Russian VC funds - nothing ventured, nothing gained

By bne IntelliNews January 28, 2008

Ben Aris in Berlin -

Russia's venture capital industry was born in 2007 when President Vladimir Putin personally pushed the effort to create the industry from scratch by ordering the establishment of a state vehicle to seed VC funds. The first three funds won tenders to access the $500m that was put aside to pay for the project and will go into operation this year in an effort to tap Russia's vast intellectual potential that has lain fallow since the fall of the Soviet Union.

Thanks to the Cold War, there is no shortage of highly skilled scientists or innovative ideas in Russia. But with a plethora of opportunities in low-risk projects, anyone with money to spend has ignored risky start-ups developing exotic technology: why invest in the development of an exciting but unproven widget, when you can make double-digit returns or better from simply buying new machines for the local sausage factory?

The Kremlin hopes to kick start the sector by priming the pump. Last year, the state-owned Russian Venture Company (RVC) was set up under the auspices of the newly established Russian Nanotechnology Corporation holding company, and will contribute seed capital to 10-12 funds.

The first tenders were held in March and three funds have already been allocated $50m of funds that they have to match and start to disburse this year. More recently, RVC has said it plans to double the amount of money available for investment in start-up companies in 2008 from RUB15bn to RUB30bn (about $1.2bn).

Although Putin is clearly motivated by his desire to recapture Russia's technological prowess, his business timing has been excellent as VC funds were already on the agenda for most investors.

VC funds managed by Allianz Rosno Asset Management and Troika Dialog have led the market, the former having invested in four companies and the latter due to announce several transactions shortly. State-owned venture funds RVK and Rosinfocominvest have been set up, with assets of RUB15bn and RUB2.9bn respectively.

International fund managers, especially those with a Brazil, Russia, India, China (BRIC) remit, have started to more actively target Russia. Intel Capital and Cisco both have BRIC VC funds and have made investments into Russia. Ashish Patel, managing director of Intel Capital, described Russia as a country with an incredible number of innovations. And Cisco announced plans to invest $100m in Russian projects over the next three years.

Analysts are rightly wary of any state-backed plan to pump money into promoting a sector, which often turns into a feeding trough for the well connected. But market participants are pretty happy with the way the Kremlin has structured this project: the state will retain a 49% stake in each fund it finances, leaving the control and management to private fund managers that have to bid for, and match, the state's money in an open and transparent way. So far, some five funds have already pitched for the RVC money and will be making their first investments this quarter. "The idea is to create five funds in the first year and three are already working," says Kirill Dmitriev, head of the Russian Private Equity and Venture Capital Association, which has been instrumental in bridging the gap between private fund managers and the state during the process of setting up RVC.

The first three funds are joint ventures with: the EBRD and Troika Dialog; the American VC fund Draper Fisher Jurvetson (DFJ) and state-owned VTB Bank; and the $120m fund BioProcess Group and Asset Management Company.

The new funds are targeting the start-up and early stage companies, which offer the possibility of high rates of return and have been almost completely ignored until now. But for the government it's not about the money. "The government really wants this to work," says Dmitriev. "If the going is slower, then that is good because the government is being careful not give money to anyone with a bad reputation. And the people in charge of allocating the money are not playing games, partly as Putin is personally interested in the success of the programme."

EBRD pulls out

However, the programme almost immediately ran into problems when the EBRD pulled out of a deal to co-invest in one of the first three funds. The EBRD had linked up with Israeli-controlled Tamir Fishman Russia Venture Capital Fund to set up a RUB2bn (€57m) fund in November, but pulled out after the minority shareholder in the management company Oleg Shvartsman, whose Finansgroup actually won the tender for the RVC money, caused a scandal with remarks he made to the Russian daily Kommersant.

Shvartsman is the president of Finansgroup and chief manager of Finance Trust, which won the state tender in May. Finance Trust - made up of Tamir Fishman, the EBRD and several Russian companies including Finansgroup - was to receive RUB980m of the RUB2bn pot.

In the interview, Shvartsman suggested that the head of the so-called Siloviki fraction in the Kremlin Igor Sechin was actually the beneficial owner of Finansgroup. When asked who owned the company, he said: "There are various offshores, in Cyprus and other countries. These are not the presidential administration members; these are their relatives, high-placed people. There are individuals among them, all relatives, from FSB or SVR.... For us, [decisions come from the] power bloc headed by Igor Ivanovich Sechin."

