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What is venture capital?

The Australian venture capital industry may not be as developed as the US or Europe but interest and opportunities are growing. Industry Fund Services looks at why investors should consider the asset class and examines the best ways to participate in the industry.

Venture capital is an asset class, which involves investment, via equity-based instruments in companies that are predominantly unlisted. While the vast majority of companies considered for investment are not listed on the stock exchange, some investment can involve participating in private placements from public companies or investing by acquiring the former subsidiaries of public companies. In addition to equity, investors will often take debt-related positions. The main characteristics that are used to classify investments in venture capital are: stage, which refers to the stage of the company development cycle the investee company is at; size, the size of the investee company; industry, the industry the company operates in; geographic location of the company; and the vintage year, the year in which the investment was made. The various stages of company development include seed, start-up, early stage expansion, late stage expansion, turnaround/restructure, management buy-out, management buy-in, and institutional buy-out and privatisation.

Why invest in venture capital?

The principal reason for considering investment in venture capital is that it is expected to provide excess returns above more traditional asset classes, such as listed equities, commensurate with the risks taken.

Investors can, through venture capital investment, diversify their equity portfolios by investing in sectors and industries that are not represented in the listed market. This is particularly the case with new and emerging industries, as in the technology sectors, or industries that are dominated by offshore investors, eg food, or fragmented sectors of the economy, eg agriculture.

The market place for venture capital contains many inefficiencies, particularly in the availability of pricing information, and can allow astute managers to purchase equity at attractive prices vis à vis the listed market.

There is limited performance data available for the venture capital sector in Australia. In the United States there is a very high level of performance data, while in the UK and Europe there is a lower level of data than the US but more than in Australia.

One very significant reason for the lack of data in Australia is the relative immaturity of the sector. There are very few management teams in Australia that have completely exited all of the investments in a fund that they manage and there is a limited number of management teams that have managed more than one fund. This means that any performance statistics collected would contain only a few entries and may provide a misleading picture. The depth of performance data is expected to increase over the next five years as more management teams exit all of the investments in the funds they manage.

In light of the lack of Australian data, data from other countries may be considered as a guide. However, investors should be wary of suggestions that performance achieved in one country can be achieved in another. This is particularly relevant when considering the US experience, where both the venture capital market and the listed equity market are considerably more developed than any other country in the world. While it is not a proxy for the potential Australian experience, the US data should not be dismissed outright, because it does provide an indication of what is possible if there are, amongt other things:

• A pool of good investment opportunities in a market that is willing to look at new products and innovative solutions to problems
  
  
• Investee companies able to access good quality management
  
  
• Public equity markets with participants that can and are willing to take risks and can provide liquidity to the smaller end of the market
  
  
• Other companies, such as trade buyers, that are able to identify the merit of acquiring private companies.

The US venture capital market has a long history of returns. Returns are measured using the Internal Rate of Return (IRR). Within each year the range of returns is wide. The range between the upper quartile and the lower quartile of managers averages 24 per cent and the range between the median manager and the upper quartile averages 13 per cent. The wide dispersion of returns illustrates the value added by selecting the better managers for investment. Consistently investing in upper quartile managers will significantly enhance investment returns. AVCAL, in its recent survey of members, undertook to gather performance data for the first time. The sample size was small - 14 funds - and only reported returns for 79 individual investments that had been sold, not funds that had completely sold all of the investments. The results showed that the average IRR for the 79 investments exited was 27 per cent, with a median IRR of 21 per cent. The survey concluded that the high rates of return reflected the small sample size, and the early sale of the better performing assets. The survey included investments that recorded IRRs of over 100 per cent and investments that were complete write-offs. The results do, despite the limits, illustrate the level of returns that may be achieved by the sector and the wide distribution experienced - findings that are consistent with the overseas experience.

How do investors participate in VC?

There are three main methods by which investors can participate in the venture capital asset class; direct investment, pooled fund investment and investment in a fund of funds.

