Ecosystem of Venture Capital in Malaysia
The VC industry has shown to be very cyclical with its growth dependent on the economic and regional conditions. A lot of new businesses during the good times spur up and this provides VC companies opportunities to get good investee companies.
A factor that is quite important and affects the survival of the VC industry is the technological developments such as biotechnology, ICT and green technology. A large percentage of VCs in Malaysia have invested quite a lot in ICT related businesses. The ICT industry growth would be quite dependent upon the adaptation ability of these companies in terms of the fast changing demands of the demands and tastes of the customers. These technology companies therefore have to obtain advanced research capabilities as well as R&D facilities so as to develop new technology to ensure they remain competitive within the industry. Another very important factor that would also affect the VC industry growth is the existence of the well-developed capital market and this in itself assists Vcs to be able to exit the industry and make profit. This is also one of the problems for the VCs in Malaysia due to still developing Malaysia capital markets and the market being quite thin in comparison to the capital markets in more advanced countries.
Risk Aversion
The most prominent problems faced by VCs in Malaysia include risk aversion, limited funding,a cyclical industry and difficulty exiting the industry. Governments are the main funding source for VCs in Malaysia funding over 50% in the industry and this has contributed to the issue of limited funding. Most of the VCs tend to invest in businesses in later stages such as expansion/growth, mezzanine and pre-IPO. VCs funded by private individuals, corporations or banks in contrast tend to invest in earlier stage businesses such as start-ups or seed level. Since most of the VC funds tend to come from the government, most of the investee companies will be in their later stage. This indicates risk aversion of the VCs in Malaysia. Companies that are at later stages tend to have higher prospects with secured markets and therefore higher potential of going public. The probability of receiving high returns on their investment is quite high when these companies are selected. Another reason for the risk aversion of the Vcs is due to the fact that they must report to the investee company’s progress to investors on a regular basis. They therefore try to avoid reporting poor investment results to the investors.
The main point is that with a loan structure VCs are forced to only look for risk free investments and this has resulted in a risk nature being present. VCs therefore do not have much of a chance to make higher returns due to searching for low risk investments and that is why local VCs tend to have low returns. A risk averse VC is doomed to fail.
In the USA the VC industry has also had its fair share of struggles. Also the uncertainties created from the past of the Global Economy are quite harmful for the VC industry and investors may prefer to retain cash instead of making long term investments into new ventures. The VC managers also have a vital role to play in mentor-ship and giving strategic advice. VC is more than just money to start-ups it is not just capital. VC provides supportive capital in difficult years as well as in the economic cycle. The VC managers have to help with active support and hard work so as to solve the tough problems.
Lack of incentives
Another challenge in Malaysia is the local VC fund managers. In a conventional VC structure the fund managers are rewarded with carried interest that is normally 20% of the profit that is made by the fund after the invested capital has been returned plus the agreed interest. This is the real incentive to manage a fund for VCs. If the managers are smart the 20% carried interest can be huge. If the fund makes RM100 million profit the managers then make RM20 million and they are also paid monthly fees to manage the fund and thus makes up about 2–3% of the entire fund size for the fund duration. This then covers the monthly expenses of the fund including the salaries for the managers. In Malaysia however the government-backed managers receive salaries and there is no big incentive for them to invest well due to the fact that they do not have a share of the profits. The fund does not lose money as long as they invest reasonably well and they continue to receive their salaries.
North America is at the top of venture capital investments with deals amounting up to $54bn which is more than half of the 87bn in 2014. The European economic crisis affected the Vc industry and numerous deals declined by 18%. Deal value remained almost static at $9bn in 2014 and 25 VC funds that were created in London are yet to see an exit since 2010.
Funds are insufficient
The government has pumped an estimate of RM1 billion or RM2 billion into VC over the years. This has however been spread out over 20 years and in accordance with Malaysian Venture Capital association (MVCA) statistics the total available funds for investment as at 31 December 2017 was RM3.3 billion but in 2017 only RM18 million was invested. A third of this was allocated to private equity and other investments and not venture capital.
Funding is also typically classified into different stages from pre-seed funding to to the regionalization and globalization of the business. The funds needed at stage A is usually between RM1 million to RM5 million and stage B would be around RM20 million and stage C being in excess of RM20 million. In Malaysia it is quite difficult to obtain VC funds but it is possible at stage A and due to VC funds being small they do not have the capacity to invest too much so it may be quite impossible to raise RM20 million and above. The companies that need that size of funding then approach Singaporean based Vc funds and after Singapore based VC invests they then pull the companies to set up their headquarters there. Most of the Malaysian Cs have a total fund size of less than RM50million and only are able to invest at seed level and small portions in stage A funding. There are also quite a few fund sizes above RM50 million and even less than RM100 million. In more mature markets endowment and pension funds as well as large corporations usually allocate a portion of their capital to VC. Malaysia has one of the largest pension funds within Asia however still does not allocate funds to VCs. Without support the VC fund managers are unable to raise money hence the small fund sizes which also often have support from the government.
