Cover Story: Adventures in venture capital

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on January 15, 2018 - January 21, 2018.

I believe the US stock market is resilient enough to offset any negative effects of a rising interest rate environment. > Deepak

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India-born Deepak Natarajan has enjoyed an illustrious career in some of the world’s top technology and venture capital (VC) firms. A 20-year veteran of Silicon Valley, he has carved out a successful career in product marketing, business development and exploring frontier markets. 

He then parlayed all that experience into a venture capital career, first with a brief stint at California-based Redwood Ventures, followed by an eight-year run as investment director for Intel Capital in Southeast Asia. Much of what he picked up throughout his career has influenced his personal investment habits over the years. 

“My own investment behaviour has changed over the years. When I was younger, the focus was to invest for growth and capital appreciation. Now, however, I have a balance between those two as well as capital preservation,” says Deepak, who is currently adjunct professor at INSEAD Business School and lectures on entrepreneurship and family enterprises.

As he got older, Deepak realised that his habit of investing in individual stocks was no longer going to work for him, even if the stocks he held were some of the biggest names in the tech industry such as Oracle, Autodesk, Sun Microsystems, Hewlett-Packard and Intel. Having learnt the hard way that investing in individual stocks required a lot of attention and daily tracking, he made a dramatic shift a few years ago. 

“Frankly, I could not see the outsized returns [from individual stocks and mutual funds]. It became clear to me that most of the actively managed mutual funds could not outperform the market. So why bother to do all that work [managing a stock portfolio] when the institutional players themselves cannot beat the market?” 

So, Deepak made the bold move of adopting an exchange-traded fund (ETF) investment strategy. Simply put, he has not held any individual stocks since 2013, having placed all of his equity allocation in several ETFs. 

After optimising his holdings to gradually reflect his current risk profile and desire for income, Deepak now maintains a strict and disciplined approach to managing his ETF portfolio. “I don’t have money in 20 different ETFs or anything like that. I just have six ETFs in my entire portfolio, but each is relatively diversified,” he says.

“For my allocation, I have 50% in US stocks, 15% in emerging markets, 15% in developed international markets outside of the US, 10% in real estate investment trusts (REITs) and 10% in US bonds. I have strictly maintained this allocation since 2013.” 

Deepak currently has holdings in the SDPR S&P 500 ETF Trust, SDPR S&P MidCap 400 ETF Trust, the MSCI EAFE ETF (which comprises large and mid-cap developed market equities, excluding Canada and the US), the MSCI Emerging Markets ETF, the Vanguard REIT ETF (which tracks the performance of various REITs in the US), and the iShares core US Aggregate Bond ETF. “I chose them because they are all very liquid,” he explains.

Deepak expects US stocks to do well this year. He believes that the recently passed Tax Cuts and Jobs Act of 2017 will be a boon for multinational corporations based in the US. “The savings and tax breaks that the multinationals retain will be reflected in their earnings per share. I believe this will drive US stock prices up even further.”

He says another key investment objective of his is to outperform the S&P 500, albeit while taking less risk than the index itself. “If I can beat the market index while taking less risk than the market, then I would consider that a good achievement as it is the risk-adjusted returns that one is ultimately looking for.” 

Deepak foresees other major economic regions — Japan, South Korea, China and the European Union — doing relatively well compared with last year. “In fact, I think 2018 will see the markets continuing to outperform despite an interest rate adjustment. I believe the US stock market is resilient enough to offset any negative effects of a rising interest rate environment,” he says. 

According to Deepak, his portfolio gave him a return of 19.4% last year, compared with the S&P 500’s 21.7%. “The only thing that is going to give you alpha is if your allocation heavily favours the markets that are doing well. The reason I underperformed the index is because I also hold securities outside the S&P 500.”

He is candid about the fact that he has not yet achieved his investment objective of beating the S&P 500 while taking less risk than the index. “I would rather be upfront about the performance of my portfolio than be somebody at a cocktail party talking about that one brilliant stock pick that made a lot of money — because what you will never hear is that their last nine stock pics lost them money. They had to kiss nine frogs before finally landing a prince, as it were.” 

Peaks and valleys 

Deepak made his first major foray into VC at the height of the dotcom bubble at the turn of the millennium. The year was 1999 and he had taken some time off work, effectively closing the chapter on his career in product marketing and business development. 

By sheer coincidence, he bumped into some ex-colleagues from his Sun Microsystems days. “They were keen for me to join them as a venture partner and identify some promising software companies. They told me that they would be happy to invest in a software company with me on the management team.” 

A venture partner is a person brought into a VC firm to help it make and manage certain investments. The venture partner is not a full and permanent member of the firm. Permanent members of a VC firm are typically referred to as general or managing partners. 

“The VC firm they founded was Redwood Ventures. One founder was a chip specialist while another was a guy who made hundreds of millions of dollars starting three networking companies. He managed to sell these companies for billions,” says Deepak. 

