GETTING IN EARLY

For an organisation that gambles by backing innovation at an early stage, it seems appropriate that the UK's Nesta (the National Endowment for Science, Technology and the Arts) was itself the product of gambling. The £300 million (€379 million; $591 million) endowment upon which Nesta was founded in 1998 was committed from proceeds generated by the National Lottery.

Since then, Nesta has set about delivering on its mission “to make the UK more innovative”. It has done this in many different ways, including offering support to the likes of musicians, academics, health workers and fashion designers. One of its more notable current projects is “The Big Green Challenge”, which is offering a prize fund totalling £1 million “to encourage and reward people working together to find new and better ways to tackle climate change”.

And then there's venture capital. The aim here, says Nesta Investments managing director David Hunter, “is to show successful investments in early-stage technology and thereby influence stakeholders to change policy”. With its focus on encouraging innovation, it's not surprising to learn that Nesta's investment arm focuses its efforts on early stage, “70 percent of which is related to university spinouts”.

The investment operation was launched two years ago following a previously restricted investment remit, which Hunter says was not fully commercial and “was not producing a great return”. It is divided in two: Nesta Ventures, which makes direct investments in companies, and Nesta Capital, which invests indirectly through third-party funds. Hunter says that each unit was given around £25 million to commit. For Nesta Ventures, this was expected to equate to around 50 direct investments “across all technology sectors”.

SHRINKING FUND UNIVERSE
Hunter says that the £25 million of available capital for fund investments “doesn't sound like a lot, but then the number of opportunities to invest is quite small”. He estimates that only around six funds in Nesta's sweetspot were closed last year. “The problem is,” he reflects,” “that the poor returns during the dotcom boom and bust have put a lot of people off investing in this area. They forget that the returns being achieved before that period were quite respectable.”

Indeed, although its total capital may seem modest, Nesta is one of the more sizeable and influential LPs in an area where, Hunter points out, “every new set of figures confirms ever more conclusively the existence of an equity gap”. He acknowledges that an early-stage venture capital allocation will always struggle to move the needle of an LP's overall portfolio. In addition: “Buyouts have been hugely profitable and therefore people have been drawn to that end of the market.”

Hunter ponders whether things may be changing however. The stalling of the large buyout market may encourage investors to look again at what early-stage investment has to offer. What they would find, insists Hunter, is “no lack of good things to invest in. It's a remarkably uncompetitive space compared with buyouts.”

Nesta Capital has so far found five projects to back, described in brief below:

  • •The IP Venture Fund (August 2007): £1 million handed to the IP Venture Fund, a £31 million fund managed by Top Technology Ventures, the venture capital subsidiary of IP Group, a firm that specialises in the commercialisation of intellectual property. The fund commits around 25 percent of the total amount invested in post-seed financings of IP Group portfolio companies – the rest of which is provided by external investors.
  • •Pentech II Fund (2007): Nesta committed £3 million to the second fund raised by Glasgow-based technology-focussed venture capital firm Pentech Ventures. Pentech models itself on Silicon Valley venture capital firms and works closely with entrepreneurs to build software companies.
  • •Seedcamp (October 2007): an undisclosed sum invested in the innovative €600,000 Europe-wide Seedcamp initiative, the brainchild of Saul Klein, a partner at London and Geneva-based venture capital firm Index Ventures. Hunter explains the concept: “It's a new way of sourcing web-based business ideas. A panel selects five projects and then gives them €50,000 to work up a business plan. They come back after six months and Seedcamp will fund the best ones.”
  • •UMIP Premier Fund (April 2008): £3.5 million committed to the £35 million UMIP Premier Fund, a joint technology transfer venture between venture capital firm MTI and the University of Manchester which invests in businesses emerging from the University's academic departments. It is Europe's largest institutional fund to have a single university focus.
  • •GP Bullhound Sidecar Fund (July 2008): £500,000 invested in the GP Bullhound Fund, which backs technology, media and telecom companies alongside investors introduced by GP Bullhound, the technology-focussed investment bank with offices in London and San Francisco. The fund has made four investments to date.
  • Hunter says the firm is looking for a return of around 10 percent from the whole of its investment portfolio. He adds: “If you look at the history of the sector, that's quite ambitious. But it's not as good as a typical long-term mid-market buyout return, which could easily be 15 percent or more.”

    The problem is that the poor returns during the dotcom boom and bust have put a lot of people off investing in this area. They forget that the returns being achieved before that period were quite respectable

    David Hunter

    Hunter has been in a position to observe the long-term performance of private equity during his own career. Having joined 3i at the age of 27, he spent fully 20 years there – ultimately as managing director of the investment management group, where he had responsibility for the performance of the firm's £3 billion UK portfolio of around 2,000 businesses. He left 3i in 2003, becoming an adviser to Partnerships UK, where he oversaw an equity investment business relating to commercialisation of public assets and IP. The move to Nesta followed three years later.

    MORE BULK REQUIRED
    Returning his thoughts to the equity gap, Hunter reflects: “It needs to be easier to invest in early stage. In order for institutions to commit meaningful amounts, there has to be more funds of funds activity. We do it in our own small way, but there is a need to build bulk. Time has elapsed since the dotcom bust – it's six or seven years now, and the figures from early-stage investment will start to look better.”

    Furthermore, amid all the gloomy economic forecasts, Hunter remains resolutely optimistic about the future of innovation in the UK. “Theoretically, a bigger company looking to buy one of our portfolio companies using debt might be affected but we've not seen it, and we've not seen any change in the flow of opportunities. Tough economic conditions may make people more risk-averse but, when there are restructurings and redundancies, people often come up with new ideas.”

    It is the aim of Nesta to help ensure that when these ideas evolve into new businesses, they do not suffer for lack of available capital. While there are some signs that confidence in the early-stage investment space may be returning, access to capital still appears to be too much of a lottery.