Venture capital and private equity – what’s the difference?

RYK VAN NIEKERK: Welcome to my weekly Market Commentator podcast, during which I normally speak to the top fund managers at South Africa’s top asset managers, and I try to pick their brains about perceptions of the markets and the opportunities they see.

But today I’m going to stretch this mandate a bit and speak about venture capital and private equity. It is slowly but surely growing into a standalone asset class, and may offer some exciting opportunities as part of diversified portfolios. My guest today is Llew Claasen, one of the founders and the managing partner of Newtown Partners.

It is a venture capital firm that was founded on the set of Dragon’s Den [SA TV programme] and this business specialises in investments in technology-driven businesses.

Llew, thank you so much for joining us. Tell us about this Dragon’s Den experience. How could a firm be born on the set?

LLEWELLYN CLAASEN: Ryk, thanks for having me on the show today. It is a bit of an interesting story, isn’t it? My partner Vinny Lingham was participating in season one of Dragon’s Den, which I think was in 2017.

We had been talking about getting into venture capital for a long time and had been doing some angel investments, but wanted to put together a team.

When we were sitting on the set and he had made a couple of these investments, we decided that now was the right time in using those first couple of investments, and I guess the visibility of participating on Dragon’s Den was an opportunity to launch what became Newtown Partners.

RYK VAN NIEKERK: What has been the most successful investment you’ve made?

LLEWELLYN CLAASEN: We are very active in crypto blockchain projects. From a pure returns perspective, those have done very well for us. But I think that the investment that I’ve enjoyed the most is actually one of those we did first.

In the first couple of months of Newtown Partners, maybe four months in, we invested in SweepSouth [a company offering home cleaning, gardening and maintenance services], investing at a time where there were two founders and maybe five customers, or something like that. At that point in time we were fortunate that we had the time that we could commit to them.

We spent a lot of time with them for the first couple of years, and it’s been rewarding for me to see that it turned into something that ultimately had a major social and economic impact.

I don’t know what the most recent numbers are, but something like 10 000 people who were underemployed and unemployed have managed to use the platform to earn money. I’ve really enjoyed that.

RYK VAN NIEKERK: SweepSouth of course is a peer-to-peer solution, much like Uber, where domestic workers can find piecework. It’s a very interesting model and very successful. You sold that to Naspers?

LLEWELLYN CLAASEN: That’s right.

RYK VAN NIEKERK: An unbelievable investment. But let’s talk about venture capital and private equity. What is the difference between the two?

LLEWELLYN CLAASEN: I think that private equity is typically looking for businesses that are capable of generating free cashflow, where you can use financial engineering and debt instruments in order to change the capital structure and ultimately optimise the returns that the business is able to create. Once debt has been paid off, we exit the opportunity again.

Venture capital takes a very different approach and says we want to take something from, say, zero to one – and ultimately to 10. So it’s about building something which doesn’t exist and turning it into something really compelling and, I guess, economically large, because there’s this expectation that if you can use smart capital, without the expectation that it is going to generate profits or the business will be profitable, you can grow it to scale. You can benefit from the advantages that I guess many software businesses have – a non-linear relationship between revenue and costs.

And so venture capital is, as I said, very much about growing, and private equity is arguably more about financial engineering.

RYK VAN NIEKERK: Venture capital typically would be more inclined to be startups than existing businesses which just need some capital to take them to the next level?

LLEWELLYN CLAASEN: I think there is that expectation. At least, the way we look at it, is that we invest when something is sort of less than five years old.

There are a couple of different reasons for that, but one is that we want high-growth early-stage opportunities, so we can get in early when we can still impact on the growth to market or the route to market. I guess we also want the returns associated with getting in early.

Businesses that have been around for a long time and haven’t experienced two to three times top-line revenue growth year on year – which is typically what a VC [venture capitalist] expects – have different characteristics. That doesn’t make them bad businesses; it’s just that they are not necessarily conducive to venture capital.

I think you can think of venture capital as a little bit like we want to add nitrous oxide to a business so that it can grow really fast – and create an opportunity for us to be able to exit within a reasonable amount of time and return money back to investors.

RYK VAN NIEKERK: How developed is the venture capital market in South Africa – maybe relative to, say, comparable markets?

LLEWELLYN CLAASEN: I think we’ve seen a lot of growth in it over the last five years. There are more people raising funds in excess of R100 million. For a long time it was really hard for any VCs to have a fund of R100 million. A lot of people did growth equity, and called themselves VCs, and that’s okay. But they weren’t sort of taking a pure VC approach to investing.

I would say there are probably at this point in time somewhere between five and 10 VCs in South Africa that have funds of at least R100 million. Many of them are reaching the point now where they’ve got sort of R300 million, R400 million in committed capital.

