JO OLIVER, investment director at Octopus Ventures, which manages the UK’s largest generalist VCT, Octopus Titan, explains how they operate.
The issue of how best to finance early-stage and growing companies has been around for a long time and governments obviously aren’t very good at doing it. How successful do you think the VCT model has been?
I think it’s been really successful investing billions of pounds into companies that have created tens if not hundreds of thousands of jobs since inception. So, in terms of payback from the industry as a whole, I think it’s been very positive. That said, it is fair to say that the VCT industry has changed significantly over the last 30 years. Historically at least a proportion of the VCT industry has been focused on downside protection and lower-risk, lower-return asset-backed investments.
There have been some very significant rule changes, particularly in the last two years, which mean that the VCT industry as a whole is now much more targeted at areas that the government wants to address – filling the equity gap, driving innovation and helping to scale up British businesses. The industry is having to evolve and become much more focused on those objectives, though we expect Titan VCT to be largely unaffected as it has always invested in early-stage, fast-growth, innovative and disruptive UK companies.
Titan VCT has a portfolio of approximately 50 companies which in 2016 grew their aggregate revenues by £91m and created 700 new jobs. A great example of a VCT success story is Zoopla, which Titan VCT first invested into in 2009 when its valuation was just a few million pounds and it had only £100,000 of revenues. Zoopla floated three years ago and now has a market cap of £1.5bn. It employs hundreds of people and pays millions of pounds in taxes as it’s very profitable.
Another Titan VCT success story is SwiftKey, which develops predictive text on smartphones. Two young ex-Cambridge graduates came to us in 2009, when we made a very small investment to start off with, which we followed through with a series of subsequent investments. Without our investment, SwiftKey would probably have struggled to raise capital. The team grew the business to over 100 employees and it was bought by Microsoft for $250m in 2016 when the SwiftKey product was on over 200m smartphones around the world. It has really helped establish the UK as a continued leader in technology, particularly in artificial intelligence.
Octopus is the largest VCT still doing pure early-stage investing. Was that a conscious decision to go down that route?
Yes, it was. A company called Katalyst was set up in the early 2000s by a few individuals. One of them, Alex MacPherson, now heads the Octopus Ventures team here. Katalyst was effectively an angel investor network. In some respects, it pre-dated crowdfunding. The model that they had was for the Katalyst team to source deal flow, some of which was introduced by the investor group of about 100 individuals, agree the investment terms and then it would be offered out for investment to the rest of the investor group – the crowd, if you like. The group of investors was typically quite broad in terms of background and so as well as providing capital to invest and deal flow, it was also a validation and due diligence network.
Katalyst was bought by Octopus Investments in 2007, and became Octopus Ventures, raising the first Titan VCT fund in 2007–2008. At that stage, a lot of people in the industry said: “You’re not going to succeed.” They recognised that early-stage investing is tough, as you need sufficient weight of capital to diversify the risk of early-stage investments and provide follow-through on funding.
I think we were fortunate in the sense that we managed to achieve a few exits early on – including Evi to Amazon and graze.com – which proved the ability to generate positive returns and enabled us to continue fund raising to support the existing companies and make further new investments. Some of the first investments were sourced from the relationships that had been build up over the previous years by the Katalyst team, which in some ways gave Titan VCT a head start.
One of the things we’re very proud of is that we’ve got a number of serial entrepreneurs whom we have backed multiple times over. For example, Katalyst invested into a business called ScreenSelect, which consolidated with a number of other businesses to become LoveFilm, and LoveFilm was bought by Amazon a number of years ago. It was not an amazing investment for Katalyst investors, but it was still a huge success for us because the team that had set up ScreenSelect subsequently came back to what was now Octopus Ventures when they had set up their next businesses and said, “We enjoyed working with you. You see things through a similar lens. Can you invest into our new business?” These relationships have spawned numerous Titan VCT investments including Hoopla, graze.com and Secret Escapes, which are some of our most successful investments.
They come from the network, is what you’re saying, based on the contacts you’ve had previously?
Yes. Venture capital is about investing in people. If you have worked with them before, particularly if you worked with them successfully, then that’s a massive de-risker. The fund’s reputation really matters as we live on our deal flow. As we have had more and more success with exits, it has attracted better and better deal flow – which means that we should be making better and better investments, which results in getting enhanced returns and that positive feedback loop continues.
