THIS
POST WAS ORIGINALLY PUBLISHED MAY 9, 2007
Investing in Russian IT Sector – Is it Worth Your While?
Venture Financing in Russia
From historical point of view venture investments in Russia surfaced at the beginning of the 90-ies; however it was not the requirement of market development – rather an administrative-political decision behind which there was a purpose to give to transformed Russian economy the mechanism promoting the prompt development of both stand alone companies, and of the economy as a whole. At that time EBRD established 11 regional venture funds. Approximately at this period several funds were introduced with the participation of IFC and of U.S. capital. A number of experts and institutions (The Russian IT and Communication Ministry, iKS Consulting, Troika Dialog, etc.) produced sufficient research data on venture financing, particularly in IT sector.
A healthy influence of venture financing is supported by the statistics data:
- For the last 7 years the share of the Russian sources of capital in financing of domestic venture projects has increased up to 26%, while in 1998 it made only 3%.
- Average profitability of Russian venture projects for the period of existence of the market (1994-2005) is not less than 11% per annum.
- At the end of 2005 the volume of the capital under management of all operating funds in Russian market of direct and venture investment had reached $ 4.8 billion.
Salient points of the Russian direct and venture investment market:
- New big funds are emerging
- The government implements active policy of development of infrastructure and is keenly interested in IPOs.
- In 2005 there were $ 247 billion invested in Russian companies.
- There are about 50 venture and direct investments funds; most of them are established with
participation of foreign investors.
As of 2006 only 10 funds were directed towards technology companies. The majority of investors, both Russian and foreign, continued to favor the companies that are at the latest stages of development and are not involved in technology. However, this was true for the IT-sector too. Until recently the prioritized companies were the mature and the ones with a good market history. Investors were cautious, but now their interests are shifting towards the early stage companies.
Russian IT Sector Investment Points
Russian IT sector is growing phenomenally – starting from 2000 with the annual growth rate of 25-30%, overstepping all other industries. After the collapse of the Soviet Union this sector was the one that suffered the most drastic losses. However, the emergence of a new business reality, and almost total lack of infrastructure led to changing of the picture and to extensive development of IT industry. Quite naturally, initial steps were associated with import of variety of hardware and this led to the current market structure where the hardware segment is prevailing with 58%. The other market specific is that most of the companies exercise all-round approach to business as opposed to individual new products.
General Drivers for IT Development
- Long-term underinvestment in the country’s IT infrastructure is now being gradually changing. Installed hardware increases the demand for IT applications that can be used on it. Current projections call for increase of the share of software and services to 52.4% of the market.
- Challenges in the modern economy dictate the need for advanced IT products.
- Due to the booming economy the companies have ample cash to spend on IT projects, especially those in resource, banking and finance, telecommunications sectors.
- Russia is emerging as the key partner in outsourcing software development.
- The growing complexity of modern IT systems means that they can no longer be supplied, maintained and run by in-house teams.
- The government and major corporations are currently the principal buyers of IT goods and services. However, this situation changes with emergence of small and medium enterprises (SMEs) and small office/home office (SOHO) with their growing demand for IT products and services. Increasing Internet penetration adds more to it.
We at FINAM INVESTMENT COMPANY have accumulated substantial experience in dealings with IT and telecommunications companies. In fact the company invested in a number of existing and established players of the market as well as in new ones. Analyzing the market trends, we have distinguished the following priority areas for investments:
- Development of software, its applications and services
- Outsourcing of IT services
- Services and software targeted towards SMEs, SOHO and individuals
Specific Investment Focus
- Online advertising. Advertising segment is one of the most promising in terms of growth tempo and revenues. Available data shows that in 2006 media advertising sales in Russia topped $ 100 million – a 1.6 increase as compared with 2005. At the same time sales of contextual advertising reached $ 110 million – this is historic maximum – for the first time contextual advertising overshadows media one. Online advertising in Russia has massive growth potential stemming from the fact that it currently constitutes only 1-2% of the total advertising market, compared with 5% in EU countries and 8-10% in the USA. Development of such segments as e-commerce and “pay gaming” will boost the online market as well.
- Russia is experiencing explosive growth of Internet users: since 2000 to 2005 Internet penetration increased from 2.1% to 15.5%; projections show that the number of users will double over the next decade. One of the key driving factors is the government program to provide Internet access to each school in the country – this would make penetration of 50% by 2012. (The Russian IT and Communication Ministry will provide broadband Internet access for 95% of the Russian schools). Penetration growth leads to the increase of Internet usage. Both SMEs and SOHOs, plus individuals require more and more services. As an example by the end of 2006 there were 718,236 domain names registered in Russia – annual growth of over 60%. When we look at the popular “Goods & Services” part of Russian Internet it is easy to note its expansion – 30-40% per annum (over 50,000 projects in 2006). As the result of this the demand for services for optimization of Web-sites and provision of contextual advertising is immense. The market of media (banner) advertising is growing at the rate of 60-70% per annum.- This overflow of information needs its own instrument to deal with. Here the role of the search engines is becoming more and more prominent. It is interesting to note that the market of search engines optimization (SEO) shows tremendous growth rates – 200-300% per annum. Development of Internet mass media adds more to momentum – all these news feeds and publications need to be found, managed, and syndicated by content.