For us, we’ve always said that any VC fund is suboptimal or subscale until you have at least $20 million in committed capital, just because the economics of it struggle to work at below that number.

There’s definitely a lot of development in this space, but it is still early days.

If you take, for example, the R400 million, which to my knowledge is the largest individual VC fund in South Africa that has a South African focus, and convert it to dollars it’s not that significant any longer. Compared to other markets, it’s tiny compared to the US. It’s actually also small compared to European markets, Asian markets. Even if you compare it to, say, Nigeria or Kenya, there are much larger funds there addressing those markets as well.

RYK VAN NIEKERK: What is the name of this R400 million fund?

LLEWELLYN CLAASEN: I don’t know if that’s public information, so I don’t know if I can share that.

RYK VAN NIEKERK: Why is it so small? Are there structural reasons for it?

LLEWELLYN CLAASEN: It’s hard to raise from international investors.

Local investors who have the capital – family offices and high-net-worth individuals – are typically not looking for ways to deploy capital back into South Africa. They’re looking for ways to deploy money outside South Africa, typically money that has previously received Sarb [South African Reserve Bank] approval or money that was earned on investments that were originally offshore.

So you kind of have this problem of international money that wants to come in and struggles to get in [and] the money that used to be here is on its way out.

RYK VAN NIEKERK: Interesting. And is there an appreciation of this problem within the authorities?

LLEWELLYN CLAASEN: In the conversations that we’ve had – and I think perceptions are changing – I think government has a perception that venture capital is something that doesn’t really have the potential to impact the lives of ordinary people.

So it’s not really being taken seriously as something that needs to be addressed, in my opinion.

I say that it’s changing because there have recently been engagements with different government organisations that ultimately led to a conversation with the president about two weeks ago around what a group of people are working on, which is called the SA Startup Act.

There really just are a number of different measures that the ecosystem believes need to be attended to in order to create an environment that is conducive to more high-technology startups being created and funded in South Africa, and ultimately creating high-value employment.

We talk about VC startups not necessarily creating the most employees, but they certainly create very high-value knowledgeable workers who can create global competitiveness.

RYK VAN NIEKERK: The industry, as you’ve said, is growing. But from an investment perspective, many South African investors would look for example at the JSE where we’ve seen a steady decline – [an increase] in the number of delistings on the bourse, as well as a slowing down of new listings, especially for smaller companies looking for capital. It seems as if many companies would rather look at the venture capital and private equity opportunities available to them to raise capital and funding. Do you think the sector offers opportunities for investors to diversify their portfolios, owing maybe to the equity market not growing in the number of options that it used to?

LLEWELLYN CLAASEN: I absolutely do think so. I think people just haven’t really considered it an option because asset managers don’t take it very seriously. We don’t get allocations from asset managers. I think there are just concerns that it’s high risk, that it’s illiquid and that, frankly, most customers are not asking for it – so why bother? What we see is that instead of high-net-worth individuals putting money into established VC funds, those who have a serious interest in this space will tend to become angel investors and join angel-investment networks. But that’s hard work and it does mean that there’s a lot of capital out there that is looking for these kind of opportunities, but is not allocating capital to VC funds.

RYK VAN NIEKERK: Yet many international markets have opened up significantly, with institutions actually creating collective-investment schemes which invest in alternative investments – including venture capital and private equity.

LLEWELLYN CLAASEN: Absolutely. I think the original arguments [were] about it being sort of high risk and volatile, long-time-to-value and [with] J-curve characteristics, which sort of make it look as if it’s highly unprofitable initially. Then it sort of turns around, because the losers lose early on, and the winners realise that only much later on in the fund’s life cycle. But within a balanced portfolio we think it has a super-important role to play.

The South African Venture Capital Association had its 2021 conference on Monday [November 15]. A key theme that came out of those conversations was: ‘Why are asset managers not allocating money to the VC asset class?’ We had somebody from Siemens Pension Fund who joined from Germany and spoke about how they approach adding the VC asset class and private equity into their portfolio, and how they manage these sort of perceived downsides [so as] to benefit from the upsides as well.

The overall principle is just, I think, that they put something like 1.5% of the capital under management – or assets under management – into venture capital. They split it up across a whole lot of different fund managers and they do also sort of do new allocations to those that are performing best.

There are some really, really smart people who know how to integrate this asset class even into vehicles like pension funds.

There is an interesting report that came out, I think, authored by the central bank in the UK in 2019. Fair enough, it was sort of pre-Covid, but what it suggested is that by adding VC as an asset class to pension funds you had the opportunity to increase fund returns by between 7% and 12%. That gives you an idea of yes, of course there are risks, and yes, of course it’s a little bit harder to work with the asset class, but we genuinely believe it is worth the effort.

RYK VAN NIEKERK: And not only probably from an investment perspective, but also the economic contribution it offers the country.

