Business

Sharper than they were

Anyone who thought all venture capital (VC) for start-up IT companies was blown away by the deflation of the telecommunications, media and technology (TMT) bubble, might be forgiven for being wrong.The fact according to Ethos Private Equity is there is about R1.5 billion worth of VC funds waiting for the appropriate start-up company looking for a cash injection to get products and services to customers.This year has seen the start of two new venture capital funds, both worth more than R200 million, while another established fund has closed its second tranche.In March this year, Vantage Venture Partners announced the formation of its R300 million fund targeting the information, communications and technology sector. And then, in July, private equity fund manager Ethos announced the formation of a VC fund destined to be worth more than R250 million. Archway, the joint Gensec and Dimension Data fund, managed to raise R160 million to follow on from its first fund, worth the same amount. (Disclosure: Archway is a shareholder in ITWeb, publisher of this magazine.)While common financial wisdom dictates one buys cheap and sells expensive, the volatility and problems that have beset the TMT sector mean only the most stout-hearted investor would be brave enough to wander back in.The heyday of cheap capital and unlimited pots of cash from over-eager, naïve investors is past – or is it? Could we be seeing the start of a more mature approach by VC funds looking at capitalising on the innovative prospects within the IT industry?According to KPMG`s 2001 Private Equity Survey, private equity and VC funds under management in South Africa are valued at R35.3 billion. Of that, R26.9 billion is already invested in various ventures, and the remaining R8.4 billion is ready to be called upon.Combining Ethos`s number with the total picture suggests about four percent of the total is in VC for IT companies. But, of the waiting-to-be-used pool, funds for IT venture capital accounts for 20 percent. No more chancersDuring 2001, the portion of private equity and VC funds declined to 16 percent of the total invested in rand terms, from the 18 percent in 2000. In other words, the investment picture for IT VC funds is little changed from the heyday of two years ago. And, if projections are anything to go by, the propensity to invest in start-ups may actually be increasing.While these numbers are not as accurate as they could be (the survey does not strip out VC and private equity funds), they show a trend of sustained investment and a commitment to invest in TMT.Jo Schwenke, chairman of the SA Venture Capital Association (SAVCA), is enthusiastic about the prospects for TMT investment.“The fact that the IT bubble has burst means the chance takers are now out of the market. We are now left with the real players,” he says.At the peak of the IT bubble, VC funds and other investors often paid prices reflecting a forward price:earnings ratio of 80 – leading them to expect, at best, a 10-year return on their capital.“People did overpay drastically during those times. But now the price correction has happened, there is a more realistic appraisal going on. Venture capital is about getting in at grass roots levels for grass roots prices,” Schwenke says.The traditional source for VC funding is large, institutional-type investors that include pensions, banks and development agencies. However, while these have not closed their doors to investing in IT companies, they are doing so with more strings attached.While Ethos and Vantage have secured commitments from the likes of Industrial Development Corporation, Dutch and German development banks and institutions, local banks and the Transnet, Eskom and the Mining Idustries pension funds, the air of scepticism that had developed meant the cash was not as easy to raise as in the past.Leonard Bruhns, general manager of the Archway funds, says: “The institutions needed a bit more convincing about where they should place their money. But they did come to the party.”Morris Mthombeni, a director at multi-fund manager M Cubed, which acts as advisers to funds, is emphatic there is nothing worthwhile in IT to invest in at the moment.“The short to medium term outlook for IT companies is bleak at the moment. I believe the world problem of overcapacity has come to this country. All this has made things very difficult for VC funds.”Pensions are constrained by legislation that limit their investments in perceived risky business to a very small fraction of the funds. “The pension industry has become extremely risk averse and they won`t be changing that for some time,” Mthombeni says.He says IT is considered a small cap business and that is where it will stay for a while yet.“Not so,” says Archway`s Bruhns, “IT will be in demand in 10 years time. It is here to stay and there will be a continuing demand for it.” Wanted: a track recordSo what are the VC funds looking for in a start-up IT company, now that the period of naïvete has passed?Firstly, they are no longer seed capital suppliers. They want companies that have gone through the initial start up phase and are looking at second or third round funding requirements.Claudia Koch, the Ethos partner responsible for the IT fund, says capital is no longer the issue, but rather the ability of funds to attract the quality entrepreneur who has developed a product or service that can be exported.“The SA market is limited in the returns it can generate for a new product or service. However, we can leverage on what is developed here through exports,” she says.Archway has similar requirements for its investigations.Wayne Philips, a technical director of M Cubed IT subsidiary AOS, is cynical about the prospects of finding such targets. He says while the world is littered with developers who can design or programme objects, “it is those who are able to link those objects into business logic that are going to make money”.The team Ethos has assembled to lead its fund certainly think the time has come for a more structured approach to investing in IT companies. What they feel differentiates them from other funds is that most have had some exposure to the IT industry, either as developers of products and directors of companies, or through having been industry analysts.“Most funds have assembled a generalist team that understands the financial workings of a company,” says Koch. “But our team is probably the first in South Africa which has a fundamental knowledge of technology and business building.”Archway`s strategy is the opposite to that of Ethos. “The IT industry is full of specialities,” says Bruhns. “So we have a generalist team and then outsource the specialists as we need them.”Koch counters by saying Ethos`s own research shows that in order to get the most out of an investment and understand what a company is trying to do, a VC fund must have the skills in-house. “If necessary we will outsource some specialised skills, but we also need to have our own people at hand. Because they have gone through the mill in the IT industry, they understand what makes a start-up IT company tick. It is also the matter of setting realistic expectations for entrepreneurs and investors,” Koch says.Exiting an investment is always a problematic situation for any VC fund. The classic way out is to list the company, and this works in a country like the US that has a ready-made market in the form of the Nasdaq. However, things in South Africa are not as easy, with the JSE being deemed quite inefficient at providing such a route.“By far the most favoured exit strategy for a VC fund is a trade deal, where it finds another investor to take up its share in a company,” SAVCA`s Schwenke says.This is the route Ethos plans to take, after holding an investment for between four and seven years.“We believe that is the optimum period,” Koch says.So, while the cash to take a fledgling IT company to the next stage of growth is available, the old “shotgun” approach is no longer applicable. It is no longer tenable for a VC fund to invest in 10 ventures in the hope that at least two will make it and outweigh the losses of the failures.And VC funds are no longer willing to be passive investors; they want to be involved.“We are looking for companies able to generate dollar revenues off rand costs. And we don`t adhere to the scepticism that is out there about South African technology. But the way in which we advance funds has to be structure by the performance of the investment,” Koch says.

07 October 2002

Anyone who thought all venture capital (VC) for start-up IT companies was blown away by the deflation of the telecommunications, media and technology (TMT) bubble, might be forgiven for being wrong.

This year has seen the start of two new venture capital funds, both worth more than R200 million, while another established fund has closed its second tranche.

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