- 2005-2006 were the years of emerging broadband Internet access. And this in turn gave spark to increase of e-commerce, online gaming, and interactive services. More and more personal services are in demand. Online dating services were the biggest earners among Russian web-sites in 2006 with $34 million in profits in 2006. The figure is expected to double in 2007.
Within the scope of specific drivers, FINAM thinks that the most promising directions for IT investments should be the following ones:- Companies that exploit the opportunities within online advertising segment, specifically contextual advertising.
- Companies that provide comprehensive services to users: support e-commerce, provide interactive services (specifically, on-line dating), help create and maintain Web-sites, develop and implement search engines; utilize creative potential of Internet users.
Western InvestmentsWestern financial capital for quite a time understands the challenges of Russian IT-sector. This is well supported by the statistics of transactions for financing of sector’s companies. Analyzing investment information that is open to the public, it is easy to understand that substantial part of these investments was in mature and in already established companies that have a market history. This may be explained by the effectiveness of profitability/risk ratio, and by availability of companies from this group that did not yet receive investments. According to a number of experts, investors are really interested in acquisition of Russian technology businesses, but at the same time are cautious, valuating the market and waiting for the moment when the companies would be mature enough.
Presently potential investors receive positive sign when the company’s turnover is in the $5-$10 million range; thus acquisition of equity coincides with the rapid capitalization growth. The most characteristic example is acquisition by Martinson Trigon, a Nordic venture capitalist company, of minority (25-20%) stake in the REKSOFT company in 2005 for $2 million. Looking at existing situation in the market the big funds with foreign capital cannot be yet considered as the major investment source in start-ups. Thus the major part of investments in start-ups goes to domestic investors.
There are some prerequisites for the interest to start-ups from the major industry players – direct investment funds and from the funds with foreign capital. As it was previously stated these funds look for mature mid caps with average turnover of several million USD. However, the number of such candidates – the ones that have been selected from the market and adhere to all criteria – is limited; and “maturity” period for them is about 3-4 years. Thus the funds’ interests are slowly shifting towards early stages companies.
From historical point of view venture investments in Russia surfaced at the beginning of the 90-ies; however it was not the requirement of market development – rather an administrative-political decision behind which there was a purpose to give to transformed Russian economy the mechanism promoting the prompt development of both stand alone companies, and of the economy as a whole. At that time EBRD established 11 regional venture funds. Approximately at this period several funds were introduced with the participation of IFC and of U.S. capital. A number of experts and institutions (The Russian IT and Communication Ministry, iKS Consulting, Troika Dialog, etc.) produced sufficient research data on venture financing, particularly in IT sector.
A healthy influence of venture financing is supported by the statistics data:
- For the last 7 years the share of the Russian sources of capital in financing of domestic venture projects has increased up to 26%, while in 1998 it made only 3%.
- Average profitability of Russian venture projects for the period of existence of the market (1994-2005) is not less than 11% per annum.
- At the end of 2005 the volume of the capital under management of all operating funds in Russian market of direct and venture investment had reached $ 4.8 billion.
Salient points of the Russian direct and venture investment market:
- New big funds are emerging
- The government implements active policy of development of infrastructure and is keenly interested in IPOs.
- In 2005 there were $ 247 billion invested in Russian companies.
- There are about 50 venture and direct investments funds; most of them are established with
participation of foreign investors.
As of 2006 only 10 funds were directed towards technology companies. The majority of investors, both Russian and foreign, continued to favor the companies that are at the latest stages of development and are not involved in technology. However, this was true for the IT-sector too. Until recently the prioritized companies were the mature and the ones with a good market history. Investors were cautious, but now their interests are shifting towards the early stage companies.
Russian IT Sector Investment Points
Russian IT sector is growing phenomenally – starting from 2000 with the annual growth rate of 25-30%, overstepping all other industries. After the collapse of the Soviet Union this sector was the one that suffered the most drastic losses. However, the emergence of a new business reality, and almost total lack of infrastructure led to changing of the picture and to extensive development of IT industry. Quite naturally, initial steps were associated with import of variety of hardware and this led to the current market structure where the hardware segment is prevailing with 58%. The other market specific is that most of the companies exercise all-round approach to business as opposed to individual new products.
General Drivers for IT Development
- Long-term underinvestment in the country’s IT infrastructure is now being gradually changing. Installed hardware increases the demand for IT applications that can be used on it. Current projections call for increase of the share of software and services to 52.4% of the market.
- Challenges in the modern economy dictate the need for advanced IT products.
- Due to the booming economy the companies have ample cash to spend on IT projects, especially those in resource, banking and finance, telecommunications sectors.
- Russia is emerging as the key partner in outsourcing software development.
- The growing complexity of modern IT systems means that they can no longer be supplied, maintained and run by in-house teams.