Within six months of joining as a venture partner, Deepak managed to sell one of the firm’s investee companies to a larger software company called Epiphany. “That sale made a lot of money for Redwood Ventures,” he says. 

Soon after, the firm decided to start a new fund called Redwood Ventures Fund Four. This time, however, Deepak was brought in as a full-fledged managing partner. “We raised US$130 million, with US$25 million coming from one major institutional investor. The remainder was acquired from about 45 high-net-worth individuals, who pledged between US$1 million and US$5 million or so,” he says. 

In 2000, the Nasdaq began its fateful slide. By the end of the dotcom bust in 2002, the index had lost a whopping 78% of its value, declining from 5,046.86 points to 1,114.11. 

“We closed the fund in September 2000. In the next 17 months, we drew down half the fund and invested the money in 15 companies. As investments go, we made them really quickly,” says Deepak. 

“We put that much money to work quickly because every time the Nasdaq fell, there was this perception — not just among ourselves, but the whole Silicon Valley — that this was just a temporary setback and the index would rebound. Well, it turned out that it would take a long time before the Nasdaq could regain its value. 

“In March 2002, we went back to our investors and asked them to put up their third tranche of investment dollars. But nearly 70% of our individual investors told us they no longer had any money to give the fund.”

According to Deepak, two of these investors had boasted a net worth of US$20 million each in September 2000. “They had committed US$2 million to us at the time. Mind you, their net worth was tied up in their company’s stock.” 

The Nasdaq crash wiped out nearly all of their net worth. “Between September 2000 and March 2002, their net worth dwindled to just US$800,000. They simply did not have any money left to commit,” says Deepak. 

He and his co-founders were in damage control mode at this point. Instead of commencing legal action to force the individual investors to pay up what they promised, they worked out a compromise. “We calculated all the investors’ stakes in the fund’s holdings, based on the amount of money they had contributed to date. If the fund somehow managed to generate a return by the end of its life cycle, we would give back these defaulting investors just that amount of money, sans the returns. Whatever the fund made in returns would be channelled in full to those investors who stuck with us and fulfilled their pledges.” 

In the end, Deepak left the company in 2002 as the fund size had shrunk dramatically. “You don’t need four people managing such a small fund. Of course, it was a very chastising experience. But honestly, it was one of the best learning experiences I could have asked for,” he says. 

Following this, Deepak spent a few years in executive positions at a number of tech start-ups. However, he would soon get another crack at being a venture capitalist. 

“Intel Capital — the venture capital arm of Intel Corp — wanted to set up an office in Singapore in 2008. I had heard about this from a contact in the company and that it was looking for someone like me to head the new office.”

Deepak, who had more than 20 years of market development and marketing experience at this point, made the move to Singapore. “My job was to make strategic investments in companies that would contribute to Intel’s wider business goals. For mature markets, that entailed us looking out for a lot of product innovation,” he says.

“In an emerging region such as Southeast Asia, however, where innovation is not yet a prominent feature of the economic landscape, I was investing in infrastructure that would enable the penetration of new technologies into these markets. In Malaysia, for example, we invested in Packet One Networks before the company was sold to Telekom Malaysia Bhd. 

“Intel Capital invested in a group-buying deal platform in Malaysia called DealMates. We also invested in a company called Select-TV, which manufactured television set-top boxes using our Intel processors, and a private luxury flash sales company called Reebonz, which operated out of Singapore.” 

But Intel as a company was beginning to reorganise its investment priorities. When Deepak joined Intel Capital in 2008, investments undertaken were subject to two considerations. “If we brought in an investment deal that was highly strategic to Intel Capital, for instance, and one of Intel’s business units saw great revenue potential for the product, or if it was a technology that could greatly enhance one of Intel’s many products, Intel would be willing to let us invest in the company at a lower internal rate of return (IRR),” he says.

“And then there were investment deals that were moderately strategic to Intel’s goals, and typically it would be an e-commerce deal. Only this time, the onus was on us to generate a much better IRR because this deal did not have as much strategic value to Intel. Of course, low strategic deals were dismissed.” 

In 2013, however, when new Intel CEO Brian Krzanich came on board, Intel Capital shifted its investment focus to strategic investments only. “Sure, we could invest in Facebook, but that had little to no strategic value to our shareholders, who could just as easily invest in Facebook themselves,” says Deepak.

One company that Intel Capital did invest in was a Chinese drone maker called Yuneec. One of the world’s largest manufacturers of its kind, it depends on Intel’s range of heavy-duty processors to fly, steer and navigate dynamic environments. Intel Capital pumped US$60 million into the company in 2015. 

Given the sheer volume of drones that Yuneec was manufacturing for the consumer market, the investment was a highly strategic move as it could give Intel a foothold in the burgeoning consumer drone market. 

