Unstable dynamics. In order the venture process in Russia doesn't skid, it's necessary to provide for funding of young innovation firms and attract groups of direct investments to technological sector
Yuri Ammosov
Three years have passed since the beginning of the world technological business crisis. The dust has settled. The outlines of a new market situation in the field of information technologies (the Internet has reached its maturity by entering our lives and businesses), telecommunications (wireless technologies have development in several directions covering more and more devices), biotechnologies (the role of bioinformatics has become more important), organization of technological business (outsourcing is a routine nowadays) are clearly seen. New growth directions are defined but the most important thing is that the world venture capitalism hasn't died yet. What about Russian venture business? Is it still alive three years after the crisis or has it ever existed at all?
Hidden way of life
The Expert magazine has collected data concerning all announced transactions with technological companies and venture capital for the years 1999-2003. The collected data included company names, investors, date and sum of transaction. It was a hard job to do as venture business leads a hidden way of life.
We have taken into account only those transactions that included funds invested into a company: company sales from one owner to another were not accepted. We also haven't accepted transactions that were announced without indicating key parameters, mainly volume of investments. As a result we had to put aside some of the transactions that we were aware of. In some cases we could specify the sum of a transaction from parties that took part in the transaction, and sometimes we had to rely on the opinion of people closely connected with those transactions. However, by the next review we hope to fill at least a small part of the gap in our statistics with help of our readers.
When recording investments we had a methodological problem: how should we record transactions that took part in international companies? There are many examples of companies that were founded in Russia and then spread their business activities to other countries. If these companies have left Russia, there are no questions because in that case they don't fit our statistics. However, what shall we do, if a company maintains its partial presence in Russia, for example has a research laboratory here? Here we face a problem of double recording, as investments counted here can also be counted in another country. For example, the Mail.ru company is legally an American company, but it operates mainly in the Russian market. The Cybiko company keeps (or at least kept for the moment of receiving investments) part of its employees and all its developments in Russia. This list can be continued. We've come to the conclusion that the degree of connection to Russia should be determined in each case separately, interpreting all doubts in favor of Russia, but if we find out that certain investments have already been recorded in other reviews (for example, Pricewaterhouse MoneyTree Survey), we should exclude them from our review.
Investment process dynamics built in this way presents the following figures. Overall sum of investments to Russian technological companies in 1999-2003 made 150 million venture dollars. The greater part of this money was given to a few companies. The record-holder here is the Cybiko company, the second place got Rosbusinessconsulting (RBC) closely followed by Rambler, IBS and Ru-Net. And if we take into account that the greater part of money given to Ru-Net was actually assigned to its portfolio company TopS BI, which had already received 3 million dollars of investments, we'll see that RBC and TopS share the second place in the list of recipients. We should also note, that such transaction was not the only one for IBS, but as all previous investments had been received during pre-crisis times they were not counted in the total sum.
Vicious circle
Rapid growth of technological investments began in the middle of 1999 provoked by boom of the Internet and reached its peak not in 2000 as many experts thought but in the middle of 2001 as our survey showed. To our mind this shows first of all sluggishness of investors' way of thinking: having realized the huge interest of European and American investors in the Internet rather late, during almost the peak of the development, they at same time lost their interest also with a considerable delay (see diagram 1). We can say that the reaction was belated and intensive almost to the same extent. The decline that began since the second half of 2001 has not yet been overcome.
The volume of investments in technological companies has increased but the structure of investment demand has changed. Almost all of the transactions were large-scale and they were carried out at a later stage of company development. There were few investments in earlier stages (to growth stage). Only five investments were carried out in 2002-2003: 13.3 million dollars in Rosbusinessconsulting, 12 million in IBS, 10 million in Ru-Net Holding, 5 million in A4Vision, 2.7 million in Egar Technologies. Only A4Vision case can be considered as investment at an earlier stage, as by that time the company didn't have any sales, but still it was the second round for the company and it had been operating for 2 years already.
Three companies out of five (IBS, Ru-Net/TopS BI and RBK) are purely service companies and are primarily oriented at Russian domestic IT-market that has shown financial stability and good growth since 2001. The Egar company (manufacturer of financial software for operations with derivatives) is also quite active in the Russian market. That's why we can say that the predominant reason for investors was not their striving for technological superiority and wish to remain trendy in the world innovation process, but orientation on capitalization of results of economic growth in Russia. The absolute majority of companies are not young (five-ten years old).