He also claimed that he was the treasurer of the Union of Social Justice of Russia, an informal organisation set up by the Federal Security Service, or FSB, in 2004 that, "would bend, bow, torture, and impose social responsibility on all sorts of Khodorkovskys [the jailed owner of the bankrupted Yukos oil company]," Shvartsman said in the same interview. The Union of Social Justice of Russia has also been mentioned as one of the organisations that may have ordered the death of Alexander Litvinenko, who was poisoned with radioactive tea in London last year.

Shvartsman went on to say that venture capital was not important for him, but he saw it more as a duty as developing Russian technology had been set as a state task. He also suggested that co-investors Tamir Fishman and the EBRD would benefit from this association with the Siloviki, as it could make use of administrative resources to ensure its projects were profitable.

The EBRD was horrified by these comments and quickly put the kybosh on their project, though critics have pointed out that if the allegations are true, then why didn't the development bank uncover any of this during their due diligence process? It is also worrying that someone like Shvartsman could get so far in the process, which was supposed to be immune to special interests. Still, analysts expect the whole affair to blow over and are putting it down to the birth pains of a newborn sector.

Undaunted, the EBRD joined forces to form another venture fund with leading (and more respectable) investment bank Troika Dialog in the same month. The Emerging Technologies Fund is a $100m venture capital fund that will invest in Russian companies developing innovative technologies. The EBRD will commit to invest up to $15m in the equity alongside Troika and other investors and each of the fund's equity investments will typically be in the range of between $2.5m and $5m. It is looking at projects targeting enterprise infrastructure and application software, optoelectronics, wireless applications, alternative energy and clean technology, according to the EBRD's website.

VTB's fund

The California-based DFJ teamed up with state-owned VTB Bank in November to form a venture-capital fund, DFJ-VTB Aurora. The fund, which will target high-technology projects in Russia, will manage a total of $150m of assets, which includes both the state's contribution from the RVC and the partners' investment.

"People talk about the great potential Russia has, but so far there have been very few concrete deals to show for it. There are plenty of financial resources, but the real problem is the lack of management. Venture capital is in its inception and very few people understand the industry," says DFJ's fund manager Alexandra Johnson, who has set up funds around the world. DFJ is a well-established venture-capital firm and has been looking at the obvious potential of Russia for years. However, it took Putin's RVC project to spur it into action.

With the money committed, DFJ were on the verge of committing to four investments before the end of 2007, and have several hundred other prospects in the pipeline for 2008.

Creating an industry from scratch is fraught with problems, but the upside is that there are opportunities galore and returns from a successful investment promise to be astronomical. "In many countries, we go in on our own account, but in Russia we were looking for a strong partner and we found it in VTB," says Johnson. "The devil is in the details. The government's idea is great and the direction is right. We see plenty of deal opportunities and the VTB team is very experienced and professional. The issue now is what kind of investments you want to make. There are plenty of things that you can invest into that are relevant for Russia, but ideally you want to find a company or product that could compete on a global level."

Target projects can be broadly broken into two categories: catch-up and innovation. The first is simply creating things in Russia that have already been done elsewhere. The second is the invention of a truly new idea that is relevant on a global scale, not just in Russia. Both types of project can be very lucrative.

An example of the domestic-bounded companies is, the Russian version of (indeed, when it launched, if you typed in, you were taken to the ozon page). The product didn't exist in Russia, but the idea was already a proven winner. Now ozon is established in Russia, it has nowhere else to go.

Other companies, like SWsoft, were founded by Russians in the US and are truly global; these pioneers are regarded as American not Russian. SWsoft is a global leader in virtualization and automation software that helps consumers, businesses and service providers optimize their use of technology. The founders and employees are Russian, and although this is exactly the kind of company Putin is hoping RVC will create, it was lost to the US.

It will take a while for the RVC project to gain traction. Ideally, the government is hoping the programme will produce a "signature" deal, like the Estonian-created internet telephone company Skype Technologies, which was sold to eBay for $2.6bn. "The domestic market projects will work, as there is lots of money to be made. However, it would be nice to create a few global companies too. There is no recipe for success, there are lots of problems to be overcome. But if you go in with your eyes wide open, it might work. We are aware of the trends and investors are now starting to tap that famous potential," says Johnson.

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Russian VC funds - nothing ventured, nothing gained

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