You describe yourself as primarily technology-based. Why is that? Is it because that’s where you think the potential for getting your best returns is going to come from? Or is it that you just love technology and you think that’s the place you want to be?
I think it’s a combination of factors. We’re generalists. There are certain areas that we won’t invest in – gaming, for example, as we don’t really understand it. Biotech also is too capital-intensive, the cycles are way too long. But generally we are open to investing into early-stage, huge-potential tech and tech-enabled businesses that meet the VCT investment criteria and are led by talented teams with ambitions to build global businesses. The way we look at it, you need to embrace technology to optimise a business model and generate a sustainable competitive advantage.
The pace of technological change means that you can now build a very valuable business multiple times faster – maybe multiple magnitudes faster – and cheaper than you could have done even ten years ago. In simple terms, it’s the ability to grow, differentiate, take away business from incumbents, go international and create significant value over a relatively short period of time on a relatively capital efficient model – those are the reasons why we focus on tech and tech-enabled businesses.
You’re based in the UK and most of your ideas are generated in the UK. How would you assess how the UK is doing in this field?
I think we’re doing well. Since 2010, of the 57 companies that have grown to a value of more than $1bn in Europe, 22 of them are British. On the funding side of things, I think the UK, led in part by the government, is in a much healthier place than it was even five years ago. Additionally, we’ve now got serial entrepreneurs who are reinvesting their money – and, more importantly, their time and experience – back into business, sharing all of the lessons, good and bad, that they’ve learnt. The UK is also incredibly strong in certain sectors, driven by a combination of factors, including a world-class academic resource and a very open multicultural and multinational society. It remains a global leader in artificial intelligence, fintech and, in many respects, e-commerce too.
One of the questions that is always asked is, “Is the UK ever going to produce a Google or an Apple? Are people selling out too early?” Well, in some respects they have had to, because there hasn’t been the capital or the confidence to enable businesses to continue to build beyond a certain size, albeit that we’ve seen some exits recently for tens of billions from the UK. I think that’s going to change over the course of the next few years, in part because it’s a confidence thing. Someone like Alex Chesterman, CEO and founder of Zoopla, is a good example. He had already had some success prior to Zoopla and so had the confidence, capability and ambition to build Zoopla into a £1.5 bn business.
Another good example is Stan Boland, who’s had two very successful exits. He has recently founded an autonomous driving business called FiveAI. We’re not investors in it, but his ambition is to build a leading global autonomous driving technology business. It’s not without its challenges, but it’s British, it’s British-based and its vision is to be a global dominator. That confidence has come out of his previous success, which should enable him to attract the capital and talent needed to maximise his chances of delivering this huge ambition.
What can you say about the kind of people who start businesses that you back, other than that they’re slightly crazy?
I admire everyone that has the bravery to set up a business. It takes courage, ambition, resilience, perseverance, and vision. It has moments of incredible success and joy, but also lots of tough periods when things aren’t going your way and everything rests on your shoulders. The best entrepreneurs are geniuses, which I don’t say flippantly.
If I was oversimplifying I would say that there are two types of brilliant entrepreneurs. There are those that just keep running through walls regardless and have that titanium head guard so that they can keep doing that. They’re a force of nature and if you’re in their way, you’re in their way. It doesn’t matter, you’re going to get run over. There are others who are more emotionally intelligent, generally more mature, and they’ll recognise that there is a smarter and more enduring way of getting there. They’ll bring talent in alongside them to make sure they complement their weaknesses and achieve their objectives as smartly and with as little clash or damage as they possibly can.
Uber’s ex-CEO Travis Kalanick is a good example of the former. He created something very special, but is now paying the consequences for some of the collateral damage that he caused along the way. The other type of entrepreneurs tend to build longer, more sustainable businesses or are able to stay in those businesses for longer periods of time. Of course, in reality, it takes all sorts, but typically the best ones share the characteristics that I mentioned earlier, have the ability to make good decisions most of the time (and learn from the bad ones) and the magnetic ability to attract the best talent to work with them.
Do you think that Dragons’ Den and The Apprentice and those kinds of television programme are helpful in encouraging entrepreneurs?
I think on balance they are helpful. They raise awareness of entrepreneurship. A lot of people identify with the idea that, ‘This is what real business is about. This is what drives job creation. This is what drives GDP growth’. It is something to be admired when people have the get-up-and-go and say, “I’m going to put myself all in here and try and build a business.” I think the credit crunch changed a lot of people’s mindsets about what was important. One of the reasons I left the City and was attracted to venture capital is because I stepped back and asked, “What am I actually doing here? I am an analyst and a cog in a big financial wheel. But out there, somewhere, something tangible is being created. Some good is being done. But I’m currently just being part of a cog that’s moving money around.”
