Ben Aris in Moscow -

Russia's venture capital industry was born at the start of this year by a Kremlin fiat, with the first three privately managed funds founded with seed capital from the newly minted state-owned Russian Venture Company (RVC). But there have been few deals and Thomas Nastas, CEO of Innovative Ventures, argues the funds are looking in the wrong place for success.

Venture capital in Russia is going to be a very different business to its cousin in the West, where most investment finds its way into science and technology companies. These are popular as, although the risks are high, so are the rewards. In Russia the risk-return profile is completely different.

"Where is the growth in Russia? In high-tech?" says Nastas, "No, it's in construction, in food processing, in guys selling toilets to the developers of new apartment blocks. That is where the returns are. The problem is not the lack of money, it is the lack of deal-flow. Tech is not attracting money - it will be hard to force investment into tech when the economy is going in a different direction."

Venture capitalist

Nastas has been working in the venture capital industry all his life. In 1993, he arrived in the former Soviet bloc to advise the government of Kazakhstan on setting up the voucher funds that underpinned the privatisation process. Then in 1997, he moved to Volgograd to advise the European Bank for Reconstruction and Development (EBRD) on implementing its regional investment fund programme. And he has also advised the US Russian Investment fund on promoting the growth of the fund industry in Russia. These days he sits on the board of a second-tier bank as an independent director and lectures business students at a Moscow university, but keeps his hand in the funds game.

The RVC is one of President Vladimir Putin's pet projects. The underlying idea is that Russia has a huge intellectual capacity that is current unused as all the investment money is going into building toilet factories and little is going to the scientist to develop their ideas.

The president has a point. However, there is flaw in the argument. Russia is like the UK in that while the standard of science is world-class, the Russians are not good at turning good science into products that can fill shop shelves. "Russians are good at the basic research, but they are not good at making user friendly machines that you can sell," says Nastas.

He cites the example of lateral drilling technology - oil rig drills that can turn through 90 degrees underground and drill horizontally. The technology was invented by a Russian in the 1950s and was what Nastas calls a "game changing" technology. "The trouble with most oil wells is that geography of the deposit is that you can pump out half the oil but to get to the oil in the other half of the field, which is in a separate pocket, you have to drill another hole," says Nastas. "The beauty of this technology is you can pump the whole field dry with just one hole and that saves you an enormous amount of money."

Despite the obvious advantages of the technology, it was not widely adopted until engineers from the US oil services company Schlumberger saw it and improved on the basic design. These days Russian companies are in the humiliating position of having to buy this technology from Schlumberger.

Still, the Russian VC programme could do well. What the Kremlin has done is copy Israel's highly successful initiative, which was set up in the 1970s and spawned a very competitive high-tech industry. Even so, Israel's programme took nearly 20 years to pay real dividends.

Most of the main features are the same: Israel's government, like Russia's, put up 49% of the capital for funds that typically had $50m under management. The government also subsidised the losses of these funds and capped its own returns as a way of feeding more money into the fund's projects. "The Israeli experience was very positive, however, there is no tradition of private equity or venture capital in Russia," says Nastas. "Up to now, almost all the private equity investments have been made by international financial institutions, like USAID, the IFC and the EBRD. The first true domestic funds only appeared in about 2001 with the likes of Alfa Capital and Renova Capital. We are right at the start of the process."

Nastas is worried that the Russian RVC is barking up the wrong tree. Any economy needs to be underpinned by competent machine tool producers - one of Germany's strengths - that supports almost all sectors of the economy. Without this, companies are forced to import expensive foreign-made tools and so are less able to compete with international peers.

Also the Russian plan to leverage its technological advantages in the military industrial complex and produce civilian-use spin off products has a poor record. "America tried this in the 1970s with a domestic defence conversion programme," says Nastas. "But all that happened was the state burned billions of dollars with little to show for it."

More realistic projects are those like Norislk Nickel's heavy investment into hydrogen fuel cell technology. The metals company has been funding an institute to the tune of hundreds of millions of dollars, looking at ways of improving cells that could eventually power electric cars among other uses. "The point of this type of investment is that it produces a technology that relies on the products the parent company makes and so will support their core business in the long term," says Nastas. "Western companies, like Intel's investment into mobile phones, have been very successful in this respect."

But these sort of projects remain fairly exotic in Russia's economy. Nastas says the most obvious place to invest is in the core industries that are at the heart of Russia's economic boom: oil service and the automotive industry, especially in car components. "Investing into these things would produce the machine tool producers that underpin everything and this is where the technology needs to be developed," says Nastas. "You can't just import German tools as you need people who understand how to use them. It is better to develop this stuff yourself."

Send comments to The Editor