In the public interest

NESTA is the National Endowment for Science, Technology and the Arts, the National Lottery endowment set up by the UK Government to support innovation and creativity across the country. A wide-ranging remit, it also has an investment arm, which has already made three commitments this year following the launch of a £50m fund in March 2007 after a hiatus from early stage investing that lasted almost 18 months as the organisation restructured.

EVCJ spoke to investment director Anthea Harrison about NESTA’s business and the role the public sector plays in the development of new companies.

You set up the fund-of-funds business a year ago – how is the business progressing?

NESTA Investments launched a £50m fund in March 2007 split into two distinct areas: NESTA Ventures, which invests directly into early stage companies and NESTA Capital, our fund-of-funds business. NESTA Ventures builds on the organisation’s successful track record in backing early stage technology business, which began in 1999. The fund-of-funds approach was completely new for NESTA, and something we were particularly excited to break into. Our first task was to go out into the market place and say we were interested in fund-of-funds and looking for deal flow. With so few institutions in the UK investing in early stage or seed technology funds, information was scarce and performance data almost non-existent. However, over the last year we’ve developed a good understanding of the space in terms of who the players are, how active they are, what the funding cycle looks like, and what kind of quality there is.

What is the environment like for early stage technology funds?

The number of VCs out there looking for this type of funding actually surprised me. From a standing start, we saw about 20 to 30 fund proposals over the course of 2007. Part of the reason I think we saw that level of fund proposals is due to the time it can take to close a fund. When you first go into the market as a new provider you’re hit with all the pent-up demand from people whose funds are open. After sifting through that initial batch I was expecting the flow to die down a bit but it has actually stayed strong. In the first couple of months of 2008 we have seen a continuous stream of early stage fund of all kinds.

It’s becomes easier to understand when you think about the environment for early stage technology funds, which remains a very challenging one. Not only can it take one to two years for a fund to close but, as I’ve said, some funds don’t ever close as they never reach critical size. The difficulty comes from the historic lack of decent returns in this area. As we move away from the Internet Bubble years, I am hoping that fund returns will start to look better but for the time being, they are comparatively unattractive, particularly in relation to returns from later stage funds. There is a real challenge to attract investors into this critical space.

What is NESTA’s approach to investing in early stage technology funding?

One of the things that NESTA is in business to do is to show that it is possible to make money in this area and thereby get more money to come in. As such, we are focused on investing our money in the ‘best of breed’. Early stage investment is all about risk-taking but it is also essential that we show that people can make adequate returns from this kind of investment so our risks must be well-calculated.

As a result, we are very selective and are only expecting to invest in three to four funds a year. The strong deal flow we are seeing means we can make decent selections on these terms. We’re trying to invest in things that are different and specialist .

I’m finding it increasingly difficult to get excited about what I would describe as “plain vanilla”. We look for funds that operate in very narrow areas so that the management team is highly specialised and has very particular skill sets that they bring to the party. Another plus point is where the management team has come from the industry that they are specialising in, as opposed to being venture capitalists or financiers – this feels more like the American model. Of course there can be a mix of financiers and people from the industry but it seems clear that ‘all-finance’ is no longer the way to go at this end of the market.

What funds have you committed to so far?

We’ve committed to four funds so far, the first being the UMIP Premier Fund, a £50m venture capital fund to invest in intellectual property from Manchester University in partnership with commercial investment manager, MTI Partners.

We’ve also contributed to the IP Venture Fund which is the follow-on fund for IP Group, the largest UK Universities spin-out investor. The IP Venture Fund’s sole purpose is to provide follow-on funding for IP Group’s portfolio. This is an area we’re particularly interested in because one of the problems in the early stage market is that people run out of money to follow their initial investment – as such, it becomes diluted, which makes eventual returns poor, and dissuades investors.

As NESTA is trying to show that you can make money in the early stage investment space, we are trying to tackle this problem of follow-on investment. There are a couple of ways in which we can do this. One is to make sure funds are big enough so they can follow-on their own investments, the other one is to invest in funds specifically aimed at providing follow-on funding.

In the second half of 2007 we committed €200,000 to Seedcamp, an organisation dedicated to helping entrepreneurs in the Web 2.0 space to start businesses from across EMEA (Europe, the Middle East and Africa). The initiative kicked off with Seedcamp Week in September, where successful applicants attended a week-long networking and mentoring event in London.