The way that Dragons’ Den is set up and the way they behave there is obviously not reflective of how it works in the venture capital world. But I think the awareness and exposure is really positive. It’s something that we tap into when we go out and talk about Titan to potential individual investors. They want to hear about the companies. “If I put my 20 grand into Titan I can say, ‘I’m part owner of Zoopla.’ Or ‘That’s one of mine’, when Secret Escapes comes up on telly.” I think people really like being associated with success stories. It helps to attract capital into the VCT sector.
Where does the money you raise and invest come from? Is it from people who want to be involved in armchair investing, or is it from wealth managers recycling the funds of their clients in your direction?
We’ve got about 11,500 investors in Titan. They’re individuals. The median investment is about £15,000. So these are not just well-heeled high-net-worth individuals. This is a very generalist product, spread across literally thousands of investors, who typically remain invested in Titan for well over five years, which is the minimum holding period to retain all of the VCT tax reliefs. In terms of democratising and achieving what the government wants to do, filling the equity gap from a broad capital base, I think it’s fantastically successful.
So it’s not just people who are trying to cut their tax bills?
Well, I think there’s an element of that. How do you separate the tax advantages from the pure investment returns? It’s interesting that whenever we speak to an investor, they don’t talk about, “I am only investing 70p in the pound in this.” They want and expect a return on their gross investment. I think that people are also enthused about smaller company investing in a way that they perhaps they weren’t 30 years ago. The rise of the AIM market, which launched at a similar time to VCTs, has done a lot to attract people to that.
If you’ve invested in early-stage companies, you’re thinking of big capital gains. But in practice, with a VCT your return comes in the form of dividends rather than capital gains. Why has it worked out that way?
The VCT structure means that while the returns may nearly all be capital gains, they still get distributed as a tax-free dividend. That’s just the most tax-efficient way of doing it. Typically we try to keep the NAV at a stable 90–100p, but make sure we’re paying out excess returns, particularly if they’ve been realised, as tax-free dividends. Equally, on the downside, we’re not distributing more capital than we need to.
There is a secondary market where investors can sell their shares but it’s illiquid and not that attractive because of the discount that you get. So, Titan VCT operates a share buyback, as most VCTs do, in order to provide liquidity. In Titan, the policy is to target a 5% discount to the prevailing NAV. What’s interesting is that the redemption rate is very low. Investors are holding their investments on a medium- to long-term basis. The redemption rate is only 2–3% per annum.
What then do you think the government’s Patient Capital Review is all about? Is it a positive or negative? What’s driving it?
The raft of measures that the government introduced around 1995 – the AIM market, EIS, VCTs – we think have been phenomenally successful. The industry’s really active and off the back of the capital that has been raised, you see ecosystems flourish and thrive, with incubators and accelerators coming up everywhere. The Patient Capital Review noted that the UK is third in the OECD as a place to start a business. So the early-stage start-up scene is working really well.
Where there are still challenges is when companies outgrow those current interventions. How do those companies get access to capital to scale up further to become even bigger companies? What we see is that some of them have had to take their foot off the accelerator because they can’t get capital. Some of them will be sold to US companies with deep pockets – the Microsofts, the Googles, the Amazons. Some might just go to the deep pockets of US venture capital. That’s what we think the genesis of the Patient Capital Review is all about. How do we continue to support those companies as they scale up?
So you don’t think there is any risk to you from the Review?
There shouldn’t be any risk, based on what the government has been trying to achieve. If you look at the Titan portfolio, over the last three years over 2,300 new jobs have been created and the success of high-growth small businesses is increasingly recognised as being the engine of the economy. If you look through the Patient Capital Review to see what they define as good vehicles for deployment of patient capital, they basically describe a VCT in all but name.
Remember that one of the key attractions of VCTs – and this is very relevant in the context of the Patient Capital Review – is their evergreen, long-term nature. From an effectiveness and efficiency of capital perspective, that is very positive for the government because when you sell businesses, the cash can go back into the fund. You may distribute some of the profits, but you can also reinvest that cash into another investment. That way you get multiple uses out of every £1 that is invested. You get a compounding effect over time.
