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Tuesday, May 29, 2012

Business angels: hurdles to overcome and alliances to look for

We talked a few weeks ago about how important business angels are. Everybody seems to understand it here in this country. But there’s no explosive growth in this investor class in Russia’s regions; and a major disconnect between achievements in research labs and their market applications still exists. Why? To see an answer we might have to view this from an international perspective.

The problem that we’re discussing was already visible more than twenty years ago in the United States. At that time, business angel investors were primarily start-up entrepreneurs who developed their projects in IT. And all of a sudden the technologies began to get more and more complex. This process of exponentially advancing knowledge in biotech, nanotech, material science and things like these made it harder and harder for angel investors to dive in and do what they can do best: form a team, assess the market, and so on.

Part of the reason was that a horizon of how long it took to develop a technology project became longer and longer. For example, when you’re developing a medicine project you have to go through all sorts of government regulation, you have to have FTA approval, you have to have clinical trials, and so on. So instead of just being able to start a new company, develop it for two or three years and then sell it, with advance technologies you might have a six-seven-eight year horizon to develop that technology to a point that it could be sold to a strategic buyer or a VC fund.

One of the mechanisms that came to bridge this gap was the first proof-of-concept center at the University of Colorado initiated by a man whose name is David Allen. His idea was to create a form of a consulting center which would assist tech-transfer offices that typically assess at universities the legality of a technology by doing patent search. David decided to create a center which would help understand the commercial viability of the technology.

The goal was to be able to explain that to investors so that they were not just worried about how long this process would take. If you can map out and show that this is a market worth $20bn a year and within five years you can take 6% of that market and the market’s growing at 27% annually, then you can understand how to value that technology. If you don’t have anyone in the technology team that can understand that, and if the angel investor isn’t clear on it, then you have no way to strike a deal.

So proof-of-concept centers came out of the idea of how to bridge the gap between the advance fundamental science innovators and the angel investors. This system has evolved remarkably in the last 20 years. Today there are several dozen proof-of-concept centers, advance incubators, accelerators, etc. They vary in forms. One of the most highly publicized and successful is the Deshpande Center at MIT. Others include the von Liebig Center in California or University of Utah’s proof-of-concept center. Their main idea is to develop the infrastructure and mechanisms to help scientists and innovators create their commercialization strategy.

Jointly investing is the way they reduce risk

We just had guests here in Nizhny Novgorod, including Brigitte Baumann, president of EBAN (the European Trade Association for Business Angels, Seed Funds, and other Early Stage Market Players), and Frank Peters from the Los Angeles business angel club. I asked Frank: “Why are you here? Are you looking for angel-level deals here in Russia to invest directly in?” And he said: “No, I’m not looking for deals. I’m looking for Russian angel investors to partner with.”

Angel-level investing has become its own investor class representing more than 250,000 individual angel investors across the United States in hundreds, if not thousands, different clubs with a total investment of between $20bn and $30bn a year in start-ups. There are many syndicates of angel investor clubs; for example, Frank’s club in LA has more than 250 members, and he himself belongs to five other clubs around the country. Let’s say that as an angel investor each member should invest not less than $25,000 in a given project. With a technology project that requires $500k, for example, 20 different people get together to each contribute $25,000. Jointly investing is the way they reduce risk.

This is an absolutely amazing phenomenon to me, and I’m very excited to see that because I think that that type of mechanism would work very nicely in Russia.

As Frank Peters explained, they advise their members that those should develop a portfolio of around 30 projects, about $25,000 per project or $750,000 of their personal money to invest in 30 different ones. Out of these 30 projects, a big percentage will go bust; some of the projects will probably struggle along and may pay some money back. And Frank set an example of one project he was involved in that went public and all the investors got 117 times their money. Each investor who invested $25,000 received back almost $3m.

If out of your portfolio of 30 projects you’ve invested between $500k and $1m, and one project goes public, you will have made a million-dollar profit. In the meantime, you will participate in mentoring and advising dozens of different projects along the way. And the reason to do that is to make an interesting life and to change the world.

Today’s business angels feel that their territory is the world

One problem that Frank raised, however, was that they feel that they are not getting enough advance science projects. Most of the projects presented to angel investors are quick turnover IT projects. Advance fundamental technology coming from universities is reviewed by tech-transfer offices, packaged by proof-of-concept centers and then immediately sold to corporate strategic investors for further development.

Why? Because the super-high fundamental technologies are too risky for most private investors.