- The government and major corporations are currently the principal buyers of IT goods and services. However, this situation changes with emergence of small and medium enterprises (SMEs) and small office/home office (SOHO) with their growing demand for IT products and services. Increasing Internet penetration adds more to it.
We at FINAM INVESTMENT COMPANY have accumulated substantial experience in dealings with IT and telecommunications companies. In fact the company invested in a number of existing and established players of the market as well as in new ones. Analyzing the market trends, we have distinguished the following priority areas for investments:
- Development of software, its applications and services
- Outsourcing of IT services
- Services and software targeted towards SMEs, SOHO and individuals
Specific Investment Focus
- Online advertising. Advertising segment is one of the most promising in terms of growth tempo and revenues. Available data shows that in 2006 media advertising sales in Russia topped $ 100 million – a 1.6 increase as compared with 2005. At the same time sales of contextual advertising reached $ 110 million – this is historic maximum – for the first time contextual advertising overshadows media one. Online advertising in Russia has massive growth potential stemming from the fact that it currently constitutes only 1-2% of the total advertising market, compared with 5% in EU countries and 8-10% in the USA. Development of such segments as e-commerce and “pay gaming” will boost the online market as well.
- Russia is experiencing explosive growth of Internet users: since 2000 to 2005 Internet penetration increased from 2.1% to 15.5%; projections show that the number of users will double over the next decade. One of the key driving factors is the government program to provide Internet access to each school in the country – this would make penetration of 50% by 2012. (The Russian IT and Communication Ministry will provide broadband Internet access for 95% of the Russian schools). Penetration growth leads to the increase of Internet usage. Both SMEs and SOHOs, plus individuals require more and more services. As an example by the end of 2006 there were 718,236 domain names registered in Russia – annual growth of over 60%. When we look at the popular “Goods & Services” part of Russian Internet it is easy to note its expansion – 30-40% per annum (over 50,000 projects in 2006). As the result of this the demand for services for optimization of Web-sites and provision of contextual advertising is immense. The market of media (banner) advertising is growing at the rate of 60-70% per annum.- This overflow of information needs its own instrument to deal with. Here the role of the search engines is becoming more and more prominent. It is interesting to note that the market of search engines optimization (SEO) shows tremendous growth rates – 200-300% per annum. Development of Internet mass media adds more to momentum – all these news feeds and publications need to be found, managed, and syndicated by content.
- 2005-2006 were the years of emerging broadband Internet access. And this in turn gave spark to increase of e-commerce, online gaming, and interactive services. More and more personal services are in demand. Online dating services were the biggest earners among Russian web-sites in 2006 with $34 million in profits in 2006. The figure is expected to double in 2007.
Within the scope of specific drivers, FINAM thinks that the most promising directions for IT investments should be the following ones:- Companies that exploit the opportunities within online advertising segment, specifically contextual advertising.
- Companies that provide comprehensive services to users: support e-commerce, provide interactive services (specifically, on-line dating), help create and maintain Web-sites, develop and implement search engines; utilize creative potential of Internet users.
Western InvestmentsWestern financial capital for quite a time understands the challenges of Russian IT-sector. This is well supported by the statistics of transactions for financing of sector’s companies. Analyzing investment information that is open to the public, it is easy to understand that substantial part of these investments was in mature and in already established companies that have a market history. This may be explained by the effectiveness of profitability/risk ratio, and by availability of companies from this group that did not yet receive investments. According to a number of experts, investors are really interested in acquisition of Russian technology businesses, but at the same time are cautious, valuating the market and waiting for the moment when the companies would be mature enough.
Presently potential investors receive positive sign when the company’s turnover is in the $5-$10 million range; thus acquisition of equity coincides with the rapid capitalization growth. The most characteristic example is acquisition by Martinson Trigon, a Nordic venture capitalist company, of minority (25-20%) stake in the REKSOFT company in 2005 for $2 million. Looking at existing situation in the market the big funds with foreign capital cannot be yet considered as the major investment source in start-ups. Thus the major part of investments in start-ups goes to domestic investors.
There are some prerequisites for the interest to start-ups from the major industry players – direct investment funds and from the funds with foreign capital. As it was previously stated these funds look for mature mid caps with average turnover of several million USD. However, the number of such candidates – the ones that have been selected from the market and adhere to all criteria – is limited; and “maturity” period for them is about 3-4 years. Thus the funds’ interests are slowly shifting towards early stages companies.
A good exapmle is that OpenView Venture Partners of Boston and ABRT Venture Fund of Moscow have announced their new "Partnership for Russia"
investment program. The goal of the joint effort is to identify and
invest in the best software and IT companies in Russia and East-Central
Europe "Partnership for Russia" will jointly focus on fast-growing
software companies and other IT start-ups that are looking to expand
their sales and marketing operations in the US and Europe. The combined
capital available for investments between both firms exceeds $100
million.
Thus, summarizing, we may make a conclusion - IT Sector – is a really viable alternative to investing in telecommunications. This is supported by experts’ projections - the Russian IT sector is set to grow much faster in the nearest years than the telecommunications sector (20-25% a year versus 15-17% for telecoms).
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