The VC industry in the USA has mostly been centered in North America however has been having encouraging signs in emerging markets recently. Five of the top 10 venture capital investments in the past year have been from India and China. The aggregate value of deals in both of the countries jumped three times over the past year. China also witnesses about 500 deals at a value of 13bn and India with 4000 deals at $5bn. India and China both contribute about a third of the population offering good opportunities for start-ups. Even though they did not go into a recession they are both passing a slow down phase. Start-ups typically take five to about 10 years to mature and the VC managers have to wait longer to exit from their investments as well as make a reasonable return.
A recent study in the United States demonstrates that a dollar invested in venture capital creates three times more patents than a dollar invested in research and development. This suggests an important benefit of venture capital is in encouraging the transformation of R&D into commercially useful patents. The consequence is diffusion of technology across the whole economy, increasing productivity and augmenting both the economic and social return on venture capital investment. Since 1982, the US has created 40 million new jobs net of restructured lost jobs. Seven US companies in the information technology sector, most of which did not exist in the mid 1980s and all financed by venture capital, have created 250,000 direct jobs and have a market capitalization greater than the whole of the Paris Stock Exchange. Below shows the capital invested between 2010 to 2018.
A study showed that the percentage of VC investment in early stages of venture development went down in the US from 42percent in 1995 to 23 percent in 1999, while it went up in Europe from11 percent in 1995 to 27 percent in 1999. These figures point to the longer maturity of the US venture capital market as against the higher demand for seed capital in Europe.It also expressed the importance of venture capital invested in terms of GDP. In 1999, VC represented 0.49 percent of GDP in the US versus 0.28 percent in Europe. Netherlands with 0.34 percent, Belgium with 0.27 percent, the UK with 0.21 percent and Sweden with 0.20percent had the highest percentage in Europe but all still lagged far behind the US level
The venture capital industry experienced a dramatic increase in funding levels starting in 1999 and culminating in mid 2000, mirroring the stock market bubble of the same period. The bursting of the bubble resulted in dramatic declines in investment levels, with more trouble
to come. This bubble is thought to have altered the investment patterns of the industry. Also, with the larger funds and the increase in the number of deals, the value-added dimension of venture investing became less pronounced in the USA, with many venture capitalists stretched thin across several portfolio companies. As companies rushed to second rounds of private equity financing, in part due to the increased availability of this capital, the value-added start-up business experience of angel investors became discounted. Research has indicated that business experience provided by angels is considered by the majority of entrepreneurs just as important as the capital provided by angels. Typically, an angel’s influence wanes as the company progresses to venture capital backed later rounds. In the normal sequence, the start-up experience of the angel is not deemed as critical as in the early stages of development. Unfortunately, these were not normal times. These young companies, still in the critical start-up phase of development and in acute need of angel advice, progressed quickly to later venture capital backed rounds, whether they were appropriate or not for their stage of development. Thus, the angels value-added was diminished through the rapid influx of new investors, at precisely the time that the entrepreneur and management team needed this valuable advice.
Structural Problems
The Malaysian VC industry over the past two decades have been funded by the government and in any new industry the corporate sector normally does not take large risks and to seed the industry the government tends to play the initial role as a funder. It made a mistake however by structuring the funding as a loan and not an investment. Due to the funding being structured as a loan to be paid with interest it made the managers immediately risk averse. Each VC fund in the world is structured not as a loan but an investment. This allows for risk taking by the fund managers. VC is characterized by high gains and high risk though this can be tempered by having experienced fund managers who then spend time nurturing their investments. The better the fund manager is, the lower the risk of the investment going bad is. With the loan structure VCs are forced to look for mainly risk free investments and this has led to a risk averse nature of a lot of local Vcs.By only looking for low risk investments the VCs do not quite have a good chance of making higher returns. Quite a lot of Vcs have negative or low returns.
In the USA, the inherent high failure rate in high growth ventures was overlooked by many novice and experienced investors. The mantra “invest what you can afford to lose” was often replaced by dreams of capital gain multiples never before witnessed. Even in good times, good companies fail. This, coupled with the proliferation of the designer companies, brought many promising ventures down with the falling tide. Angels are reasserting their fundamental role as the major source of seed capital for high growth entrepreneurial ventures. Patient investing is back in vogue, both by choice and by the dictates of the market. Recent studies showed that there are approximately 1000 venture capital funds, and this number will likely decrease slightly in the near future as funds mature and are not replaced on a one to one basis. These funds currently manage about $175 billion in investments. Venture capital funds invest between $30 and $35 billion annually in entrepreneurial ventures and bankroll less than 3,000 companies per year. In addition, many of these financing are for ventures already in their portfolios, rent and near term future of the private equity market.
Lastly, the inherent high failure rate in high growth ventures was overlooked by many novice and experienced investors. The mantra “invest what you can afford to lose” was often replaced by dreams of capital gain multiples never before witnessed. Even in good times, good companies fail. In general, the carnage has resulted in the needed culling of the forest. Angels are reasserting their fundamental role as the major source of seed capital for high growth entrepreneurial ventures. Patient investing is back in vogue, both by choice and by the dictates of the market.
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