Deepak adds, “It was my years of business development and marketing experience that stood me in good stead in terms of my VC career — I knew how to sell a company, who to talk to, the kind of value proposition to be pitched and how to negotiate and close the investment.”

Opportunities in Asean

Having made strategic investments in Southeast Asia with Intel Capital, Deepak has a good perspective on the region’s investment opportunities for the year ahead. “Southeast Asia, as well as Australia and New Zealand, is a very interesting part of the world. The region is basically a microcosm of the entire world,” he says. 

“Now we know that demand arises from product innovation. So, consider then, where does one find high levels of product innovation in Southeast Asia? It is in economies where the R&D spend as a percentage of gross domestic product is relatively high.” 

According to the Organisation of Economic Cooperation and Development’s (OECD) data, Singapore’s R&D spend as a percentage of GDP in 2014 stood at 2.18% — below the OECD average of 2.37% that year. The OECD average climbed slightly to 2.38% in 2015. 

The 2015 data also showed that South Korea ranked second in the world at 4.23%, just behind Israel at 4.25%. While OECD data is not available for Southeast Asian nations, data provided by Unesco puts Malaysia’s 2015 R&D spend at just 1.29% of GDP. Simply put, the number broadly reflects the level of innovation taking place in Asean. 

“Emerging markets tend to spend less than half of the OECD average on R&D. So, I don’t see Southeast Asia as a destination for major investments in deep technology sectors,” says Deepak.

“That is not to say there isn’t money to be made, of course. It is just that the money will continue to be made in relatively low to mid-tech sectors.” 

According to him, some of the most innovative sectors — those still ripe for investment dollars — are in online PC and console gaming, related gaming hardware and, to a lesser extent, e-commerce. “If you look at Singapore-based Razer, it has been growing well over the last few years, fuelled by the gaming community. Quite honestly, I think Razer is one of the most innovative companies in the region right now,” says Deepak. 

A gaming hardware and peripherals manufacturer, Razer has become a household name within the gaming community. Its listing on the Hong Kong stock exchange last November was one of the most eagerly anticipated last year. As at Jan 10, the stock was trading at HK$3.94 per share.

Founded by Singaporean Tan Min-Liang, Razer is currently operating out of the US. The company counts some of the most prominent Asian families as early investors. They include Berjaya Group’s Tan Sri Vincent Tan and son Robin Tan, Indonesian billionaire brothers Robert Budi Hartono and Michael Bambang Hartono, and Lee Hsien Yang, the youngest son of Singapore’s first prime minister, the late Lee Kuan Yew. 

Deepak also cites e-commerce as a sector to watch, although he concedes that the window of opportunity may not be open for much longer. “Yes, we are at the point where local heroes will be made in the relatively straightforward e-commerce application space. Given that e-commerce and internet penetration rates are still low, mobile-based apps that play to these Southeast Asian growth areas are where the money will be made. 

“However, you have to bear in mind that Amazon recently opened a Singapore office. I shudder to think what may happen to some of the regional players as a result.”

Referring to Singapore-based Carousell, a popular mobile-first listing service for second-hand goods and services in the region, Deepak expressed doubts about the prospects of the start-up’s recent major funding round. According to news reports, Carousell closed a major Series C investment round that Deepak says amounted to US$75 million. 

“I don’t understand how Carousell managed to raise US$75 million. If this was a strategic acquisition by, say, Alibaba Group Holding Ltd, it would make a lot of sense because Alibaba is a legitimate competitor to Amazon. It has deep pockets and diversified revenue streams,” he says.

“However, if it turns out that a group of private investors ponied up that kind of money for Carousell with a view of generating returns on investment, they may be feeling very nervous right now.”

Having accumulated a wealth of experience working in Silicon Valley and beyond, and then applying all that know-how when he moved into venture capital, Deepak is not very optimistic about an emerging venture capital trend. Although common in mature markets like the US and Europe, it is now becoming the norm in this part of the world for scions of high-net-worth families to set up venture capital funds with their family’s wealth. 

These young VCs tend to make investments in early-stage companies with the view of reaping high returns later. “But without the experience of founding a company and handing out pay cheques to employees, how will they know what makes a company worth investing in?” asks Deepak. 

Instead, the children of these high-net-worth families could follow another emerging trend in the US, where they serve under the tutelage of experienced venture capitalists for a number of years before coming out on their own.

“Suppose ABC Capital is looking to raise a US$500 million fund. The founder could approach a billionaire for a financial commitment to the fund. The billionaire may decide to pledge US$50 million — 10% of the fund — on the condition that the founder takes his son on as a principal and allows him to go through the entire lifecycle of the fund,” says Deepak.

“This way, he would know that his money is being managed by a seasoned professional. On top of that, his son would be able to learn from some of the most experienced financiers in the business.”