Back to basics: investing in start-ups

As western economies take a slash and burn approach to their burgeoning public sector deficits, the private sector will increasingly be relied upon to drive growth. At one end of that spectrum, innovative, high-growth start-ups with the potential to deliver exponential returns in the medium to long term are back on the radar of investors.

In particular, there is a premium on companies that will produce disruptive technologies in sectors such as clean technology, healthcare and digital media. But for them to realise their potential, they require support from like-minded investors in the form of venture capital.

"Venture capital innovation will be central to a new economy based on low-carbon industries and high-tech manufacturing," says Simon Walker, CEO of the British Private Equity and Venture Capital Association.

But while analysts agree that such opportunities are certainly out there, potential investors remain sceptical of another dotcom crash which left many with red faces and significantly lighter wallets.

However, Walker believes this presents a real opportunity for family offices: "Many institutional investors rashly deserted venture capital after the dotcom crash and have been reluctant to return. This is a mistake and presents an opportunity for the sophisticated, long-term family office investor."

Stephen Lowery is a partner at Frog Capital, a London-based investment management business backed by one of Europe's most significant family offices that specialises in early and growth stage venture capital.

He remains optimistic and sees a number of benefits for family offices. "What these companies allow you to do is to participate in and be part of a growth story. I think that is one of the main reasons for including them in your overall asset allocation strategy," he says.

Constantin Salameh, CEO of Abu Dhabi-based single family office Al Masaood Group, is also a big supporter. "If you choose well then you can achieve very high returns on investment. Start up companies will also give you portfolio diversification as they are a good way to spread risk," he says.

But before any family office can get carried away with potentially high returns, both Lowery and Salameh agree there are certain things you need to be aware of in order to succeed.
Lowery, for example, acknowledges that it is not an easy sector to get into. "It's a closed market in some ways. By the time you see the growth, its almost too late to invest," he says. To succeed in finding companies before they grow, Frog relies on networks the managers have built up over the years.

Family offices need to adopt a different mindset to other investment classes, according to Lowery. "They are longer term investments that require investors who are patient. This is about supporting a company, investing in it, building it and then realising the value," he says. What it must not be about is following the whims of a family principal who's heard of the next "big thing".

Says Salameh: "In the past investment decisions were taken by our chairman based on whether he liked a person or if something seemed like a good idea. Then you realise millions of dollars later that it was not the right partner, market or product because we didn't go through the process of meeting the people and really looking at the technology.

"If the investment is not aligned with your core competencies, your ability to add value and understand that company is very limited. So you need to take time to get to know the people, the management, to meet with them and make sure the fit is right."

Traditionally, family offices have preferred to invest in companies that operate in sectors in which they are familiar. However, Lowery says you don't have to restrict your-self to sectors in which you have specific knowledge.

Frog invests primarily in the cleantech, IT and digital media sectors. Says Lowery: "You can invest in new areas you think are going to be important or successful in the future, but you need to surround yourself with experienced investors or other families who do have that knowledge."

Salameh adds that you must also identify a clear exit strategy and ensure there is a cultural alignment between the family office and the investment.

Al Masaood uses its investments, which usually amount to between $1 million and $2 million per venture, to assess the viability of new markets. "The best way to test a new sector or technology is to invest in them as start up companies then incubate them," explains Salameh.  "We launched close to 10 companies last year and we will be doing the same this year. Based on the success of our investments, we then decide whether to invest heavily in that sector or not."

In contrast, Frog usually leads or partners on investments where companies require between €2 million and €20 million of funding.

Crucially, Salameh says you must be realistic: "Make sure you don't overestimate the size of the market or your ability to gain a share of that market. Some of our unsuccessful investments were in companies where we overestimated the market for that product or our ability to gain market share, so we now try to make our assumptions as realistic as possible." This usually comes down to gaining an understanding of what's going on in the sector you are investing in and an understanding of what companies need as they go through their growth phase.

Once you find a company the normal due diligence process applies, but Lowery points to spending a lot of time with the management team, understanding what it is that makes that company important within a specific market place and in particular why it has got an advantage that can make it a market leader.

These considerations all form part of Salameh's investment framework, which is a three part screening process. He and his team look first at whether the investment follows the group's guidelines. "Does it fit our model?" Salameh asks. "Through our guidelines we can assess what's in it for us and if we initially think it will be a good fit for the family office.

"If it fits the guidelines, we then conduct a preliminary investment review. Our business development team go through the proposal, meet the people, ask the questions, get all the data and write a four or five page investment brief that is submitted to our investment committee." If the proposal makes it through the first two stages the group will then engage in thorough due diligence.

"Depending on the size of the investment this can be a lengthy or short process. We take a more comprehensive look at the market, the competition, the growth potential and the financials. We will write a proper business plan, which is submitted to the investment committee and the chairman for final approval," says Salameh." When it comes to assessing the performance of an investment, both agree that normal economic rules still apply.

Salameh says the most important measure is return on investment and he aims for a minimum of 20%. "Other measures of success include your market share, how accepted the new technology is, customer satisfaction and how well we have executed our business plan," he says. "The fact that it's a less liquid asset class should mean that you'll be rewarded for that patience," adds Lowery, who doesn't subscribe to the view that you have to be in a company for 10-20 years before you realise your investment.

"I think companies can mature and grow on shorter time scales, but this isn't about trading positions," he says.

In fact, Lowery likens such investments to what investing was like 50 years ago: "If you talk to people about what investment used to mean, it was generally about making stable, long-term investments through which you would support a company.

"Looking at venture capital investing with that frame of mind will mitigate risks or disappointments as it manages the expectations of what this asset class means."

Finally, Salameh cautions that you have to be realistic about the risks. "You need to accept the fact that you are going to have some investment failures. Working with start ups is risky, there will be two or three times the failure rate but at the same time the return on investment is three or four times higher," he concludes.

New study underlines growth in Asian markets

Evidence from the US suggests that you may have to head east to profit from the best venture capital deals.

The US National Venture Capital Association estimates that the country's 794 venture capital firms active in 2009 invested approximately $18 billion into nearly 2,400 companies last year. However, it believes consolidation is on the way.

Its 2010 Global Venture Capital Survey, which measured the opinions of more than 500 venture capitalists in partnership with Deloitte, found that 90% of US survey respondents expect the number of venture firms to decrease between now and 2015.

A majority of venture capitalists in China, India and Brazil anticipate adding more venture firms in their country during the same time frame.

Venture capitalists in Europe and Canada also expect an industry contraction in their respective countries though to a lesser extent than in the US.

Only 34% of all respondents indicated that they expect to increase their investment activity outside their own country, suggesting that cross border investing activity has reached a plateau for the time being. Factors cited most often for an unfavourable investment climate in the US were difficulty in achieving successful exits (88%); unfavourable tax policies (59%) and unstable regulatory environment (53%).

When it came to valuations over the next five years, 32% expect increases, 34% expect decreases and 34% expect val-uations to hold steady. Valuation expectations are the most optimistic in India and China.