From the entrepreneur’s perspective, one of the key attractions is that we can say to them, “We’re going to be around for a long period of time. We can fund raise significantly every year if we want to. We can continue to support your journey all the way through.” With most venture capital funds, which are our typical competitors, they only have a limited life. Even if they raise a new fund, they may not be allowed to invest in an earlier portfolio company. So on all sides I think that VCTs are very powerful entities. It is a really good mechanism for deploying patient capital.
You have managed to raise proportionally bigger amounts of money every year. At what point does that become indigestion?
That is a good question. We debate that a lot, both internally and also with the Titan board, which is made up of a majority of independent directors. The strategy has been to make a relatively small investment to start off with. If the businesses are doing well then we will look to deploy more cash into them and build a bigger stake. If they’re doing less well then we’ll try to limit our exposure.
In a portfolio of 50 companies, we’ve got really good visibility on our follow-on pipeline. We know that we’ve got the ability to invest so many millions over the next one to two years. Titan has grown proportionally to meet the needs of the growing portfolio and their ambitions. We have achieved two large fund raises over the last two years and we are targeting another large fund raise in this tax year as well. We know that at least 70% of the fund raising is going into follow-on investments in portfolio companies.
We have always made in the region of eight to ten new investments each year. In the current environment, due to the quality and quantity of the deal flow that we receive, and our ability to build world-class companies, we can see an opportunity to double that new investment rate over the course of the next one to two years. The opportunity out there is extremely attractive at the moment.
Suppose I was an investment banker and said that you could generate higher returns for your investors by doing other things such as targeting a higher annualised return, possibly using gearing, what would you say to that?
We look at this as a long-term asset play. When you speak to our investors, they want visibility and a certain yield. We target a dividend of 5p on a NAV of 93p. So it’s slightly more than a 5% yield. For a higher tax-rate payer, that is nearly 8%. Then we pay our special dividends. When we get big exits, or we generate excessive profits, then we’ll look to distribute those as well. If you can keep doing that, we’ll have lots of very happy investors. That’s the equation that we’re always balancing the whole time and one of the things we look at very carefully when we’re raising large amounts of money.
Would you not expect returns from your kinds of business to be higher than a quoted smaller companies fund? But they’re not. Why is that?
Our underlying return, the rate of return in our portfolio, is in excess of 20% per annum, but there’s a trade-off here between short-, medium- and long-term returns. We raise a lot of cash. In a fund of £435m, we had cash of £175m at the end of April, around two-thirds portfolio, one-third cash roughly. The cash sitting there is not earning very much at all and that is depressing the overall return.
The way that I square it in my mind is that the portfolio is going to continue to generate returns into the future. If we didn’t raise any cash at all and we didn’t invest further into our portfolio, you’d remove the dilutive effect of the cash but you would probably run out the fund before too long. You would have higher returns in the short term, but then you’d have a cliff edge because the assets were all sold and you wouldn’t be able to reinvest them.
Instead, we are using the cash that is raised today to maximise the return of our best current investments in the future and to also make new investments so that we can continue to deliver our investors’ required returns over the medium to long term, remembering that the investments that we make today may not be sold for another seven to ten years.
We’re not a passive manager, we’re not even an active manager – instead we are a step beyond this and are properly hands-on with our portfolio. We’re helping entrepreneurs build big businesses. If we’re good at what we do, we get good performance. 68% in the last five years, with positive performance every year, is a pretty good return.
There are two common questions you hear about VCTs. One is why don’t you publish more regular valuations? And two, aren’t the fees too high?
We publish the NAV on a regular basis as required. But valuing early-stage, private companies is not an exact science and so it would be disingenuous and impractical to publish a NAV on a very regular basis – it’s not like quoted companies, which have a real-time price. We disclose the valuations for the top ten holdings, which is about 43% of the investment portfolio.
We stopped disclosing the latest valuations across the whole of the portfolio about two years ago. The reason was that we were finding it was proving counter-productive for the companies and for Titan investors. Normally, private company valuations are private and when you are looking to do a funding round, or when a business is being looked at to be acquired, they don’t have that pricing information. We had a number of examples where we found out that because we’d disclosed the latest valuations, the company was getting worse terms on the follow-on funding, or it was getting a much lower price as an acquisition.
