Australia VC: Debutantes’ ball

Fundraising in Australia’s small venture capital space has been supported in recent years by substantial backing from government agencies, renewed interest from large institutional investors, and the emergence of an inspiring cohort of homegrown tech giants. Ecosystem creation is grassroots business, however, which means that even with a helping hand from the industry’s biggest players, a trying experience in the trenches lies ahead. 

This point recently came into focus when Sydney-based Equity Venture Partners (EVP) closed its second fund at A$35 million ($25 million). The five-year-old firm’s success is defined by an ability to translate government tax breaks for early-stage strategies into GP-defining milestones. Its breakout bet was Deputy, a darling of the booming local workforce management segment that raised A$111 million last year.    

At the same time, EVP’s progress offers a reminder that the limited scope of the Australian venture opportunity will keep the pace of growth in check. Fund II represents only a modest uptick on the A$25 million debut vehicle, and both were backed entirely by high net worth individuals (HNWIs) and family offices. Although the larger institutions that have begun to back local VCs are part of the long-term plan, angel-style networking is still a necessary exercise in laying foundations.  

“We want to create a community among our investor base, but you can’t really do that when you’ve got one LP coming in with a check for $50 million. We like having a diverse base of investors we can communicate with and rely on if they’re experts,” says Daniel Szekely, an investment director at EVP. “Having 200 HNWIs on your register can be a major asset when you’re dealing with early-stage companies that need support through people like that.”

On the rebound

Growing appetite for Australian venture capital is reflected to some extent by hard numbers, but trends are often difficult to discern given the market’s undersized nature versus other developed countries. Government data typically clocks VC investment as a proportion of GDP at about 0.02%, compared to figures around 0.35% for both the US and Israel.

According to AVCJ Research, domestically based and focused VC fundraising has warbled between $100-300 million for most of the last 18 years. That stasis lifted as high as $978 million in 2016 but retreated to $238 million in 2018. Clearer traction can be seen in the growing number of locally focused vehicles, which has historically tracked around five launches per year but has topped eight launches per year four times since 2013.     

This climate is usually framed as a gradual rebound from the dotcom busts of the early 2000s, which effectively consumed all the operating VCs of the day and left local LPs such as superannuation funds with a wariness for the asset class that has only recently begun to thaw. Hostplus, which has some A$33 billion under management, is recognized as one of the leaders of the rebound, having claimed A$1 billion in venture exposure as of October 2018.

“When we were raising our second fund three years ago, we were reaching out to super funds, but now it’s the other way around,” says Daniel Petre, a co-founder at AirTree Ventures, which raised A$250 million across a two-tranche Fund II in 2016, with 60% of the money coming from two super funds. “We’re not raising now, but we’re getting lots of inbound calls from super funds. It’s the biggest new channel of money that has opened up.” 

Confidence the momentum will be sustainable is based on the maturation of the overall industry. For the first time, local success stories such as Atlassian, Campaign Monitor, and Seek, have begun to feedback into the ecosystem through entrepreneur-led firms such as Skip Capital and Grok Ventures. The government subsequently hailed the environment as an “ideas boom” and pursued a A$1 billion innovation agenda in support.

Meanwhile, the rise of corporate VC has added strategic credibility. Telstra Ventures, a Silicon Valley-based firm that serves the interests of Australia’s largest telecom operator is the standout, having launched a A$675 million fund last year alongside HarbourVest Partners. But domestic banks have also been notable players, especially National Australia Bank and Westpac Banking, both of which set up A$50 million funds last year. 

As a result, a new breed of repeat fundraisers appears to be approaching critical mass, with the biggest players usually cited as AirTree, Blackbird Ventures, Brandon Capital, OneVentures, and Square Peg Capital. More quietly snowballing firms include Artesian Venture Partners, which is managing five funds of A$50 million or less; and Southern Cross Venture Partners, which has raised three funds, including a A$200 million renewable energy program.    

“A number of the fund managers that I advise have received investments from LPs outside of Australia, often professional LPs, including corporates in the science, technology and sometimes military sectors,” says Andrew Sharp, a tax partner at EY who helps Australian VCs raise capital. “We’re also seeing more super funds deploying into the venture capital space via the VCLP and ESVCLP structures.”

Workable structures

The government’s venture capital limited partnership (VCLP) and early-stage venture capital limited partnership (ESVCLP) programs may ultimately prove to be the biggest catalysts. These initiatives, launched in 2002 and 2007 respectively, have largely displaced a globally unfamiliar trustee structure for LP commitments, which previously required investors to pay tax on the partnership itself rather than on gains. 

With VCLPs, offshore investors pay no tax in Australia on the exit proceeds from locally based companies with assets of up to A$250 million. For ESVCLPs, the cap is A$50 million worth of assets, but the concessions are more generous: investors pay no tax on eligible investments whether it relates to exit gains, dividends during the period of ownership, or investment by the financial sponsor. 

As of year-end 2018, VCLPs had raised A$11 billion, with 60% of the capital coming from foreign investors. ESVCLPs raised A$2 billion by the same point, about 6% of it from overseas. ESVCLPs’ runaway popularity among domestic HNWIs, however, is the sharpest indicator of how tax rules are reshaping the industry. Over the 10 years to 2018, the number of registered VCLPs increased from 35 to 81, while ESCVLPs grew from one to 85.