We have had certain difficulties with classification of some transactions: Rosbusinessconsulting declares officially investments from IPO received in the second quarter of 2002. However, judging by a number of indicators it was a private placing with listing and RBC shares didn't appear at the secondary market (not to count a few spontaneous orders caused by abundance of “hot money”). IBS attracted 12 million dollars from IFC in the form of a convertible credit in the third quarter of 2002. In both cases we had doubts whether these transactions could be included to the category of venture capital. In the first case we decided to interpret all doubts in favor of RBC, and in the second case we turned to IFC representatives for some clarification, and after we had received additional information we also included IBS to our catalogue. However, if we exclude these transactions from our survey, the venture process in 2002-2003 will look sporadic: the second and fourth quarters of 2002 ran without any transactions. No transactions were also registered in the first quarter of 2003.
On the whole it's possible to make the following conclusions. First, the investment activity is not high, although the amount of transactions partially compensate for their infrequency. Second, this activity isn't spread on young companies and is satisfied with the companies that have operated for a long time already. In the nearest future this conduct is sure to create problems for new venture capitalists, as there are only few transactions of required investment quality and their number is not getting bigger, and the pipeline (new companies entering the market from earlier stages) is empty. At the same time we can suppose that companies of the earlier stage are underestimated in comparison to those at the later stages, and this creates an attractive possibility for those venture capitalists who would like to play on the filed of earlier stages. Of course, if they manage to find enough companies at the earlier stage: inaccessibility of investments at the pre-sale stage and lack of positive examples affect businessmen adversely thus discouraging them from establishing new companies. It's a vicious circle, isn’t it?
In 2002-2003 venture capitalists preferred reliable variants. Many market players or candidates to market players questioned by us underlined that they were going to invest only in companies with time-proved products, stable cash flow and last but not least high profits. Such interest is quite understandable as venture capitalists do their best to minimize risks and overhead expenses for transactions. However, there's another question: does a profitable and stable company need venture money at all? But for quite obvious situations when it's necessary to credit plans of new growth, such companies won't have great interest in venture investments as venture money is one the most expensive kinds of funding. At the same time venture capitalists try to get out of situations where their money (in lesser amounts, by the way) can show considerably greater profitability. It's obvious that Internet crisis frightened everyone, but there's no non-risk venture in nature.
Technologies lack money
On the whole the pool of venture capital available to Russian businessmen is estimated at 40-60 million dollars. This is not much, two orders less than money under control of direct investment funds and about the same amount of money that is now invested in the USA for one and a half days.
There was only one venture fund in Russia last year - Mint Capital. It was established at the end of the Internet boom by two former employees of AIG Brunswick and Delta direct investment funds and managed to attract 20 million dollars. Mint invested in six companies, four of them (ParallelGraphics, jNetx, ABBYY and already disappeared RBC/Pentakom) fall under definition of technological companies, another one (television company Studio 2B) belongs to the category of media assets. Established in 2001, nowadays the fund has been almost invested (not to count reserves for additional investing), and now Mint studies opportunities to establish another fund.
All other funds that started their activity in 1999-2000 (there were 14 of them) failed to survive by the end of 2001. After a number of unsuccessful investments Sun Capital closed its subsidiary fund Vesta, Russian Funds group also stopped its activities (among other causes there were disagreements between partners). Ru-Net Holding that had been started as a specialized integrator fund by Barings Vostok Capital Partners (BVCP), UFG and Rex Capital was further reoriented to system integration, and BVCP that was its managing organization quietly left the field of technological investing. Many "venture" investors were reoriented to investments in realty, retail sales and similar businesses usually popular among traditional direct investors.
A small Russian Technological Fund (RTF) from Sankt-Petersburg has also carried out a not very active policy during that period. Mainly trade and service firms present its investment portfolio. RTF continues its business activities and even plans to attract new money, this time in larger amounts, however it still lacks experience with technological business.
