed to underdeveloped deal intermediaries such as incubator- and

accelerator programs, whilst the lack of exit opportunities relates to the poor private

liquidity options and underdeveloped financial markets, making IPOs a rare occurrence

(Gugu & Mworia, 2016). In an extensive report by The World Bank on PE in Kenya from

2018, the lack of information available to investors was further highlighted as a major

factor, hindering investments in SMEs. The lack of knowledge on formal reporting

mechanisms, corporate governance and financial capacity to navigate the information

required by VC firms, make due diligence processes lengthy and costly. As such,

navigating the local context is crucial for making good VC investments (Divakaran et al.,

2018).

In document Venture capital and the finance gap in emerging markets: (Sider 50-56)