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Venture capital outlook in New Zealand

New Zealand's venture capital industry has grown rapidly in recent years from a low base. While 2001 was a grim year for the venture capital industry worldwide, as venture capitalists concentrated on shoring up existing investments with no hope of exiting in the short term through the IPO markets, the sector in New Zealand approached 2002 with some cause for optimism. Andrew Lewis and Shelley Cave of Simpson Grierson look at the opportunities in New Zealand.

The principal catalyst for that optimism is a government initiative known as the New Zealand Venture Investment Fund (VIF), under which the New Zealand government will co-invest with the private sector in emerging New Zealand companies at the seed and start-up stages of development.

The VIF initiative is intended to give further impetus to the drive towards a knowledge-based economy, which is one of the key focuses of the present government. It follows on the heels of (and supplements) various other initiatives aimed at fostering entrepreneurism and increasing the depth and skills of the venture capital industry.

A late starter

Despite strong recent growth, the latest Global Entrepreneurship Monitor report released in November 2001 has shown that New Zealand ranks 20th of 24 OCED countries cited in terms of the level of venture capital available as a proportion of annual economic output.

While independent New Zealand reports show more positive results (there are now 40 companies active in the New Zealand venture capital industry and investments are said to total around NZ$1.3bn dollars with a further NZ$1.7bn dollars available to invest, representing a similar percentage of national income to Australia, the venture capital industry is still in its formative years and immature by comparison to the US and leading OECD economies.

The late development of the venture capital industry can be attributed to a number of factors.

New Zealand had a strongly growing venture capital industry prior to the 1987 sharemarket crash, but that crash (which had longer lasting effects on the New Zealand economy than it did on other OECD countries) virtually wiped out the entire industry. The New Zealand Venture Capital Association, which had been set up in 1985 and had 36 members by 1987, ceased to function and was only resurrected in 2001 as a forum for the re-emerging industry.

Another factor which has constrained the availability of capital for investment in emerging technology companies has been a preoccupation of New Zealand investors, particularly since the 1997 sharemarket crash, with property-based investment. Small to medium investors have tended to favour property investments over equity or fund investments because of their perceived lower risk and traditionally high capital gains. Partly because of a soft property industry, those investors are now reweighting their investment portfolios back towards equity investments.

The third factor hampering private equity/venture capital investment has been the small and shrinking New Zealand sharemarket. There is an increasing trend for larger New Zealand companies to relocate to Australia or further afield to be closer to the larger capital sources and for the most successful emerging public companies to become targets for larger multinationals. Those companies have not been replaced by sufficient new listings and the lack of a strong vibrant IPO market means private equity investors often have to look further afield for exit opportunities or rely on a trade sale.

Recent developments

The New Zealand Stock Exchange, perhaps recognising that any future as a separate exchange (and there have been continuing discussions around a possible merger with the Australian Sock Exchange) lies as a feeder market, established a junior capital market (known as the New Capital Market) in 2000, targeted at smaller companies with special rules designed to lower compliance costs. The New Capital Market has been only moderately successful -  with 10 listings so far - however, that performance has been relatively strong in comparison to the paucity of main board listings.

An interesting recent development, and counter-cyclical to the recent world trend of shying away from ‘blue sky' offerings, has been a growth in secondary (unlisted) public offerings at the seed stage of developing new technologies (normally the domain of venture capital). Three recent offerings, all out of the provincial centre of Otago and relating to bio-technologies which are some years away from commercialization, have been astoundingly successful, many times oversubscribed.

Over the same period, there has been strong growth in the venture capital industry and a proliferation of business incubators, local enterprise schemes and central government funding schemes.

While the growth in recent years of the New Zealand venture capital and private equity sectors slowed in 2001 (feeling the effects of the worldwide technology malaise), the above factors and government VIF initiative discussed in more detail in the next section provide cause for optimism heading into 2002.

NEW ZEALAND VENTURE INVESTMENT FUND (VIF)

The New Zealand government has committed NZ$100m to a fund of funds, which will co-invest with the private sector in a series of drop-down venture investment funds (VIF seed funds), targeting investments at the seed, start-up and early expansion stages of development of promising New Zealand technology companies, which is where the major gap in venture capital funding is perceived to be.

The government's goal is to be a minority investor in the VIF seed funds managed by the private sector, and it would ideally like to have its investment matched by private sector investment at the ratio of 2:1. The principal incentive offered by the VIF to the private sector is a right to buy out the VIF at any time up to the midpoint of a fund (five years where the drop-down funds will be 10-year closed-end funds). If the private sector co-investors do not buy out the VIF by the midpoint of the fund life, then the VIF will remain in the fund until the end, and share any profits or losses on a pro rata basis with the private co-investors.

The VIF funds will be allocated following a contestable process by which prospective fund managers apply to manage a fund specifying the capital contributions sought from the VIF and the amount of capital they will source from the private sector. In assessing the applications, the VIF is primarily focused on the ability of the applicants to raise the specified private capital, their investment intentions and their experience and expertise to invest and successfully manage investments at the seed and start-up stages of development of emerging companies.

The first stage of the selection process attracted strong international interest and 44 applications. Of those 44, 16 have been selected to provide full detailed proposals. The third and final stage of the process will be to negotiate progressively with the best applicants to finalize co-investment and fund management terms. The VIF is targeting establishment of the first drop-down fund by April/May 2002 and a full allocation of the government funding commitment over the ensuing 18 months.

While NZ$200m to $300m (around $100m) may not sound particularly significant by international comparison, well targeted investments of that level at the early development stages in New Zealand have the potential to achieve significant results and flow-on growth in later stage venture capital funding and the IPO market. A low cost base for developing technologies, a small but technologically advanced consumer marketplace for testing and incubating new technologies and an innovative resourceful population provide comparative advantages for this type of investment in New Zealand, which should counter-balance any perceived disadvantages attributable to New Zealand's geographical isolation, size and limited capital base.

Simpson Grierson, Simpson Grierson Building, 92-96 Albert Street, Private Bag, 92518, Wellesley Street, Auckland, New Zealand, 64 9 358 2222 www.simpsongrierson.com

© Copyright IFLR 2002

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