So we took the pretty hard decision to go down the road of less disclosure. We thought it was much more important to help maximise returns for investors. We had this debate with a couple of the commentators. The board totally buy in to this. We made that trade-off because we feel that it’s in all of our shareholders’ interests for that information not to be in the public domain. As for the valuation process we go through, we’ve got an independent board, we’ve got the auditors that sign-off our valuations, there’s a lot of governance around our valuations which will hopefully provide most investors and commentators comfort that the valuations are appropriate.
And what about fees?
Our total expense ratio is about 2.5%. You’re looking at an asset class which is very active in terms of engagement – not just the deal sourcing, which itself is clearly much harder than deciding, ‘Today I want to go and buy Vodafone shares’, but also much more resource-intensive after you have made the investment. We’ve reinvested a lot of our fees in the team. So, we’ve gone from five investment professionals in 2010 to 15 investment professionals now and a total team of nearly 30. It’s one of the largest VC teams in Europe. We’ve set up a US office, which is solely to the benefit of our portfolio. We’ve got three full-time employees over there. We don’t make any investments in the US. It is all about helping our businesses expand into the US as best they can.
When you look at the cost of managing the portfolios, it’s very different from a passive investor. It slightly confuses me when people say, “VCTs are really expensive.” Compared to what? The VC industry is all funded by institutions, and institutions are smart and hate paying away fees. Yet typical management fees in the VC industry are similar to those of Titan VCT and can be as high as 4%. Even with admin and other expenses, we are at the lower end of that range.
The extra piece that people struggle to get their heads around is that we don’t benefit from economies of scale. If you think about Woodford’s income fund, which typically holds 70 companies, but in a £7–9bn fund. As VCTs we can only put £5m into each company each year and £20m into a company over its lifetime. If we want to scale the fund, we have to scale a number of portfolio companies. That means more board seats, more people. When you put all that in context, we think it is pretty reasonably priced.
In terms of risks, we haven’t had a recession for several years. How badly will the next one affect you and your investments?
Historically, the best returns from venture capital investing and smaller company investing generally come out of uncertain economic times. Titan VCT has some of its best returns from investments made in the last recession, including Zoopla, graze.com and SwiftKey. There are several reasons. Firstly, there is normally a scarcity of capital so prices go down – we make investments at lower valuations. Secondly, times of uncertainty create more opportunities for young businesses than for slower moving businesses. I don’t wish for a massive recession. Don’t get me wrong. It’ll be tough, but I think that through the cycle we’ll do really well out of it.
The worst thing that could happen for Titan VCT is if we run out of cash on an unplanned basis. We want to make sure that we’ve got sufficient cash to fund our forward investment requirements. In the credit crunch, you saw perfectly good businesses going under because they didn’t have access to capital. If you’ve got access to capital to plough through those periods of opportunity/uncertainty, you stand in good stead to come out all guns blazing. We manage Titan to make sure that we’re not going to run out of cash.
So they will not be too worried about Brexit then?
There is a significant challenge around talent retention – given the multinational nature of the UK and the teams of earlier-stage companies, in particular – but generally they’re going, “Game on, when the going gets tough, this is where we win.”
Of course, we still don’t know what Brexit means – so I think it will take time for it to fully play out. But over the last year or so that we’ve been aware of it, a combination of things has happened. Firstly, sterling has significantly depreciated, which has meant for our international businesses that their revenues have grown in sterling terms. They tend to be funded in the UK and have revenues internationally. So, from an asset to liability perspective, it’s been very favourable for them.
The second thing is that it’s made UK assets much cheaper. That makes inward capital investment more attractive, whether that’s the £24bn acquisition of ARM or VC investing more broadly. Capital inflows are good for our portfolio companies and the venture capital landscape more broadly.
As just mentioned, the largest concern that we have – and all of the rhetoric coming out of the government is positive so far, but until we know the outcome, we won’t know – is the attraction and retention of talent. A lot of early-stage tech and tech-enabled businesses are multinational in terms of their employee base. The most important ask that we have of the UK government is to make sure that the borders remain open for this talent and that the friction of attracting and retaining that talent is minimised as much as possible.
You’ve said you always wanted to get into this field. What appealed to you about this business? Is it because of your experience in public markets, or despite that?
I’ve always been fascinated by young businesses, those with ambition and the vision to try to do something different and do it better than anyone else. From a purely financial perspective, the appeal is obvious as there is undoubtedly potential to deliver very significant returns from investments that we make. No day is the same. I sit on the board of four companies at the moment. They all have their challenges and it’s never an easy ride but when the companies get through those bumps you realise the extraordinary potential the UK has to build truly world-class businesses.