Direct investment involves directly investing in a private company. Pooled fund investment involves using the services of a specialist venture capital manager and investing in a fund (with other investors) that then invests in a number of private companies. A fund of funds is a specialist manager operating a fund that invests in a range of pooled funds, direct investments and co-investments. This is often a very cost-effective avenue for investors as it provides access to specialist resources and provides a diversified venture capital portfolio.

Investing in venture capital — the risks and special characteristics

Venture capital risk exceeds that of listed equities, particularly due to the illiquid nature of venture capital investment, the longer investment horizons and the lower levels of information available in the unlisted market. The table below provides the relative risk expectations across a number of different stages.

Venture Capital with a Balanced Portfolio

Investors in the asset class need to identify their asset allocation requirements for venture capital and develop a strategy to achieve them. A key factor in venture capital investment is the lumpy and unpredictable nature of the opportunities that arise.

The small allocation venture capital has in a balanced fund (normally in the two to five per cent range) means that when trustees consider the sector they should avoid being trapped into devoting a disproportionate amount of time to it.

Venture capital is an underdeveloped area of the Australian capital markets. While there is limited empirical evidence in Australia to support investment in this asset class there is strong theoretical justification. Investors should be able to capture a risk premium for investment in venture capital above that of listed equities.

Investors do need to be wary when investing in this asset class and consider the risks that are inherent in these investments.

Trustees should seek specific advice that considers the needs of their fund and what is the appropriate course for it to pursue.

If trustees do decide to invest in venture capital they should establish a target rate of return requirement that is consistent with the objective of exceeding the return on publicly listed equities. The target may be absolute or relative, for instance common targets adopted by investors in venture capital are an absolute 15 per cent per annum after fees or a relative five per cent pa above the listed market. In order to achieve the targets the allocation made to venture capital should be considered in a portfolio context and exposure should be spread across the different stages of investment.

The preferred method for many superannuation funds investing in venture capital is via pooled funds rather than direct investments. The process for investing in pooled funds is as follows. A pooled fund is established by a management team, and investors commit capital to the fund. The manager then draws down pooled fund commitments made by investors over a three to five-year time frame, as investments are made. The actual level of investment rises gradually as each draw down is made. During this three to five-year period, earlier investments may mature and give rise to distributions of cash as they are sold. Thus, the investor could be experiencing draw downs concurrent with distributions from the fund.

Once the commitments are fully drawn down, or the period of time for draw down elapses (mostly five years from the fund close), then the manager is fully focused on the management of the portfolio and the exit opportunities for the investments. Pooled funds have a limited life, usually ten years with some allowance for extensions. Thus, the latter part of the funds life is focused on enhancing value in the investments, achieving exits, and returning the capital and gains made to investors.

The timing and lumpy nature of the cash flows in venture capital investing creates difficulty for investors in achieving their desired exposure levels. Commitments do not necessarily equal exposure. If the targeted exposure level is equal to the commitments made then, on average, over the life of the investment in venture capital - which can be a long period of time - the actual investments made may be below the targeted level, particularly if the superannuation fund is growing. To overcome this, and reach the required actual investment levels, the commitment level should be set at a multiple of the actual level required, ie, one and half to two, to compensate for the problems of matching commitments and exposure and the growth in the superannuation fund. This should enable the investor to achieve and maintain the target level of exposure over an extended period of time.

Alternatively a planned venture capital program, if structured correctly, can achieve a similar outcome. This model would involve using a specialist venture capital adviser who would be able to address the investor's individual venture capital requirements. An appropriate commitment level and time frame is established and the program proceeds with the adviser recommending appropriate venture capital funds.

Industry Fund Services
Casselden Place
Level 29
2 Lonsdale Street
Melbourne VIC 3000
Tel: +61 3 9657-4321
jsmith@mail.ifs.net.au

© Industry Fund Services 2001