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Tax reforms for investors in Australian private equity funds

Recent tax reforms could net an extra $A1bn for Australia's growing private equity industry. AVCAL explains why it believes the new regime will benefit overseas investors and takes a whistlestop tour around the current Australian market.

Even the most ideal venture capital opportunity doesn't look so good when tax laws and regulations place barriers in the way of investment. That's been a big issue for Australia in the past few years, just as it has been in many other countries.

Now, fortunately, the Australian government has announced some of the broadest - and most welcomed - reforms ever made in Australian private equity. The changes are especially important for investors outside Australia, who will now benefit from broader tax exemptions when they invest in private equity and venture capital funds in Australia.

We believe that these reforms will help attract an additional $A1 billion in foreign investment into our funds. Our surveys have told us that international investors such as funds of funds are ready and willing to invest in Australia if favourable tax rules are in place.

The new rules give these investors a good reason to have another look at Australian opportunities, which include major buy-outs as well as highly successful technology and biotech start-ups. The rules have also won praise from Venture Economics, which says that they will be enormously beneficial to the Australian venture capital market.

The government announced its changes on October 15. It said it would extend the existing capital gains tax exemption on venture capital investments by providing venture capital limited partnerships with flow through taxation treatment. The changes will apply from July 2002.

These reforms are especially important because they encourage investment in Australia by overseas funds of funds.

Under current Australian tax law, funds of funds and entities such as university endowments are not granted the tax exemption accorded to overseas pension funds when they invest in Australian venture capital funds. The reforms will extend this tax exemption to non-resident endowment funds, funds of funds and taxable non-residents holding less than ten per cent of a venture capital limited partnership.

This change is certain to encourage more investors to direct some of their funds to Australia. A study by Econtech, an econometric modelling group in Australia, estimates that the additional foreign venture capital will vary from a low of $A700 million to a high of $A1.1 billion. In turn, this will impact growth. Econtech estimates that the reforms will add $A350 million to Australia's GDP.

Jesse Reyes, the vice president of Venture Economics, expects that international funds of funds and tax-exempt organisations, many of which had previously been reluctant to invest in Australian private equity because of the unfriendly regulatory regime, will look positively on the changes that bring Australia into line with the US, the UK and other developed countries.

The reforms come at a very positive time for the Australian venture capital industry, which set a record in 2000 by raising more than $A1.2 billion during the year, according to the AVCAL 2000 Yearbook prepared by AVCAL and Venture Economics.

The industry saw 42 new venture capital funds formed during the year, a record increase and twice the number of funds created in 1999. The new funds included international investors such as JP Morgan, ABN AMRO and Ericsson Deutsche Technology Fund.

International interest in Australia's venture sector continues to grow. Asian investors now account for more than 18 per cent of the committed capital at Australian venture capital funds. The percentage of capital from Australian sources in Australian funds fell from 96 per cent in 1999 to 76 per cent in 2000.

Just as importantly, Australian venture funds demonstrated strong returns for the year. Australian funds that were formed between 1986 and 1999 achieved an 18.3 per cent internal rate of return (IRR) as of 31 December 1999. Returns at some funds were much higher, with the top quartile achieving IRR results between 19.7 per cent and 71.5 per cent.

Most importantly of all, we continue to see fresh investments in Australian innovation. Here are some examples:

• Cap-XX, a developer of supercapacitor technology, raised $A34 million in September from ABN AMRO, Walden International, Acer Technology Ventures, Innovation Capital, Intel Capital and Technology Venture Partners.
  
  
• Redfern Polymer Optics raised $A8 million in seed funding from Redfern Photonics and others to commercialise its polymer planar and fibre components and polymer optical fibres.
  
  
• Alchemia raised $A12.4 million from Start-up Australia, Medica Holdings, AMWIN, Biotech Capital and Rothschild Bioscience Australia to develop carbohydrate compounds for drug discovery, and to expand its office in Silicon Valley.
  
  
• Cards Etc raised $A16 million from Citigroup, First Data Corporation and Monetti for its software to personalise smart cards.
  
  
• Bullant raised $A40 million from JP Morgan Equity Partners and First Data Corporation for the development of software to speed the performance of Internet servers.
  

There's no doubt that several hot sectors - especially biotech and information technology - continue to inspire entrepreneurs and attract capital. However, there are other opportunities as well. We are seeing a lot of activity in management buy-outs where good businesses can be expanded with an infusion of capital. We also see some management buy-ins, a variation on this trend.

Overall, the outlook for Australian venture capital remains strong as a result of the industry's cautious approach to investments in private companies in recent years. Put simply, most funds weren't swayed by the euphoria on the public markets during the boom period of the late 1990s. They kept a level head about their investments, which means that our funds are now in a relatively strong position.

Now that we have an agreement on taxation reform to further attract international capital, we believe the Australian private equity sector will show sustained growth. With lots of world class IP, and great success stories, the future is bright.
 
Andrew Green is the CEO of the Australian Venture Capital Association Limited.