MATCHING RUBLES

The US, Israel, Taiwan, Singapore, India and China are all countries to have successfully used government programmes to stimulate venture capital activity. Russia is now following suit with an early-stage investment stimulus programme of its own.

In creating the Russian Venture Company (RVC), the Government is moving full-steam ahead with the hope of creating a larger venture capital market and high-tech industry by luring Western venture capitalists to Russia. The Government is poised to unleash an additional RUB9 billion (€243 million; $380 million) after financing two funds to date with a third declining to proceed. The Government hopes to attract experienced investors despite underdeveloped Russian corporate law.

“I believe we will have our own Silicon Valley right in the heart of Russia,” says Boris Eykher, head of US operations for the RVC.

The RVC is a RUB30 billion ($1.2 billion; €816 million) Government-backed venture capital fund of funds, the largest of its kind in Eastern Europe. It was established in May 2006 to diversify the Russian economy and promote entrepreneurship.

The money is intended to be deployed among eight to 20 new Russia-focussed venture funds. These funds are projected by Eykher to invest in 200 start-ups and serve as an “indirect catalyst” for an additional 1,000.

“I believe we will have our own Silicon Valley right in the heart of Russia.”

The programme lays off a great deal of risk to the Government, providing greater assurance to overseas investors that their downside is protected in Russian venture capital deals.

The RVC will provide up to 49 percent of the capital for a new venture fund established in Russia. General partners are then left to raise 51 percent from private investors. The general partners and investors are then offered the option of buying out the RVC's share at a 5 percent nominal interest rate at any time.

“Such inflation-adjusted free financing effectively allows the general partners of an RVC-sponsored fund to double their return on investment at no additional cost,” says Eykher. “The Government shares the risk yet is willing to limit its potential profit.”

STRINGS ATTACHED
The funding and support is not without strings attached, however. All venture capital funds established by the RVC will be required to adhere to the standards established for high-risk investment funds by the Russian federal investment regulation authority and issue an investment declaration obligating them to invest exclusively in “innovation companies” limited by factors including industry and revenue. The RVC also requires funds to invest only in Russian-headquartered companies.

Funds are chosen for the programme via a competitive selection process, the first of which was completed in May 2007. The RVC offered financing to three vehicles: VTB-DFJ Aurora, a joint venture between Silicon Valley's Draper Fisher Jurvetson and a Russian investment bank; Bioprocess Capital Partners, a biotech fund created with the advice of Silicon Valley venture capitalist Franklin “Pitch” Johnson; and FinansTrust, established by the Israeli Tamir Fishman Group.

Of the three funds, VTB-DFJ Aurora and Bioprocess have completed raising the additional 51 percent of capital and begun operations. FinansTrust decided not to move forward in establishing its venture fund due to a disagreement between Tamir Fishman and minority shareholders.

VTB-Venture Fund closed last year on RUB3.1 billion along with Bioprocess Capital, which closed on RUB3 billion. The second competitive selection process will occur in the second quarter of 2008, when up to RUB9 billion will be distributed.

In developing the RVC, Russia examined a variety of similar programmes established in other countries including the Small Business Investment Company (SBIC) in the US and Yozma, Israel's highly successful venture stimulation programme launched in 1993.

The funding of experienced, foreign venture capitalists instead of inexperienced Israelis was an enormously successful element of Yozma. Foreign firms hired people to be their partners on the ground, creating a flow of knowledge. After one or two funds, local venture capitalists were then able to raise their own funds, often receiving funding from the same limited partners. “Clearly, Russia has looked at elements of Yozma,” says Josh Lerner, a professor at Harvard Business School who has advised a number of countries on developing such initiatives.

The ideal candidate for funding is “a team that ‘marries’ Western venture capital experts with prominent Russian financial professionals,” says Eykher. All three companies awarded funding to date have had some degree of foreign involvement. The RVC, in fact, hired Yigal Erlich, the former managing director of the Yozma programme, to serve on its board of directors.

The absence of venture capital in Russia stands in contrast to its abundant, highly educated human capital. “There are a lot of smart and underemployed people in Russia,” says Don Wood, managing director at Draper Fisher Jurvetson. “[The RVC] is a great outlet for those talented people to create companies.”

“The quality of ideas and people are very high,” agrees Asset Management Company managing director Evgeny Zaytsev, who works with Bioprocess Capital advisor “Pitch” Johnson and has advised the Russian Government on the RVC. “[But Russia] needs efficient mechanisms to commercialise the ideas.”

Both Lerner and Zaytsev note that the most crucial role of the RVC is to create an infrastructure upon which venture activity in Russian can flourish.

TOO MUCH OF A GOOD THING?
Despite these infrastructural challenges, Wood says the initial capital pool controlled by the RVC may, in fact, be too large. “The RVC is a good concept but they may try to put too much capital in the system in too short a period of time,” worries Wood.

Adding up numerous smaller programmes for promoting venture capital and high tech investments, some estimates place the total pool of available capital at more than $10 billion, says Zaytzev.

Other challenges face venture capitalists in Russia. The country has an inefficient corporate legal system, says Zaytsev. In addition, funds in Russia cannot be set up as limited partnerships, only as corporations. This means limited partners must provide their full commitments up front, which has the effect of reducing IRRs.

“Policy makers are trying hard to make the environment favorable for investors and entrepreneurs,” says Zaytzev, citing legislation currently underway to allow for limited partnerships. However, tax reform and intellectual property protection are arguably further from change.

“There is not a whole lot of history yet to examine and assure offshore investors that their money is completely safe,” says Wood, who believes a history of successful exits is needed to create a significant inflow of capital.

The RVC's limits on investments made by venture firms taking part in the initiative pose a hurdle to the programme's success, according to experts. In addition to restrictions by industry and revenue, the RVC also requires funds to invest only in Russian-headquartered companies. The regulation eliminates the ability to invest in a company that is legally based outside the country but maintains most of its operations within Russia. “The world's capital markets don't have a lot of experience with Russian-headquartered companies going public,” Wood notes, indicating a lack of investor confidence in exit possibilities.

This restriction of allowable investments is of great concern to Lerner who advises countries not to make investment restrictions an element of their programmes lest they “end up in situations where the regulations are self defeating”. Such micro-management has the potential to scare off top-tier venture firms. “Even if they come in they can get hamstrung by the regulations,” Lerner adds.

The Russian Venture Company is experiencing growing pains in its early days but nonetheless has high hopes of attracting Western talent to Russia with the lure of cheap money and an untapped market. Time will tell whether it can emulate the success of similar programmes elsewhere.