What ails venture capital in Malaysia and why consolidation is not the answer
By Dr Sivapalan Vivekarajah October 9, 2018
- The government backs most VC funds because the private sector doesn’t believe in them
- Many entrepreneurial ventures are unable to grow big because of a lack of funds
VENTURE capital (VC), the very word elicits brickbats from the entrepreneur community as they feel that venture capitalists (VCs) have mostly failed in their role of funding startups and helping them to become regional success stories. But ask any venture capitalist and inevitably they will say that there aren’t enough good companies to fund in Malaysia.
I stand on the side of entrepreneurs because I truly believe that there are many gems in Malaysia that aren’t able to shine because local VCs are too risk averse. Some examples of gems that were not funded by Malaysian VCs but by foreign ones are Grab, iMoney and Jirnexu (Ringgit Plus). However, this is not entirely their fault - it is a systemic problem that has made them so risk averse.
The VC industry is not doing well in Malaysia. There is barely a handful still offering funding (I can’t name 10 active funds) and of those that do, many will run out of funds soon. Also, the government backs most VC funds because the private sector doesn’t believe in them because of a lack of a track record of success.
With all of these factors, it looks grim for startups in Malaysia. There is a proliferation of tech-based entrepreneurs through the efforts of agencies like Cradle Fund, Malaysian Digital Economy Corporation (MDEC), MaGIC and even many government ministries. These initiatives have been hugely successful, but while we have created many entrepreneurial ventures the vast majority are unable to grow big because of a lack of funds.
This gap in the funding of entrepreneurial ventures has been around for two decades, but very little has been done so far. With the change in government perhaps this is an opportune time to analyse why VC has failed in Malaysia and find a proper solution to give Malaysian tech ventures a chance to grow into regional success stories.
So what really is the problem, why is VC not working in Malaysia and why don’t we have more regionally successful entrepreneurial ventures?
1. Structural problems
Malaysian VC over the last two decades has mostly been Government funded. This is not a bad thing because in any new industry, the corporate sector will normally not take big risks and to seed the industry, governments will play that initial role as funder. However, it made a huge mistake when the funding it provided to VC funds was structured as a loan and not an investment. Nowhere in the world is funding for VC done as a loan.
Because it was structured as a loan which had to be paid back with interest, immediately it made the fund managers risk averse. How can you take risks when you have to repay the loan to the Government?
Every VC fund in the world is structured as an investment not a loan. This structure allows for risk-taking by the fund’s managers. VC is all about high risk, high gains, although this can be tempered by having experienced fund managers who spend time nurturing their investments. The better the fund manager and the nurturing, the lower the risk of the investment going bad.
The point here is that with a loan structure, it practically forced VCs to look only for almost risk free investments, which led to the risk averse nature of many local VCs. And by looking for low risk investments, the VCs don’t really have much of a chance of making higher returns. That’s why many local VCs have low or negative returns. A risk averse VC is doomed to be a failed VC.
2. Lack of incentives
The second problem is that all the local VC fund managers are employees and not really fund managers. In a normal VC fund structure, the fund managers are rewarded with “carried interest”, usually a 20% share of the profits made by the fund, after returning the invested capital plus an agreed interest. For VCs, this is the real incentive to manage a fund.
This 20% carried interest can be huge if the managers are smart. Imagine if the fund makes a RM100 million profit, the managers make RM20 million. On top of that they are also paid monthly fees to manage the fund and this is usually about 2-3% of the fund size, for the duration of the fund. This covers the fund’s monthly expenses including a salary for the managers.
However, in Malaysia the government-backed fund managers are only salaried, so there really is no big incentive for them to invest well because they don’t have a share of the profits. As long as they invest reasonably well, and the fund doesn’t lose money, the will continue to earn their salaries and everyone is happy. Ok, this is a little simplistic, but in general without an incentive like the carried interest there is no motivation for them to take risks. So this is a big failing of the local government backed VCs.
3. Funds are too small
Over the years, the government has pumped around RM1 billion to RM2 billion into VC. But this has been spread out over 20 years, so at any one time the amount is much smaller. According to Malaysian Venture Capital Association (MVCA) statistics, total funds available for investment as at Dec 31, 2017 is RM3.3 billion, but only RM418 million was invested in 2017. One third of this, about RM133 million, was actually for private equity or other investments, not venture capital.
Hence in one year only RM285 million was invested in venture capital. In US Dollars it’s a pittance amounting to only around US$70 million. Grab alone has raised almost 60 times this amount. And there are many funds that invest this entire amount just by themselves, not an entire country’s total funds invested, but a single VC fund. That’s how small the total available VC funds in this country is.
With this size of available funds it will be impossible to build great companies in Malaysia.
4. Shortage of funds at Series A and above
Funding is typically classified into different stages, starting with Pre-Seed which is usually for prototyping, then Seed to commercialise the prototype, Series A for scaling up commercialisation and then Series B, C, D onwards for regionalising or globalising the business. The amount of funds needed at Series A is usually RM1 million to RM5 million, Series B would be RM5 million to perhaps even RM20 million and Series C and above in excess of RM20 million. If the company were in Silicon Valley the above would be in US Dollars.
