In early 2008, VC fund managers were already struggling to get the cash they needed to maintain the rapid growth of the small, precocious and risky companies in their portfolios. Then the international finance crisis hit. From its rock-bottom vantage point, the local VC industry could see the rest of the financial sector plummet in its direction. At least the VCs could sink no further.
"We're no worse off," says Stuart McKenzie, general partner of science and technology VC specialists Endeavour Capital. "We didn't have much to begin with. You can't subtract something from nothing."
VC veteran Jenny Morel of Number 8 Ventures is less sanguine. "How do you measure the difference between hard and harder?"
New Zealand sorely needs a healthy VC market. McKenzie describes it as the "missing bit" of New Zealand's innovation system. "We have the people, we have the IP, but the big hole is capital." Think of it as the petrol in the engine, the air in the lungs, the fight in the dog.
And even more, we need a couple of unheralded New Zealand-based billion-dollar companies to come virtually out of nowhere. Such big companies from smaller countries— Nokia in Finland, Ericsson in Sweden and Acer in Taiwan—have given a massive boost to those economies, not just as net contributors to national GDP but as feeders to the next generations of innovators and entrepreneurs. Out of HP grew Intel. Out of Intel grew Cisco. Out of Cisco grew … you get the idea.
At the moment, the odds of a budding star getting the money its needs to bloom are nowhere near as good as they need to be. Which makes the next year in the VC market look like the most important yet.
Ho humming
It's not the humming VC scene that then-Minister of Research, Science and Technology Pete Hodgson had in mind in 2001 when he announced the launch of the now $200 million government-backed New Zealand Venture Investment Fund (VIF). In the heady, post-Knowledge Wave burst of innovations, enthusiasm was high for the government to step in where the market had failed.
Even now, seven years on, the New Zealand industry is small. In 2005 New Zealand's VC investment was 0.04 percent of GDP, compared with 0.12 percent for the top quarter of OECD countries.
Hence the need for white knight Hodgson and his trusty steed, VIF. The VIF normally invests up to one-third of the total capital (to a maximum of $25 million) in each of the VIF Venture Capital Fund partnerships with private sector fund managers. These managers must raise matching capital from private sector investors.
VIF Venture Capital Funds are typically worth between $30 million and $60 million and are expected to run for up to ten years before terminating and distributing the profits to investors. The VIF has two pots of money: the $160 million Venture Capital Programme (which had $85 million committed and $35 million allocated at the end of June) and the $40 million Seed Co-investment Programme aimed at early stage businesses.
Initially, VIF worked. For four or five years, VC fund managers had been successfully establishing new funds to support many of New Zealand's best and brightest companies. VIF invested alongside six private sector fund managers: BioPacific Ventures, iGlobe Treasury, Endeavour Capital, No 8 Ventures, TMT Ventures and Pioneer Capital Partners. There are a couple of VC firms not tied up with the VIF, notably Stephen Tindall's K1W1. Private sector fund managers have chipped in with $160 million in private capital, taking the total of VC invested to about $253 million, according to the Venture Capital Monitor.
The 45 companies receiving VIF investment include some of the country's great business hopes such as Proacta [see '
The Kill Bills
', Idealog #9, page 50), OpenCloud, Right Hemisphere and BioVittoria ('
Sweet science
', Idealog #13, page 62). Endeavour Capital has notched up one exit—collaborative learning technology company Ectus—which McKenzie says returned fivefold on its original investment when it was sold to Norway's Tandberg in 2005.
Party's over
But the party ended when funding came to a grinding halt early in 2008. Cash started to dry up thanks to a slowing market; some gnarly scraps involving institutional fund managers didn't help either. McKenzie says the situation is compounded by the current global credit crunch as investors are happy to sit on the sidelines waiting for assets that are cheap now to become even cheaper tomorrow.
The resulting shortage of VC cash hits home in a number of ways. Fund managers find it hard to get financial backing for new funds and most VIF-backed funds are near fully drawn, or have finished making new investments. Their remaining capital is earmarked for existing portfolio companies.
Morel says the New Zealand VC industry's lack of size is holding back both the industry and the companies it supports. "We all get hung together. You can't do business properly unless we do it on a proper scale."
New Zealand VC funds are too small to reach break-even point. "This leaves us in a situation where we are desperately trying to cobble together funds, which often means there is not good structure in the funds."
Morel says many of the VC funds are now chasing investors for new funds because their first funds weren't rich enough to put aside cash for the future needs of the companies.
Another consequence of small funds is the difficulty in attracting offshore investors. "At the moment our funds are too small for the levels [offshore investors] invest in. That means we can't partner properly."