Just lastly, you are also involved with a very interesting venture with the logistics group Imperial. You manage a specific venture capital fund on their behalf. Tell us about this fund.

LLEWELLYN CLAASEN: Four years ago we started having conversations with what was at the time the group CFO, Mohammed Akoojee. The idea was like they were in a fairly traditional, mature business. They knew that the spaces they were operating in were being disrupted and will be disrupted in the near future. The conversation sort of centred around how you engage with startups, how you counter some of the work that the startups are doing. This is not an Imperial-specific thing, but any sufficiently large and mature business tends to optimise for efficiency rather than for innovation.

That’s a good thing, but when you do that, what you do is make it harder for the organisation to innovate. There’s really good work that has been done in this space that suggests that the best approach is to take a medium- to long-term view and separate it from the parent organisation and create something called a ‘corporate venture capital fund’.

The idea behind the fund was that we spend the first three to six months just figuring out Imperial’s medium-term strategy and how we could invest into areas with the potential to create long-term competitive advantage and capabilities likely to be important to Imperial at that point in time, but which, perhaps even more importantly, would give intelligence [around] how these markets and service areas would evolve over time and which business models were likely to win out and, in general, areas that were going to be disrupted.

Imperial made a first commitment to $20 million, and we’ve almost finished deploying most of that money now.

We have invested in nine startups. I think we’ve got about another two that are on the verge of closing, and one or two others that are not too far away. It really is about, I think, creating a safe space for Imperial to innovate and to have somebody who has experienced working with startups, and to get the benefit of having a sort of corporate relationship without the disadvantages which typically come with a corporate trying to do it itself and investing directly into a startup.

RYK VAN NIEKERK: So it’s almost as if they are outsourcing their innovation and technology function or research?

LLEWELLYN CLAASEN: No, I wouldn’t say it’s quite as bad as that. I think our approach is that corporate VCs are really good at investing into disruptive innovation capabilities, so we’ve created a matrix that kind of looks at the level of disruptive potential and something called time-to-value. At what point in time is it disruptive? At what point in time is it capable of affecting revenue or creating new revenue? Things like that.

So we’ve said the opportunities that have high disruptive potential – as in Clayton Christensen’s theory of disruptive innovation, not sort of Oxford-dictionary disruption – those that have a five- to 10-year sort of timeframe, and high disruptive potential, are the opportunities that you should invest into using a corporate VC fund. Those that have got a near-term zero- to five-year revenue impact, and some disruptive potential, are more conducive to building those capabilities internally or licensing them, or to acquiring those capabilities.

So what we do is we work with Imperial to identify where opportunities fit into this matrix. They either incorporate them into their, I guess you could call it, incremental innovation programmes, or otherwise it get invested via the fund.

RYK VAN NIEKERK: How many other South African companies actually utilise such funds to go and find the next disruptive technology within their sector?

LLEWELLYN CLAASEN: There are a couple of corporates that have looked at their ESD [enterprise supplier development] programmes and have kind of started to look [at the possibilities] in that way. So I think it’s easy to look at the ESD programme as something that’s a tick-box exercise and maybe create some economic impact for small suppliers. But I have recently seen one or two businesses that are taking a slightly different approach and saying, well, why can’t we also have compelling, disruptive opportunities addressed through that.

Now I’m not sure it’s exactly the right vehicle to use it for, but it’s good for people to try new things, and we’ve seen that.

As to a true venture capital fund the way that we’ve created for Imperial, there are no other corporates in South Africa that have done it yet. We are talking to some of them that are thinking of doing it and some are further along than others.

It’s a difficult thing to sell internally in a corporate. It’s a large amount of capital that you have to commit over long periods of time. There’s got to be a lot of trust in the people that you’re going to be working with in that period as the fund manager.

It’s very tempting for corporates to try to do it themselves and sort of say: ‘We’ll give it an annual budget allocation and see how it goes.’

That’s also one of the reasons why these programmes usually fail and corporates try to do it themselves. They typically get under-funded, under-resourced and don’t have people with the right kinds of skill and experience and economic incentives to make the programme work.

It’s early in South Africa, but there are many conversations happening. I think there are good conversations to be had and everybody needs to go through their own cycle of getting to a point where they realise what works and what doesn’t work.

RYK VAN NIEKERK: This model is being used elsewhere in the world. In fact, it’s been used quite frequently elsewhere in the world, so we are slightly behind the curve on this one.

LLEWELLYN CLAASEN: Absolutely. There are really large organisations, particularly in Europe and in the US, which have very successful programmes.

RYK VAN NIEKERK: Llew, thank you so much for joining me today and for sharing your insights.

LLEWELLYN CLAASEN: You’re welcome. Thanks for your time.

RYK VAN NIEKERK: That was Llew Classen, one of the founders and the managing partner of Newtown Partners.