This explosion in first-time early-stage fund managers has been the cause of some concern. Industry participants see the implementation of tax incentives with widespread behavioral impacts as walking a fine line between coaxing competent investors into venture and souring market sentiment by enabling a field of unprofessional players.

“It’s something that does need to be carefully monitored, and we keep a close eye on first-time funds with the federal government,” says Yasser El-Ansary, CEO of the Australian Private Equity & Venture Capital Association (AVCAL). “We want to encourage new participants, but we also want to get the balance right between doing that and not allowing the asset class to be adversely impacted by the decisions made by new entrants who don’t possess the experience and skill to meet the expectations of investors.”

Measures to curb this risk can be inferred by some policy particulars. For example, a condition that fund managers have at least A$10 million in committed capital to register as an ESVCLP is seen as an attempt to keep wildcat prospectors at bay. “I know quite a few people who have put together funds of A$1-3 million, and they’ve been trying for years to raise A$10 million for an ESVCLP,” says one investor. “They’re just not getting there.”

The scope for growth implied by such anecdotes is seen as both a frustration and an opportunity to take VC activity to a higher level. The superannuation system, although the world’s third largest accumulated savings pool at A$3 trillion, is still seen by many venture investors as a standoffish and relatively unsophisticated marketplace versus more mature pension environments of Canada and Europe. But therein lies its promise. 

Upside is also seen in a strong culture around ground-level ecosystem development, including moves to lower entry barriers to starting a business and fund manager efforts to educate HNWIs about the asset class. In this context, the surge in VCLP and ESVCLP launches is commonly projected to take on a bell-shaped curve, with a few big winners and losers eclipsed by a larger contingent of modest successes that establish a more robust core for the industry.   

“There are funds being raised by people who probably don’t have the experience base to effectively invest other people’s capital, and I don’t think there’s necessarily as many successful companies as people think,” says AirTree’s Petre. “But I have no doubt that in a few years, we’ll have 10 quality, large venture firms, each raising a few $100-million funds – and that will come from the ESVCLP landscape.”

Wider appeal

Optimism for this outlook is further underpinned by the fact that many first-time managers taking advantage of the tax breaks are bringing appreciable track records to the table. Jelix Ventures, a technology-focused firm founded in 2015 on the strength of an angel investment that generated a 10x return, offers an interesting case in point. 

To date, Jelix has operated via an equity crowdfunding platform that is only available to a personal network of about 500 wholesale investors. LPs access a recently introduced government credit for direct investment in innovative companies, while start-ups benefit from a model that consolidates an unwieldy capitalization table of HNWIs into a single entity. Thirteen such investments have been realized across Australia and New Zealand. 

Now, the firm’s debut fundraise is underway with a A$30 million target under the ESVCLP structure. The impetus for the change was a conversation with a large institutional investor in the US that was more interested in the familiarity of the structure than its tax concessions. Andrea Gardiner, CEO and founder at Jelix, says that the organization in question appears likely to come in as the cornerstone LP, with a spectrum of HNWIs and family offices offering support.  

“A lot of family offices and HNWIs who have invested in start-ups have been badly burned, and when you talk to them about it, you realize that they’ve approached venture the same way as their previous investments,” Gardiner adds, noting plans to introduce investor education and financial workshops to her firm’s business plan. “That doesn’t work because although the parameters may be the same between start-ups and small to medium-sized enterprises, they’re very differently weighted.” 

Perhaps the most interesting aspect of the Jelix story is the firm’s mission to pull foreign institutional investors into the mix – a coup even the largest Australia-focused VCs have yet to achieve. So far, an international mandate has proven a prerequisite for international LP backing. Southern Cross, which has a presence in the US and Asia through a partnership with SoftBank China Venture Capital, is a notable example. 

More foreign capital will inevitably filter in, however, as the industry shifts investment focus from early to late-stage companies. Indeed, on a macro level, Australia has always had to operate as a net importer of capital to fund the growth of its economy. Most of the capital in local private equity funds already comes from offshore. 

“It’s important for the venture side of our industry to have a long-term vision where we seek to attract capital from institutional investors in offshore markets,” says AVCAL’s El-Ansary. “If we want to have a venture ecosystem that is comparable and proportionate to other developed markets, offshore investment from institutional LPs will need to be a feature of that.”

The gradual uptake of interest from domestic and foreign institutional investors, as well as the local technology boom and regulatory incentives, have provided the ingredients for an ecosystem of funds sizeable enough to bankroll the creation of sophisticated teams on a 2% management fee. At this point, the only inputs yet to be stirred into the equation are time and positive returns. 

“We’re at the very beginning of a long cycle where [fund managers] are now deploying funds to companies. All that’s happened so far is that some people are getting a shot,” observes Tushar Roy, a partner at Square Peg. “But in the next 5-10 years, you will see certain managers perform well, and invest the money with discipline and rigor, which will manifest in great results and prime the pump for more investment into the sector.” 

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• Topics
• Australasia
• Venture
• Fundraising
• GPs
• Australia
• AirTree Ventures
• AVCAL
• Square Peg Capital