Octopus Extends Its Reach

A decade ago, three 20-something university graduates raised £2.25 million to finance a new investment firm— Octopus Investments Ltd. Today, that firm has its arms securely wrapped around early stage British venture capital.

London-based Octopus Investments manages 17 venture capital trusts (VCTs) valued at nearly £300 million. Over the past 10 years, the firm has raised £1.75 billion and ploughed around £800 million into U.K. businesses and has become the country’s most active private investor.

So far this year, Octopus has done the most U.K. deals in the range of £250,000 to £5 million (excluding seed deals), according to Private Equity Insight, a market research firm. Octopus has struck 16 new deals and 10 follow-on deals, collectively worth £37.8 million. At one point, it did 10 deals in 10 weeks, more than many rivals do in a year, says firm co-founder and Chief Executive Simon Rogerson.

In more ways than one, Octopus has invested from cradle to grave. It has put money into everything from a disposable baby bottle company to an eco-friendly graveyard, and has backed successes alongside failures.

The recession has brought mixed blessings. It has proven good for deal flow, as banks have curbed lending, and a “real opportunity” for firms such as Promotion Space to grow market share, says Chris Allner, managing director of Octopus Ventures, a division of Octopus Investments, which has invested £7.3 million to help Promotion Space fund acquisitions.

The recession has also led to a lack of exit opportunities, and Allner concedes he has let some companies go to the wall. “August 2007 was the top of the market for the retail and leisure sectors and, in 2008, we decided to let some companies fall over, because we knew they wouldn’t survive the recession,” Allner says. Octopus lost £6 million on restaurant chain Grill Group and £3 million on female clothing brand Golddigger.

Looking ahead, weak economic growth and tax increases could “upset” venture capitalists and worsen the environment for business startups, says Alan Wallace, a senior investment director for Octopus’ early stage team. Britain’s outgoing Labour government hiked the top rate of income tax from 40% to 50% in April, while the new coalition government of Conservatives and Liberal Democrats increased capital gains tax for anyone earning enough to pay more than the basic rate of income tax from 18% to 28% in June, and will raise value-added tax (VAT) from 17.5% to 20% in January.

“If consumer confidence goes, investor confidence goes,” says Wallace. “The recession has been good from an investment perspective, but we need improved market conditions to sell businesses.”

The U.K. government seems committed to helping. Octopus is managing £32 million of the £75 million Capital for Enterprise fund, which is two-thirds funded by the government and a third by Britain’s big four banks (Barclays, HSBC, Lloyds and RBS). Capital for Enterprise provides equity and quasi equity of £250,000 to £2 million for companies with a turnover of up to €50 million. The government is also poised to launch a £200 million Growth Capital fund to provide £2 million to £10 million to small and medium enterprises (SMEs) with growth potential.

“We’re seeing a return to old-fashioned banking, with low leverage and asset security,” says Allner. “There’s a need for large-scale [VC] operators at this end of the market. We’re keen to be at the forefront of that. More support will lead to better returns and more money being made available.”

Octopus’ early stage team, borne out of its acquisition of Katalyst in 2007, invests an average £2 million in companies valued at up to £10 million, with the goal of exiting after three to seven years. While Katalyst selected four to five deals out of 1,500 proposals a year, Octopus typically invests in 15 to 20 companies after considering 3,000 investments, reviewing 900 business plans and meeting with management for 200 of the companies.

Octopus’ growth capital arm, headed by Allner, typically invests £2 million to £5 million in companies valued at up to £30 million. It strikes an average of 12 deals a year from 600 proposals.

Both the early and growth stage teams can talk of success. The early stage team cites Lovefilm International, an online DVD rental business, and ITM Power (AIM: ITM), a sustainable energy firm, as two of its biggest triumphs. Lovefilm was valued at £2 to £3 million when Octopus led a £1.25 million funding round in July 2003. Today, the business is worth a reported £200 million, and last year the company was reportedly mulling an IPO and was in talks with private equity firms KKR and Silver Lake Partners.

ITM, meanwhile, listed on the London Stock Exchange’s AIM at 50 pence a share in 2004, two years after Octopus invested at a price of 7 pence (equal to 5.6 pence when accounting for 20% EIS tax relief), according to Octopus. By the end of the three-year holding period to qualify for tax-free gains, the shares were worth 90 pence, or 16 times the original vestment, Octopus reports.

