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Filling the VC gap

aa12-oct-nov-2005-filling-the-vc-gapThe Australian superannuation industry is capital rich but reluctant to invest in emerging technology industries, such as biotechnology. Brad Howarth goes searching for solutions to fill the venture capital funding gap.

Sitting in a hotel room in San Francisco, it is difficult to forget that you are in a city that lives and breathes technology-based innovation, with new companies emerging and millions of dollars in investment being made daily. There always seems to be plenty of money around – unlike Australia, where debate rages over the allocation of superannuation funds and the question of whether government employee ‘nest-eggs’ should be used to bolster Australia’s early stage venture capital industry.

Right now that debate is focusing on Australia’s ever- fledgling biotechnology industry, and the media has leaped with feverish enthusiasm on the highly political suggestion that governments should be involved in the investment selection process. Where this idea came from is anyone’s guess, but it’s fair to say that no-one, not even governments, would welcome the prospect of bureaucrats managing anyone’s compulsory retirement savings.

The even more political suggestion that employee superannuation funds would be risked has also gained its fair share of airplay. The debate, however, is not that complex and has been tackled elsewhere in the world already.


As far as Australia’s entrepreneurial fast-growth companies are concerned, there is never enough money around. Banks are usually reluctant to touch anything other than established businesses, and once the generosity of friends and family has been exhausted, there are often few places left that an entrepreneur can go to raise the funds they need to build their business.

This lack of available private capital means many entrepreneurial companies resort to raising funds on the Australian Stock Exchange – a potentially costly exercise not often suited to early stage or pre-profit organisations. In most advanced nations, such as the US, this funding gap is largely filled by structured venture capital funds, as they take a company from the angel investment phase through various rounds of funding until it is either ready for a trade sale or listing, or is mature enough to stand on its own two feet.

In Australia, however, venture capital is a relatively new form of private equity. It has only existed in any meaningful way for roughly a decade. And, perhaps because the industry is young, returns from venture capital have not kept pace with other asset classes. The upshot is that the superannuation funds, a traditional source of capital for venture capital funds, have shown a general reluctance to do much more than dip their toe into the pool.

The cause and effect of this scenario is nothing new to people who work and construct policy in this space. How to channel more funds from superannuation into venture capital has been the focus of ongoing debate in Australia for several years. Numerous proposals have been discussed, leading to the Federal Minister for Industry, Tourism and Resources, Ian Macfarlane, announcing a review of the venture capital industry in May.

According to Macfarlane: “The review is to assess the impact of the Government’s support for venture capital, the contribution the industry makes to the national economy and to ensure we are keeping abreast of world’s best practice in Australia.” One organisation to put forward a submission is the influential Victorian think tank, the Committee for Melbourne. The Committee’s report, Expansion Capital for Innovation, formed the basis for recommendations to the Federal Government, and then the Victorian Government, calling for special incentives (below) for superannuation funds managers to direct further monies into structured early-stage venture capital. It is this report that has so effectively re-ignited the debate, particularly to the extent that it was politically reported in the Victorian media.


The Committee for Melbourne commissioned Boston Consulting Group to find out why our superannuation funds appear so reluctant to allocate funds to venture capital. Their answer was quite reasonable.

Venture capital has offered seven to eight percent returns over the last ten years. Other asset classes have offered 10 to 12 percent returns. This contrasts sharply with the more attractive returns from venture capital in the US.

The submission also describes the Australian superannuation funds and their advisors as “conservative”, and suggests that they do not see the prospect of returns improving until there is “greater depth of specialised commercialisation experience in Australia within both investee companies and locally-based venture capitalists”.

Further, the report highlighted how, in 2000, the California Public Employees Retirement Scheme (CalIPERS) redirected US$500 million from tobacco holdings into biotech funds, while the Oregon Public Employees Retirement Fund placed US$100 million of its US$44 billion funds under management into a fund to finance life science start-ups.

Again, this is nothing startling. But reports in Victorian newspaper The Age (published on 8, 9 and 10 September 2005) suggest that politicians and the media might have grabbed the wrong end of the stick, focussing on the issue of whether governments should be involved in the investment selection process.

But according to Chairman of the Committee for Melbourne, George Pappas, his group has never advocated that public superannuation funds be directed by government into the hands of the fast-growth companies. Indeed, their report contains no such claims. Rather, the Committee advocates the creation of incentives to entice more funds into the sector.

“What we’re saying is that superannuation funds – the people with the money, who seem to be reluctant for a whole variety of reasons to make investments in real venture capital up to a level that is common in other developed parts of the world – should be given incentives,” says Pappas.

“We’re not advocating that governments go out and pick winners or make direct investment decisions, or force people to invest in areas that they don’t want to invest in. We’re saying that governments are in the business of providing incentives that determine particular kinds of behaviour to facilitate industry development. We’d like to see some incentives directed at the superannuation industry so that it can overcome its reluctance and conservatism and invest in real venture capital.”

Pappas is also not advocating that the Victorian Government emulate the Queensland Investment Corporation, which manages the Queensland BioCapital Fund. The latter is a $100 million biotechnology-specific fund, established in 2002 from funds set aside to meet the Queensland Government’s superannuation liabilities, and aims to establish globally enduring biotechnology businesses. This group has invested less than a quarter of its funds in six companies.

“The important thing is to discuss the substantive issue, which is: do we as a nation and as a state want to support the development of the kinds of industries that will be important to us in five, ten or 15 years,” says Pappas.


Australia has the fourth largest pool of managed funds in the world, and the highest ratio of managed funds to gross domestic product in the world.

Accordingly, we are not capital short in Australia, but all signs do suggest that our institutions are reluctant to back our early-stage, emerging technology industries.

