3i’s blurred vision

Russ Cummings, UK head of software and Internet investments at venture capitalist 3i, was recently asked at a conference if his company had any investments in security hardware. "Not that I'm aware of," he replied.

A moment later, he was forced to retract. Yes, he admitted, after being prompted by a member of the audience, 3i does in fact have a long-standing stake in the UK security hardware company nCipher – now listed on the London Stock Exchange.

Although Cummings laughed the incident off, it highlights just one of growing concerns that are beginning to emerge at Europe's largest technology VC company. 3i, which has in recent years earned a reputation even in North America as one of the world’s most switched on VCs, is struggling to control a sprawling portfolio of unco-ordinated technology investments. And its decentralised structure – with 36 offices across 16 countries – and its hands off approach to investments, is making effective investing extremely difficult.

All that, say those inside 3i who have begun a major internal review, has made 3i more vulnerable to the crash in technology company valuations. Over the past 18 months more than £1 billion (€1.6bn) has been wiped off the value of its portfolio, much of which relates to technology companies.

In a move that appears to recognise the urgent need for an overhaul at the company, outgoing chief executive Brian Larcombe has appointed executive director Rod Perry to the newly created role of global head of technology. His remit – to rein in renegade investors within the company and bring clarity to 3i's bulging portfolio. Perry's job, he says, is "to drive best practices". It forms part of a broader strategy to, in Larcombe's words, "adopt clearer responsibilities for parts of our business".

Three months into the job and Perry is spearheading his assault on the company's processes and organisation with a review of all the 800 plus technology companies that 3i has invested in. Over and above the regular reviews conducted by the company, this detailed audit will be used to determine which companies 3i will continue to back and will herald significant changes in the way the company makes and manages its investments. According to insiders, a significant minority of investments have been labelled as having no long term future.

Investors believe 3i certainly needs to do something. The value of its technology portfolio looks set to sink further, and Cummings expects further bankruptcies among its investees. Financial provisions for this are on the rise – £252 million (€413.2m) at the most recent set of interim results.

3i's exposure to the downturn has been exacerbated by the large number of early-stage technology investments in it portfolio. Its first such investment was in optical components group Bookham Technologies in November 1996. At the time the deal was considered unorthodox, particularly as 3i invested £1.8 million (€3.0m) – a large sum for a company with a patent but no proof that it could manufacture a commercially viable product.

It was precisely these types of investments that Brian Larcombe encouraged when he became CEO in 1997 – and on the basis of Bookham's highly successful flotation, with good reason. In 1999, £292 million (€478.7m) was invested in technology companies; this quadrupled to £1.1 billion (€1.8bn) in the year to March 2001. By this time, technology accounted for a whopping 40% of the portfolio, exceeding Larcombe's own target of 30%.

But by mid 2001, it had all started to go wrong. Valuations crashed, portfolio companies were seeking more money to keep going, and the weaknesses in 3i's model were being exposed.

Like its peers, 3i began to realise how many businesses it had invested in that would probably never return the investment. Among them were failed business-to-consumer dot-coms, such as online news providers (thestreet.co.uk, Moneygator and Ecountries) and business-to-business trading exchanges (moddo.com, efoodmanager, grouptrade.com, startruck.com). Even in core technology areas, such as middleware, wireless technology infrastructure and optical components, the company appears to be exposed, with a large number of competing companies that have little chance of differentiating themselves in the broader market.

That is the challenge that Rod Perry now has to sort out. "We have eight companies in the same sector – in different countries, but still in the same sector," admits Perry. For example, 3i's optical networking component investments include $9.5 million (€11.0m) in the UK's Kamelian, around $10 million (€11.6m) in Denmark's Ibsen Photonics and $30 million (€34.8m) in Singapore's Denselight, plus a number of smaller investments.

To try to cut down on such duplication, the management has now issued dictates ruling out certain sectors entirely, although 3i continues to invest heavily in technology as a whole. In the first half of its financial year (April to September 2001), for example, £301 million (€493.5m), or half of all funds invested, went into technology companies. But of this, most went into keep existing portfolio companies going.

It has taken some time for 3i to grasp the implications of all this. It was not until the end of October 2001 – long after the portfolio had been decimated – that the FTSE 100 company reacted by axing 185 jobs. And the global strategy review has only recently been carried out. Much of the current confusion and duplication in 3i's portfolio has been attributed to its unconventional internationalisation strategy. Before the tech bubble burst, many VCs talked of ‘going global', a strategy intended to benefit from scattered pockets of geographical expertise, such as mobile telephony in Northern Europe. Equally, they wanted to offer portfolio companies access to international networks of contacts.

Not many VCs acted on this. But 3i, spurred on by the rhetoric, rapidly expanded into every continent. Most controversially, it returned to the US markets in 1999, having retreated in 1991 only to miss the biggest bull market in history.

This strategy had never been tried before – at least not on such a scale. The most successful VCs to date have used local networks to make investments locally; this explains the concentration of VC firms around entrepreneurial pockets such as Silicon Valley. But the Internet years brought with them unprecedented optimism. An international presence, 3i believed, would bring added value to portfolio companies and would help it spot trends very early on.

It now admits the execution was flawed. "An awful lot of investment decisions are taken locally," admits Cummings, who also concedes that handling communication between 3i's 140 technology-dedicated investors worldwide has proved difficult. Although large investments go through a central investment committee that sits in London, many smaller deals have slipped through without validation.

3i's approach to technology investing does mean that it has picked up some strong companies. But executives find it almost impossible to keep track of this bulging portfolio. One of the reasons for this, suggest critics, is the 3i policy of not taking a seat on the board of its investees; a strategy that is in sharp contrast to best practice in Silicon Valley. Instead, says Cummings, investment executives keep an eye on portfolio companies through regular meetings.

How does this work? Each of the 140 tech-dedicated executives looks after three or four companies. Working on the assumption that each executive looks after the maximum four companies, that accounts for 560 investments. If this maths were to be followed strictly, that would leave 240 remaining companies without any active 3i management at all.

Perry admits this structure needs to reviewed. Ideally, he would like each technology investment executive to be familiar with each investment, "so we could avoid the situation that Russ found himself in when he had to be reminded of a 3i investment." But he says he'll be happy enough if executives in each of the four technology sectors – software and Internet, electronics, communications and healthcare – are "au courant" with the companies in their area. That works out at roughly 200 companies each.

But even this modest aim doesn’t begin to address the problem of transforming an international group into an integrated global network. Making this work is crucial for 3i. "If they can harvest it the right way, having a global presence is their biggest point of differentiation," says Michael Elias of Kennet Capital. "But it doesn't help just having offices everywhere." The restructuring at 3i, it seems, has some way to go.

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Ben Rossi

Ben was Vitesse Media's editorial director, leading content creation and editorial strategy across all Vitesse products, including its market-leading B2B and consumer magazines, websites, research and...

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