For example, when a UK investor offered to put US$4 million into OpenCloud if No 8 could match it, Morel recalls that it had to say, "We can't do $4 million."
McKenzie makes a tough comparison: imagine two companies in the same sector, with roughly the same product and roughly the same market. One in the US attracts $20 million. The Kiwi company has just $2 million. "I worry about our ability to compete," he says.
Patience, grasshopper
With the manner of a practiced investor, VIF chief executive Francesca Banga urges patience. "It's a 15- to 20-year journey we're on, and we are about five to six years into it."
And progress has been made. The first cohort of VIF-backed series A seed funds was launched in 2002 and 2003. All this money has been spent or is committed and VC fund managers are now attempting to raise series B and C funds to support the expansion of companies in their portfolios. It's an industry truism that it's easier to do the hundredth VC deal than the first. To get from the latter to the former requires patience and a steady nerve.
Two government moves have strengthened the industry. Of most immediate importance was last May's axing of tax and liability rules that had put the New Zealand VC industry at a disadvantage when it came to attracting international investors.
It took the industry four years of lobbying to persuade the government to draw up legislation allowing VC and private equity investment funds to be established as limited partnerships, a standard investment vehicle for international investors. The lack of a limited partnership option meant these investors often saw New Zealand as 'too hard'.
The other positive government move for the industry was the introduction of KiwiSaver, though it may take some time for funds from this source to flow through to the VC industry.
"KiwiSaver will be really important, but it will take time before it will [have an] impact," says Banga. "In Australia, it was five to ten years before the compulsory savings scheme started to have an impact on the private equity market."
But while regulatory changes can help, New Zealand Private Equity and Venture Capital Association executive director Colin McKinnon says the most important ingredient for the future health of the VC industry in New Zealand will be its people.
The industry needs funds managers who will inspire investor confidence through the quality of their investment choices and ability to nurture young companies through to a successful exit from their funds. These managers should be part of a vibrant network that includes capital markets, serial entrepreneurs, serial institutional investors and a financially literate public.
He too recommends patience. "We will have a vibrant VC industry when all the planets align; it is a matter of time. We will get results. What we don't know is how good the results will be, and we cannot know this until some exits are achieved over the next three years."
Australia fare
Ironically, the major beneficiaries of all this investment are likely to be our cousins across the ditch. That's because Kiwi financial institutions—as opposed to companies and individuals—have failed to join the VIF party. Indeed, VIF's current Statement of Intent describes difficulties raising capital from local institutional investors as "the number-one limiting factor in developing a sustainable industry".
"It's going to be the Australian funds that [will] benefit from growing New Zealand companies," says Banga.
In 2006 it was estimated that over 55 percent of VC and private equity investment in Australia came from institutional investors. In New Zealand the figure was about ten percent.
"New Zealand sorely needs a healthy VC market. Stuart McKenzie describes it as the "missing bit" of our innovation system. "We have the people, we have the IP, but the big hole is capital." Think of it as the petrol in the engine, the air in the lungs, the fight in the dog."
Only one New Zealand financial institution, ACC, has taken the plunge into VC. The corporation currently has $32.2 million in VIF funds, about 0.31 percent of its total investments. It has also committed another $12.7 million, which remains undrawn by the funds that may, for example, be earmarking capital for existing portfolio companies.
The great hope of the VC industry is the $15 billion New Zealand Superannuation Fund, which independently invests government contributions towards future superannuation payments. It has been extensively lobbied by the industry to open its purse strings, so far without success. Matt Whineray, general manager private markets at Guardians of New Zealand Superannuation, says VC "sits at the more risky end of the private equity spectrum, relative to, for example, expansion capital and buyout opportunities.
"The venture capital market in New Zealand is relatively small and young compared with the US and European markets. This presents even higher perceived risks to investors like us because of the lack of investment diversity available and a track record of investors."
But McKenzie says the Super Fund's reluctance to get into VC is creating a blockage with offshore investors. "They know about the Super Fund—it's of a size that registers internationally—so with offshore investors often the first comment they will make is, 'Is the Super Fund in?'
"We've had two US investors saying, 'Come back when the Super Fund is in.' They use the Super Fund as a proxy."
McKenzie, as you'd expect, has faith in VC as an investment class. It delivers, he says, but the absence of the institutions leaves everyone stuck in neutral.
McKenzie says this reality, combined with the shortage of VC cash, drives VC fund managers towards picking companies where value can be added without spending much cash. "Drug companies create a whole lot of money while spending a whole lot of money.
"We are trying to do a lot with a little."
Didn't Lord Rutherford say something like that?