There are always exceptions, and the dream of every angel investor is that they’ll actually get this exception—a super-high-performing, exotic disruptive technology project. But that’s not as often as they would like. And that’s the reason that Frank Peters came here. Today’s business angels feel that their territory is the world, and they are looking for alliances. A business angel in LA can’t do a deal on his own in Nizhny Novgorod or Novosibirsk; he needs to have a local angel partner.

So the beauty of what happened here four weeks ago was that Russia’s business angel community grew up and achieved a certain milestone where the EBAN members decided to have their major event in Moscow. I would congratulate Konstantin Fokin, the president of the Business Angels Association of Russia, and Eduard Fyaxel, the chairman of the board of the Association, for raising the profile of Russian business angels to international business angel groups, to attract them here to Russia, and encourage them to first come to Moscow and then go out into the regions. And it’s a great encouragement for Russian business angels who’re looking for partners, who’re looking for advice, who’re looking for allies.

In this world, the people who want to do investing into technology take on a tough burden, and it’s important to always look for sharing risks. Russia as we all know has a very cyclical economy. If the European Union has a sneeze, then Russia gets bronchitis. If America has a recession, Russia goes into a depression. Whatever happens in the global economy will impact Russia very dramatically. If you’re a technology investor and you’re investing in this highly risky, highly cyclical, high-inflation system inside the Russian Federation—as it exists now as a commodity economy—then the best hope you have is to take your technology and immediately find an international partner.

Friday, May 25, 2012

The economy of blat, or Russia's 20-year transition

Gregg Robins, head of UBS Wealth Management in Russia and a Marchmont Advisory Board member, is presenting in his blog his article first published in Spear’s Magazine, #5 (19), 2012.  

I can remember in the late eighties / early nineties when “Transition Economics” was a growth business, with new university courses, books, consultants, and so on. Indeed, I was a beneficiary of it, having written a book on the subject. Today we no longer speak of transition economies any more than we do of centrally planned ones. If I look at the last two decades in Russia, there are three major areas that have fascinated me, none of which has anything to do with the macro transition to a market economy. Where transition economics featured debates between advocates of “shock therapy” or “gradualism,” the central issues and developments since the advent of perestroika have been elsewhere.

First, capitalism itself has faced major crises over the past decades, during which we have seen the rise of the BRICs and Emerging Markets more generally. It was not foreseen – especially under the so-called “Washington consensus” - that these countries would not only become the engine of world growth, but more that they would also become far better models of fiscal management than their long-time capitalist neighbors in the West.

And as Emerging Markets have ascended, many developed countries have experienced severe economic shocks emanating from a deep-seated financial crisis. All along, the world has become flatter and flatter – to use Tom Friedman’s term – and people, information, and money have become infinitely more mobile, and more rapid in their mobility. The past decades in Russia’s transition did not happen in isolation. The trends I mention have especially affected the younger generation in Russia in terms of life choices and opportunity.


Returning to Russia, then, the second major observation is the importance of institutional economics. By this I mean that the macro economic situation was always manageable through policy shifts, but the institutional fabric of the country was far more difficult to transform. Let me be more specific. “Formal” institutional changes, such as new laws and regulations, are relatively easy and quick to put in place, and it is not difficult to copy best practices from elsewhere. What is far more difficult is to make them work properly.

It is clear that the long-desired, law-governed state (pravovoe gosudarsto) is still evolving, and is dependent upon people, courts, and outside influences far more than the laws themselves. A stock market is not difficult to create, but it is a long-term process to effect acceptable levels of corporate governance, including proper insider trading laws, for instance. On the latter point, Russia is making real progress today, and this will help its stated goal of becoming a more important financial center.

And then there are the “informal” institutional changes required. These are also slow in the making, as heavy dependence on personal relationships and other behaviors persist. Corruption – in Soviet times known as blat - has remained an endemic issue and one that, repeatedly, was not especially addressed in the earlier days of transition economics.

Further, there is the high differentiation that has developed between generations in Russia, along with the expectations they bring. What was once seen as a shift to a market economy that would carry all along with its prosperity has come to mean very different things to different groups. For large segments of the older generation, the new Russia is foreign to them, with many being quite lost. They were brought up to understand that there existed a right to work, to healthcare, to culture, and more, and this is clearly not what they have found. It is too late for many to reinvent themselves, so they get by as best as possible. For the generation in the middle, the transition to the market has brought greater wealth, for some dramatically so, and new careers and opportunities. They have benefitted from their understanding of and connections in the old system at the same time as they have adapted to the new one.

