| Jul 02, 2015
Promoting 40 years of wealth generation
Venture Capital (VC) and private equity (PE) investment could play a crucial role in ensuring that Australians enjoy the positive and prosperous future that is envisioned in the Intergenerational Report.
Intergenerational Report: the positive view
One of the most anticipated documents published by the Australian government this year is the Intergenerational Report, which considers what the economy and society of this country could look like 40 years hence, in 2055.
In many ways, the Intergenerational Report is an optimistic document. It envisages that, over the next four decades, economic growth will be 2.8% annually on average. Given the anticipated growth in the population, this rise is equivalent to growth in per capita income of 1.5% per annum, or from $66,400 to $117,300.
Growth of the overall economy, and of per capita income in the coming 40 years is expected to be a little slower than it was in the past 40 years, when the equivalent figures were 3.1% and 1.7%. The main reasons why the Intergenerational Report expects that the growth rates will slow are the ageing of the population and a gradual decline in the participation rate (i.e. the percentage of people in the workforce who are employed or who are actively looking for work).
The Intergenerational Report expects that the participation rate will fall by around 0.1% annually. This should be roughly offset by a 0.1% rise each year in the share of the population that is aged 15 years or over (i.e. of working age). Other key metrics, such as the unemployment rate and average hours worked are expected to remain unchanged.
In other words, for real per capita income to rise by 1.5% annually, there will need to be a similar increase in productivity and no lasting increase in unemployment. However, these outcomes need to be achieved in the context of a cyclical downturn in Australia’s resources industry and the secular decline of traditional manufacturing businesses
Therefore, a key question for policymakers is: how should they maximise the likelihood that productivity rises, and ensure that labour market conditions do not deteriorate, so as to support the positive vision of the Intergenerational Report?
VC and PE: boosting the chances of a successful outcome
This is where a vibrant VC and PE scene has an important role to play. VC-backed Australian companies have a demonstrated ability to innovate and to boost the productivity of the overall economy.
A case in point is Hatchtech, an Australian pharmaceutical company backed by Sydney-based VC firm OneVentures. Hatchtech has developed Xeglyze™, a next generation treatment for head lice, and plans to file a New Drug Application with the United States’ Food and Drug Administration (FDA) in the second half of 2015. The company is currently in advanced discussions with US and global pharmaceutical companies to bring the product to market, subject to FDA approval. The imminent commercialisation of Xeglyze™ shows how Australian innovations can not only be developed with the right mix of capital and expertise to compete globally, but also provide good returns to Australian investors and further expand domestic drug development and innovation capabilities.
VC-backed companies are ‘hard wired’ to innovate. In its February 2015 pre-Budget submission, the Australian Private Equity & Venture Capital Association Limited (AVCAL) noted that companies which are backed by the $25bn PE and VC funds account for one tenth of all corporate research and development (R&D) spending in this country. On average, these companies spend 200 times more on R&D per employee than do other businesses.
Aside from contributing to R&D and higher productivity, VC-backed companies also promote employment. They usually attract highly skilled staff and have a good record in job creation. As AVCAL points out, well known VC-backed companies such as SEEK, Cochlear and ResMed are substantial employers. Even smaller businesses such as Pharmaxis, SIRTeX and Finisar Australia have created a significant number of new jobs. AVCAL notes that a joint report by Google and PriceWaterhouseCoopers has found that new businesses – or start-ups – have the capacity to contribute 4% to annual GDP and to provide 540,000 new jobs by 2033.
The main challenge: lack of funding for smaller businesses
A key message in AVCAL’s pre-Budget submission was that small and medium enterprises (SMEs) find it difficult to access the finance that they need. Research by the NSW Business Chamber and the Australian Bureau of Statistics (ABS) noted that lack of finance is the biggest barrier to innovation and a common reason why SMEs in this country have missed a good business opportunity. It showed that nearly one third (30%) of SMEs missed out on business opportunity due to lack of credit. Bank loans are more expensive for SMEs than they are for households and large companies. SMEs often raise equity from owners and their friends and family.
To date, SMEs have only been able to access limited amounts of equity capital from other sources. AVCAL observes that the regulation governing crowdfunding is still being developed. Crowdfunding has been restricted to small-scale personal offers and sophisticated investors. Australia still has few angel investors, and they tend to invest in small amounts.