Since 2000 (and the start of Katalyst), Octopus’ early stage team has achieved a realised internal rate of return of 39.1% annually, according to the firm. The unrealized equivalent is 12.5 percent. Around 20% of its portfolio companies have failed, against a European industry average of 50%, with 10% of capital lost, the firm notes. “Good money doesn’t follow bad,” says Wallace.

Among Allner’s success stories is distressed debt broker TDX. Octopus sold most of its stake in 2008, making a total return of 9.7x for investors in the Octopus Eclipse VCT. Setting up that fund, which launched at £30 million in December 2004, is a highlight for Allner, who joined Octopus earlier that year to establish the private equity team. “We had no money, no team and no deal flow,” he says.

Much has changed in the past decade. “Back then, we were naïve, wet behind the ears,” says Rogerson, who co-founded the company alongside Managing Director Guy Myles and Chief Financial Officer Chris Hulatt. “If you want the sob story, we aimed to raise £2.75 million to capitalise the company and it took us nine months to raise £2.25 million from 82 investors—friends and family, former colleagues and 60 or so people we networked our way to. It was a good thing. Many people who work for private equity houses have never run a business. We have.”

A quarter of equity remains in the hands of those who invested in 2000. The remainder is owned by Octopus’s 165 employees, with the founders holding 50 percent.

The trio met fresh out of university when they joined the global equities team at Mercury Asset Management. (Through merger and acquisition, Mercury became Merrill Lynch Investment Management, then BlackRock.) Rogerson and Hulatt ran research for pharmaceutical and retail stocks, while Myles invested in North American equities. None had had any VC experience, but they shared a clear vision.

“The level of engagement between fund managers and underlying customers was terrible and remains so,” says Rogerson. “Like banks and insurance companies, they are nasty companies to interact with. They don’t understand their customers well, and we saw an opportunity to change that.

“There was a lot of financial engineering, a lot of leverage,” says Rogerson. “Big private equity firms were interested in the kudos of running bigger and bigger funds. We’ve never been interested in that. We want to build the next generation of successful companies by not just providing money, but expertise. We want to open up VC to the man and woman on the street.”

Arguably, Octopus—named to set it apart from traditional financial services firms and because the word has 100% recall—has achieved both of those things. It boasts a panel of 110 venture partners (VPs)—captains of industry and serial entrepreneurs—who validate opportunities, as well as 30,000 retail investors. Altogether, these investors have entrusted a net £860 million to Octopus last year and continue to invest £50 million to £100 million per month.

The Octopus model is unique, says Rogerson. “Investor networks like Pi Capital and Hotbed put propositions to their members and ask them to invest, but we have our own funds, and ask VPs to invest alongside us. That’s a very different proposition.”

Some 10% to 20% of funding for early stage firms comes from venture partners. The growth team can call on their expertise, too. “For many of them, it’s a very private affair,” says Wallace. “Around 25% are entrepreneurs who’ve built businesses and sold them, and the balance is [made up of] experienced, sophisticated businesspeople—leaders of industry from a diverse range of sectors. We have the wisdom of the crowd.”

One Octopus venture partner who isn’t shy of the limelight is William Reeve, the London-based serial entrepreneur and business angel. He has been involved in a plethora of businesses backed by Octopus: he helped found Lovefilm and is a non-executive director of Zoopla, Britain’s second largest property portal behind Rightmove.co.uk, and Graze.com, which sells healthy snack boxes by post and is “growing like a weed,” according to Reeve.

Reeve is also chairman of True Knowledge, which aims to improve how people use the Internet to find answers to questions, such as, “What is the address of the Golden Curry restaurant in Cambridge, U.K.?” Octopus has invested several million in True Knowledge, including £2.6 million since 2008.

Wallace says True Knowledge is just this type of company that will be the next big thing. “When a computer answers questions, that will be the Holy Grail,” he says. “We look for businesses that are disruptive—so different that they can change consumer behaviour. The problem with Google and Bing is that they come back with millions of listings.”

He expects “structured data” that allows people to find goods, services and information quickly to become a growing trend, as exemplified by Google’s $700 million acquisition of VC-backed airline data firm ITA Software and its July purchase of VC-backed Metaweb Technologies for an undisclosed amount. Octopus is currently looking at four companies in the Internet search space.

As for Octopus’ next decade, international expansion is on the cards. It has designs on becoming the biggest player in Europe in the sub-£5 million VC market. “We’ve shown that the opportunity is far broader than the U.K.,” says Rogerson. “We want to roll our model out across Europe. After Europe, who knows?”