The younger generation is quite different: many have been educated, indeed raised, abroad, and are not entirely in touch with the new Russia. Research has shown that in Russia there are low levels of succession planning in family businesses on the part of the current-generation owners, not to mention the numerous young people that have other plans for their future in any case. As the world has become flatter, and Emerging Markets such as Russia have prospered, high numbers in the younger generation have studied and worked abroad, and continue to do so. They are the future and have much to bring back and share for the good of the country, should they chose to do so.

As institutions continue to develop, and as we recognize the generational dynamics in the country, we see the importance of the development of a true middle class that is able to fuel the domestic economy. With a middle class we see the development of civil society, something that has varied a great deal in speed and degree across the so-called transition economies.

As I mentioned at the outset, “transition economics” is more suited to the history books than to the current situation. But it has been replaced by fascinating developments and challenges in institutional change, and generational dynamics, all within the context of a dramatically changed global economic environment. To me these have been surprisingly central themes that didn’t find their way into the early debates on the pace and degree of economic reform. It would be interesting to speculate what the issues of the day will be in twenty years time, but that is for another forum.

Saturday, May 5, 2012

I wish for a defense alliance of the 'good guys'

The Russian government has recently announced its $680+bn pledge to the across-the-board rearmament of the national Army and Navy over the next eight years. The Kremlin airs belief that rekindling demand for new weapons and equipment will give a good boost to Russia’s industrial growth. Russia might also bet on an increase in war armaments exports as a way to achieve the growth. I just heard colleagues argue if it is the right path for a country like Russia to follow in developing its economy. Let me share with you a few ideas on this.    

For me, I’m not very happy to see any nation selling war armaments internationally. I’m an economist; I look at everything from a business perspective. This is the framework which I come from.

However, looking at this from a historical perspective, we should not forget that Russia’s legacy is being part of the Soviet Union, which as a block was diametrically opposed philosophically and economically to the Western world. For the last twenty years Russia has been restructuring itself, and has achieved a certain level of stability. It is now joining the WTO as a friendly partner on our very small globally integrated planet.

Friendly trading nations don’t go to war with one another—as simple as that. We’re all working together towards improving the standards of living in the global economy. There’s no conflict between Russia and other nations.

At the same time, Russia has to choose how to modernize itself. Political choices have to be made in how to utilize and leverage the historical investments which have been made in Russia’s economy. And there are two foundation pillars of this economy. One is oil and natural resources extraction and sale of commodities globally; and the other, for better or worse, is defense and military.

So, I personally believe it would not be logical for Russia to choose not to modernize this sector of the economy. Russia needs to integrate its system into the global system. In this context, Russia purchasing the Mistral class helicopter carrier from France is a great example.

As a leading country Russia cannot afford to be passive. In any situation, military strength is a sign and signal of economic strength. The ability to defend one’s borders from any threats is a right of every nation. While being on friendly terms with most other nations, Russia still has to protect its national interests and those of its partners, so the government is restructuring this sector.

Just as the U.S. relies on very large global-level corporations which make armaments, those same companies use government subsidies to make new military aircraft and simultaneously utilize the technology created with those subsidies in developing new commercial aircraft.

In fact, even most advanced sectors of the economy using the most advanced technologies cannot be driven by purely commercial interest alone. The role of the government to stimulate modernization through investing in the defense sector is understandable and quite acceptable, but the main aim should be to help restructure these defense companies to develop, in parallel, their commercial assets.

Look at Boeing: it has its military aircraft and uses this technology and subsidy from the government to make new and highly competitive commercial aircraft. The same applies to General Electric, Siemens and any other companies.

Russia’s defense system needs to be diversified to be able to use the support of the government to develop military products and at the same time draw on this technology to improve its competitiveness for developing the commercial arm. Otherwise companies themselves—which are, in most cases, 100% defense-focused—cannot compete without government money, creating a catch 22 situation when defense companies cannot modernize themselves to make commercial products, and eventually face dying.

So, this is absolutely logical that this will be a priority for the government in an effort to diversify the economy. But I’m sending another message here. I would be very, very, very happy to see the development of a strong alliance with Russia and the U.S. and NATO; to see integration in jointly developing new defense systems for our planet against ‘rogue’ nations, against the ‘bad guys.’ General Electric, Siemens, Boeing—they will all be delighted to work with Russian companies and develop joint projects, being part of the ‘good guys’ with responsible global business working to shield the planet from those who want to stick their fork into our side.