According to Nixon Apple, a director of the STA super fund and industry and investment policy advisor for the ACTU, super funds managers would put more money into venture capital if previous efforts had generated better returns.

“It is very, very hard for us to hit the mark with venture guys,” says Apple. “When we look at the books for the last round, it was the dot-com bust, and that has put VC on the back burner. Among fund managers, the risk return equation just isn’t there.”

Apple believes that much of the reluctance of super funds to invest in venture capital results from a dearth of experience among venture capital fund managers in Australia.

“Here we don’t have too many managers on the venture side who are much past their second fund,” says Apple. “If you look at the pipeline, there is a surplus of opportunities compared to the funds available. But there aren’t the managers for us to invest in.”

In terms of venture capital investment as a percentage of gross domestic product, Apple says that for the period from 1996 to 2002, Australia invested less than half of the amount invested in Europe and North America.

“The North American benchmark is one percent of GDP,” says Apple. “In Europe it was 0.07 percent and Australia was considerably less than that.”

Apple believes that Australian venture capitalists would need to pump $350 million into entrepreneurial ventures every month in order to keep up with development in Europe. The figure would be even higher if compared to North America.

Contained in the Committee for Melbourne’s submission is a proposal for a possible incentive model that provides grants equal to five percent per annum over five years of the value of investments into venture capital by super funds, pending certain conditions.

The Committee recommends the creation of five new VC funds to be backed by this model, and estimates that its creation could lead to the pooling of around $500 million in new venture funding from superannuation funds over the next two years to accelerate the development and maturation of technology businesses. The total cost of a five percent grant to support $125 million of funds would be $6.25 million annually.

That, on face value, offers a significant reward, especially considering that the cost to the government is relatively small – $31.25 million over five years.

Of course, the question of risk must still be asked. Can we afford to risk superannuation funds on early stage, traditionally high-risk ventures?

According to Pappas, his report doesn’t presume, “that all early stage ventures supported by superannuation or any other fund will succeed. But we are only talking about one percent or two percent of total funds under management. Over time, market forces should address the issue of adequacy of capital supply. Just as the cycle for resource companies turned upward recently after twenty years of miserable returns, it is highly likely that the cycle will improve for biotechs and other emerging technology companies.”


The executive director of the Australian Venture Capital Association Limited (AVCAL), Andrew Green, has also cautioned against government picking winners and making direct investments. However, he is in favour of government acting as a limited partner, possibly through the creation of a $50 million fund made available to those venture funds that have demonstrated that they are also able to gain institutional support.

Green says: “AVCAL’s view is the government needs to be very careful in picking winners, be very careful in allocating funds to people who do not have institutional grade support.”

Green says that, at present, investment is restricted by the VCLP regulations, which prevent investment in large transactions or in companies domiciled outside of Australia, or in the field of financial services.

“Probably the best thing is to provide us with a level playing field so that we can attract capital on the same basis as people in India and China and other parts of the world,” says Green. “The VC industry will only open up when government comes to the view that capital is a commodity, free from the encumbrances of government. Putting taxes on foreign capital is akin to having tariffs on imported products.”

Green also stresses that it is important to not underestimate how difficult it is to run a successful venture capital fund, particularly when assessing their performance. “It is always hard to get money into VCs funds, and kicking goals in the VC space is extraordinarily difficult,” says Green.

The founder and managing director of Titan BioVentures, Harry Karelis, was one of those interviewed for the Committee for Melbourne report. Karelis says his primary recommendation for channelling funds to venture capitalists is that money will flow to where the opportunities are.

“If investors believe that the sector is unattractive, due to low returns measured against other asset classes, then the only way to get money to flow is by increasing returns,” says Karelis.

“This can be achieved through better quality deal-flow, better execution of business plans, or through financial engineering that may or may not include tax benefits. What I mean by financial engineering is essentially the creation of ‘leverage’, so that $1 of investor money is backed with government funds. This model is already being used by the government-backed Pre-seed Funds and Innovation Investment Funds programs.

“Unless returns, and more importantly risk-adjusted returns, are in the zone where investors become interested, then money will not flow,” says Karelis.

He adds that money is just one component of the mix, albeit a vital one.

“We still need people, innovative and protected intellectual property and, most importantly, strong linkages with the northern hemisphere and companies that are prepared to take Australia seriously to the point that they will get their cheque-book out and invest/buy companies down under.”


However, the climate is not all doom and gloom.

There are signs that the superannuation funds are beginning to circle the venture capital bandwagon and, in some cases, they are taking steps to climb aboard, albeit slowly.

According to Ovidio Iglesias, Managing Partner of the fund-of-funds management division of the Australian arm of US group Wilshire, interest in private equity is growing in all forms, but specific interest in venture capital has been retarded by poor performance, leading fund managers to favour the better performing expansion capital and buyout funds.

“It’s a product of VC being at the smaller end of the industry, and it has yet to blossom,” says Iglesias. “Success breeds success. Buyout funds have done a great job, as have the expansion capital funds. All of those ventures have gone on to raise additional funds. What has happened with the VC funds is that very few, if any, have delivered. So, investors are dragging their heels, until the existing fund shows a bit more promise. Nothing will give them a greater shot in the arm than to see these guys kick some goals, and then investors will come.”

So, it seems that investors, from superannuation funds or elsewhere, will not be attracted to venture capital investments until returns improve. But will returns improve without support from these same investment groups?

In the meantime, this ‘chicken and egg’ debate rages on and I am sure that it will continue raging well after I have filed this story. But, as Pappas says, at least the issue is being debated.

“If we can have a decent debate, on the substance rather than the froth that has attracted the attention, then we would be happy and satisfied. If that leads to some change in behaviour and an acceleration of the funding of venture capital, then that would be even better.”