“The biggest mistake for a corporate is to be a passive investor”

Harvard Business School Professor Henry Chesbrough talks about the recent downturn in corporate venturing and assesses the role of strategic investing in a successful portfolio.

Corporate venture investing all but collapsed when the economy turned – a surprise?
The severity of the contraction of corporate venture investing is a bit of a surprise, but I think the speed of withdrawal reflects a reckoning with the reality of VC returns for private VC as well as corporate. In fact, you could make a good case that CVC actually faced up to the writeoffs and writedowns faster than their private VC brethren, some of whom are still in denial.

Which key mistakes have been made in the past?
The biggest mistake is to be a passive investor, where you invest purely for financial return, and make little use of your own capabilities with the portfolio company. This is arguably a misuse of shareholder funds. Corporations no longer seek to diversify their businesses to smooth out earnings across different sectors for their shareholders, because modern portfolio theory has taught us that shareholders can do this quite well on their own. They don't need any ?help? from the corporation. The same logic applies to CVC. Shareholders have many ways to participate in private equity these days without the corporation doing it for them.

Are ?advance and retreat? investment programs inevitable?
My own research suggests that many CVC programs were initiated and managed primarily or exclusively for financial returns from the portfolio of investments. These programs are indeed likely to be strongly cyclical with the returns in the private VC market ? perhaps lagging the private VC cycle by a year or so. Contrary to some companies' impressions, they are seldom smarter, more knowledgeable investors than private VCs. I cannot think of any corporate CVC programs that have sustained superior returns to private VC over any significant period of time.

However, other CVC programs are initiated and managed for strategic benefits to the corporation, to stimulate additional revenues for the corporation, or cut costs in its value chain, or to move legacy costs off of proprietary architectures on to broad, robust platforms that can be sustained over a much broader base of activity. These programs seek financial returns as well, but the strategic rationale is the higher priority. These programs are somewhat affected by the financial returns, but are more insulated from the swings. And these continue to make sense, even in this environment.

Is it possible to rank the key aims of a CVC fund objectively?
The corporate context of each company should determine its CVC programme, so there is no single template or checklist that would apply to all companies, in my view. I have also found that the most important goals of CVC programmes are very hard to measure. In one company, for example, they assessed whether the investment was made for strategic purposes, or not. Later, they called the CEO of the portfolio companies, and asked if the corporation had actually delivered on the strategic aspects of the relationship. When the CEOs replied that the corporation had, the returns on those investments were higher, while returns on similarly ?strategic? investments initially, but where the follow-through had been lacking, were far lower.

Which corporates are proceeding with their venture strategies at present?
All of the leading computer and IT companies, such as Intel, Microsoft and Sun, have re-upped. I expect them to continue to do this indefinitely. Another area of increased CVC interest is in the life sciences, where Lilly, Merck, and Millennium, among others, have initiated CVC programs in the past year.

Intel has been criticised for ?drive-by investing? – what does the charge consist of, and is it fair?
The charge is essentially that Intel has made so many investments (more than 800 since the mid-1990s), that they cannot possibly manage them all effectively, and cannot add real value to each of these investments. In a deeper sense, the charge is that there are few real economies of scale in the venture capital business.

agree that venture capital, and corporate venture capital, are hard processes to drive to scale, and Intel may well be at the limit of what is doable. But the Intel people have impressed me as smart and thoughtful people, and I think they know what they are doing. First, they never lead a round, and always rely on a private VC firm to set the valuation for the next investment. Second, they rely on an internal business to ?sponsor? the investment within Intel, with the goal of making that sponsor the internal champion once the investment is made. Third, they have strong due diligence processes within the firm, that extend to their internal research staff, to vet these investments. Many times, Intel can do a much more thorough analysis than an external VC. This also educates Intel's own research staff on the cutting edge of technology, and often broadens their own internal thinking. Personally, I think every company with significant internal R&D should pay close attention to start-ups. Intel is one of the few that actually does this.

Lucent recently sold off NVG to a secondary buyer – a good move?
This was a great move for NVG and for the buyer, Coller. It may have been a necessary move for Lucent, given its cash constraints, which may have impaired its ability to support the portfolio companies with follow-on investments in the next couple of years. However, I suspect Lucent left a lot of value on the table. I also worry that Bell Labs has lost a second path to market for technologies it is not utilizing fully internally. Occasionally, NVG projects went out as ventures, began to achieve success, and were later reacquired by Lucent ? reflecting the benefits of an external structure for growing new ideas.

This is a great time to be in the secondary market, buying out a corporation's CVC portfolio. I think we will see some fantastic returns here, though it will require 2-3 years to reopen the IPO window for the portfolio companies.

Is there an argument that corporates should outsource their venture activities and invest in venture firms with a relevant sector focus?
There is indeed a good argument for this. The financial returns may well be higher, even after giving a general partner a 20 per cent share of the gains. And many CVC managers do not stay with their programmes long enough to do their jobs effectively. Those CVC managers who do stay, and who achieve good returns, leave to become highly prized partners at private VC firms. However, the ability of corporations to achieve strategic benefits may be diluted in these programmes. One would need to supplement one's capital with some dedicated internal staff, to foster connections between the corporation and companies in the portfolio, at a minimum, to offset this.

Henry Chesbrough is an assistant professor of business administration at the Harvard Business School where he holds a joint appointment in the Technology and Operations Management and Entrepreneurial Management areas. He can be reached at hchesbrough@hbs.edu