There are the so-called venture funds of the EBRD that were established in 1995 through initiative and with money of the European Bank for Reconstruction and Development. Fund management was directed to foreign financial institutions that provided for 10% of fund capital (an exception to this rule was Quadriga Capital, where the proportion of the EBRD money to money of the managing company was 99:1). For a long period of time only these funds represented Russian venture business, and they also became founders of Russian Association of Venture Investing. However these funds have nothing to do with technologies: their initial target was to support socio-economic development of Russian regions. Their financial results are not high partially because they fulfill a social mission, partially because they were established on the verge of the crisis. The fund assets nowadays (almost 10 years later) are equal at best to their starting investments. The EBRD is nevertheless sure that the funds will be successful and show acceptable profitability (no less than 15-20% per year). As the EBRD program curator Andrei Tikhomirov told the Expert magazine, the attitude towards the funds in the EBRD changed sinusoidally, but in the final analysis the bank is not disappointed in the program. The restriction for "socially significant investing" in regions was abolished in 1999, however the only example of near-technical investments could be found in Sankt-Petersburg fund Quadriga (although the year 2000 saw several other of the EBRD funds trying to find their way to the Internet companies, still with no investments). We don't think that these funds will ever turn into active participants of technological financing: many of them have already been fully invested. It looks like the EBRD is going to step up in the process by itself, as it possesses a structure for co-investing directly in companies that was developed during the Internet boom period in London.
It's interesting to know that nowadays the largest venture investor in Russia is not a private fund of direct investments or a private firm but the International finance corporation (IFC), quasipublic UN agency for development of the private sector in the developing countries. IFC invested 19.5 million dollars in three transactions in 2002-2003. IFC was expected to be the last company to show such activity. The presence of such a player in the market gives certain grounds for optimism as IFC is a major co-investor (Delta Capital and Intel Capital have already invested with IFC). The fact that IFC has shown great interest in the technological market plays an important role in stimulating other investors who can get additional benefits from IFC that supports their financial risks (by using debt financing, reducing their portfolio risk etc).
The Expert magazine has already written that the current situation is characterized by active development of new private venture funds. Two new funds were established in 2003: regional division of Intel Capital (with possible amount of transactions up to 10-15 million dollars a year) and Russian technologies fund (with 20 million dollars) that belongs to Alfa group. Moreover, Draper Fisher Jurvetson came to Moscow with serious intentions. According to the latest information they will be working through a local partner co-investor.
Unfortunately not all oligarchic corporations were as attentive to the technological market as the Alfa group. The sluggish process of venture division development for the studied period has almost stopped in NIKoil and Rosbank (some prominent managers left this place), Bazoviy Element that was trying to increase its activity in this field suddenly closed its venture division and announced its principal decision not to deal with technologies.
Indifference of oligarchs
Most likely the further growth of venture capital in Russia is not possible without active participation of large direct investment groups. However, except for Alfa and Delta Capital all other groups are only getting acquainted with the process. The most likely candidate to establish a new fund can be considered Sputnik group, which had some experience with technologies in 2001 (investments in Sputnik Labs CRM-integrator) and according to unconfirmed information it also invested small amounts of money in a few technological projects. Trojka Dialog investment bank has been carrying out plans to create its own technological fund since 2000. Other groups of direct investments haven't shown any technological ambitions (that, however, doesn't mean that there are no such ambitions).
The Russian Ministry of industry, science and technologies believes in the program of Venture investment fund (VIF). VIF, state fund of funds with capital of 10 million dollars, was launched as early as 2000. According to VIF rules, a venture fund can take from the fund 10% of its capital. That makes 1 million dollars, and so it is planned to establish ten funds with capital of 10 million dollars each. If the program is successful the Russian venture market could grow for another 100 million dollars. The Expert magazine has already told its readers about similar programs in Israel (Yozma) and Finland (Sitra). Two contests were carried out: the first one was won by Akadem-parntyor managing company, and the second one by Liding investment company. The major investor of the first company is ERBC Holding German technological holding, and Tekhsnabexport (TENEX) of the Ministry of atomic industry of the second company according to our information. However none of the two funds has earned a ruble for more than two years, and no other funds have been established. Both players and observers of the Russian venture market explain such situation in the following way: if the state plans to make money on technologies, it should take greater risks on itself, for example provide at least for a quarter of the capital of established funds.
We can call the results of our survey of the venture process in 2002-2003 as both reasonably optimistic and reasonably pessimistic, whatever you like. The business has already passed the bottom of 2001-2002 recession. The process dynamics is positive: new investments are coming, new funds are launched. However, it would be prematurely to consider this dynamics stable. In order the venture process in Russia starts accelerating, it's necessary to make at least two changes: first, the venture process should somehow shift from the later stage of company development to the earlier one, thus involving more young and newly established innovation firms. This is possible through launching a number of new funds with less conservative management, changing the strategy of already existing funds and stirring up of "angels". And second, a quality spurt of the market from the current level is only possible due to groups of direct investments that can come to the technological sector and bring not only large financial resources, but also great experience gathered in other sectors. If it doesn’t happen, the venture process will surely start slipping.