In Malaysia, while it is hard to obtain VC funds, it is still possible at the Seed to Series A stage. Since VC Funds are small in size, they cannot invest too much, so raising RM20 million and above for a venture is an almost impossible task in Malaysia. Hence companies that need this size of funding will approach Singapore-based VCs. This is when we lose our companies. The minute a Singapore-based VC invests, they will pull the company to Singapore to set up the headquarters there. So we will lose our best companies almost every time. What a waste. After spending time, effort and money nurturing these companies we just lose them to Singapore.
Most VCs in Malaysia have total fund sizes less than RM50 million. They can only invest in Seed and perhaps a small portion in Series A. There are very few with fund sizes above RM50 million and even less with funds above RM100 million. In US Dollar terms these are mosquito funds. I’m sorry; I don’t mean to insult our VCs. They are not to blame because our pension funds and large corporates don’t invest in VC so how can they raise their fund sizes.
In mature markets, pension and endowment funds as well as the large corporates often allocate a portion of their capital to VC. Malaysia has some of the largest pension funds in Asia yet they don’t allocate any funds to VC. Without this support VC fund managers cannot raise money hence the small fund sizes, often with government support.
It is no surprise that entrepreneurs cannot raise funds in Malaysia.
5. No entrepreneurs running funds
In the US you will find many funds run by successful entrepreneurs. In Malaysia bankers and corporate finance professionals run VC funds. Admittedly, some of them have done well, but I think VC funding will be enhanced only if successful entrepreneurs are part of the management teams at these funds.
Bankers and corporate finance professionals are by nature or training risk averse. They also don’t have the experience of running a successful business and haven’t felt the pain that this can bring nor the ecstasy of success. Successful entrepreneurs will also better understand how to run a business and how to successfully execute plans to build a successful venture.
6. Archaic bank-like terms and conditions ruin investments
There are even VCs who use really archaic bank-like terms in their investment agreements. It came as a shock to me that a VC in Malaysia asked for personal guarantees from the promoters for investments made and even insisted on setting up a sinking fund for the business to deposit money monthly into the fund so that in the event of a failure they will have some recourse to the sinking fund to minimise their loss. This is not VC; this is a glorified bank.
The managers of the fund admit that when entrepreneurs discover these terms most will back out of the deal, so they spend months trying to secure the deal only for it to be turned down because of these terms.
Frankly no real entrepreneur should agree to such terms. The ones that agree are the desperate ones who will most likely fail anyway. I am truly surprised that in this day and age we have VCs that operate like this.
7. Geographic, stage or racial limitations of funds
Most government- or corporate-funded VCs have limitations set on how or what they can invest in. Most have geographic limitations because they can only invest in Malaysian majority-owned startups or can only invest in early stage deals or even worse, need to invest a majority of the funds in a particular racial group. These limitations severely limit the potential of the funds to invest in the best deals and this is one of the reasons for the poor return of these funds.
The Singapore-based funds have no such limitations except for the limits that the fund managers themselves set. Ordinarily these limits would only be sector based (for example some only invest in information technology or Internet based businesses) or stage based i.e. Seed stage or perhaps Series B onwards. Even if there are geographical limitations (e.g. only In Southeast Asia, or only in Indonesia) it would be out of choice but not dictated to the managers by their funders.
All of the above are reasons why VC has not succeeded in Malaysia. It’s been two decades since MSC Ventures, our first real VC fund, was set up but we have still not made much progress. Some VCs have been fairly successful, yes for sure and I know some of them, but on the whole we could have done much better in two decades but we haven’t.
And now there are moves to “consolidate” the industry but is this the answer to our VC woes? I can assure you it is not. In fact we need diversification not consolidation. We need more diversity in terms of funds that invest in different sectors, different stages, we need more entrepreneurs as managers, we need to remove limitations and we need to get pension funds and corporates to allocate funds to VC.
Entrepreneurs also need to have different options for funding as different VCs may view deals in different ways. That’s why sometimes many VCs will reject a deal but another VC may spot an opportunity and that may be a hugely successful company. Grab for instance was rejected by all the VCs they pitched to in Malaysia but were funded by a Singapore VC and today are the most valuable startup ever founded in Malaysia.
Instead of consolidation there are better and more important things we can do to revive and create a thriving VC industry in Malaysia. In a following article I will share 10 things we can do to revive and strengthen VC in Malaysia.
Dr. Sivapalan Vivekarajah has a PhD in Venture Capital studies from the University of Edinburgh, Scotland. He is also President of the Malaysian Business Angel Network (MBAN) and Co-Founder of Proficeo Consultants, the leading Entrepreneur Coaching organisation in Malaysia. The opinions expressed are his own and do not represent that of MBAN.
Tomorrow: 10 ways to revive and strengthen the VC industry in Malaysia
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