Various structural factors have constrained the availability of funds for VC and PE managers. One is a tendency for Australian institutional investors to move away from funds-of-funds – which had traditionally been an important conduit of money for VC investments – in the wake of the global financial crisis. Another factor has the tendency for institutional investors in this country to focus on low costs and low fees – an approach which militates against specialist investment products such as VC and PE funds. This is despite forthcoming research, carried out for AVCAL by Rice Warner Actuaries, which highlights how an optimally diversified portfolio should have an allocation to illiquid assets such as infrastructure, VC and PE.
Some of Australia’s leading institutional investors do understand the opportunities that exist in PE and VC. Over the nine months to the end of March 2015, the Future Fund’s assets grew to $117bn. Its return for the period was 15.1%, and well in excess of its target of 4.5%. The return last year generated by the Future Fund exceeded the return from the median super fund last year, which was 8.5%. Performance has been helped by the Future Fund’s allocation to PE: at the end of March 2015, this amounted to a little over $11bn, or 9.6% of the entire portfolio.
However, a problem is that many of the largest funds are too large relative to Australia’s VC and PE industry. This means that it is much easier for them to invest in VC and PE outside this country. In essence, the Australian VC industry is too small for them to deal with.
Steps in the right direction
The federal budget for 2015/16 included a number of steps in the right direction. The Australian Securities and Investments Commission (ASIC) will receive $2.6mn in the current financial year – and $7.8mn over four years to develop a regulatory framework that will facilitate crowdfunding. The new framework may include simplified reporting and disclosure requirements.
The Significant Investor Visa (SIV) programme now requires that migrants who want to take advantage of these visas must invest at least $500,000 in eligible VC, or growth PE funds that focus on start-ups and small private companies. Provided that the VC/PE industry does not have to bear the cost of ensuring that the money complies with Australia’s Anti-Money Laundering/Combating the Financing of Terrorism (AMLCFT) regime, SIV visa applicants could be a significant source of funding.
The government has also gone a long way to reverse the tax changes of 2009 which effectively froze employee share/option schemes. The new tax rules are a step in the right direction and will make it significantly easier for innovative companies to reward employees with stock. This is important because stock and options are useful for attracting and motivating key staff at the early stages of development, when a new company typically lacks cash flow. As the market for talented employees and innovators is global, option schemes allowing employees to share in the generation of wealth that results from their work will enable Australian companies to draw and keep the best from across the globe. Essentially, Australian small businesses need a full and flexible tool kit of incentives to make this country a place of choice; to both retain our home-grown talent and attract the highest calibre international talent to our shores.
Unfortunately, the restrictive definition of “start-ups” to which the new rules apply will limit tax breaks to companies that are less than 10 years old, which have annual turnover of less than $50mn and which are unlisted. The new rules will therefore exclude many genuine and successful small or early stage companies, including those backed by VC, as they move into critical stages of growth; arguably one of the most important times to attract and retain staff.
Other ideas for removing the roadblocks
The various roadblocks that have constrained the availability of finance in the recent past mean that the main sources of funding for VC and PE funds in this country are high net worth investors (HNWIs) and some of the larger self-managed superannuation funds (SMSFs). The vast majority of the nearly $2 trillion in assets that are held by Australia’s still rapidly growing superannuation industry are inaccessible to the Australian VC and PE fund managers, who could play a much more important role as sources of equity finance for SMEs in this country.
A possible solution to the problem would be new regulations that would give members of retail and industry funds an option to ‘opt in’ to investing in building Australia’s innovation economy which would include approved VC and PE fund managers. The ‘opt in’ would operate in a similar way to the ‘opt in’ that some of the larger funds provide to members who want to commit to sustainable investing. Those members who ‘opt in’ would have, say, 1% of their superannuation assets invested in suitable funds, such as properly constituted Venture Capital Limited Partnerships (VCLPs)
AVCAL has also identified a number of other positive initiatives that the government could undertake. These include: simple changes to tax settings to develop more research-intensive early stage companies; and cutting the tax red tape that is faced by start-ups and small businesses. As highlighted, innovation needs innovative people, as well as money. The government could help Australia to become a magnet for suitably experienced foreigners (and returning Australian expatriates) through offering tax incentives or providing relocation packages. These incentives could be provided as a part of the government’s existing Entrepreneurs’ Infrastructure Programme (EIP).
Looking ahead four decades
The latest changes to ESS and SIV regulation are an encouraging sign that the government truly understands how innovative SMEs and start-ups can contribute to achieving the positive outcomes that are envisaged in the Intergenerational Report. If the government can introduce changes that will mobilise more of this country’s enormous superannuation assets so that they are available to VC and PE managers, the improvement in productivity – and the development of the labour market – could be substantial. The result would be even greater generation of wealth over the next four decades.