Seedcamp Week will take place annually in different locations across EMEA and NESTA has committed funding for the next three years.

The investment will also help support the best of the successful candidates during a three-month stay in the host city after Seedcamp Week. Over that time, they continue refining their products and will be able to build relationships with the experts that they were introduced to at the week-long event through a series of mentoring events. It is hoped that with continued mentorship they will be able to grow their ideas and establish viable businesses that change the technology landscape. At the end of the three months the businesses are given the opportunity to pitch for further cash from those investors they have been introduced to over the course of the programme.

NESTA is particularly interested in new models of investing, so Seedcamp gives us a really good opportunity to see how this sort of “fast-track” approach works. It also matches up very well with our belief that it’s not just good finance needed to make successful start-ups but tailored mentoring and support.

Most recently we’ve committed to Pentech Ventures, one of the UK’s leading early stage software funds. We are contributing £3m to their second fund, Pentech II. They are an excellent example of the specialised kind of fund that we are looking for and they’ve put together a great management team that really knows the software space.

How important in your view is the public sector in the venture capital space?

It’s very important. There is currently a big gap in investment at the early stages in the UK and so public sector support is vital, whether through Regional Development Funds or Enterprise Capital Funds. Public funds have a critical role to play in drawing in private sector investment. If we are to take advantage of the wealth of good ideas out there, then public funds are going to need to show the private sector that investment in this space can provide returns. Done right, this should result in a shift in the balance from a public to a private sector dominance in the early stage investment space. As I’ve said, this is a very big part of what NESTA is trying to do at the moment.

The other important role that the public sector has to play is in providing business support. It’s no good just throwing money at start-up businesses. Money combined with expert business support and mentoring – be it help with networking, business plans, or the recruitment of staff and Board members, is what helps grow successful businesses.

What does the future hold for NESTA?

NESTA is trying to fill the vacuum in early stage funding, working in partnership with the private sector. To complement our investments we are also doing research focused on the early stage investment arena. We’re working with London Business School and Library House to devise a new model to measure the performance of investments in the years between initial investment and exit.

We’re also involved in a European Commission project to build a framework for cross-border investment . The project is designed to understand the barriers, for example, to different ways of valuating businesses, and how to overcome them, increasing the flow of risk capital at the early stages and helping companies become internationally investment ready. Following three international events, there are already five cross-border deals going through and the project, which should ultimately lead to an investment fund.

Since our launch last year we have committed only a small percentage of the £25m we plan to invest over the next five years in the early stage fund-of-funds area, so we’ve got a lot more to invest. Although this may seem a very small amount in view of the sums talked about at the top end of the VC market we can use it to leverage investment from other sources as typically NESTA does not account for more than 10% of a fund.

Having had a good first year and got ourselves established in the market by making some initial investments we now plan to build on this by investing in some highly specialised areas, particularly aimed at some of the areas of technology where we are strong in this country. There is a huge task at hand if we are to close the gap in early stage venture capital and make the space attractive to investors and the investments we make over the next couple of years must contribute to this.

Anthea Harrison

Anthea Harrison’s background is in corporate finance and venture capital. She spent several years with Charterhouse before joining Lloyds Development Capital, where she was responsible for completing a large number of mid-market MBOs. Over that period, she was a non-executive director of 10 companies, covering a wide variety of industry sectors.

She then joined Deutsche Bank’s Emerging Markets division, looking at investments in Latin America and Eastern Europe before transferring to the asset management division to take on responsibility for a portfolio of technology investments.

She joined NESTA in January 2007.

She has worked in all areas of the venture capital market, from the very big to the very small. “I started my career as a relatively hands-on venture capitalist and have found that this is important when dealing with the seed stage VC market. At this end of the market you are dealing with real companies, people, products and problems and for me that makes it that much more interesting. Although as a fund-of-funds investor I tend not to get involved in the underlying investments, I still find it to be a very creative part of the VC market and enjoy it more than some of the other areas I have worked in. As far as I know, my role at NESTA makes me the only dedicated early stage fund-of-funds investor in the UK and that has quickly given me an overview of the market that it would be hard to find elsewhere in the VC world.”